1. Introduction and Background

Statement of Purpose

In his memorandum of April 25, 2001, to the Energy Information Administration (EIA),¹ Secretary of Energy Spencer Abraham requested both a long-term and a short-term study of North American natural gas markets. This report presents the results of EIA’s short-term study.

Natural gas prices rose dramatically in 2000 and have remained high through the first part of 2001, raising concerns about the potential for natural gas to fuel the growth of the U.S. economy. Exacerbating those concerns are the current low levels of natural gas in storage and the prospect that a higher than normal rate of injection will be needed in the summer of 2001 during the off-peak (non-heating) season to restore storage to normal levels—which could lead to further price increases in 2001 and 2002. The central questions addressed in this report are “Why have natural gas prices risen so high and so quickly?” and “What is the outlook for the U.S. natural gas market in the short and mid-term?”

Organization of the Report

Chapter 1 of this report provides a brief description of the U.S. natural gas market, its participants, and their relationships. Chapter 2 describes recent market trends in natural gas consumption, supply, storage, prices, and pipeline infrastructure and discusses the challenges facing the natural gas industry, including an examination of the challenges presented by the current situation in California. Chapter 3 completes the report with discussions of the short-term and mid-term outlook for natural gas.

Background

The Natural Gas Market in the United States

Natural gas represented 24 percent of the energy consumed and 27 percent of the energy produced in the United States in 2000. The industrial sector was the largest user of natural gas—for plant operations, cogeneration of electric power, and as an industrial feedstock. In addition, natural gas is the largest energy source consumed in the residential sector and the fastest growing energy source for electricity generation. In recent months, the high prices of natural gas used in the industrial, residential and commercial, and electricity generation sectors have caused exceptional public concern about the present and future operations of the natural gas industry and markets.²

Consumption of natural gas in 2000 is estimated to have surpassed the previous peak for natural gas consumption in 1972. Curtailments of natural gas supplies during the winter of 1976-77, as well as regulations governing the market during the 1970s, constrained interest in natural gas use for many years. The process of price deregulation began with the Natural Gas Policy Act of 1978 (NGPA), which provided for phased decontrol of natural gas wellhead prices. The deregulation of wellhead prices was completed with the Wellhead Decontrol Act of 1989. In addition, beginning in 1985, the Federal Energy Regulatory Commission (FERC) developed new regulations for interstate pipelines, which changed their role in the delivery of natural gas. At the same time, many State public utility commissions (PUCs) began to accommodate new competition for local distribution companies (LDCs) in supplying end users in local markets.

During the 1980s and most of the 1990s, when natural gas demand was low and end-use prices were regulated, natural gas prices were low relative to other energy sources,³ except for coal. In 1997, for example, natural gas accounted for about one-half of the energy consumed in the residential sector but less than one-quarter of household energy expenditures for space heating, air conditioning, water heating, and appliances. Similarly, throughout most of the 1980s and 1990s, electricity generators paid less for natural gas than for residual oil, and the relative prices of natural gas and coal remained about 2 to 1. This price relationship, together with higher efficiencies, low capital costs, short construction lead times, and the fact that natural gas is a cleaner burning fuel than coal with respect to emissions of sulfur dioxide, nitrogen oxides, and particulate matter, led to a strong increase in use and planned use for natural gas in the industrial and electricity sectors.

In the 1990s, however, demand for natural gas grew at a pace faster than the rate of growth in domestic natural gas production. Imports from Canada and elsewhere increased to meet the demand, but the overall supply-demand balance tightened significantly, and seasonal consumption patterns changed. Circumstances related to supply, consumption, and infrastructure capacity have become increasingly important to price and reliability in regional markets. Large and small decisions made in the gas supply industry, natural gas user community, and State and Federal regulatory bodies are all important when supply and demand are tightly balanced. Consequently, it has become increasingly important to prices and reliability that all portions of the supply and demand infrastructure operate smoothly, with clear market signals.

Natural Gas Market Participants and Their Relationships

The U.S. natural gas market is composed primarily of producers, pipeline companies, storage companies, LDCs, marketers (sometimes also referred to as “aggregaters”), and consumers. These are functional distinctions that are oversimplified in the current gas market, because some companies in the industry combine various segments, with ownership of production wells, pipelines, storage facilities, and even LDCs. For purposes of explanation, however, it is useful to think of the participants as distinct.

Producers include firms that explore for new gas resources and expand production from known reserves. The market for wellhead natural gas purchases is unregulated; that is, producers may negotiate prices and delivery terms with consumers or with other firms, such as marketers and LDCs, for the sale of their products.

After production, gathering lines deliver the gas to processing plants and/or to transmission pipelines. The vast majority of gathering pipelines are under State jurisdiction. They can be owned by producers, pipeline transmission companies, marketers, LDCs, or independent operators. During the restructuring of the 1990s, most pipeline gathering facilities were sold or spun off into separate companies. The gas processing plants remove noxious gases, such as hydrogen sulfide, separate out useful hydrogen and other light hydrocarbon liquids (natural gas liquids) for resale to refineries and other industries. They can be owned by firms in virtually any other market segment.

Pipeline companies connect to the production field or after-treatment points (often via gathering lines) and deliver the gas under either short term or longer term firm or interruptible contracts to their customers. The pipeline delivers gas to specified delivery points, which may be a storage facility to which the owner of the gas has rights, a “citygate” of an LDC,  an end-use customer, or another point on the pipeline system. Rates (tariffs) and terms and conditions of services charged by interstate pipeline companies are based on rate proceedings approved by the FERC. The FERC also approves construction of interstate pipelines. State PUCs are responsible for approving the construction of and rates charged by pipelines entirely within the borders of their States. Pipeline safety is regulated by the U.S. Department of Transportation’s Office of Pipeline Safety.

Storage firms are firms that have developed the facilities to store natural gas for later delivery. They may be federally regulated if their facilities are used to ensure pipeline reliability as part of FERC rate proceedings; otherwise, they are not federally regulated. State PUCs have regulatory authority over storage facilities that are used to serve LDC customers.

Underground storage is a vital part of the natural gas infrastructure. The ability to store gas ensures supply reliability during periods of heavy or peak demand by supplementing pipeline supplies and providing an alternative source of gas in case of supply interruption. Storage also allows load balancing of daily throughput levels on pipelines. More recently, storage is also being used to take advantage of expected price movements and to support futures market trading.

Natural gas can be stored in a variety of ways. The most common method of natural gas storage is in underground geologic formations, largely former producing reservoirs for which further production is uneconomical—hence the term “depleted fields.” Two other types of underground facilities are aquifer reservoirs and salt caverns.⁴ Storage injection and withdrawal rates can vary dramatically for different geologic formations. Salt domes or beds usually can be emptied in 2 to 4 weeks and refilled in 4 to 8 weeks, depending on compressor capacity. Depleted oil and gas formations usually have much greater capacity than salt deposits, but their injection and delivery periods usually are much longer. Most depleted field storage facilities are designed to provide for withdrawals over the 151-day heating season and refilling over the 214-day non-heating season.

LDCs are companies that control local gas distribution facilities. They may be transporters of natural gas owned by their LDC customers, or they may be both suppliers and transporters. LDC customers may also choose the LDC to provide all scheduling, fuel acquisition, and delivery functions (the “merchant function”) for them. LDCs are regulated by State PUCs.

Marketers are unregulated firms that typically perform the “merchant” function for natural gas customers, usually packaging supply, storage, and pipeline delivery capacity on either a firm or interruptible basis. The number of marketers offering natural gas services increased dramatically with implementation of FERC Order 636, which restructured the interstate pipeline companies by separating their merchant and transportation functions. Many marketers are affiliated with pipeline companies, LDCs, or producers.

The complexity of the deregulated natural gas market⁵ and its growing interrelationship with electricity markets that also are moving toward deregulation have increased the need for coordination among market participants. For example, in addition to production challenges, timely additions of natural gas pipeline capacity and other infrastructure present challenges that will require coordination among pipeline companies, consumers, the FERC, and State regulatory bodies.

Notes