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The Triumph of Markets in Natural Gas

Fortnightly Magazine - April 15 1995

During the last decade, the natural gas industry in the United States has been transformed from a heavily regulated business to one facing competitive markets. This transformation grew out of the failure of regulation; regulators, suppliers, pipelines, and customers all played a part. It continues today as the industry restructures and builds new institutions.A series of regulatory crises forced deregulation in stages: First, wellhead prices; second, gas contracts; and finally, pipeline transportation. As markets responded, the Federal Energy Regulatory Commission (FERC) and the state regulatory commissions were forced to change. The growing efficiency of markets demanded better access to services. "Bypass," that quaint industry term for access to markets, emerged as a goal for gas users and suppliers. Regulators answered with the now-famous series of "open access" orders permitting shippers to bypass pipelines as sellers of gas and letting pipelines elect to transport gas under contract. By about 1985, enough pipelines had opened up that gas buyers and sellers could deal directly with one another and make arrangements to transport gas with assurance. This development marked the beginning of the modern gas market.

By 1989, a mature form of competition had come to natural gas. Enough pipelines had opened their systems to form a pipeline network. Markets had evolved far enough to coordinate gas and transmission trading. The gas market had gained the broad participation of buyers and sellers, giving it the depth and liquidity characteristic of a competitive market. The gas pipeline industry is no longer a natural monopoly.

How did it all happen?

A way of thinking . . .

Gas flows from wells located in distant producing fields, through pipelines to users. The interstate pipelines end at state borders or at gateways to urban markets (the city gate), where gas is transferred to a distribution system for delivery to consumers. With certain minor exceptions, form follows function. Pipelines do not produce gas. Nor do producers own pipelines, beyond local connections to the trunk line. Distributors do not own pipelines or produce gas. But these functions could have been organized differently.

As it was, the gas industry splintered into segments to fit the jurisdictional boundaries that divided regulatory agencies. Regulatory policy barred shipper and producer joint-venture pipelines. Linear supply chains arose from production areas to city gates, largely as a consequence of federal certification of pipelines. That scheme required dedicated supplies and long-term contracts between pipelines, upstream suppliers, and downstream buyers. But certification of pipelines created a protected monopoly from the fields to the city gates. Pipelines operated independently of one another, each supplying cities with dedicated gas volumes. Regulators balkanized the industry into minute pieces and institutionalized monopoly.

that fell apart . . .

Interstate natural gas pipelines have long been considered natural monopolies, marked by economies of scale in size and output and making competition wasteful. With function following form, pipelines were built to serve a theory and were regulated as the theory prescribes: A monopoly is chartered to serve the market, prices are controlled, entry is closed, and cost-based rates are set. The state acts as central

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