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The Triumph of Markets in Natural Gas

Fortnightly Magazine - April 15 1995

time in the production areas. By 1991, more than 65 percent of the production-area spot markets had become cointegrated. The level of cointegration did not depend upon the number of pipelines in a market. You can't measure market competitiveness by counting pipelines; you must look at prices.

as shown at hubs, city gates, and futures markets.

Next, we looked at market centers. Market centers are the points where pipeline systems intersect in a radial pattern of spokes through a hub. The significance of these hubs is that pipelines are close enough to be connected readily. This means that new links expand the number of arbitrage paths between markets. (In our forthcoming book, we show that the number of paths expands as a power of the links in the system; thus, opening a hub greatly expands the number of paths in the network.) By 1990, some of the hubs connected more than a hundred markets. We considered three networks: those centered on the Northern Town Border Station, on Maumee, OH, and on Broad Run, WV. Each of these pooling points offers 114 arbitrage paths. Our tests revealed competitive pricing in these networks.

We also examined prices at city gates. We asked how closely these prices are linked to prices in the production fields and hubs. We found that a few city gates are well integrated with production-area markets, but many are not. City-gate prices are in line with prices in the fields, but do not stay within the narrow limits one finds between the fields and market centers. It is not distance alone that makes the difference (em very distant market centers are highly integrated with production fields, and their prices track one another closely. Instead, it is access through the city gate that matters, and it turns out that the city gate is not yet open far enough. City-gate markets need have little fear their prices will be too strongly influenced by local conditions, with the exception, perhaps, of a few capacity-constrained city gates like Southern California. Price volatility is damped by links to the pool of gas throughout the United States and Canada.

Lastly, we found that most field and hub prices are highly cointegrated with the futures price. However, the futures contract offers a less satisfactory device for hedging price risk at some locations. The futures market is unarguably competitive. So, any price that is cointegrated with the futures price must also be competitive. Most markets we examined met this condition, leading one to conclude that their prices are competitive. t

This article is based on the forthcoming book The Emerging New Order in Natural Gas: Market versus Regulation (Quorum Books, Westport, CT). Arthur De Vany is a professor in the Department of Economics and the Institute for Mathematical Behavioral Sciences at the University of California, Irvine. David Walls is an assistant professor in the School of Economics and Finance, and a Fellow at the Centre for Urban Planning and Environmental Management at the University of Hong Kong.

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