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The Triumph of Markets in Natural Gas

Fortnightly Magazine - April 15 1995

in a spot market somewhere within the network to predict a price change later at another point in the network. Instead, every price will reflect the same information. Note in Figure 1 shows how the changes in these two prices coincide, and how narrow, over time, becomes the band within which the two prices move.

Our evidence shows that this convergence of prices took place all over as open access emerged and opened alternative network paths for transmitting and trading gas. New interconnections at pipeline hubs hastened the process, as did the creation of sophisticated gas trading techniques.

whether measured systemwide . . .

Our first look at markets considers the system of spot prices over the entire pipeline network. We wanted to test whether the "very strong form" of competitive pricing held. In this form, prices are so closely tied together that every price reflects the same information, making it impossible to exploit information about a prior price change anywhere within the system. (See sidebar "A Competitive Model," on p. 23.)

We tested this "strong" hypothesis (em that prices are competitive in every spot market simultaneously over various networks. To do so, we analyzed portions of pipelines that form parts of networks connecting supply basins. The supply basins and pipelines forming these networks are listed in Table 1.

During the period from July 1987 to June 1988, none of the six networks reveals "strong" competitive pricing. During the same period a year later, from July 1988 through June 1989, prices in the five-pipeline Network 6 in Oklahoma became "strongly" competitive. But after one more year, from July 1989 through June 1990, prices had become strongly competitive for all networks but Network 3. Prices in Networks 1, 2, 4, 5, and 6 all reflected the same information; no opportunities arose for profitable arbitrage in these market networks. By 1989 most pipelines had opened their systems to transportation. The number of paths in these networks expanded to bring about strongly competitive prices.

We also found that the competitive spot prices converged rapidly. To gain some understanding of the speed of price convergence, we simulated price shocks on Network 1 equal to one standard deviation, and measured how long it would take before the market damped the shock. We found that the damping period shrunk from seven days in 1988 to three days by 1990.

or between pairs of markets . . .

What about direct competition between any two specific markets? To examine competition between market pairs, we measured the cost of arbitrage.

Part of the cost of arbitrage is transportation. Thus, in a simplified example, if the price in market i increases by one unit, while the cost of transmission remains constant, then the price in market j should rise by the same amount as in market i to restore equilibrium. In other words, if the cost of arbitrage remains relatively constant (represented here by the cost of transmission) then the price difference between two spot markets should also remain relatively constant over time.

We found that market integration drifted upward over