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

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By having kept natural gas prices artificially low, drilling for gas for sale in the interstate market was depressed.  But because intrastate gas markets were not regulated, the bulk of the industry’s focus shifted to these markets.  In 1965, a third of the nation’s proved natural gas reserves were earmarked for intrastate markets.  That share increased to almost half by 1975. 

In 1965, a third of the nation's proved natural gas reserves were earmarked for intrastate markets that increased to almost half by 1975

In 1976 and 1977, severe cold weather led to forced curtailment of gas supplies to the Midwest forcing schools and manufacturing plants to shut down.  At the same time, there were no shortages experienced in states with large and active intrastate natural gas markets.  The shortage of supplies in the interstate market raised concerns among industries that needed gas to operate.  The existence of sufficient and readily available gas supplies in large natural gas producing states such as Texas, Louisiana and Oklahoma, drove many industrial companies to relocate or to shift some of their manufacturing to plants in these states.  While gas was available, it was not necessarily cheap, but for businesses, supply trumped cost.  In the mid 1970s, natural gas prices in the Texas intrastate gas market were often in the $7-$8 per Mcf.

To remedy this market imbalance, in November 1978, at the peak of the gas shortage, Congress passed the Natural Gas Policy Act (NGPA) that accompanied the National Energy Act.  The FPC was abolished and the Federal Energy Regulatory Commission (FERC) was established with power to regulate pipelines and break down the barriers between intrastate and interstate pipeline markets.  Gas prices were still regulated, but the government created various classes of production with significantly higher prices reflecting the increased cost of finding and developing new gas supplies.  While pre-NGPA gas supplies were locked into historic prices, there were plenty of incentives to stimulate gas drilling.  At the same time, the allowance of higher wellhead gas prices and the loosening of pipeline regulations planted the seeds of the industry’s next crisis – the collapse in demand.

The allowance of higher wellhead gas prices and the loosening of pipeline regulations planted the seeds of the industry's next crisis - the collapse in demand

Pipelines that were free to compete for transportation volumes and able to bid for gas supplies decided to sign up long-term supply contracts at high prices and with “take-or-pay” terms.  The memory of the challenges of supply shortages in the face of strong demand growth driven by low gas prices haunted pipeline company managers.  Being without gas supply was considered a greater risk than having a little too much gas supply.  But as the economy entered the 1980s it was hurt by the recession of 1981-1982.  The high-priced gas that pipelines were delivering to their industrial customers contributed to the huge drop in demand.  This put the pipelines in the box of having to buy high-priced contracted gas supplies when cheaper supplies were readily available in the marketplace.  Because of high-priced gas, numerous industrial and utility customers switched to cheaper alternatives.  The gas pricing challenge motivated some interstate pipelines to create Special Marketing Programs (SMPs) allowing customers to buy gas directly from producers with the pipeline company only transporting the volumes.  Of course, these SMPs further hampered the pipeline take-or-pay problems and further undercut the pipelines’ economics.  Before long, virtually every interstate pipeline company was facing potential bankruptcy under the weight of its “take-or-pay” obligations. 

The SMPs were found to be discriminatory in several 1985 court cases and hastened the government’s move to deregulate the pipeline and gas businesses.  The continued low natural gas prices as a result of reduced demand and greater gas resources due to stepped up drilling forced the pipelines and gas producers to seek resolution of the massive take-or-pay obligations.  All of these issues culminated in a ruling by FERC – Order No. 436.  That order made transportation the primary function of the pipelines rather than the traditional bundled merchant service role of the past (rolling the cost of natural gas and its transportation into one charge).  With this shift, a wide variety of gas purchasing and transportation arrangements evolved.  One development was “netback” pricing in which the final gas service price was established at the consuming end and the transportation charge backed out leaving a net price for the natural gas at the wellhead.

While Order 436 helped change the industry, not all the take-or-pay obligation issues were resolved.  This led to Order 500 that forced the pipelines to buy out those obligations with the right to pass some of the cost through to transportation customers in order to attempt to preserve the financial stability of the pipelines.  It was not until the passage of the Natural Gas Wellhead Decontrol Act of 1989 that gas prices were totally deregulated after more than a century of control.  There was a transition phase incorporated in that legislation that delayed complete gas price decontrol until January 1, 1993.  As this process was moving forward, FERC issued Order No. 636 in 1992 that eliminated the ability of pipelines to provide any gas bundling services.  It forced the producing arms of interstate pipeline companies to have to transact business on an arms-length basis.  The net result of this order was to place all gas sellers on the same footing and all pipelines in the transportation-only business.  Decontrol of the natural gas industry finally was complete.

It was not until the passage of the Natural Gas Wellhead Decontrol Act of 1989 that gas prices were totally deregulated after more than a century of control

Over this historical period, each time regulated natural gas prices were raised, there was an increase in gas drilling and production.  This is clearly seen in the change in the ratio of development wells drilled to natural gas exploratory wells drilled over the period.  From about a 5:1 ratio in 1973, the ratio moved to about 17-18 in the early 1990s.  In contrast, the ratio of crude oil development to exploratory wells moved from about 15 to 18 over the same period.  These divergent trends suggest that higher natural gas prices did achieve the desired effect of increasing gas drilling, reserves and production.

When we look at marketed natural gas volumes since 1973 there was a general decline in the early period until the mid 1980s.  Looking at this period more closely, however, the decline in marketed gas volumes that began in the 1970s ended about mid-decade in the 1980s before growing in the latter years of that decade.  (This can be seen by examining the red line in Exhibit 2.)  What is clear is the impact of the early 1980s recession on natural gas demand.  Between 1975 and 1980 marketed gas production was stable or rising before starting a sharp downward move coinciding with the recession.  The gas production decline finally ended about 1986.  In response to the higher natural gas prices allowed and the interstate pipeline decontrol steps, marketed gas volumes began a steady climb until the turn of the century when demand was undercut by the economic recession following the 9/11 attacks.  (This trend is marked by the blue line in Exhibit 2.)  For the next few years, high gas prices and a weak economy depressed gas volumes.  What then becomes clear is that gas production rose beginning in 2005 in response to the economic recovery, the substitution of natural gas for coal under increased environmental pressure and low gas prices.  The rise in gas production was facilitated in this period by the growing success of gas shale drilling.