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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

a spot basis by the difference in spot commodity prices between the two competitive markets connected by the pipeline. The pipeline will have no market power, even if it is the only pipeline between the particular markets, as shown by the following example.

Suppose there is only one pipeline running from Texas to Chicago, but gas supply is competitive both in Texas and at the city-gate in Chicago. Texas suppliers have access to many city-gate markets other than Chicago; Chicago consumers have access to many suppliers outside Texas.

Suppose the gas price in Texas is $2.50 and the city-gate in Chicago is $7.00. The value of the transportation by the pipeline is $4.50. If the pipeline charges $5.00 for its service, the delivered cost of Texas gas in Chicago will then be $7.50. But nobody will buy it, since Chicago consumers can purchase from other suppliers at a delivered price of $7.00. The only way the pipeline could charge $5.00 is if it could purchase gas in Texas for $2.00. But this scenario is unlikely since the gas market in Texas is competitive. In the end, no gas will flow from Texas to Chicago. The pipeline is unable to set an above-market price. So although only one pipeline runs between Texas and Chicago, it will not have monopoly power because it connects two competitive gas commodity markets.

If pipelines connecting competitive commodity markets are unable to exercise market power, then rates on those segments can be deregulated with no adverse impacts on competition. A first step in identifying pipeline candidates for market-based rates, therefore, is to identify workably competitive gas commodity markets.

Competition in Commodity Markets

A fundamental premise of wellhead price deregulation and pipeline open-access mandates was that gas wellhead markets were essentially competitive. The growth of regional spot markets, the popularity of gas futures contracts, and the emergence of gas trading hubs and market centers have confirmed this assumption. A large body of economic research has documented the integration of various regional gas commodity markets into an increasingly unified national (or North American) gas market over the past decade. %n4%n

A visual examination of prices from January 1996 through August 1997 shows that price levels are not only moving in similar directions but are now actually converging across the country in both supply areas and market areas. Figures 2 and 3 show commodity prices in several market and supply areas, respectively.

The market areas in the East (see Figure 2), experienced extremely cold weather and highly volatile prices at the start of 1996. Simultaneously, prices in Los Angeles (Topock and Wheeler delivery points) were low and stable. By April, however, gas prices in the eastern market converged. Los Angeles prices followed suit in early August 1996. Since then, city-gate prices across the country appear to have moved in a single pattern.

Similar trends are observed in production areas (see Figure 3). Price patterns in production areas supplying the East were similar to those in the end-use markets. Similarly, prices in these production areas began to converge by April 1996 and