Deregulation of the Natural Gas Industry
JUNE 01, 1986 by J. D. STEELMAN JR.
Mr. Steelman practices corporate and commercial law in Tulsa, Oklahoma. He has particular experience in oil, gas, and mineral rights.
How the free market efficiently allocates energy resources.
No industry has been more heavily regulated than the natural gas industry. From the wellhead to the burner tip virtually every level and aspect of the industry is regulated in minute detail by the state and federal government. Today the industry, like other previously regulated industries such as transportation and finance, is being deregulated and thrust into the competitive marketplace. The result, not surprisingly, is lower gas prices.
In 1848 John Stuart Mill first applied the concept of “natural” monopoly to the gas industry of the City of London and thus began more than a century of gas industry regulation in the English-speaking world. As pointed out by the late Ludwig von Mises and by Murray Rothbard, a “natural” monopoly is merely a limited-space monopoly.
A gas company desiring to commence service to a local market must reach agreement with the owners of the streets and the subsoil for the installation of pipelines and meters. In most instances this means the gas company has to contract for an easement or the purchase of real estate with the local authorities who own or control the streets and real estate through which the gas company must lay its lines. Given the limited supply of land through which the gas company must lay its lines, the local authorities of necessity have to allocate the available supply of real estate which is to be used for the pipeline easements. Thus only one or a few gas companies is normally allocated the land rights within a city in which to lay pipelines. This right is frequently called a franchise.
Local authorities reasoned that granting the gas company or companies a natural monopoly would result in “monopoly” prices. Thus, the local politicians felt compelled to protect the consumers of natural gas by insuring that the gas company’s rates were “just and reasonable,” a common euphemism for price controls. Controlled prices are not market prices since the dynamics of the marketplace will always tend to make the controlled price higher or lower than the market price, thereby resulting in surpluses or shortages.
As Rothbard points out, every business has a monopoly on the space occupied by that business. Since consumers utilize many subjective factors, including the location of a business, in valuing goods and services, it is impossible to determine whether a price premium is due to the spatial monopoly of the business. Monopoly price cannot be conceptually distinguished from competitive price and thus as Roth-bard says, “All prices on the free market are ‘competitive’.”
In 1877 the United States Supreme Court, in a decision extending beyond a mere spatial monopoly, held that a business (grain elevators) could be so affected with a public interest that the state could grant a monopoly to that business and thereby limit competition. This established the philosophical and legal framework for subsequent regulation of American business, including the extensive regulation of the natural gas industry in the thirties.
Until the passage of the Federal natural gas legislation, regulation of the gas industry was purely a matter of local and state concern. It was limited primarily to the granting of franchises and the local regulation of rates. Federal regulation extended only to oil pipelines, and the Supreme Court expressly precluded regulation of interstate natural gas pipelines.
The regulation of the interstate natural gas industry had its beginnings in the early 1920s as a result of alleged abuses by public utility companies. The “abuses” alleged were control of the interstate pipeline systems by a few holding companies, resulting in high prices to the consumer, and domination of the purchase of gas, resulting in low prices to producers.
in 1928 Congress passed a resolution directing the Federal Trade Commission (FTC) to investigate and report on these allegations of public utility “abuses” and to recommend legislation to remedy the “abuses.” The FTC found a number of “abuses.” The most important ones were (a) the concentration in purchasing and transportation of natural gas, (b) discrimination in the purchases of natural gas from producers, (c) the unregulated competition in construction of natural gas pipelines, (d) costly competition among pipelines and holding companies, and (e) excessive variations in wholesale natural gas rates.
The natural gas industry was experiencing a tremendous expansion during the period covered by the FTC investigation. Large discoveries of natural gas were found in Louisiana, Texas, Oklahoma, and Kansas. At the same time as the natural gas fields were undergoing development, major oil fields having substantial quantities of natural gas were also being developed. The end result of such discoveries was a substantial increase in natural gas supplies in the local and regional marketplace. Prices fell and gas production was shut-in for lack of markets.
As a result of the low prices for natural gas, long-distance transmission line companies saw an opportunity to sell gas in markets that were great distances from the producing fields. At the same time, construction and operating costs for such pipelines were declining due to improved technologies (such as seamless steel pipe which enabled gas to be transported long distances at high pressures), and other efficiencies, while prices for competing fuels were beginning to rise. Thus transmission companies began to purchase the surplus natural gas and transport it to the more distant markets. The natural gas market in the 1920s and 1930s had all the ingredients required for a profitable undertaking in the long distance transmission of natural gas.
Affected with a Public Interest
Unfortunately, the FTC investigation resulted in Congressional action. In 1935 the Federal Power Act and the Public Utility Company Holding Act were passed into law. Then in 1938 the Natural Gas Act was enacted. The interstate natural gas industry was deemed to be affected with a “public interest” and therefore became a fully regulated industry. Natural gas companies are granted exclusive service areas and market entry is subject to approval of the regulators through issuance of certificates of public convenience and necessity. In exchange the regulators require rates to be “just and reasonable.”
The Natural Gas Act, which was administered by the Federal Power Commission (FPC), extended to the transportation and sale of natural gas by natural gas companies. In 1954 the Supreme Court extended regulation to the prices paid by interstate pipelines to independent natural gas producers. Gas being sold in the interstate market was controlled at what proved to be below market prices. Not surprisingly shortages developed in that market. At the same time, the intrastate natural gas market which was not Federally regulated had an abundance of gas.
Under the Natural Gas Act, virtually every aspect of the interstate transportation and sale of natural gas is regulated by the Federal Energy Regulatory Commission (FERC), successor to the FPC. Rates are set on a cost- plus basis. The rate of return is calculated as a percentage of invested capital and is virtually guaranteed once set. Expenses are reimbursed, as are the costs of natural gas supplies, the largest component of a pipeline’s costs. In order to increase a pipeline’s rates the company must file a rate case. A hearing is held in which customers, suppliers, regulators, and any other interested party may participate. As one might expect, the issues become complex. Resolution of the issues is often difficult, expensive, and time-consuming.
The price disparities between interstate gas and intrastate gas which developed in the mid-1970s and resulted in shortages in the interstate market pointed out the below-market pricing of interstate gas by the Federal regulators. To avoid the loss of sales due to the shortage of natural gas and the increased risk of under-recovery of their fixed costs, pipeline companies actively sought new sources of gas supplies. A favorite inducement to natural gas producers during this period of shortage was the take-or-pay provision in long-term supply contracts in Which the purchasers agreed to pay for gas even if they did not take it. Later when the market changed from shortage to a surplus supply of gas, pipeline companies were saddled with this liability under their take-or-pay contracts.
While these unrecovered fixed costs could be theoretically recovered in the next rate case filed by the company, regulators were reluctant to pass on to consumers the take-or-pay liabilities which amounted to tens of billions of dollars. Since industrial and commercial consumers were switching to alternative energy supplies such as residual fuel oil and coal, the pass-on of the take-or-pay liability would only increase substitution of energy alternatives resulting in what became known in the industry as “the death spiral” which would ultimately lead to receivership. Thus producers and pipeline companies were encouraged to renegotiate their contractual arrangements to reduce the take-or-pay liability.
The Move Toward Competition
I n response to the natural gas shortages which developed during the period 1975 to 1977 in the interstate market the Natural Gas Policy Act was enacted in 1978 for the purpose of gradually deregulating the prices paid by the pipelines for gas (significant deregulation did not start until 1985), thereby encouraging development and production of gas.
In early 1981 the Reagan administration deregulated oil prices. The result was an immediate and sharp increase in prices followed by a dramatic decrease. Fuel oil became extremely competitive with gas. As pipeline companies scrambled to meet the competition of fuel oil they curtailed purchases of gas from producers and other suppliers and renegotiated contracts. This created a surplus of natural gas. The pipeline companies and distributors initiated a number of programs to make natural gas more competitive with fuel oil.
Rather than buy the gas and resell it to industrial consumers, pipeline companies began to transport gas for the producer or industrial consumer. Due to the FERC rate regulations, this means of doing business was not as profitable to the pipeline companies; but because such transportation would help to reduce take-or-pay liability to producers and prevent further sales losses, it became attractive to some companies. Thus by 1984 many companies and producers had voluntarily readjusted contractual relations, and pipeline companies were beginning to carry more gas from producers to industrial consumers. However, producers continued to have a surplus of natural gas.
The Natural Gas Policy Act deregulated approximately 40 per cent to 60 per cent of the natural gas in the United States as of January 1, 1985. The United States Department of Energy’s new Import Guidelines of February 1984 and the new Canadian Natural Gas Export Pricing Policy implemented in the fall of 1984 reduced the price of imported Canadian gas by 30 per cent. In the summer of 1984, FERC further deregulated the gas industry by reducing take-or-pay liability between pipelines in what are called minimum bill contracts.
Then in early 1985 the FERC began to advocate substantial deregulation of the natural gas industry to encourage companies to assume greater risks and have the opportunity for greater returns. In the fall of 1985 the FERC formally implemented its deregulation policy and the Department of Energy filed with the FERC to aleregulate the remaining categories of natural gas still under price controls.
Industrial consumers began to search in earnest for cheaper gas which more producers were willing to sell. Brokers and marketers, neither of whom are regulated by the FERC, saw the profit potential to be gained from matching producers and industrial consumers. A national clearinghouse developed to broker gas as more pipelines began to carry gas and soon a national spot market began to emerge as the industry became more competitive.
The Competitive Marketplace
I n this new era of deregulation, the name of the game in the natural gas industry is marketing and competition. Producers, pipelines and distribution companies are all beginning to respond to the demands of the consumer, especially the large industrial consumers. As in the transportation (rail and air) and financial industries, competition is transforming the way in which the natural gas industry does business and is making it more efficient.
As one industry executive has said, “The future holds the promise of an industry free at the wellhead, free at the gathering line, generally free and competitive at the transmission line, and much less restricted at the distribution end.”
Pipelines are beginning to position themselves to be primarily transporters of natural gas rather than merchants. In 1985 a number of interstate pipelines merged in order to expand their markets from regional to multi-regional or national transportation markets. In addition to expanding their markets, the mergers have enabled pipelines to enlarge their supply sources. The natural gas market is becoming a nationwide market for the first time in its history.
Not only have pipelines begun to compete with each other, they also have found themselves competing with national brokers and national marketers. In order to meet this competition, marketing companies have been created by the pipeline companies. The result has been new alternatives for the large industrial and commercial consumer and the distribution companies supplying the residential user.
A new and thriving spot market in which gas is bought and sold on short-term contracts at prices reflecting current market conditions has come into play. The California spot market which has developed into one of the most competitive is just one example. In the words of the president of a large interstate pipeline company, “The spot market is growing by leaps and bounds. There are virtually no barriers to where you can sell gas today.”
The future, says another industry executive, “is full of growth opportunities for nimble firms, intensely competitive at the burner tip, and unforgiving of ponderous bureaucracies or strategic errors. The business prizes will go to those who can shed their past intellectual baggage and embrace the new world of natural gas entrepreneurship.”
Competition and lower prices eventually would have come to the natural gas industry as a result of lower prices for competing energy products even if the regulators and the legislators had not moved to deregulate the industry. For even regulated companies having exclusive market areas, dedicated supply sources, and guaranteed rates of return are not guaranteed customers or immunity from competition when the prices of competitive products drop significantly below the price of the product of the regulated company.
The marketplace ultimately removes price disparities between competitive products in an effort to efficiently allocate resources, it subjects regulated companies to the laws of economics and the rigors of the market. Absent deregulation, the marketplace would have caused the regulated companies to compete or go out of business. Thus the best role for regulators and legislators to play in such a dynamic environment is to encourage maximum flexibility, freedom, and competition by deregulating as quickly as possible, since the most effective and efficient allocation of natural gas resources is through a competitive and free market. 
3. 49 U.S.C. § 1(1)(6) (1976); Public Utilities Commission of Rhode Island v. Attleboro Steam & Electric Co. 273 U.S. 83 (1927); Missouri v. Kansas Natural Gas Co- 265 U.S. 298 (1924); See Garfield and Lovejoy, Public Utility Economics, (Englewood Cliffs. N.J-: Prentice-Hall, Inc., 1964) pp. 294-350.
6. FERC Order No. 436; Notice of ProposedRulemaking Docket No. RM86-3-000. In late February 1986 the Reagan administration circulated for consideration by Congress proposed legislation to deregulate the remaining categories of natural gas prices which are still regulated under the Natural Gas Policy Act.