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Pipelines: Are Regulators in for the Long Haul?

An economic perspective on long-term contracting for gas pipeline service.

Fortnightly Magazine - July 2005

time. In line with transaction-cost economics, these changes have lowered the relative transaction costs of shorter-term trading arrangements. In other words, the market participants are acting rationally in preferring shorter-term transactions as the natural-gas market environment has evolved.

Although many shippers, especially local gas utilities, generally prefer multi-year contracts for firm gas transportation, they also have opted for shorter-term and more flexible arrangements. These transactions make it easier for a shipper to vary its take in adapting to changed conditions in the absence of irreversible commitments. The evolution of market centers and hubs has expanded the market services by providing shippers with greater gas supply and transportation choices.

Price basis differentials (for example, the difference between gas prices at two market hubs located in different regions) and perceived demand are the driving forces for pipeline capacity expansion. In the past several years, most local gas utilities have procured a portfolio of pipeline arrangements. Many non-utility shippers, such as marketers and large gas consumers, have preferred shorter-term arrangements strictly for economic reasons. (For example, electric generators selling power without long-term commitments from its buyers would be hard pressed to economically justify signing a long-term contract with a pipeline.) Overall, emphasis has shifted toward shorter-term transactions and flexible arrangements with regard to the amount of pipeline capacity reserved, as well as the duration of contracts.

Trying to Make Sense of This

The evolution of the natural-gas market has made long-term contracting for pipeline services less attractive for shippers, whether local gas utilities, marketers, or large gas consumers. Shorter-term transactions have become the economically preferred arrangement for transacting gas pipeline services in addition to transactions for the gas itself and other industry services that have become more competitive over time. Local gas utilities see the risks associated with long-term contracts with inflexible terms and conditions, particularly when they endure beyond their planning horizons, which have shortened in recent years.

As they often do, local gas utilities have long-term contracts with pipelines, but they generally prefer a portfolio of pipeline arrangements that gives them more flexibility in adapting to changing market conditions. In FERC Docket No. RM98-10-011 , when discussing the matching-term cap under the right-of-first-refusal mechanism, the American Gas Association (AGA) argues that long-term (beyond 5 years) agreements with pipelines “may expose the [gas utility] and, ultimately, the end-use consumer, to investments for capacity commitments beyond needs specifically identified simply because a lengthier contract term would be required in order to secure supply in the short term.” AGA goes on to say that a “lengthy contract” could force a gas utility to “bear all the risk associated with that contract, including the underlying financial obligation, regardless of future events that might lessen its capacity requirements.”

Events in the natural gas industry over the last several years have made new pipeline capacity less of a relationship-specific investment (which, as discussed above, is the primary condition for long-term contracting). This is partially a result of increased competition in the wholesale gas market induced by the creation of market centers/hubs and the secondary capacity-release market. For example, since