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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

characterize the trading environment, vertical integration may be most economical. (This would be especially true with the presence of high transaction costs from coordinating, synchronizing, and harmonizing different complicated processes through market arrangements.)

In the case of contracts, transaction costs originate from:

(1) search and information acquisition;

(2) initial negotiation;

(3) monitoring;

(4) enforcement;

(5) haggling at contract renewal; and

(6) deviation of evolving market conditions from contract terms and conditions.

When these costs are high relative to the transaction costs of spot transactions and vertical integration, contracting becomes untenable. In terms of the optimal duration of a contract, two opposing forces come into play. The first, favoring longer-term contracts, pertains to the cost of negotiating terms of trade on a period-by-period basis (for example, annually, or even more frequently as in the case of a spot transaction), which other things held constant, would drive up transaction costs over time. The second, causing longer-term contracts to be less attractive, relates to the risk of being constrained under an inflexible arrangement over a longer period of time. The main problem here is that this rigidity could be highly costly in an uncertain market environment and could lead to the shipper being stuck with overpriced gas to sell.

The Context: The Current Gas Pipeline Sector

Long-term contracting is a legacy of the pre-1980s natural gas industry. Contracts were generally for 20 to 30 years, at fixed prices, for both producer-pipeline transactions (take-or-pay contracts) and pipeline-local gas utility transactions (minimum-bill service agreements). The unraveling of long-term contracting, especially with rigid terms and conditions, coincided with the restructuring of the natural gas industry in the early 1980s, with wellhead price liberalization and major FERC actions opening up wholesale gas markets. In fact, a major impetus for restructuring of the natural gas industry was the high social cost associated with rigid long-term contractual arrangements that became more evident as the industry transitioned to a more liberalized structure.

With the natural-gas sector restructuring from a highly regulated industry to a much more market-oriented one, trading arrangements have become much more short term and flexible in both price and in terms and conditions. We have observed this phenomenon throughout the natural-gas sector, from gas procurement, gas storage, and retail transactions, to capacity contracting for pipeline services.

The primary force behind this broad reshaping of trading arrangements lies with simple economics. For example, retail consumers now have more choices of suppliers and gas utilities face more uncertainty over future prices and their load requirements. As gas utilities downsize the bundled-sales-service side of their business, they will invariably have less demand for long-term pipeline capacity. Overall, competitive pressures have made long-term commitments a more expensive proposition for gas utilities as well as other shippers by increasing risk.

The pronounced trend away from long-term contracting during the past 20 years is the result of the natural-gas industry becoming more open and competitive. The shifting of trade toward shorter-term arrangements, for both gas supplies and transportation, is compatible with the dramatic change in the market environment that has occurred over this period of