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How Commodity Markets Drive Gas Pipeline Values

Has rate regulation become obsolete for natural gas pipelines?

Fortnightly Magazine - February 1 1998

rate is equivalent to $1.00 on a volumetric basis. The shipper pays only $1.00 for a service worth $4.50, gaining economic rent from the pipeline. Moreover, the shipper has no incentive to release the capacity in the secondary market, since the FERC's price cap limits the release price to $1.00. This shipper will hoard capacity, shutting out other potential shippers who might be willing to pay more for the resource.

A SUMMER EXAMPLE. During hot weather, suppose gas sells for $1.85 in Texas and only $2.00 at the Chicago city gate. Thus, the value of transportation from Texas to Chicago is no more than $0.15. Any shipper paying the regulated rate for transportation (again, the volumetric equivalent of $1.00) would naturally seek to release the capacity to mitigate costs, but would find other shippers unwilling to pay more than $0.15, and certainly unwilling to match the

regulated price of $1.00, whether for short-term firm or interruptible transportation.

Overall, these examples demonstrate a central feature in pipeline transportation. Gas commodity markets establish the value of pipeline services. It is the basis differential (em in this case, the difference in price between Texas and Chicago (em that measures the value of gas transportation through the interstate pipeline network (see Figure 1).

In fact, a strong case can be made for market-based rates on all pipeline routes between competitive commodity markets. Market-based rates on these routes would remove bottlenecks and improve pipeline use and efficiency.

Discovering the Transport Price

By definition, the delivered price of gas in a market area consists of the supply price and the transportation charge: Supply Price + Pipeline Markup = City-Gate Price.

These three components have, over time, been related in a variety of ways. When the gas market was completely

regulated, the city-gate price represented the sum of the regulated wellhead price and transportation charge. Later, as wellhead price deregulation proceeded and the gas bubble developed, many producers considered their prices as a netback (em computed as the difference between the regulated city-gate price and the transportation charge. Today, however, where competition exists at both ends of the pipeline, the city-gate and supply prices are market-determined; the difference between them represents the value of the transportation service.

If both commodity markets are competitive, then the supply and city-gate prices will be determined separately by conditions in their respective areas. The pipeline will be a price-taker, forced to accept a residual markup. In this case, the equation is transposed. The competitive supply and city-gate prices determine the pipeline markup: Pipeline Markup = City-Gate Price - Supply Price.

In other words, when a pipeline connects two competitive gas commodity markets, the value of the pipeline's services can be determined by competitive forces and is measured by the price differential between the two commodity markets.

In this case, shippers will be unable to buy gas at a price below market or sell gas at a price above market. They will refuse to pay more than market value for pipeline transportation services. The market value of the pipeline service will be determined on