The natural gas industry and interest rates

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RWORTH E M A N

Energy Poli¢T. Vol. 23, No. 9, pp. 781--787. 1995 N

0301-4215(95)00069-0

Copyright CO1995 Elsevier Science Ltd Prinled in Great Britain. All rights reserved 0301-4215/95 $10.00 + 0 O0

The natural gas industry and interest rates FERC Order 636

Yong J Yoon Public Service Commission of the District o f Columbia, Washington, DC, USA

in discussing the impact of Federal Energy Regulatory Commission (FERC) Order 636, the latest rule on the restructuring and deregulation of the US natural gas industry, the effect of interest rates on the success of the FERC policy is often overlooked. The thesis of this paper is that interest rates play an important role in integrating seasonal gas markets and in stimulating investment in storage infrastructure. We propose a model to analyse the equilibrium condition for an efficient gas market. Also analysed are the implications of pipeline rate design of FERC 636 for gas despatch decisions. Keywords: FERC Order 636; Storage service; Interest rates

Regulatory policies can have large impacts on the industries to which they apply. While Federal Energy Regulatory Commission I (FERC) Order 636 (released on 8 April 1992), the latest FERC rule on the restructuring and deregulation of the US natural gas industry, is being implemented, the gas industry undergoes uncharted changes. In discussing the changes in and the impacts of the FERC rules, what often is overlooked is the effect of interest rates on the success of the FERC policy. Interest rates, however, play important roles in integrating seasonal gas markets. FERC Order 636 requires interstate pipelines to unbundle merchant (sales) and transport services and to provide open access to end users. These changes will presumably promote competition at the wellhead and create a national gas market. Gas prices vary considerably by season. Summer spot gas, being off seasonal, is relatively inexpensive and winter spot gas is more expensive because of its seasonal demand for heating. The two spot markets are usually considered segregated markets. tThe Federal Energy Regulatory Commission is an independent US government agency that oversees the USA's natural gas industry, electric utilities, hydroelectric projects and oil pipeline transportation system.

Under the ruling of FERC, gas storage will play an important role in integrating the seasonal markets. Gas storage services become attractive when short-run interest rates are low, and low long-run rates will stimulate investment in storage infrastructure. Industrial customers of natural gas have already benefited from the deregulation. For instance, in the state of Maryland, average annual burner tip cost of gas has declined by 40% during the last 10 years, between 1984 and 1993.2 The thesis of this paper is that such benefit was possible because of the low interest rates and that the benefit will be much reduced if interest rates continue to rise as we are observing now. We trace these implications using a simple model. The next section describes the natural gas industry and the essence of FERC Order 636. This section determines the equilibrium condition for an efficient gas market. The condition is simply that the price differential between winter and summer spot gas is equal to the interest rate plus the storage cost. The industry equilibrium is then discussed in the context of financial markets. The 2See Maryland Public Service Commission (1994).

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The natural gas industry and interest rates: Y J Yoon

fourth section presents a model for a local gas distribution company, in which the cost minimization by gas distribution companies is consistent with the industry equilibrium condition obtained previously. This section analyses the implications of pipeline rate design of FERC 636 for gas despatch decisions. The final section draws relevant conclusions.

FERC Order 636 and gas industry equilibrium FERC Order 636, known as the restructuring rule, makes significant changes to the structure of services provided by interstate natural gas pipelines. The changes are intended to maximize the benefit of the competitive wellhead gas market. To analyse gas industry equilibrium in the postFERC 636 period, we discuss the salient features of that order. Previously, interstate gas pipelines combined merchant (sales) and transport functions between upstream gas producers and downstream end users. FERC Order 636 requires the pipelines companies to unbundle sales and transportation services by providing open access to end users, and to move to a straight fixed variable 3 (SFV) rate design. The structure and operational characteristics of the gas industry will be significantly affected by these FERC rules. Even before Order 636, the gas industry had been undergoing changes. By 1991 nearly 80% of gas was sold under transport arrangements rather than as bundled pipeline sales.4 Gas wellhead prices were deregulated, 5 and markets for spot gas and financial futures had developed. A major impetus for unbundling was that unbundling allows for the transport of cheaper gas throughout the year. This was based on the FERC finding that during winter peak periods, most buyers prefer to buy the gas from sellers other than pipelines and have it transported by the pipelines. In the past, interstate pipelines insured that promised quantities of gas were delivered to the city gate, while the role of a local distribution company (LDC or gas company) was limited to the distribution of gas. Gas companies now have to secure both natural gas and the capacity to deliver it. FERC 636 requires different pipeline rate resign to incorporate this feature.

Straight fixed variable and storage gas The contract between a local distribution company and pipelines for delivery of gas has two price components3The SFV rate design separates the fixed and variable costs of gas services provided by pipelines. See below for more on SFV. 4See, for instance, Primer on Gas Integrated Resource Planning (1993). 5See Phillips (1993) pp 701-702.

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the 'demand charge' and the 'commodity charge'. Only the commodity charge depends on the volume of gas, while the demand charge is a capacity reservation fee that reflects fixed costs. The SFV rate design in FERC Order 636 requires that all fixed costs associated with pipeline transport service be recovered in a demand charge. 6 The previous modified fixed variable (MFV) system allocated some portion of fixed costs to the commodity charge. The move to SFV rates implies that the reservation fees for peak capacity become higher. This will encourage gas companies to look for less expensive ways to obtain gas services. For instance, storage resources can be considered an alternative to pipeline supply. Unlike with the electricity, natural gas can be stored relatively inexpensively in both gaseous and liquid states. 7 In the USA, gas storage meets about 30% of peak day demand. Storage has some general functions for gas companies: (!) daily (supply and demand) balancing; and (2) seasonal balancing by meeting part of demand in peak winter season and peak day protection. Additionally, having storage facilities is usually more economic than relying on pipeline capacity alone, because the inexpensive gas supplies available in off-peak periods can be stored and used in times of higher prices. Before FERC Order 636, gas companies received storage services as part of bundled pipeline sale, but now they have to buy storage services on an unbundled basis. After FERC Order 636, LDCs have more supply options but face more risks. LDCs manage the risks by complementing gas supply contracts with financial contracts 8 such as futures and options. Given the move to SFV pipeline rate design, LDCs and other entities might consider investments in storage infrastructure. As a result of increased investment in storage facilities and risk spreading made possible by financial contracts, the gas industry will reach an equilibrium after some transition period. We characterize the equilibrium conditions.

Gas industry equilibrium We characterize gas industry equilibrium by relating interest rates to the price differential between winter and 6For further description of demand charge and other contractual provisions, see Bonbright et al (1988) or Phillips (1993). 7Except in North America, however, gas is extremely expensive to store. Investment in new storage facility is still active in North America, but pipeline is a limiting factor. The demand charge for storage service is in the range of US$5-10 per therm, which could be a proxy for the capital cost of a new storage facility. SSince April 1990, a natural gas futures market has been open on the New York Mercantile Exchange (NYMEX). The futures market performs two functions for the gas industry: price discovery and risk sharing.

The natural gas induso y and inteJ~est rates: Y J Yoon

summer spot gas. This relationship can be obtained by an argument based on 'no arbitrage condition'. No arbitrage condition means that an efficient market does not allow a positive return to an arbitrageur who holds zero net investment in assets by combining long and short positions simultaneously. Suppose an arbitrageur borrows from the bank and purchases one additional therm 9 of natural gas in the summer by paying the spot pricep.~. By paying c (storage cost) dollars he injects the gas into storage. In the winter, the spot price rises to Pw because of higher demand in the winter. No arbitrage condition requires that arbitrageur's return, the winter spot price net of the storage cost, is just enough to make the payment to the bank, the principal and interest payment:

\ \\\ \\\

if_

Supply

Therms of gas (Sin or W) F i g u r e 1 Natural gas supply and demand at the wellhead

pw-c

= (! + r)p,~

(1)

where r is the short-term interest rate. By rearranging the terms, we obtain the equilibrium condition in a more convenient form:

for the summer and (3)

Pw = D ( W - S )

Pw-Ps =Ps r+ c or

[ p w - p s ] / p . , = r + c&.~

p~ = D( S m + S )

(2)

Equation (2) says that in equilibrium, the expected seasonal price differential is equal to the interest rate plus the storage cost. The price differential is determined by the supply and demand conditions at the wellhead. We further elaborate the industry equilibrium in the next section.

The gas industry and interest rates The demand for summer spot gas at the well-head consists of gas consumption in the summer and gas purchase for the storage purpose. The demand for winter spot gas at the wellhead consists of additional gas consumption in the winter beyond the storage gas. The storage cost in our model reflects the long-run marginal cost of investment in storage infrastructure, and investment in infrastructure is a function of the long-term interest rates. I° Thus the storage cost is exogenous to the industry equilibrium condition in Equation (2). Formally, the demand for gas, denoted by function D, at the wellhead can be described by the following equations: 9Therm is a unit of heat equivalent to 100 000 British thermal unit. The heat content of about 100 ft3 of natural gas is one therm, See Gas Facts"

1994. I°lnterest rates affect the operation of an LDC through revenue requirements which reflects the bond rates and stock returns of the LDC.

for the winter where S,, is gas consumption in the summer, S is the storage gas and W is gas consumption in the winter. Figure 1 depicts the determination of equilibrium at the wellhead. The dotted demand curves show demand at the well-head when the winter and summer markets are completely segregated, with zero level of storage gas. The price~luantity pair A, in Figure 1, denotes the summer equilibrium, and B denotes the winter equilibrium. If the gap between these two prices is greater than the cost, rps + c from Equation (2), then the storage gas becomes attractive to LDCs. If this condition persists, there is the need for market integration and incentive for investment in storage infrastructure. As storage gas is purchased in the summer, the demand curve for summer spot gas shifts up; likewise, the demand curve for winter spot gas shifts down, until the two markets are integrated. If there is adequate storage capacity in the industry, the new summer equilibrium will be A ', the winter equilibrium will be B" and the price gap will be exactly equal to rps + c, from Equation (2). If storage capacity is not sufficient, the equality in Equation (2) will still hold with higher storage charges, and there will be additional investment in the storage infrastructure. In this analysis, we note that interest rates have impact on the gas industry through the storage gas. The effect of interest rates on the gas industry, either through domestic monetary policy or international currency markets, did not attract much attention so far. The fall of the dollar in June 1994, for instance, caused confusion in Energy Policy 1995 Volume 23 Number 9

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The natural gas industry and interest rates: Y J Yoon

Table ! Rising Interest rates and falling dollar Year/month

1991 1992 1993 1994 January February March April May June July August September October November December

Exchange rate Yen per dollar

Interest rates Short-term

Long-term

134.6 126.8 I I 1.08

5.86 3.89 3.43

8.16 7.52 6.45

I 11.4 106.3 105.1 103.5 103.75 102.5 98.4 99.9 98.8 98.3 98.0 na

3.39 3.69 4.11 4.57 5.03 4.98 5.17 5.25 5.38 5.72 6.09 6.75

6.29 6.49 6.91 7.27 7.4 I 7.40 7.61 7.49 7.79 8.02 8.16 7.97

Sources: Exchange rates are from Federal Reserve Bulletin, International Statistics, January 1995. Interest rates are from Federal Reserve Statistical release for interest rates. The short-term rates are US government Treasury bills l-year. The long-term rates are US government securities/composites/over 10 years (long-term).

the international finance market and raised concerns about domestic monetary policy. The USA has enjoyed low interest rates since 1990. However, a tendency to higher interest rates is shown in Table 1. The dollar has declined in value since 1985. Ten years ago a dollar bought 250 Japanese yen, and in September 1994 it buys less than 100 yen, the lowest value for half a century.1 l Some analysts even speculated that to strengthen the dollar, the Federal Reserve Bank might increase the returns on dollar denominated assets by increasing interest rates. The analysis in this paper shows that a policy which makes sense in a low interest rate environment may fail to work in higher interest rate situations. High interest rates discourage dispatch of storage gas and investment in storage infrastructure, and the winter versus summer price differential will not be reduced. This will make FERC rules less effective in achieving an efficient gas market. The benefit of unbundling and creating a national gas market will be limited, because summer and winter spot gas markets will remain separate markets.

The gas dispatch model The equilibrium in the gas industry presented above can be viewed as the result of economizing behaviour of local distribution companies in the gas industry. In this section, we formulate a model for gas dispatch decisions by an individual gas company. A gas company selects a portfolio of gas supply options to minimize the cost of meeting the demand at a tolerable risk. The storage gas | ISee Krugman (1992) for different explanations offered by economists.

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plays an important role in this process. In this setting, we derive implications of FERC Order 636, especially the SFV pipeline rate design. A gas company purchases spot (fieldline) gas and arrange for transport to the city gate. Alternatively, purchased gas can be injected into storage for delivery later. For transportation from the city gate to the end user, LDCs use their own distribution systems. We formulate gas company's portfolio by first describing the features of contracts. Optimal portfolio o f gas supply options

Gas procurement decisions begin with LDC's assessments of gas demand 12 (or load). The load forecast specifies the number of therms required for the peak day (we assume one day in January) for the summer and winter seasons. The level of peak day therms (required on the peak day) is denoted by P and the summer and the winter therms are designated by S m and W respectively. The winter therm total W includes the peak day demand. The gas company considers three major types of resources. They are finn transport (FT), storage service (SS) and interruptible transport (IT).13 Firm transport contracts 14 specify the maximum daily quantity and number of days for gas entitlement. The contract also specifies its demand charge and the commodity charge. 15 The demand charge corresponds to the fixed costs of the pipeline company and depends on the amount of maximum daily entitlement. The commodity costs correspond to the variable costs and depend on the actual withdrawal of gas. For a simple exposition, commodity charges for FT and SS are ignored in the model. The contract provisions for finn transport are listed below: f MF DF

= demand charge (dollars per therm) = maximum daily quantity (in therms) = number of days of gas entitlement

During the summer season when the spot gas is relatively inexpensive, the entitled gas can be injected in storage. Storage service has contract provisions for a demand charge, a maximum daily quantity, and the number of days of gas entitlement as listed below:

12This should not be confused with the estimation of a demand function. 13Other supply resources are propane plant, used for peak-shaving device, and interruptible service which can be curtailed during the system peak when burdensome conditions arise to LDC. 14Firm service is interrupted only under circumstances beyond the control of the pipeline. Such incidence does not incur liability for nonperformance. For details, see Bonbright et al (1988) or Phillips (I 993). 1SNore that commodity charge here does not include the cost of gas itself.

The natural gas industry and interest rates: Y J Yoon

s MS DS

Resources

= demand charge (dollars per therm) = maximum daily quantity (in therms) = number of days for gas entitlement

FirmT ~

Interruptible transport provides services on a 'best efforts' basis and is not as reliable as FT or SS. The IT service is purchased in the winter and does not require demand charges. The contract provisions involve only commodity charges that depend on the volume of gas delivered: 1 cc

(4)

subject to F < M F and S < M S

where the two inequalities are resource constraints imposed by the contract provisions. During the summer season, the gas company purchases S m therms for summer consumption and X therms for storage service. Thus the amount of gas purchased in the summer season is S m + X, and the despatch condition can be expressed by: Sm < MF*DF

and (5)

The winter load, W including the peak therm, is met by three resources: the storage gas (X), additional FT contract service (Z) and interruptible transport (1). The dispatch condition is: X+ Z + I = W

Storage service

~,

~

P(peak)

W (winter)

Figure 2 Seasonal demand and contract resources a

Given the load forecast and the contract provisions, we can calculate the costs of meeting the seasonal demands. Summer gas consumption is met by FT, and winter consumption is met by all three types of contract - FT, SS and IT services. The relationship between seasonal load and contract resources is summarized in Figure 2. The peak day therm level (P) is met by the maximum daily quantities for firm transport and partly by storage services. If the gas company chooses Ftherms of FT and S therms of storage service for the peak day requirement, the condition for a peak day gas dispatch is:

X= MS*DS

Sm(summer)

Int T

= annual entitlement of therms = commodity charge per therm

F +S=P

Seasonalgas

(6)

In addition to these constraints, Equations (4), (5) and (6) for seasonal gas demand, we complete the resource

aT is an abbeviation for transport; Int T is interruptible transport services.

constraints by adding the resource constraint for firm transport (FT) contract, S m + Z <_ M F * D F

(7)

In calculating the total costs, it is convenient to sort out the costs by demand charges (capacity costs), commodity charges, and the costs of the gas. In our model, the demand charges are s * M S * D S + . f * M F * D F ; the commodity charges are cc*l; and the expenses for purchasing spot gas are ps(Sm + X ) in the summer and p w ( Z + I) in the winter; the spot gas prices are Ps for the summer and Pw for the winter. These three types of costs are the main components of the total costs. Another cost item in the total costs is the cost of risk introduced by the cheaper but less reliable resources, storage and IT services. Firm transport service is most reliable, and interruptible transport is least reliable. This is incorporated in the relative sizes of demand charges and commodity charge:f> s > co. This risk becomes an important consideration for LDC's gas procurement after the FERC Order 636. The risk introduced by storage and interruptible resources are captured by function R(X, 1), which measure the risk in dollar terms when X therms of storage service and I therms of IT service are dispatched. The risk function, R(X,1), is increasing in both arguments and reflects the gas company's risk aversion: that is, Rj > 0, R 2 > 0, and Rll > 0, and R22 > 0, where R i iS the first derivative and Rii is the second derivative of R with respect to argument i. The cross term is ignored. Now the total cost (TC) can be expressed in present value terms as follows: TC

= demand charges + risk costs + commodity charges + gas costs = f * M F * D F + s * M S * D S + R ( X , I) + cc*l + ps(Sm + X ) + pw(Z + I ) / ( 1 + r) (8) Energy Policy 1995 Volume 23 Number 9

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The natural gas industry and interest rates: Y J Yoon

or

TC = f * M F * D F + s * M S * D S + p~Sm + pwW/(l + r) + R(X, I) + cc*I + X [ P s - P w / ( l + r)] (9)

We obtain more first order conditions and analyse implications of the pipeline rate design (SFV) in FERC 636. Further implications o f FERC 636

where r is the short-term interest rate. Equation (9) was obtained from Equation (8) by noting that the winter consumption, W, is met by storage gas, firm transport (Z), and interruptible services: X + Z + I = W from Equation (6). We now have a complete formulation of the problem. The objective of the gas company is to minimize the total cost in Equation (9), subject to the constraints in Equations (4) to (7). This problem can be solved by standard techniques in mathematical programming. Formally, given parameters of the contract provisions, choose X, Z and I to minimize the total costs in Equation (9): TC = f * M F * D F + s * M S * D S + psSm + pwW/(! + r) + R(X, I) + cc*I + X ~ , - p w / ( 1 + r)] (10)

subject to P < M F + M S from Equation (4), X < M S * D S from Equation (5), W < X + Z + I from Equation (6) and S m + Z < M F * D F from Equation (7). The first order conditions can characterize optimal dispatch decisions using a Lagrangian: L = TC + ct(MF + M S - P) + ~ ( M S * D S - X ) + ~ ( X + Z + I - W) + I x ( M F * D F - S m -Z)

(il)

and dL/dX = d T C / d X - ~ + = - [pw/( l + r ) - p s ] + RI(X, I) - ~ + ~ = 0 d L I d D S = (s + ~)* M S = 0

and d L / d I = cc + R2(X, I) + a =O

By solving the algebra above, we obtain pw/(l + r ) - p s = Rl(X, I ) - ~ + a = RI(X, I) + s - c c - R 2 ( X , I )

(12)

Equation (I 2) is equivalent to the industry equilibrium condition we obtained in Equation (2). This is because, after an adjustment for risks, R I (X, 1) - R2(X , I), the term (s - cc) is the net storage cost, or the difference between the unit cost of storage (s) and the cost (co) of transporting the gas from the wellhead to the city gas by interruptible service. 786

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The rate design SFV for pipelines as directed in FERC Order 636 can be analysed by Equations (10) and (11 ). Our focus is that the move to SFV from MFV implies an increase in the demand charge (f) of the FT service. This is because there will be a trade-off between reliability and cost savings. In addition to first order conditions in Equation (11), consider dL/dDF = ( f + Ix)*MF = 0

and dL/dZ = cr - Ix = 0 which, together with Equation (11), implies f = cc + R 2. This means that the opportunity cost (f) of the FT service is equal to the demand charge of IT and the risk cost. Substituting this relationship into Equation (12), we obtain, pw/(i + r) - P s = s + RI(X, I) - f

(13)

Based on Equation (13), we argue that the demand for the storage service will increase when the demand chargefincreases. Since the left-side of Equation (13) is exogenous to a gas company, the equality can be maintained only by an increase in storage service, X. As the demand charge (pc)rises, storage services will replace FT services in the winter until the increased risk cost just balances the advantage of the lower demand charges of the storage gas. This is because R is increasing in Xas a result of risk aversion. On the other hand, as the unit cost of risk R l increases, the equality in Equation (12) is violated. To maintain the equality, R 2 has to rise, or interruptible transport service,/, has to increase. Thus, as a result of FERC 636, firm transport services in the winter will be partly replaced by SS and IT services. Our discussion of the supply side of the gas industry was minimal in this paper. I only mention it briefly and leave it for future research. Since Hotelling (1931), the efficient path of exploitation of exhaustible resources has been studied. Martin and Wijnberg (1988), for instance, compute efficient prices of natural gas based on intertemporal optimization. Their main result is that gas will be priced below the fuel oil equivalent price for a significant period until the time of exhaustion. This is because natural gas is not as freely traded as fuel oil across international borders.

The natural gas industry and interest rates: Y J Yoon

Concluding remarks In this paper, I have analysed a model of the natural gas market which integrates the summer and the winter spot markets. The model shows that the two markets can be linked by storage services, although high interest rates will discourage procurement and investment in storage infrastructure. In addition, the SFV pipeline rate design, a feature of FERC Order 636, will encourage investment in storage service. In evaluating the implementation of FERC Order 636, these two fundamental issues have not been discussed in a formal way. Thus the contribution of this paper has been in introducing and addressing these aspects of FERC Order 636 by a tractable model. I believe that the model detailed in this paper is potentially useful for analysing other policy issues. The currently low interest rates provide favourable conditions for implementing FERC's new rules. However, this opportune environment will not be guaranteed when interest rates rise and the dollar's value declines in international currency markets. The more the USA relies on foreign investment to finance debts, the more will it become difficult for formulation of domestic monetary policy to ignore the dollar's performance in international currency markets.

This relationship demonstrates that a traditionally domestic policy can be influenced by international finance.

Acknowledgement The author is an economist with the Public Services Commission of the District of Columbia. The views expressed in this paper do not necessarily reflect those of the Public Service Commission of the District of Columbia and its staff. The author thanks Ellen Brown and Das Purkayastha for helpful comments.

References Bonbright, J, Danielsen, A and Kamierschen, D (1988) Principles of Public Utilities Regulations Public Utilities Reports, Arlington, VA Gas Facts 1994 (1994) The American Gas Association, Arlington, VA Hotelling, H (I 931 ) 'The economics of exhaustible resources' Journal of Political Economy 39 137-175 Krugman, P (1992) Currencies and Crisis MIT Press, Cambridge, MA Martin, R and Van Wijnbergen, S (1988) 'Efficient pricing of natural gas: a case study of Egypt' Journal o f Public Economics 36 177-196 Maryland Public Service Commission (1994) A Framework/br Future Regulation of Gas Services in Maryland Primer on Gas Integrated Resource Planning (1993) National Association of Regulatory Utilities Commissioners Phillips, C Jr (1993) The Regulation of Public Utilities: Theory and Practice Public Utilities Reports, Arlington, VA

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