Musings: Is Natural Gas Heading for a Repeat of the 80s & 90s?

The battle over energy policy is heating up along with the weather.  The move by Senate Majority Leader Harry Reid (D-NV) to dump the cap-and-trade approach for regulating carbon emissions that was part of an all-encompassing energy and climate bill in favor of a skinny energy-only measure has stirred up all sides in the energy debate.  Just as Senators John Kerry (D-MA) and Joseph Lieberman (I-CT) were trying to round up votes for their energy and climate bill, Sen. Reid pulled the rug out from under them with his legislative move.  He is structuring a bill with critical provisions that he knows can be passed in the September session in order to provide fodder for the populist demands for action on energy and especially actions against the evil oil industry with BP plc (BP-NYSE) as the number one target. 

According to preliminary reports on the shape of the legislation, it will include eliminating the liability cap on oil companies under the Oil Pollution Act of 1990.  It will also restrict some oil companies from getting offshore leases based on their safety records and their willingness to repay offshore royalties from the incomplete license agreements awarded in the late 1990s.  The bill will also include incentives for greater use of natural gas in heavy-duty trucks and electricity for cars.  There will also be funds to encourage greater land and water conservation and for increased energy efficiency in homes.  There will be tax changes for energy companies and possibly some action steps to reduce greenhouse gas emissions by electric utilities.  (This latter provision was dropped from the final bill proposed by Sen. Reid.)

The bill will also include incentives for greater use of natural gas in heavy-duty trucks and electricity for cars

It is the natural gas incentives that may draw significant scrutiny.  On July 22nd, a coalition of manufacturing and agriculture organizations wrote to the majority leader urging him not to put incentives in the bill that would artificially increase the demand for natural gas in the power and transportation sectors.  Upon learning about the letter, we were reminded of the efforts of petrochemical and pharmacy companies to lobby against the government easing restrictions on the use of natural gas as a boiler fuel for power plants in the late 1980s and 1990s.  That action contributed to the infamous “natural gas sausage” of supply that depressed gas prices, curtailed gas drilling and ultimately constrained gas production and oilfield activity.  Our reaction to the letter was, “Here we go again.”

The recent letter was signed by 67 agricultural and industrial energy consumers representing farm and food concerns and makers of chemicals, fertilizer, glass, paper and steel.  Calling legislated incentives for increased use of natural gas in power generation and transportation as contrary to free markets the group points out that “…if a product is abundant and affordably priced and emits fewer greenhouse gases, the market will respond by increasing demand for the product.”  Rather than the government picking “winners” and “losers” through policy decisions, the writers argue that “Our economy needs a diverse base of price-sensitive natural gas consumers, and a diverse energy supply, in order to help reduce price volatility in all energy sectors.” 

That action contributed to the infamous “natural gas sausage” of supply that depressed gas prices, curtailed gas drilling and ultimately constrained gas production and oilfield activity

While we agree with the letter’s premise, the authors fail to grasp the fact that this is an ideologically-driven administration and a Democratically-controlled Congress that relishes picking “winners” and “losers” in furtherance of its political agenda.  This is in sharp contrast to the last time the natural gas industry was in the cross-hairs of government control.  Then, the issue was the fear that natural gas shortages would cripple the economy as critical U.S. industrial sectors would lack availability of the raw materials needed to keep it moving.  The problem was that politicians and bureaucrats lacked an understanding that their policy actions and regulation had created the imbalance between natural gas demand and supply and with reduced regulation the pendulum would rapidly correct assuring adequate supply at reasonable prices.  It was this lack of understanding of market forces that contributed to the emergence of the “natural gas bubble” that grew so large and lasted so long that it evolved into the “natural gas sausage.”  Before the sausage was eliminated, however, the gas industry and its support services were devastated by low activity due to low prices. 

Since the mid-1800s, the natural gas industry has suffered under some form of regulation due to the unique economic power of the business.  In its earliest days, the gas industry obtained its supply primary from coal and sold the gas as fuel within the municipality where it was manufactured.  It was referred to as “town gas.”  To protect against unfair power from the natural monopoly that developed in each locality, producers’ prices and returns were regulated.  Eventually, the market for town gas expanded. Gas was sold and piped to neighboring communities taking it outside of the jurisdiction of municipal regulation.  This led to various states establishing either a public utility or public service commission to oversee pricing and transactions in the developing intrastate gas markets.  New York State was one of the earliest states to regulate its intrastate gas market when it created a public utility commission in 1907.

In 1938, the government passed the Natural Gas Act that gave power to the Federal Power Commission to regulate interstate gas pipeline rates and natural gas prices along with the certification of new pipelines

Eventually technology enabled gas to be transported longer distances and between states creating a new struggle over regulation.  As various states attempted to become involved in regulation they ran into problems with the federal government and the Commerce Clause of the U.S. Constitution that precipitated a number of legal actions.  As a result of these cases, in 1935 the Federal Trade Commission issued a report indicating its concern over these interstate pipelines and the fact that they were virtually entirely owned by only 11 public utility holding companies.  This led to the Public Utility Holding Act of 1935 that regulated these companies.  The problem was that the regulations did not extend to interstate natural gas sales.  In 1938, the government passed the Natural Gas Act (NGA) that gave power to the Federal Power Commission (FPC), established in 1920 under the Federal Water Power Act, to regulate interstate gas pipeline rates and natural gas prices along with the certification of new pipelines. 

The method of regulating gas prices was somewhat nebulous under the NGA.  This lack of clarity culminated in the historic 1954 Supreme Court decision in the Phillips Petroleum case that mandated FPC regulation of wellhead gas prices based on a cost of service basis.  In 1960, the FPC determined that it needed to regulate wellhead prices on a regional basis as the commission had been overwhelmed by the number of individual pricing decisions it was handling.  But by 1970, the FPC had only established regional prices for two of the five national regions it had originally established.  Prices for the other three regions essentially had been frozen at 1958 prices.  By 1974, the FPC recognized that area-wide pricing wasn’t working so they went to a national price established on a cost-of-service methodology.  The price of gas at the wellhead was raised to $0.42 per thousand cubic feet (Mcf), double the previous price, but still well below the market value of the gas. 

 

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.

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