A Gas Crisis, Or Not?
The conclusions made by the NPC gas study raise more questions than they answer.
September 2004
By Ken Costello
In late September of 2003, the National Petroleum Council (NPC) issued a comprehensive study on the future of the U.S. natural gas industry.1
Balancing Natural Gas Policy-Fueling the Demands of a Growing Economy accentuates the pursuit of an aggressive national supply-expansion policy and increased responsiveness to changing market prices. The study estimates that gas costs will fall by some $1 trillion over the next 20 years (which averages out to $50 billion per year, or about 40 percent of the current total natural-gas expenditures in the United States) from a balanced future of increased energy efficiency, immediate development of new natural gas resources, and flexibility in fuel choice. The savings would be $300 billion from increased access to U.S. natural gas resources alone.
Major Costs
While on the surface the general findings of the study seem sensible, a serious debate should ensue over the costs of attaining the more balanced U.S. natural gas industry that the study advocates. One cost pertains to the environmental effects of expanding domestic natural gas supplies and liquefied natural gas. A second involves the cost of subsidies (for example, federal price support guarantees and tax credits) that may be required to increase supplies from particular new and existing sources. A third is the economic cost associated with advancing energy efficiency and fuel switching by industrial customers and electric generators.
Underpinning the conclusions and recommendations of the NPC study is the prediction that the United States is heading toward an untenable future as the energy sector places greater reliance on natural gas to satisfy U.S. energy demand, especially in the production of electricity, while concurrently restricting the drilling and production of substantial domestic natural gas resources. .
The urgent conclusion of the study is that the United States must decide now how to increase future natural gas supplies in addition to making the demand side of the natural gas market more responsive to prices. Any postponement would only harm consumers of both natural gas and electricity. .
A Little Perspective
No one can deny the inflation and volatility of natural gas prices over the last few years. Many analysts and industry observers, including the authors of the NPC study, attribute these recent events to the harbinger of a tight gas market that will carry forward to the years ahead unless the U.S. deviates from a status quo, do-nothing strategy. They see these developments in the natural gas market as not cyclical but structural, with long-lasting effects. .
How one interprets recent events has important implications for public policy. If recent natural-gas price inflation and volatility are truly a cyclical phenomenon, then there would be less justification for taking major initiatives to remedy what in reality would be a temporary market condition. On the other hand, the trend of a tight gas market aggravated by gas supplies not keeping pace with growing demand would call for a more proactive policy. The evidence seems to support the latter view, which is precisely in line with the findings of the NPC study. .
In recent years we have seen natural gas prices rise precipitously for short periods, followed by dramatic declines. So one fundamental policy distinction is whether the NPC is over-reacting to what has happened since 2000, or whether the United States does in fact face a serious longer-term problem that demands new and immediate governmental initiatives.2 .
The NPC report's four recommendations (see "NPC Study Recommendations," p. 50) derive from three developments that have emerged over the last few years.
n First, a fundamental shift in the supply-demand balance has caused natural gas prices to be higher and more volatile. .
n Second, North America is moving to a new era in which it will no longer be self-reliant in meeting its growing natural gas needs, as production from traditional U.S. and Canadian basins flattens. .
n Third, government policy encourages the use of natural gas but does not adequately address the corresponding need for additional supplies. This policy, both explicit and implicit in nature, was premised on the low natural gas prices of the 1990s. If policy-makers-like most industry observers-believe that the period of cheap natural gas prices ($2/MMBtu to $3/MMBtu for natural gas sold in the spot market) is behind us, the U.S. government should reconsider whether increasing dependence on natural gas to meet the nation's energy needs reflects good policy. .
If prices do remain high and volatile, the natural gas market should be expected to look at other sources of energy and a more efficient use of energy to displace natural gas. But this may take time, with probably little positive effect over the next few years. In short, a properly functioning market, such as the natural gas sector, left on its own would be expected to ultimately lower the consumption of natural gas as prices rise and become more volatile. .
Should the United States do things differently in the natural gas sector? Maybe, but before it does, analysts should lay the facts out on the table as best they can. The NPC study seems to offer this, but the study is not compelling in calling for an aggressive policy to expand natural gas supplies. .
Nine Questions for the NPC
1. What lessons can be drawn from past U.S. energy policies that have tried to increase domestic energy supplies, especially oil? Energy policies and the underlying analyses tend to overstate the problem and understate the cost of implementation. They also tend to be inflexible. This is especially true when targets (e.g., price floors) are set, generally producing bad results because markets are too dynamic and unpredictable to know today what the optimal target should be for tomorrow. In addition, energy policies are frequently not followed through. Finally, energy policies are often overtaken by new developments. Many if not most energy policies seem on the surface to be morally, economically, socially, and politically correct; it takes real work to flush out the full story. Energy policies often communicate the fantasy that we can have everything without paying a price. In the real world, however, individuals and organizations constantly have to make tradeoffs. .
2. What were the major assumptions of the NPC study? These include that the growth in natural gas demand will outpace new natural gas supplies from traditional sources; a fundamental shift in the demand-supply relationship in the natural gas market; and an indefinite tight natural gas market in the absence of major policy initiatives. .
3. Did the study include a valid cost-benefit analysis? Such analysis should account for both economic costs (for example, the cost of switching from natural gas to alternative fuels) and non-economic costs (for example, the social costs of disrupting pristine wilderness areas) of developing new natural gas supplies and promoting energy efficiency. Policy-makers have to ask themselves why the United States has not developed more of its natural gas resources and undertaken additional energy conservation, and whether this has served some legitimate public purpose-improved environmental quality or higher economic efficiency from not subsidizing uneconomical energy efficiency-rather than some narrow private interests. .
4. What major problems did the NPC study address? Does the United States have a natural gas crisis or does it simply have a serious temporary problem where the market is responding appropriately to the prevailing tight gas-supply situation? Do the volatile prices encountered since 2000 portend a long-term problem? Policy-makers need to distinguish long-term from short-term problems. What are the long-term market fundamentals? What can be done in the short term to mitigate price volatility? As an historical reminder, just a few years ago natural gas was touted as the energy source of choice for its economic, environmental, and energy-efficiency features. In 2000, the American Gas Association (AGA) in its Fueling the Future study said, "Changes in U.S. energy policy that favored increased use of natural gas could improve air quality, conserve energy, and reduce reliance on imported oil from politically unstable countries." Over the past few years, the objective of a natural gas policy has distinctly shifted from increasing the use of natural gas to moderating price and price volatility. .
5. Why does the U.S. need to act now? What is the cost of delay versus the benefit of waiting to take action when policy-makers would have better information about future developments in the energy sector? Normally, movements in the relative price of a commodity, with the possible exception of oil, have not been a serious enough concern for the country to warrant a national policy initiative. This, however, should not obviate policy actions that would, say, remove market barriers blocking potential efficiency gains. .
6. What can go wrong, and what would the net social cost be if the United States does not act now? One conceivable outcome would be higher and more volatile natural gas prices over the next 20 years and, at the extreme, supply shortages if prices are not allowed to balance demand and supply in the natural gas market. .
7. What can go wrong if the United States pursues the policies and other initiatives recommended by the NPC study? One possibility is wasted government subsidies on white-elephant projects, or what turns out to be uneconomical sources of natural gas supply; other costs include major damage to pristine wilderness areas, regulatory distortions resulting from a wrong diagnosis of the problem being addressed, and excessive monies spent on promoting energy efficiency. We have learned from the past that things can turn out worse rather than better-the Howard Hughes syndrome may apply here where in trying to reduce or eliminate risk, or to lower costs, new and unexpected and unsuspected results can arise that would cause greater risks and costs than those avoided (e.g., demand-side management activities causing older, dirty plants to operate more with the result of higher levels of pollution; the market penetration of high-cost natural gas protected by a price floor lying above the prevailing market price). .
8. What, more than anything, should be taken away from the NPC study? One thing that can be reasonably taken from the NPC study is that the ball is in the court of those who support the status quo, rather than on those who advocate major initiatives, because the estimated potential benefits are gigantic. An objective analyst should inquire as to the social costs of increasing natural-gas supplies. .
9. What micro questions should be asked? (a) Has the NPC study overstated the severity of the current natural-gas price problem? Does it reflect a "Chicken Little" mentality by overstating the urgency to expand natural gas supplies from new sources and suggesting a serious price crisis looms? (b) What factors are most important in determining future natural gas prices? These include oil prices, drilling finds and productivity, economic growth, and the evolution of U.S. energy policy over the next 20 to 25 years; (c) What results of the study seem counterintuitive? (d) Since the relationship between model outcomes and policy choices can be tenuous, to what extent did the study rely on the modeling results relative to other sources of information in reaching its findings and recommendations? As a general principle, forecasts from models should not be the sole source of information used to recommend public policies; (e) How were the supply curves for domestic natural gas derived? Specifically, how did the study treat the information about prices, costs, and how do new discoveries convert into reserves over future time periods? (f) What did the study estimate as the demand response to higher natural gas prices? This is an especially critical issue, at least for economists, who have a strong belief, validated by economic theory and empirical evidence across a wide spectrum of goods and services, that price movements depend consequentially upon how consumers respond to changing prices; (g) How were the policy scenarios selected? One scenario ("Balanced Future") is probably excessively optimistic, while the other scenario ("Reactive Path") does not represent the worst-case but pretty much business-as-usual, except for additions to traditional and non-traditional gas supplies (for example, expansion of LNG facilities, construction of Arctic pipelines, and a vigorous response in lower-48 production from accessible areas); (h) Did the study measure the effect of higher natural gas prices on the general economy? There seems to be an absence of any hard evidence in the NPC study, other than references to a few industries that have been adversely affected by high natural gas prices. No feedback loop exists, nor was systematic analysis conducted in the NPC study with regard to the theoretical and empirical relationship between natural gas prices and economic growth and other macroeconomic indicators. Theoretically, the effect of high and volatile natural gas prices on the economy hinges on whether prices are anticipated or not, the adjustment cost in response to dramatic changes in natural gas prices, and the responses of suppliers and consumers. Rising and volatile natural gas prices reflect the classic supply-side shock that reduces potential national output, jobs, and productivity, but the pertinent question is, How much? .
The need remains to carry out thorough and sound analyses of energy studies that contain policy recommendations. Even when these studies promote a particular point of view or agenda, which they often do, they should not be rebuffed as long as they incorporate sound analyses in arriving at policy recommendations. Too often in the past, however, bad analyses resulting in bad policies have unduly influenced U.S. energy policy. .
Politicians and government bureaucrats too easily have capitulated to special interests by embracing new policies and actions that are not in the public interest. The recent debate over a national energy bill carries on this despicable tradition. Appeasing competing special interests, which seems to be a hallmark of past U.S. energy policies, may run the risk of harming the overall public interest. .
Consumers should be more active in responding to changing natural gas prices, and the United States should seriously consider new sources of natural gas supplies. But how far the country should go in developing those new natural gas supplies and improving energy efficiency is up for discussion. .
At the least, policy-makers owe it to the general public to engage in a vigorous debate over the NPC study and its recommendations, since it has wide-ranging implications for not only the natural gas industry but for other sectors of the economy as well. They cannot, however, presume that the truth lies solely with the proponents of the NPC's conclusions and recommendations. Good policy requires consideration of the overall effect of those policies on the general public. Anything less will be unacceptable. .
Endnotes
- Other studies released in 2003 on the future of the U.S. natural gas industry include those of the American Council for an Energy-Efficient Economy, the American Gas Foundation, House Speaker Dennis Hastert's Task Force on Affordable Natural Gas, the National Commission on Energy Policy, and Stanford University's Energy Modeling Forum.
- Overreaction means here the development and implementation of policies that do not correspond to reality.
Ken Costello is senior institute economist for the National Regulatory Research Institute at Ohio State University. Contact him at 614-292-2831.
These comments were prepared by the National Regulatory Research Institute (NRRI) with funding provided by participating member commissions of the National Association of Regulatory Utility Commissioners (NARUC). The views and opinions of the author do not necessarily express or reflect the views, opinions, or policies of the NRRI, NARUC, or NARUC member commissions.
NPC Study Recommendations Sidebar
Utilities go shopping for deals.
The Midwest ISO (MISO), like all regional transmission organizations (RTOs), is a voluntary organization. The Federal Energy Regulatory Commission (FERC) does not require utilities to join an RTO, except sometimes as part of a market-power mitigation settlement. However, in its April 2003 Wholesale Power Market Platform white paper, FERC indicated that its final rule on RTOs likely would require all transmission utilities with wholesale customers to join an RTO.
In the meantime, joining an RTO is still voluntary, but this brings advantages and drawbacks. For example, by making a commitment to work together on structuring the organization, members become vested in the RTO. In theory, this will result in an RTO that is optimally suited to the needs of the industry it serves. But like any democratic process, RTOs' consensual nature also creates its share of difficulties.
"When you have a voluntary organization, each member is giving something up to join," says Dale Landgren, vice president and chief strategic officer for American Transmission Co. in Pewaukee, Wis. "By joining, companies give up some control of their systems, and they have to weigh that against what they get out of it."
Because RTOs can't force utilities to join, they've encountered difficulties in integrating some major transmission owners into their systems. In MISO's case, this has left some significant gaps in its territory. A few major examples include MidAmerican Energy in Iowa; Commonwealth Edison (ComEd) in Illinois; and American Electric Power (AEP), based in Ohio.
AEP and ComEd have opted to join the PJM system, even though both companies are based within the MISO footprint. MidAmerican Energy thus far has remained on the sidelines, participating in MISO only indirectly through its membership in the Mid-Continent Area Power Pool (MAPP)-one of three NERC regions overlapping MISO's footprint.
"The only large [investor-owned utility] in the Midwest not in an RTO now is MidAmerican. Otherwise they're pretty much spoken for," says James Torgerson, president and CEO of MISO. "People are always going to look at their options to see if there is a better alternative. It's up to us to ensure that we are providing the services and products that companies need, at the lowest cost."
In some sense, then, RTOs are competing for members, especially large utilities that bring strategic assets into the organization. Moreover, having utilities withdraw from an RTO in the middle of its development creates uncertainty that complicates the RTO's ability to raise financing and attract other members. Thus, competition for major transmission utilities is an inevitable by-product of RTOs' voluntary nature. Some stakeholders are asking, however, whether competition among RTOs might create unfair biases in their structures.
"In the Midwest you see utilities RTO-shopping," says Joseph Welch, president and CEO of International Transmission Co. in Novi, Mich. "RTOs will make special deals to get big utilities to join them, and the rules are being shaped to favor the hometown crowd."
As an example, Welch cites the joint operating agreement between MISO and PJM, which FERC has cited as a condition of approval for some companies (including AEP) to join PJM. "The joint operating agreement institutionalizes large amounts of loop flow through the Michigan system, such that it is starting to impair reliability," Welch says.
Torgerson asserts he's not aware of any deals being made that would affect RTO rules, but he acknowledges that RTOs will work with companies to bring them into the fold. "Did we work on the ITC [independent transmission company agreement] for Grid America? Sure. Did we agree to reimburse them for some costs? Yes, we did that based on what FERC said RTOs should be doing [to ensure financial neutrality]."-M.T.B.
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