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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

When a pipeline moves gas from Texas, where its value is $2.50, to Chicago, where its value is $7.00, the pipeline adds $4.50 to the value of the gas. Thus, the basis differential between Chicago and Texas measures the value of the pipeline's transportation service. Basis differentials therefore provide a lot of information about the markets for gas transportation services around the country (see Figures 4 and 5).

The figures show the average basis differential for the period January 1996 through August 1997 for seven supply areas and three market areas. For example, Figure 4 shows that pipeline transport services out of Opal, Monchy and San Juan are more valuable than for the other supply areas, whether gas is delivered to Los Angeles, Chicago or New York.

This information can be used to evaluate the likely profitability of capacity additions. For example, if the $1.50 average basis differential between Opal and New York is expected to persist, then a new pipeline costing more than $1.50 on a volumetric average basis would not expect to recover its costs and should not be built.

In similar fashion, Figure 5 shows that New York is the most profitable area for pipeline transportation services, followed by Chicago. The low values into Los Angeles reflect the abundance of pipeline capacity there, which has led to significant turnbacks of capacity in recent years.

The negative basis differentials into Los Angeles from the Waha and Anadarko areas require further elaboration. Since the basis differential is calculated as the city-gate price minus the supply price, a negative differential indicates that the supply price is greater than the city-gate price. During much of 1996, prices at the Waha hub and in the Anadarko basin were higher than the Los Angeles city-gate price due to high demand in the East. Most gas flowed east from Waha and Anadarko during this period. Negative differentials between Los Angeles and the Katy and Henry hubs reflect the fact that prices at these hubs are consistently higher than prices in Los Angeles. Moving gas to Los Angeles from Katy or Henry would prove highly unprofitable.

These comparisons help to explain the pattern of pipeline capacity expansions now in the planning stage. A comprehensive study by the Canadian Energy Research Institute %n5%n lists a total of 27 billion cubic-feet per day of planned capacity expansions in Canada, the United States and Mexico. None of these projects was aimed at the California market. However, 16 Bcf/day of planned capacity additions (59 percent of the total) is intended to increase access to the midwestern United States and New York market areas, consistent with the high values currently attached to pipeline services in these areas.

Pipeline Rates and Values

Historically, cost-of-service rates have been set for pipelines by the FERC, with the objective of full cost recovery. On those routes where competitive commodity markets are establishing the market value of pipeline services, however, there is no reason to expect cost-based rates to reflect market valuations. Where rates and value differ, pipelines may not recover their costs of service and inefficiencies