Gas Market Restructuring in the 21th Century trading old for … O'Neill... · Gas Market...

Gas Market Restructuring in the 21th Century

trading old for new shibboleths

Richard O’NeillChief Economic Advisor

Federal Energy Regulation Commission

Regulation, Industry Structure, and Market Power Conference

Gold Coast, Australia31 July 2003

December 11, 2008 2

The paradigm shift problem The paradigm shift problem of Urban VIIIof Urban VIII

1543: Copernicus publishes a book claiming the earth revolves around the sun then dies.

Church doctrine: earth is the center of the universe Early 1600s: Bruno burned at the stake

Galileo develops telescope, observes the universe and irritates the Jesuits Cardinal Barberini supports Galileo

1632: Dialogue is published; bubonic plague 1633 Urban orders Inquisition of Galileo

Urban probably agrees with Galileo, but will be seen as weak if he supports him. Guilty!

December 11, 2008 3

Post Galileo: Post Galileo: the quantum mechanics the quantum mechanics

Cardinal Barberini was Urban: where you stand depends on where you sit.1642: Galileo dies; Newton is born

Newton discovers gravity and the calculuscontinuity and certainty rule

1835: Dialogue removed from the Index 1992: John Paul II accepts to Galileo’s

empirical approach to science

December 11, 2008 4

does science get it right the first time? (Paradigm shifts we have no-ed and loved)

History books don’t always document the mistakes 2000+ years of Aristotelian logic

geocentrism: Aristotle, Ptolemy, Church, heliocentrism: Copernicus, GalileoGalileo’s telescope provides damaging evidence ether: Aristotle, Maxwellatom: Democratius, Aristotle, Thomson (plum pudding),

Bohr, Heisenberg, Pauli (spin)phlogiston/oxygen: Priestley, Lavoisier1905: Albert E introduces relativityquantum mechanicsAlbert E: God does not play dice with the universe discontinuity and uncertainty rule

December 11, 2008 5

The politics of paradigm shifts

“there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its outcome, than to take the lead in introducing a new order of things”Niccolo MachiavelliMarx, Hayek, Keynes, SchumpeterLenin, Thatcher, Reagan, Gorbachev Tipping point: Do you need a crisis?

December 11, 2008 6

It is about choice

socialism capitalism

State monopolies

Many: heavy industries

Few: roads, airports

cooperatives many Allowed but few

planning Central Collusion isillegal

December 11, 2008 7

Transitioning from Transitioning from planning and costplanning and cost--

based regulation to based regulation to markets and marketmarkets and market--

based regulationbased regulation

December 11, 2008 8

All markets are regulatedthe policy question is how?

☯Contracts and Property rights : common law☯eminent domain

☯Institutional rules: SEC, CFTC, …☯Antitrust (monopoly): collusion☯Does Nash behavior violate antitrust law? no

☯Utility regulation: just and reasonable prices☯Punishments for illegal behavior ☯Restrictions on behavior☯disgorgement of profits☯compensation of harm☯Fines and jail time

December 11, 2008 9

Market structure dictates efficient regulation

☯Concentration☯Supply functions depend weather, e.g.,

storms in Gulf Coast☯Demand functions depend on weather,

heat and cold☯Market mechanisms☯Contracts structure☯credit

December 11, 2008 10

The Evolution of Natural Gas Market Structure

Joint ventures between producers and local distribution companiesProducers exit joint ventures Some LDCs sell pipelinesSome don’t: Dominion Resources, Nicor, National Fuel Gas


BIRTH OF U.S. FEDERAL REGULATION

Pre-1930s: State and local regulationFair value principle as in tax value or eminent domain value (Smyth v. Ames 1898)inflation: history of deflation; inflation < 1%Cost-of-service (Sam Insull's answer)

THE 1930s ENERGY LAWS: Regulation to Fill GapsPublic Utility Holding Company Act (1935): repealingFederal Power Act (1935) and Natural Gas Act (1938)

Set just and reasonable ratesChange rates is found not just and reasonableMonitor with systematic reportingCertificate pipelines (NGA)Approve mergers (FPA)


1970sORIGINAL COST-OF-SERVICE RATEMAKING BREAKS DOWN

Increasing energy prices lead to cost trackers(PGAs and FACs)

Over regulation leads to shortages and curtailmentsBad forecasting and Resource depletion theories: Chicken Little theory/ contrary empirical evidence

High inflation: 7% per year

National Security and Resource Depletion Laws: Fuel Use Act (1978): repealedNatural Gas Policy Act (1978): only Title 3 is activePublic Utility Regulatory Policies Act (1978):

cogeneration and renewables -> stranded costs


Order 380(1983): take-or-pay/min bills eliminatedOrder 436(1986): training wheels for competition

Spot market developmentcommodity markets and interruptible transportationRegulated commodity markets as a recourseDecreasing energy prices lead to take-or-payDeregulation and the non-fly-up (1985)New resource non-depletion theories:

technological progressLower inflation: 5% per yearBad forecasting

The Wellhead Decontrol Act (1989): easy

1980s: PUNCTUATED EVOLUTIONNatural Gas Open AccessMaking an aquarium from fish soup


Wellhead Gas Price Forecastsfrom 1980 to 1990

(1995 $/Mcf)Forecast Forecast Forecast

15 Years Out 10 Years Out 5 Years OutForecast for 1995 for 1990 for 1995 for 1985 for 1990 for 1995

in 1980 in 1980 in 1985 in 1980 in 1985 in 1990

EIA 5.98 5.19 5.90 3.45 4.11 2.65DOE 8.06 6.72 5.95 5.60 3.82 2.74DRI 15.46 11.23 4.28 5.60 2.80 2.39 AGA -- 6.34 3.63 7.65 3.27 2.42Average 9.84 7.37 4.94 5.57 3.50 2.67Actual 1.59 1.96 1.59 3.44 1.96 1.59Avg/Act 6.19 3.76 3.11 1.62 1.79 1.68

Sources: Energy Information Administration (EIA), Department of Energy (DOE), Data Resources

Incorporated (DRI), American Gas Association (AGA) and Gas Resources Institute (GRI).


1990s: electric open accessmarket evolution for gas

Order 636's strong comparability (full unbundling)Energy Policy Act (1992): wholesale electric access1993-1997 (Post-636/pre-LDC open access):

Active in the marketLess active at FERC: where have all the rate cases gone?secondary markets: capacity release and gray marketsDownstream market centersOrder 636 contracts

Full pipeline open access; weak comparabilityCanadian imports grow from 1 to 3 Tcf (1985 to 95)Order 888 (1996): open access in electric marketsOrder 637(1999): greater tradability for transO2K(1999): RTO Rule separation and larger markets retail access: electric and gas; were they ready?


Order 637

@e-commerce @EBBs become Web sites: still MtoM@posting of daily transactions and capacityefficient primary rates:

term differentiated,seasonalequality of secondary market

no max rate for releaseencourages voluntary e-auctions with MBRsegmentation if operationally feasibleimbalance trading


Virtual pipelinesVirtual pipelines

= segmentation equality= nomination and confirmation equality= more primary firm = full tradability= better information= imbalance markets= no harm/no foul penalties= incentives to limit OFOs

efficient markets


MARKET CENTERS ENHANCE EFFICIENCY AND RELIABILITY

Increasing access to sources of gas and capacitypipelines often have highly correlated demand makes short-term deals and long-term deals easiercreates deeper markets

Lowering transactions costsreduced search costs and faster market responsereal price informationsimplifying multiple pipeline exchanges

Lowering reaction time in emergenciesUsing multiple system responses

greater aggregation through market centersone storage facility can serve many pipelines


Calgary, Alberta

Overthrust

Permian

Panhandle/Hugoton

Chicago

DetroitNew YorkLeidy

Niagara

Texas Gulf CoastSouth Louisiana

Kern

Atlanta

$.77 to 3.16

$.32 to 2.57

$.67 to 5.42

$.01 to 3.46

$.09 to .82

$.07 to 2.48

$.06 to 1.17

San Juan

$-.03 to 2.76

Lebanon

$-.05 to 1.22

North Louisiana/East Texas

$-.31 to 2.32$.06 to 1.79

$.25 to .64

$.03 to .30

$-.83 to .11

$.01 to .97

$-1.46 to 1.55

$-.80 to .20

$-.59 to .20$.31 to 5.28

$-.18 to .65

$-.15 to .34

$-.08 to .20

$.17 to 4.36

$-.02 to .90

$-.02 to .90 $-.04 to 1.25

$.03 to 2.15

$-1.67 to 1.01

Source: Natural Gas Week. Data through December 30, 1996.Notes: Monthly average prices for selected delivery points. Prices for Alberta and Niagara are for Canadian spot transactions of 12 months or less. Prices used Detroit are from Columbia Gas at Maumee, Ohio. Spot prices reflect transactions of 31 days or less. Monthly price is the median of the prices assigned to a

Range of Average Monthly Natural Gas Price Differences1995-96 in $/MMBtu

market center area

MARKET CENTERSERVICES

WheelingParkingLoaningStorageGas TradingTitle Transfer


Pipeline transportation study(INGAA)Transportation capacity holders(1999)

gas LDC only: 38%combined utility: 21%marketer: 26%affiliate marketer: 9%IPP/indust/pipe: 14%

firm expiring by 2005: 51% capacity release: 16% IT from 87% in ‘87 to 11% in ‘97gray market????


INGAA discount study(2000)

capacity release 54 to 57% discounted(includes assignments)average discount 59%

primary capacity 25% discountedaverage discount 43%

only 6% to affiliatesno difference in discounting to affiliates!!!!


What determines the price of gas?What determines the price of gas?

☯long-term☯floor: finding and delivery costs ☯ceiling: coal, no. 6 oil, no. 2 oil,

electricity☯environment☯short-run☯weather☯ oil prices☯ hydro


History of Price discoveryEarly 1980s: trade press editor publishes prices to stop large volume of phone callsPrice reporting becomes a significant profit centerIs te trade press compromised?Pricing anomalies

Henry hub and Chicago: cover fuel costs Atlanta and New York: arbitrage Permian Basin and California border: manipulation

Late 1990s: system breaks down


‘Wall Street’ in the late 1990s:easy money

Too much money chasing too few good investmentsEquity analysts shade analysis to get bonus based on investment business the ‘new’ economy: dot.coms and energy tradersgross revenues become more important than profits!!!! New theory: Profits follow revenues Why aren’t all companies following Enron?Late 1990s: system breaks downEarly 2000s punishing this behavior with a vengeance


Financial accounting succumbs to affiliate consulting incentives

Book (lamppost) cost: wrong measure but hard to manipulateMarket to market: correct measure but easier to manipulate Market to hypothetical market: bad

measure but easier to manipulate Market to magic


portfolio schizophrenia: spot v. contractPUC test on hedging: Spot is prudent

Lower than spot: at a boyHigh than spot: disallowance/prudence hearing

Result: buy spot Decision framework with and without forward contractsWithout forward contract

play the spot marketdefer capital expenditures

With forward contract: hedge input pricesput gas in storage to hedge commitmentcapital expenditures to meet commitment


The Index GameState commissions declare index purchasing prudentDistcos purchase at index with index schemesLarge portion of trades on indexFixed price trading thinsFixed price market becomes an attractive nuisance for manipulation


The price discovery breakdown‘statistical’ validity questioned

All trade press report essentially the same numberSampling is voluntary not random

What does it mean to sign a forward contract to be settled at the spot index price?Fixed priced market thin: 3% of tradeAn invitation to gaming traders fib: it’s wire fraud!!!!Wash and round-trip trades inflate ‘revenues’ and distort reported pricesTrade press claims it filters them out based on intuitionAnswer: auction markets


Value of affiliatesScope economies: theory v. practice

Small firm exceptionFor large firms mostly theory

Incompatible incentivesFor-profit lowers costsCost-based raise costsMove costs to utility; move revenues to for-profit

Chinese Walls, Ring Fences and other rulesDamage to competition Favoritism can be real or imaginedSuccesses? v. failures (many) settlements: Williams/Transco and El Paso


Cost-based regulated

entity

market-based

regulated entity

RevenuesInformation

LoansPersonnelDiscountsfavoritism

Costs and risks

The Affiliate GameThe Affiliate Game


The Enron phenomenon

Enron transforms itself from pipeline co. to traderWall Street encourages Enron clonesintense lobbing for unfettered markets without any transition mechanism.Enron online: Enron told the Comm it was a bad idea?Greed overwhelms reason


Williams/Transco Claims and Settlement

Improper posting of discountsaffiliates use information and computer systems not available to othersPoor recordkeeping; Confusing organization chartsAdmits no wrong doing but agrees to$20 million civil penalty to US TreasuryNo new affiliate contractsNo information preferences Four year plan for compliance: Employee training


El Paso Problem

El Paso gets exceptions from open access (Order 636) Bad incentivesCalifornia markets are badly designed with bad incentives Claim: affiliate marketer overcharged by $3 Billion via pipeline withholding


El Paso proposed SettlementAdmit no wrong doingCash and stock in millions

Cash: $100 to Cal; $65 to Nev; $23 to Wash; $17 to Or $2 from officer bonus pool$125 in El Paso stock$22 over 20 years (50% in stock)

Discounts and renegotiation in millionsGas delivery at discounts($45/yr over 20 yr)Power contracts: $125 reductions

OtherMaintain 3.3 bcf/day capacity at cal borderNo affiliate deals for 5 yearsAntitrust training


IDACORP settlement

$5.9 million in refundsAffiliate

scheduled transactions as native loadHad access to information that non-affiliates did not


National Fuel

Charged with preferential information to affiliateAdmits no wrong doing but agrees toPay $300K to cover the investigation costs No information preferences three year plan for compliance


Recent pricing problems

☯California☯US☯Reporting confidence☯1990s v. 2000s☯Drilling lagged response: 3 to 6 months


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Rigs Drilling for Gas


Average Regional Natural Gas Spot Prices

1999-2001

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Louisiana Appalachia


California Natural Gas Prices in 2000

Prices peak at $60/MMBtuGas prices for the second half of 2000 were more than four times higher than 1998 and 1999 prices

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Recent History2002

Consumption: 23.2 TcfImports: 16% of consumption (3.8 Tcf/yr)Exports: 2% (Canada, Mexico, Japan)Household conservation: 106 (‘80) to 83 (’01) mcf/yr

2003High prices: Demand response: chemical plants shut downwill gas be available for reliable electric powerElectric generators switch to coal and oil


Future: 30 Tcf? At $5/mmbtu?

LNG: Future 10-15% at $3to 4/mmbtu‘like production’: `No regulation’ for importsenvironmental review?Take a netback from the Henry Hub

‘sequestered’: don’t ‘drain America first’Artic: economics; since 70s mantra $5/mmbtu offshore areas except western Gulf of MexicoCertain areas in the Rocky Mountains


US Gas security and markets

Will gas be available for reliable electric power?NERC redispatch market failureTerrorism: automatic eminent domainCurtailments: marketsMonitoring and mitigation

Gas Market Restructuring in the 21th Century �trading old for new shibbolethsThe paradigm shift problem of Urban VIIIPost Galileo: �the quantum mechanics does science get it right the first time? (Paradigm shifts we have no-ed and loved)The politics of paradigm shiftsIt is about choice All markets are regulated�the policy question is how?Market structure dictates efficient regulation The Evolution of Natural Gas Market StructureWellhead Gas Price Forecasts� from 1980 to 1990�(1995 $/Mcf)Order 637 �Virtual pipelinesPipeline transportation study(INGAA)INGAA discount study�(2000)What determines the price of gas?History of Price discovery‘Wall Street’ in the late 1990s:�easy moneyFinancial accounting succumbs to affiliate consulting incentivesportfolio schizophrenia: �spot v. contractThe Index GameThe price discovery breakdownValue of affiliatesThe Enron phenomenonWilliams/Transco �Claims and SettlementEl Paso ProblemEl Paso proposed SettlementIDACORP settlementNational FuelRecent pricing problemsRecent HistoryFuture: 30 Tcf? At $5/mmbtu?US Gas security and markets

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