Gas Market Restructuring in the 21th Century trading old for new - - PowerPoint PPT Presentation

Gas Market Restructuring in the 21th Century trading old for new shibboleths

Richard O’Neill Chief Economic Advisor Federal Energy Regulation Commission Regulation, Industry Structure, and Market Power Conference Gold Coast, Australia 31 July 2003

December 11, 2008 2

The paradigm shift problem The paradigm shift problem

• f Urban VIII
• f Urban VIII

1543: Copernicus publishes a book claiming the earth revolves around the sun then dies. Church doctrine: earth is the center of the universe Early 1600s: Bruno burned at the stake Galileo develops telescope, observes the universe and irritates the Jesuits Cardinal Barberini supports Galileo 1632: Dialogue is published; bubonic plague 1633 Urban orders Inquisition of Galileo Urban probably agrees with Galileo, but will be seen as weak if he supports him. Guilty!

December 11, 2008 3

Post Galileo: Post Galileo: the quantum mechanics the quantum mechanics

Cardinal Barberini was Urban: where you stand depends on where you sit. 1642: Galileo dies; Newton is born Newton discovers gravity and the calculus continuity and certainty rule 1835: Dialogue removed from the Index 1992: John Paul II accepts to Galileo’s empirical approach to science

December 11, 2008 4

does science get it right the first time? (Paradigm shifts we have no-ed and loved)

History books don’t always document the mistakes

2000+ years of Aristotelian logic

geocentrism: Aristotle, Ptolemy, Church, heliocentrism: Copernicus, Galileo Galileo’s telescope provides damaging evidence ether: Aristotle, Maxwell atom: Democratius, Aristotle, Thomson (plum pudding),

Bohr, Heisenberg, Pauli (spin)

phlogiston/oxygen: Priestley, Lavoisier 1905: Albert E introduces relativity quantum mechanics Albert E: God does not play dice with the universe discontinuity and uncertainty rule

December 11, 2008 5

The politics of paradigm shifts

“there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its outcome, than to take the lead in introducing a new order of things” Niccolo Machiavelli Marx, Hayek, Keynes, Schumpeter Lenin, Thatcher, Reagan, Gorbachev Tipping point: Do you need a crisis?

December 11, 2008 6

It is about choice

socialism capitalism State monopolies Many: heavy industries Few: roads, airports cooperatives many Allowed but few planning Central Collusion is illegal

December 11, 2008 7

Transitioning from Transitioning from planning and cost planning and cost-

• based regulation to

based regulation to markets and market markets and market-

• based regulation

based regulation

December 11, 2008 8

All markets are regulated the policy question is how?

☯Contracts and Property rights : common law

☯eminent domain

☯Institutional rules: SEC, CFTC, … ☯Antitrust (monopoly): collusion

☯Does Nash behavior violate antitrust law? no

☯Utility regulation: just and reasonable prices ☯Punishments for illegal behavior

☯Restrictions on behavior ☯disgorgement of profits ☯compensation of harm ☯Fines and jail time

December 11, 2008 9

Market structure dictates efficient regulation

☯Concentration ☯Supply functions depend weather, e.g., storms in Gulf Coast ☯Demand functions depend on weather, heat and cold ☯Market mechanisms ☯Contracts structure ☯credit

December 11, 2008 10

The Evolution of Natural Gas Market Structure

Joint ventures between producers and local distribution companies Producers exit joint ventures Some LDCs sell pipelines Some don’t: Dominion Resources, Nicor, National Fuel Gas

December 11, 2008 11

BIRTH OF U.S. FEDERAL REGULATION

Pre-1930s: State and local regulation

Fair value principle as in tax value or eminent domain

value (Smyth v. Ames 1898)

inflation: history of deflation; inflation < 1% Cost-of-service (Sam Insull's answer)

THE 1930s ENERGY LAWS: Regulation to Fill Gaps

Public Utility Holding Company Act (1935): repealing Federal Power Act (1935) and Natural Gas Act (1938) Set just and reasonable rates Change rates is found not just and reasonable Monitor with systematic reporting Certificate pipelines (NGA) Approve mergers (FPA)

December 11, 2008 12

1970s ORIGINAL COST-OF-SERVICE RATEMAKING BREAKS DOWN

Increasing energy prices lead to cost trackers

(PGAs and FACs)

Over regulation leads to shortages and curtailments Bad forecasting and Resource depletion theories: Chicken Little theory/ contrary empirical evidence High inflation: 7% per year

National Security and Resource Depletion Laws: Fuel Use Act (1978): repealed Natural Gas Policy Act (1978): only Title 3 is active Public Utility Regulatory Policies Act (1978):

cogeneration and renewables -> stranded costs

December 11, 2008 13

Order 380(1983): take-or-pay/min bills eliminated Order 436(1986): training wheels for competition

Spot market development commodity markets and interruptible transportation Regulated commodity markets as a recourse Decreasing energy prices lead to take-or-pay Deregulation and the non-fly-up (1985) New resource non-depletion theories:

• technological progress

Lower inflation: 5% per year Bad forecasting

The Wellhead Decontrol Act (1989): easy

1980s: PUNCTUATED EVOLUTION Natural Gas Open Access

Making an aquarium from fish soup

December 11, 2008 14

Wellhead Gas Price Forecasts from 1980 to 1990

(1995 $/Mcf)

Forecast Forecast Forecast 15 Years Out 10 Years Out 5 Years Out Forecast for 1995 for 1990 for 1995 for 1985 for 1990 for 1995 in 1980 in 1980 in 1985 in 1980 in 1985 in 1990 EIA 5.98 5.19 5.90 3.45 4.11 2.65 DOE 8.06 6.72 5.95 5.60 3.82 2.74 DRI 15.46 11.23 4.28 5.60 2.80 2.39 AGA -- 6.34 3.63 7.65 3.27 2.42

Average

9.84 7.37 4.94 5.57 3.50 2.67

Actual

1.59 1.96 1.59 3.44 1.96 1.59 Avg/Act 6.19 3.76 3.11 1.62 1.79 1.68

Sources: Energy Information Administration (EIA), Department of Energy (DOE), Data Resources Incorporated (DRI), American Gas Association (AGA) and Gas Resources Institute (GRI).

December 11, 2008 15

1990s: electric open access

market evolution for gas

Order 636's strong comparability (full unbundling) Energy Policy Act (1992): wholesale electric access 1993-1997 (Post-636/pre-LDC open access):

Active in the market Less active at FERC: where have all the rate cases gone? secondary markets: capacity release and gray markets Downstream market centers Order 636 contracts

Full pipeline open access; weak comparability Canadian imports grow from 1 to 3 Tcf (1985 to 95) Order 888 (1996): open access in electric markets Order 637(1999): greater tradability for trans O2K(1999): RTO Rule separation and larger markets retail access: electric and gas; were they ready?

December 11, 2008 16

Order 637

@e-commerce

@EBBs become Web sites: still MtoM @posting of daily transactions and capacity

efficient primary rates:

term differentiated,seasonal

equality of secondary market

no max rate for release encourages voluntary e-auctions with MBR segmentation if operationally feasible imbalance trading

December 11, 2008 17

Virtual pipelines Virtual pipelines

= segmentation equality = nomination and confirmation equality = more primary firm = full tradability = better information = imbalance markets = no harm/no foul penalties = incentives to limit OFOs efficient markets

December 11, 2008 18

MARKET CENTERS ENHANCE EFFICIENCY AND RELIABILITY

Increasing access to sources of gas and capacity

pipelines often have highly correlated demand makes short-term deals and long-term deals easier creates deeper markets

Lowering transactions costs

reduced search costs and faster market response real price information simplifying multiple pipeline exchanges

Lowering reaction time in emergencies Using multiple system responses

greater aggregation through market centers

• ne storage facility can serve many pipelines

December 11, 2008 19

Calgary, Alberta Overthrust Permian Panhandle/Hugoton

Chicago

Detroit New York Leidy Niagara Texas Gulf Coast

South Louisiana Kern

Atlanta

$.77 to 3.16 $.32 to 2.57 $.67 to 5.42 $.01 to 3.46 $.09 to .82 $.07 to 2.48 $.06 to 1.17

San Juan

$-.03 to 2.76

Lebanon

$-.05 to 1.22

North Louisiana/East Texas

$-.31 to 2.32 $.06 to 1.79 $.25 to .64 $.03 to .30 $-.83 to .11 $.01 to .97 $-1.46 to 1.55 $-.80 to .20 $-.59 to .20 $.31 to 5.28 $-.18 to .65 $-.15 to .34 $-.08 to .20 $.17 to 4.36 $-.02 to .90 $-.02 to .90 $-.04 to 1.25 $.03 to 2.15 $-1.67 to 1.01

Source: Natural Gas Week. Data through December 30, 1996.

Notes: Monthly average prices for selected delivery points. Prices for Alberta and Niagara are for Canadian spot transactions of 12 months or less. Prices used Detroit are from Columbia Gas at Maumee, Ohio. Spot prices reflect transactions of 31 days or less. Monthly price is the median of the prices assigned to a

Range of Average Monthly Natural Gas Price Differences 1995-96 in $/MMBtu

market center area

MARKET CENTER SERVICES

Wheeling Parking Loaning Storage Gas Trading Title Transfer

December 11, 2008 20

Pipeline transportation study(INGAA)

Transportation capacity holders(1999)

gas LDC only: 38% combined utility: 21% marketer: 26% affiliate marketer: 9% IPP/indust/pipe: 14% firm expiring by 2005: 51% capacity release: 16% IT from 87% in ‘87 to 11% in ‘97 gray market????

December 11, 2008 21

INGAA discount study

(2000)

capacity release

54 to 57% discounted(includes assignments) average discount 59%

primary capacity

25% discounted average discount 43%

• nly 6% to affiliates

no difference in discounting to affiliates!!!!

December 11, 2008 22

What determines the price of gas? What determines the price of gas?

☯long-term

☯floor: finding and delivery costs ☯ceiling: coal, no. 6 oil, no. 2 oil, electricity ☯environment

☯short-run

☯weather ☯ oil prices ☯ hydro

December 11, 2008 23

History of Price discovery

Early 1980s: trade press editor publishes prices to stop large volume of phone calls Price reporting becomes a significant profit center Is te trade press compromised? Pricing anomalies

Henry hub and Chicago: cover fuel costs Atlanta and New York: arbitrage Permian Basin and California border: manipulation

Late 1990s: system breaks down

December 11, 2008 24

‘Wall Street’ in the late 1990s: easy money

Too much money chasing too few good investments Equity analysts shade analysis to get bonus based

• n investment business

the ‘new’ economy: dot.coms and energy traders gross revenues become more important than profits!!!! New theory: Profits follow revenues Why aren’t all companies following Enron? Late 1990s: system breaks down Early 2000s punishing this behavior with a vengeance

December 11, 2008 25

Financial accounting succumbs to affiliate consulting incentives

Book (lamppost) cost: wrong measure but hard to manipulate Market to market: correct measure but easier to manipulate Market to hypothetical market: bad measure but easier to manipulate Market to magic

December 11, 2008 26

portfolio schizophrenia: spot v. contract

PUC test on hedging: Spot is prudent

Lower than spot: at a boy High than spot: disallowance/prudence hearing

Result: buy spot Decision framework with and without forward

contracts

Without forward contract

play the spot market defer capital expenditures

With forward contract: hedge input prices

put gas in storage to hedge commitment capital expenditures to meet commitment

December 11, 2008 27

The Index Game

State commissions declare index purchasing prudent Distcos purchase at index with index schemes Large portion of trades on index Fixed price trading thins Fixed price market becomes an attractive nuisance for manipulation

December 11, 2008 28

The price discovery breakdown

‘statistical’ validity questioned

All trade press report essentially the same number Sampling is voluntary not random

What does it mean to sign a forward contract to be settled at the spot index price? Fixed priced market thin: 3% of trade An invitation to gaming traders fib: it’s wire fraud!!!! Wash and round-trip trades inflate ‘revenues’ and distort reported prices Trade press claims it filters them out based on intuition Answer: auction markets

December 11, 2008 29

Value of affiliates

Scope economies: theory v. practice

Small firm exception For large firms mostly theory

Incompatible incentives

For-profit lowers costs Cost-based raise costs Move costs to utility; move revenues to for-profit

Chinese Walls, Ring Fences and other rules Damage to competition Favoritism can be real or imagined Successes? v. failures (many) settlements: Williams/Transco and El Paso

December 11, 2008 30

Cost-based regulated entity market- based regulated entity

Revenues Information Loans Personnel Discounts favoritism

Costs and risks

The Affiliate Game The Affiliate Game

December 11, 2008 31

The Enron phenomenon

Enron transforms itself from pipeline co. to trader Wall Street encourages Enron clones intense lobbing for unfettered markets without any transition mechanism. Enron online: Enron told the Comm it was a bad idea? Greed overwhelms reason

December 11, 2008 32

Williams/Transco Claims and Settlement

Improper posting of discounts affiliates use information and computer systems not available to others Poor recordkeeping; Confusing organization charts Admits no wrong doing but agrees to $20 million civil penalty to US Treasury No new affiliate contracts No information preferences Four year plan for compliance: Employee training

December 11, 2008 33

El Paso Problem

El Paso gets exceptions from open access (Order 636) Bad incentives California markets are badly designed with bad incentives Claim: affiliate marketer overcharged by $3 Billion via pipeline withholding

December 11, 2008 34

El Paso proposed Settlement

Admit no wrong doing Cash and stock in millions

Cash: $100 to Cal; $65 to Nev; $23 to Wash; $17 to Or $2 from officer bonus pool $125 in El Paso stock $22 over 20 years (50% in stock)

Discounts and renegotiation in millions

Gas delivery at discounts($45/yr over 20 yr) Power contracts: $125 reductions

Other

Maintain 3.3 bcf/day capacity at cal border No affiliate deals for 5 years Antitrust training

December 11, 2008 35

IDACORP settlement

$5.9 million in refunds Affiliate

scheduled transactions as native load Had access to information that non- affiliates did not

December 11, 2008 36

National Fuel

Charged with preferential information to affiliate Admits no wrong doing but agrees to Pay $300K to cover the investigation costs No information preferences three year plan for compliance

December 11, 2008 37

Recent pricing problems

☯California ☯US ☯Reporting confidence ☯1990s v. 2000s ☯Drilling lagged response: 3 to 6 months

December 11, 2008 38

100 200 300 400 500 600 700 800 900 J a n u a r y

• 9

J a n u a r y

• 9

1 J a n u a r y

• 9

2 J a n u a r y

• 9

3 J a n u a r y

• 9

4 J a n u a r y

• 9

5 J a n u a r y

• 9

6 J a n u a r y

• 9

7 J a n u a r y

• 9

8 J a n u a r y

• 9

9 J a n u a r y

• J

a n u a r y

• 1

J a n u a r y

• 2

J a n u a r y

• 3

200 400 600 800 1000 1200

Natural Gas Price at the Henry Hub Rigs Drilling for Gas

December 11, 2008 39

Average Regional Natural Gas Spot Prices 1999-2001

2 4 6 8 10 12 14 16 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Dollars per MM Btu

Rockies Texas Oklahoma Louisiana Appalachia

December 11, 2008 40

California Natural Gas Prices in 2000

Prices peak at $60/MMBtu Gas prices for the second half of 2000 were more

than four times higher than 1998 and 1999 prices

$20 $40 $60 Jan Feb

M a r

Apr

M a y J u n J u l A u g S e p O c t N

• v

D e c

$/MMBtu

December 11, 2008 41

Recent History

2002

Consumption: 23.2 Tcf Imports: 16% of consumption (3.8 Tcf/yr) Exports: 2% (Canada, Mexico, Japan) Household conservation: 106 (‘80) to 83 (’01) mcf/yr

2003

High prices: Demand response: chemical plants shut down will gas be available for reliable electric power Electric generators switch to coal and oil

December 11, 2008 42

Future: 30 Tcf? At $5/mmbtu?

LNG: Future 10-15% at $3to 4/mmbtu

‘like production’: `No regulation’ for imports environmental review? Take a netback from the Henry Hub

‘sequestered’: don’t ‘drain America first’

Artic: economics; since 70s mantra $5/mmbtu

• ffshore areas except western Gulf of Mexico

Certain areas in the Rocky Mountains

December 11, 2008 43

US Gas security and markets

Will gas be available for reliable electric power? NERC redispatch market failure Terrorism: automatic eminent domain Curtailments: markets Monitoring and mitigation