gas market restructuring in the 21th century trading old for … o'neill... · gas market...
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Gas Market Restructuring in the 21th Century
trading old for new shibboleths
Richard O’NeillChief Economic Advisor
Federal Energy Regulation Commission
Regulation, Industry Structure, and Market Power Conference
Gold Coast, Australia31 July 2003
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December 11, 2008 2
The paradigm shift problem The paradigm shift problem of Urban VIIIof 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!
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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 calculuscontinuity and certainty rule
1835: Dialogue removed from the Index 1992: John Paul II accepts to Galileo’s
empirical approach to science
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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, GalileoGalileo’s telescope provides damaging evidence ether: Aristotle, Maxwellatom: Democratius, Aristotle, Thomson (plum pudding),
Bohr, Heisenberg, Pauli (spin)phlogiston/oxygen: Priestley, Lavoisier1905: Albert E introduces relativityquantum mechanicsAlbert E: God does not play dice with the universe discontinuity and uncertainty rule
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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 MachiavelliMarx, Hayek, Keynes, SchumpeterLenin, Thatcher, Reagan, Gorbachev Tipping point: Do you need a crisis?
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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 isillegal
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December 11, 2008 7
Transitioning from Transitioning from planning and costplanning and cost--
based regulation to based regulation to markets and marketmarkets and market--
based regulationbased regulation
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December 11, 2008 8
All markets are regulatedthe 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
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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
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December 11, 2008 10
The Evolution of Natural Gas Market Structure
Joint ventures between producers and local distribution companiesProducers exit joint ventures Some LDCs sell pipelinesSome don’t: Dominion Resources, Nicor, National Fuel Gas
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December 11, 2008 11
BIRTH OF U.S. FEDERAL REGULATION
Pre-1930s: State and local regulationFair 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 GapsPublic Utility Holding Company Act (1935): repealingFederal Power Act (1935) and Natural Gas Act (1938)
Set just and reasonable ratesChange rates is found not just and reasonableMonitor with systematic reportingCertificate pipelines (NGA)Approve mergers (FPA)
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December 11, 2008 12
1970sORIGINAL COST-OF-SERVICE RATEMAKING BREAKS DOWN
Increasing energy prices lead to cost trackers(PGAs and FACs)
Over regulation leads to shortages and curtailmentsBad 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): repealedNatural Gas Policy Act (1978): only Title 3 is activePublic Utility Regulatory Policies Act (1978):
cogeneration and renewables -> stranded costs
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December 11, 2008 13
Order 380(1983): take-or-pay/min bills eliminatedOrder 436(1986): training wheels for competition
Spot market developmentcommodity markets and interruptible transportationRegulated commodity markets as a recourseDecreasing energy prices lead to take-or-payDeregulation and the non-fly-up (1985)New resource non-depletion theories:
technological progressLower inflation: 5% per yearBad forecasting
The Wellhead Decontrol Act (1989): easy
1980s: PUNCTUATED EVOLUTIONNatural Gas Open AccessMaking an aquarium from fish soup
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December 11, 2008 14
Wellhead Gas Price Forecastsfrom 1980 to 1990
(1995 $/Mcf)Forecast Forecast Forecast
15 Years Out 10 Years Out 5 Years OutForecast 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 2.65DOE 8.06 6.72 5.95 5.60 3.82 2.74DRI 15.46 11.23 4.28 5.60 2.80 2.39 AGA -- 6.34 3.63 7.65 3.27 2.42Average 9.84 7.37 4.94 5.57 3.50 2.67Actual 1.59 1.96 1.59 3.44 1.96 1.59Avg/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).
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December 11, 2008 15
1990s: electric open accessmarket evolution for gas
Order 636's strong comparability (full unbundling)Energy Policy Act (1992): wholesale electric access1993-1997 (Post-636/pre-LDC open access):
Active in the marketLess active at FERC: where have all the rate cases gone?secondary markets: capacity release and gray marketsDownstream market centersOrder 636 contracts
Full pipeline open access; weak comparabilityCanadian imports grow from 1 to 3 Tcf (1985 to 95)Order 888 (1996): open access in electric marketsOrder 637(1999): greater tradability for transO2K(1999): RTO Rule separation and larger markets retail access: electric and gas; were they ready?
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December 11, 2008 16
Order 637
@e-commerce @EBBs become Web sites: still MtoM@posting of daily transactions and capacityefficient primary rates:
term differentiated,seasonalequality of secondary market
no max rate for releaseencourages voluntary e-auctions with MBRsegmentation if operationally feasibleimbalance trading
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December 11, 2008 17
Virtual pipelinesVirtual 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
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December 11, 2008 18
MARKET CENTERS ENHANCE EFFICIENCY AND RELIABILITY
Increasing access to sources of gas and capacitypipelines often have highly correlated demand makes short-term deals and long-term deals easiercreates deeper markets
Lowering transactions costsreduced search costs and faster market responsereal price informationsimplifying multiple pipeline exchanges
Lowering reaction time in emergenciesUsing multiple system responses
greater aggregation through market centersone storage facility can serve many pipelines
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December 11, 2008 19
Calgary, Alberta
Overthrust
Permian
Panhandle/Hugoton
Chicago
DetroitNew YorkLeidy
Niagara
Texas Gulf CoastSouth 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 Differences1995-96 in $/MMBtu
market center area
MARKET CENTERSERVICES
WheelingParkingLoaningStorageGas TradingTitle Transfer
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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 ‘97gray market????
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December 11, 2008 21
INGAA discount study(2000)
capacity release 54 to 57% discounted(includes assignments)average discount 59%
primary capacity 25% discountedaverage discount 43%
only 6% to affiliatesno difference in discounting to affiliates!!!!
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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
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December 11, 2008 23
History of Price discoveryEarly 1980s: trade press editor publishes prices to stop large volume of phone callsPrice reporting becomes a significant profit centerIs 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
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December 11, 2008 24
‘Wall Street’ in the late 1990s:easy money
Too much money chasing too few good investmentsEquity analysts shade analysis to get bonus based on investment business the ‘new’ economy: dot.coms and energy tradersgross revenues become more important than profits!!!! New theory: Profits follow revenues Why aren’t all companies following Enron?Late 1990s: system breaks downEarly 2000s punishing this behavior with a vengeance
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December 11, 2008 25
Financial accounting succumbs to affiliate consulting incentives
Book (lamppost) cost: wrong measure but hard to manipulateMarket to market: correct measure but easier to manipulate Market to hypothetical market: bad
measure but easier to manipulate Market to magic
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December 11, 2008 26
portfolio schizophrenia: spot v. contractPUC test on hedging: Spot is prudent
Lower than spot: at a boyHigh than spot: disallowance/prudence hearing
Result: buy spot Decision framework with and without forward contractsWithout forward contract
play the spot marketdefer capital expenditures
With forward contract: hedge input pricesput gas in storage to hedge commitmentcapital expenditures to meet commitment
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December 11, 2008 27
The Index GameState commissions declare index purchasing prudentDistcos purchase at index with index schemesLarge portion of trades on indexFixed price trading thinsFixed price market becomes an attractive nuisance for manipulation
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December 11, 2008 28
The price discovery breakdown‘statistical’ validity questioned
All trade press report essentially the same numberSampling 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 tradeAn invitation to gaming traders fib: it’s wire fraud!!!!Wash and round-trip trades inflate ‘revenues’ and distort reported pricesTrade press claims it filters them out based on intuitionAnswer: auction markets
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December 11, 2008 29
Value of affiliatesScope economies: theory v. practice
Small firm exceptionFor large firms mostly theory
Incompatible incentivesFor-profit lowers costsCost-based raise costsMove costs to utility; move revenues to for-profit
Chinese Walls, Ring Fences and other rulesDamage to competition Favoritism can be real or imaginedSuccesses? v. failures (many) settlements: Williams/Transco and El Paso
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December 11, 2008 30
Cost-based regulated
entity
market-based
regulated entity
RevenuesInformation
LoansPersonnelDiscountsfavoritism
Costs and risks
The Affiliate GameThe Affiliate Game
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December 11, 2008 31
The Enron phenomenon
Enron transforms itself from pipeline co. to traderWall Street encourages Enron clonesintense lobbing for unfettered markets without any transition mechanism.Enron online: Enron told the Comm it was a bad idea?Greed overwhelms reason
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December 11, 2008 32
Williams/Transco Claims and Settlement
Improper posting of discountsaffiliates use information and computer systems not available to othersPoor recordkeeping; Confusing organization chartsAdmits no wrong doing but agrees to$20 million civil penalty to US TreasuryNo new affiliate contractsNo information preferences Four year plan for compliance: Employee training
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December 11, 2008 33
El Paso Problem
El Paso gets exceptions from open access (Order 636) Bad incentivesCalifornia markets are badly designed with bad incentives Claim: affiliate marketer overcharged by $3 Billion via pipeline withholding
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December 11, 2008 34
El Paso proposed SettlementAdmit no wrong doingCash 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 millionsGas delivery at discounts($45/yr over 20 yr)Power contracts: $125 reductions
OtherMaintain 3.3 bcf/day capacity at cal borderNo affiliate deals for 5 yearsAntitrust training
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December 11, 2008 35
IDACORP settlement
$5.9 million in refundsAffiliate
scheduled transactions as native loadHad access to information that non-affiliates did not
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December 11, 2008 36
National Fuel
Charged with preferential information to affiliateAdmits no wrong doing but agrees toPay $300K to cover the investigation costs No information preferences three year plan for compliance
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December 11, 2008 37
Recent pricing problems
☯California☯US☯Reporting confidence☯1990s v. 2000s☯Drilling lagged response: 3 to 6 months
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December 11, 2008 38
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Rigs Drilling for Gas
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December 11, 2008 39
Average Regional Natural Gas Spot Prices
1999-2001
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Rockies Texas Oklahoma
Louisiana Appalachia
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December 11, 2008 40
California Natural Gas Prices in 2000
Prices peak at $60/MMBtuGas prices for the second half of 2000 were more than four times higher than 1998 and 1999 prices
$20
$40
$60
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December 11, 2008 41
Recent History2002
Consumption: 23.2 TcfImports: 16% of consumption (3.8 Tcf/yr)Exports: 2% (Canada, Mexico, Japan)Household conservation: 106 (‘80) to 83 (’01) mcf/yr
2003High prices: Demand response: chemical plants shut downwill gas be available for reliable electric powerElectric generators switch to coal and oil
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December 11, 2008 42
Future: 30 Tcf? At $5/mmbtu?
LNG: Future 10-15% at $3to 4/mmbtu‘like production’: `No regulation’ for importsenvironmental review?Take a netback from the Henry Hub
‘sequestered’: don’t ‘drain America first’Artic: economics; since 70s mantra $5/mmbtu offshore areas except western Gulf of MexicoCertain areas in the Rocky Mountains
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December 11, 2008 43
US Gas security and markets
Will gas be available for reliable electric power?NERC redispatch market failureTerrorism: automatic eminent domainCurtailments: marketsMonitoring and mitigation
Gas Market Restructuring in the 21th Century �trading old for new shibbolethsThe paradigm shift problem of Urban VIIIPost Galileo: �the quantum mechanics does science get it right the first time? (Paradigm shifts we have no-ed and loved)The politics of paradigm shiftsIt is about choice All markets are regulated�the policy question is how?Market structure dictates efficient regulation The Evolution of Natural Gas Market StructureWellhead Gas Price Forecasts� from 1980 to 1990�(1995 $/Mcf)Order 637 �Virtual pipelinesPipeline transportation study(INGAA)INGAA discount study�(2000)What determines the price of gas?History of Price discovery‘Wall Street’ in the late 1990s:�easy moneyFinancial accounting succumbs to affiliate consulting incentivesportfolio schizophrenia: �spot v. contractThe Index GameThe price discovery breakdownValue of affiliatesThe Enron phenomenonWilliams/Transco �Claims and SettlementEl Paso ProblemEl Paso proposed SettlementIDACORP settlementNational FuelRecent pricing problemsRecent HistoryFuture: 30 Tcf? At $5/mmbtu?US Gas security and markets