Primer on Natural Gas Prices
When it freezes in Florida, you'll probably pay more for orange juice. Why? Because the weather affects the supply of oranges. When a freeze causes supply to go down, prices go up.
The same is true with all other commodities, including natural gas. When market forces, such as bad weather, tighten the supply of the product or if demand for a product suddenly increases, prices tend to go up. The basic laws of supply and demand also mean that if prices for a product are high, supply will increase. Conversely, when prices are low, suppliers are not encouraged to produce more.
The actual supply base of natural gas is enormous - enough to last several hundred years, according to the U.S. Department of Energy. Even with abundant gas supplies underground, however, most gas producers find it most efficient to work on a "just-in-time" inventory basis. That is, they keep a minimum amount of gas on hand and ready to put into the delivery system, until market conditions justify the development of further supplies. This also helps to ensure that the price of the gas reflects the current demand for the product.
Federal Price Controls on Gas Create Problems
With natural gas, however, these basic laws of supply and demand haven't always been allowed to work. For many years, the federal government regulated the wellhead price of natural gas - the price paid to the producer as the gas comes out of the ground. Some regulators thought that keeping these prices low would ensure that homeowners had low-cost energy for heating. But the price controls created a distorted market: The wellhead price was so low that producers had no incentive to look for new supplies. It actually cost more to find and produce natural gas than the supplier could sell it for.
That situation ultimately created gas delivery shortages in the 1970s. These shortages led some people to believe the nation was running out of natural gas. But that's not so - there's plenty of natural gas to last for a very long time, if the market is allowed to freely and efficiently allocate gas among buyers and sellers.
Decontrol Phased In Starting in 1985
In 1978, in response to the shortages created by price controls, the federal government began deregulating the wellhead price of natural gas. The Natural Gas Policy Act (NGPA) phased in decontrol of most wellhead prices for natural gas, with the first major step occurring Jan. 1, 1985. Today, there are no remaining federal controls on natural gas wellhead prices and supply is plentiful.
The most important factor affecting natural gas wellhead prices today is the competitive marketplace, which is affected by such factors as weather, overall gas demand, the prices of competing fuels (primarily coal and oil) and competition among customers for the supplies.
Pipelines and Utilities Still Regulated
Other costs of natural gas service, however, are still heavily regulated, including the cost of transporting gas on the 1.3-million-mile U.S. pipeline system and the costs that a local gas utility incurs when providing gas service to a home or business. These costs are added to the wellhead price of natural gas, and the total is the retail price that customers pay.
In the natural gas pipeline sector, much has changed in recent years because of industry restructuring. At one time pipeline companies purchased gas from producers and then sold that gas to local gas utilities and some other large users, such as steel plants. The Federal Energy Regulatory Commission (FERC) regulated the rates, terms and conditions of service provided by the interstate natural gas pipelines.
In 1992, FERC issued its major restructuring rule, Order 636, which requires pipelines to separate their gas sales services from their other services and to provide equal access to their systems for all buyers and sellers. Pipelines also are now required to charge separately for each service they provide, which could include underground storage for gas and extra "peak-shaving" supplies for days when demand is very high. The rates that pipelines charge for any service, however, are still regulated by FERC.
Gas Utility Regulation
Natural gas service for most customers, particularly homes and small businesses, comes from the local gas utility. These companies and the rates they can charge are regulated by state agencies, usually called public service commissions or boards. Regulators are appointed or elected, depending on the state.
Traditionally, regulators divide gas customers into four classes: residential, commercial (such as schools, hospitals, restaurants, office buildings), industrial (such as factories) and electricity generation. The rates for each class of customer are different, depending on how much the utility spends to serve them. Large industrial customers, for example, usually pay less for each unit of their gas service than residential customers who, in comparison, use relatively small amounts of gas in uneven patterns and are thus more expensive to serve.
Components of a Gas Bill
Retail natural gas rates include the costs of providing natural gas service, not just the cost of the gas commodity. For residential customers, the price of the natural gas itself - the gas commodity - accounts for about one-third of the total price per unit of gas, on average. The remainder of the customer's bill includes amounts for the transportation and storage services of the pipelines and the utility; system maintenance; safety programs; customer services, such as metering and billing; a return on investment for shareholders; and state and local taxes and other costs.
Traditionally, the regulators have allowed the actual commodity cost of the gas - the wellhead price - to be passed directly through to the customer. When the price goes up and when it goes down, it is eventually reflected in customer bills. The gas utility does not make or lose money on the changes in the actual cost of gas. Some state regulators, however, are beginning to allow utilities to earn profits on their gas supply purchases through risk-management and incentive programs. For example, if a utility's gas supply costs end up being lower than some agreed-upon benchmark, the company and its customers will share the benefits. This gives utilities even more encouragement to be low-cost providers.
Adjustments for the rise and fall of the gas commodity price vary by state. Some states require monthly "purchased gas adjustment" or "cost of gas adjustment" filings from utilities. Others require quarterly filings or reports based on a six-month average. The more frequent the adjustment, the sooner customer prices will reflect the actual upward or downward movements of the wellhead price that the gas utility pays for the gas it delivers.
Changes in the wellhead prices paid by utilities for their gas supplies do not necessarily have an immediate impact on gas utility customers, because of the structure of regulation and the industry. State regulations on how utilities can recover their actual gas costs generally tend to spread out short-term increases and decreases over time. As a result, only longer trends influence gas prices to any significant degree.
Diversified Gas Supply Portfolios Help Reduce Natural Gas Costs
Utilities now have many choices when arranging a gas supply portfolio to best serve their customers' needs and reduce gas costs. Gas buyers at a typical gas utility have a mix of supply sources, which may include long-term contracts with fixed prices, mid-term contracts and short-term purchases of gas on the so-called "spot" market, where the prices react to market events and change very quickly. This diversification limits the effects of significant price swings in just one supply source, such as the spot market.
These contract and spot-market supplies are combined with gas put in storage during the summer, when demand and prices are usually lower. Some gas utilities use other "peak" demand supplies, such as liquefied natural gas (LNG). (LNG is natural gas that has been liquefied by reducing its temperature to minus 260 degrees Fahrenheit at atmospheric pressure. The liquid is easier to store above ground than a gas because, in volume, it occupies 1/600 of that of vapor.)
Strategies To Help Reduce Retail Gas Costs
In addition to using a mix of contracts of different lengths, storage and the spot market, some of today's gas supply managers use contracts for gas that are tied to price indexes, which reflect changes in the spot market, the futures market or other energy markets, such as heating oil. Some also use the gas futures market to "hedge" against price swings in their other supplies.
Still, with all this complexity and risk in ensuring gas supply, gas companies are still responsible to their state regulators for their supply practices and the prices they charge their customers.
Some Customers Purchase Gas Directly
Many customers who use large amounts of natural gas are now purchasing gas directly from the producers, just as gas utilities do. After buying the gas, they arrange for capacity on the interstate pipeline and for space through the local gas utility's system. They pay both the pipeline and the utility for transportation services. Currently, about two-thirds of the gas purchased in the United States can be bought through non-utility suppliers.
"Choice" programs for residential and commercial customers are also growing rapidly. They enable homeowners and small- business customers to choose their gas supplier by shopping among those who operate in their area, with the gas still being delivered by the local utility. These programs are authorized by state regulators.
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Copies of this primer, published in 1997, are available in booklet form. Individual copies of the booklet (catalog number G97111) can be purchased by calling 800/699-9277 or by visiting our online catalog.