Natural Gas: Factors Affecting Prices and Potential Impacts on
Consumers (13-FEB-06, GAO-06-420T).
In early December 2005, wholesale natural gas prices topped $15
per million BTUs, more than double the prices seen last summer
and seven times the prices common during the 1990s. For the
2005-2006 heating season, the U.S. Energy Information
Administration predicts that residences heating with gas will pay
35 percent more, on average, than they paid last winter. This
testimony addresses the following: (1) the factors causing
natural gas price increases, (2) how consumers are affected by
these higher prices, and (3) the roles federal government
agencies play in ensuring that natural gas prices are determined
in a competitive and informed marketplace. This testimony is
based on GAO's 2002 published work in this area, updated through
interviews, examination of data, and review of relevant
publications. GAO's new work was conducted from December 2005
through February 2006 in accordance with generally accepted
government auditing standards.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-420T
ACCNO: A46739
TITLE: Natural Gas: Factors Affecting Prices and Potential
Impacts on Consumers
DATE: 02/13/2006
SUBJECT: Consumer education
Consumer protection
Economic analysis
Financial analysis
Hurricanes
Natural gas
Natural gas prices
Price regulation
Prices and pricing
Public utilities
Utility rates
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GAO-06-420T
* Summary
* Background
* Increasing Demand and Tight Supply Have Driven Up Prices and
* Trend toward Higher Prices in Recent Years Is Due Largely to
* Extreme Price Spikes Resulted from Tight Demand and Supply C
* High Prices in Late 2005 Resulted from Supply Disruptions Ca
* Price Spikes in 2001 and 2003 Were Caused by Unexpected Incr
* Impact on Consumers of Higher Wholesale Natural Gas Prices D
* Higher Wholesale Prices May Lead to Significant Increases in
* Some Consumers Are More Sensitive to Price Changes
* The Federal Government Has a Limited, but Important, Role in
* FERC's Oversight Activities
* CFTC Oversight of Related Financial Markets
* FERC and CFTC Taking Action to Better Coordinate Oversight E
* EIA Collects, Disseminates, and Analyzes Information about t
* Concluding Observations
* Contact and Staff Acknowledgments
* GAO's Mission
* Obtaining Copies of GAO Reports and Testimony
* Order by Mail or Phone
* To Report Fraud, Waste, and Abuse in Federal Programs
* Congressional Relations
* Public Affairs
Testimony
Before the Permanent Subcommittee on Investigations, Committee on Homeland
Security and Governmental Affairs, United States Senate
United States Government Accountability Office
GAO
For Release on Delivery Expected at 8:30 a.m. CST
Monday, February 13, 2006
NATURAL GAS
Factors Affecting Prices and Potential Impacts on Consumers
Statement of Jim Wells, Director Natural Resources and Environment
GAO-06-420T
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss natural gas prices. As you know,
last fall two powerful and destructive hurricanes, Katrina and Rita, tore
through the Gulf of Mexico and several states bordering it-an important
area for the supply of natural gas. By early December 2005, wholesale
natural gas prices topped $15 per million BTUs, more than double the
prices seen last summer and seven times the prices common throughout the
1990s. For the 2005-2006 winter heating season, the Energy Information
Administration estimated in January 2006 that residential households
heating with natural gas will pay $257 (35 percent) more, on average, than
last winter. Consumers in the Midwest are expected to witness even greater
increases-paying 41 percent more than last winter.
This is not the first time that natural gas prices have sharply increased.
In 2000-2001, prices rose steadily and remained high for nearly a year. We
examined this phenomenon in 2002 and found that prices went up mainly
because supplies could not keep pace with rising demand.1 We also reported
that federal agencies responsible for overseeing aspects of the natural
gas market were actively investigating whether market participants had
violated market rules or manipulated prices.
Concerned about the recent increases in natural gas prices and the
implications of these increases on consumers in the United States, you
asked us to address the following: (1) the factors causing natural gas
price increases, (2) how consumers are affected by these higher prices,
and (3) the roles federal government agencies play in ensuring that
natural gas prices are determined in a competitive and informed
marketplace.
Our testimony today is based on our prior reports, interviews, and a
review of recent reports published by others. Prior related GAO products
are listed at the end of this statement. To update our findings from those
reports, we conducted interviews with federal agencies that included the
Energy Information Administration, the Federal Energy Regulatory
Commission, and the Commodities and Futures Trading Commission. We also
interviewed the state commissions that oversee natural gas utilities,
selected trade associations representing the natural gas industry, and
other potentially affected industries. Further, we examined data on the
natural gas industry, including prices, consumption, and supplies. In
addition, we reviewed relevant reports and other documents published by
others. We conducted our work from December 2005 to February 2006 in
accordance with generally accepted government auditing standards.
1GAO, Natural Gas: Analysis of Changes in Market Price, GAO-03-46
(Washington, D.C.: Dec. 18, 2002).
Summary
Since 1999, wholesale prices for natural gas purchased from the
short-term, or spot, market have trended steadily upward because demand
has expanded faster than supply. The domestic natural gas industry has
been producing at near capacity, and, to date, the nation's ability to
increase imports has reached its limits, given currently available
infrastructure. Tight supplies have also made the market susceptible to
extreme price spikes when either demand or supply change unexpectedly.
Prices spiked in late 2005 when two hurricanes hit the Gulf Coast region,
disrupting a substantial portion of our natural gas supply. This supply
disruption was compounded by high demand due to, among other reasons,
colder-than-expected temperatures in early December. As a result, December
wholesale prices spiked further. Although prices have dropped from these
highs, they remain higher than last year because some natural gas wells
and pipelines damaged by the hurricanes remain inoperable and because the
margin between demand and supply remains narrow. Other factors-such as
market manipulation-may also have affected wholesale prices. We are
examining futures trading in natural gas and other energy markets for
signs of market manipulation and we plan to report on the results of that
work later in 2006.
While the upward trend in natural gas prices is causing higher gas bills
for most consumers, the degree to which they see their bills rise because
of high wholesale prices depends on how much of their supply is purchased
from wholesale spot markets. Consumers who buy most of their natural gas
from spot markets, or consumers whose suppliers do so on their behalf, are
likely to see price increases commensurate with both recent price spikes
and the longer-term trend toward higher prices. According to our
preliminary work with the state commissions that oversee natural gas
utilities, some of the largest natural gas utilities in a few states
expect to buy at least 70 percent of their gas this winter at spot market
prices. The utilities generally pass these prices on to their customers.
Gas utilities and consumers that do not obtain their gas through utilities
can reduce their exposure to spot markets through a process called
hedging, which includes such techniques as buying gas at fixed prices in
long-term contracts or storing gas purchased when prices are relatively
low to be used during times when prices are high. While hedging may not
guarantee the lowest price, it allows consumers to have greater price
stability. Our preliminary work shows that the natural gas utilities in
more than half of the states hedged at least 50 percent of their supplies
for this winter. How consumers are affected by rising natural gas prices
also depends on the consumer; some consumers are more sensitive to price
changes than others. For example, lower-income residents may not be able
to absorb the price increases and may have difficulty paying their bills.
According to trade associations, industrial consumers that are heavily
dependent upon natural gas, such as chemical and fertilizer manufacturers,
may not be able to compete with foreign companies that have access to gas
at lower prices and therefore may reduce operations or close U.S. plants.
Three federal agencies-the Federal Energy Regulatory Commission (FERC),
the Commodities Futures Trading Commission (CFTC), and the Energy
Information Administration (EIA)-play key roles in ensuring that natural
gas prices are determined in a competitive and informed marketplace. FERC
is responsible for ensuring that wholesale prices for natural gas sold and
transported in interstate commerce are determined competitively. It
carries out this responsibility by, among other actions, monitoring the
markets in which natural gas is traded and investigating instances of
possible market manipulation. Since 2002, FERC has settled a number of
investigations involving natural gas market manipulation; for example, one
company agreed to pay a settlement of $1.6 billion after FERC found it had
exercised market power over natural gas prices in California during the
2001-2002 heating season. Since prices spiked in the fall of 2005, FERC
has received complaints and identified areas of concern regarding high
prices. Agency officials told us they investigate such matters where
appropriate and that regulations governing FERC's activities prevent them
from disclosing whether any investigations are under way. Similarly, CFTC
is responsible for ensuring that fraud, manipulation and abusive practices
do not occur in federally regulated financial markets such as the New York
Mercantile Exchange (NYMEX), where some natural gas contracts are traded.
CFTC monitors the markets for attempted market manipulation and takes
enforcement actions, when it deems appropriate, such as initiating legal
proceedings and imposing financial penalties. From 2002 through mid-2005,
CFTC investigated more than 40 energy companies or individuals and
assessed penalties totaling over $300 million, most of which concerned
natural gas-related settlements. FERC and CFTC recently signed a
memorandum of understanding in an effort to work together more
effectively. EIA publishes information about natural gas markets,
including aggregate estimates of supply and demand and average prices.
Background
Natural gas is a colorless, odorless fossil fuel found underground that is
generated through the slow decomposition of ancient organic matter. In
some cases, the gas, composed mainly of methane, is trapped in pockets of
porous rock held in place by impermeable rock. In other cases, natural gas
may occur within oil reservoirs or in coal deposits.2 Natural gas is
extracted via wells drilled into the porous rock. The natural gas is then
moved through pipelines and processing plants to consumers.
Historically, domestic natural gas production has occurred largely in
Texas, Oklahoma, and Louisiana. In more recent years, as older fields have
been depleted, the Rocky Mountain region, Alaska, and areas beneath the
deeper waters of the Gulf of Mexico are becoming increasingly important in
supplying natural gas; however, in many cases these supplies are not near
pipelines and other infrastructure needed for getting the gas to markets,
which increases the costs of gas obtained from the newer fields.
Natural gas consumers include
o residential users living in houses, apartments, and mobile
homes;
o commercial users such as stores, offices, schools, places of
worship, and hospitals;
o industrial users covering a wide range of facilities for
producing, processing, or assembling goods, including
manufacturing, agricultural, and mining operations;
o entities that use natural gas to generate electricity and
provide that electricity to others, such as regulated electric
utilities and competitive suppliers of electricity; and
o the transportation sector, including pipeline companies, which
use natural gas to operate the pipeline networks, as well as those
using natural gas to power cars and buses.
Most residential and commercial consumers rely on natural gas
utilities to supply their gas. Industrial consumers and
electricity generators obtain their gas through a variety of
means, including buying it directly from spot markets and natural
gas utilities.
The demand for natural gas in the United States has generally been
seasonal, with peak demand during the winter heating months. From
April through October, companies typically purchase natural gas
and place it into underground storage facilities located around
the country. Later, as the seasonal demand increases, these stored
supplies of natural gas are used to augment the supplies provided
via pipelines. According to EIA, natural gas demand during winter
months is usually 1.5 times greater than monthly natural gas
production in other months.
Over the past 25 years, the wholesale natural gas supply market
has evolved from a highly regulated market to a largely
deregulated market, where prices are mainly driven by supply and
demand. While the regulated market ensured stable prices, it also
caused severe gas supply shortages because, with artificially low
prices, producers had no incentive to increase production and
consumers had no reason to curtail their demand. Before
implementation of the Natural Gas Policy Act of 1978, which began
deregulation of wholesale natural gas prices, the federal
government controlled the prices that natural gas producers could
charge for the gas they sold through interstate commerce. Under
this regulatory approach, producers located natural gas reserves,
drilled wells, gathered the gas, and sold it at federally
controlled prices to interstate pipeline companies. After
purchasing the natural gas, pipeline companies generally
transported and sold the gas to local distribution or gas utility
companies. These companies, under the oversight of state or local
regulatory agencies, then sold and delivered the gas to their
consumers, such as homeowners.
In today's restructured market, the retail prices that consumers
pay are still regulated in many states and reflect the prices paid
by their suppliers to acquire the natural gas. However, the
federal government does not control the wholesale price of natural
gas. Since the removal of federal price controls, the wholesale
price of natural gas decreased initially and has become more
volatile. Producers still locate and gather natural gas, but they
now sell the gas at market-driven prices to a variety of
companies, including marketers, broker/trader intermediaries, and
a variety of consumers. New market centers have emerged, including
a market center referred to as the Henry Hub, located in Henry,
Louisiana. Henry Hub prices are reported on a daily basis, and
trades made at that market are often used as benchmarks for other
natural gas trades.3
The various players in the market may sell gas back and forth
several times before it is actually delivered to the ultimate
consumers. In some cases-in spot markets, for example-natural gas
is sold for immediate delivery.4 In other cases, it may be sold
for delivery in the future, through a variety of what are called
futures markets. In addition, several types of financial
derivatives related to natural gas-contracts whose market value is
derived from the price of the gas itself-can be bought and sold
through numerous sources by entities that are interested in
protecting themselves against increases in the price of natural
gas. Derivatives include natural gas futures and options, and
derivative prices typically move in parallel with the spot
market.5 Derivatives markets include exchanges such as the New
York Mercantile Exchange, which is regulated by the CFTC; and the
Intercontinental Exchange, which operates as an exempt commercial
market without CFTC oversight but over which CFTC has
anti-manipulation and anti-fraud authority; and off-exchange and
over-the-counter (OTC) markets, which are not subject to general
federal regulatory oversight.
Since 1999, wholesale prices for natural gas have trended steadily
upward due to expanding demand-largely for electricity
production-and supply that could not expand as quickly because the
industry is already operating at near capacity. This tightness in
the demand and supply balance has also made the market susceptible
to extreme price changes in times when either demand or supply
change unexpectedly. One such period of extreme price changes
occurred in late 2005, when two hurricanes hit the Gulf Coast
region, disrupting a substantial portion of the domestic supply of
natural gas. Prices spiked to high levels and, although they have
since dropped, they remain unusually high today.
Since 1999, wholesale natural gas prices have risen steadily, as
demonstrated by the moving average in figure 1. Previously, in the
early and mid-1990s, prices were generally low, usually ranging
from $2 to $3 per million BTUs, adjusted for inflation. From
January 1999 through July 2005, however, average wholesale prices
increased by over 200 percent, rising from about $2 to $6.75 per
million BTUs. Most recently, in the last half of 2005, prices rose
to over $15 per million BTUs, sevenfold higher than prices seen in
the early 1990s.
2Natural gas occurring within oil deposits is referred to as "associated
natural gas." Natural gas found in coal deposits is referred to as
"coal-bed methane."
3The Henry Hub is the largest centralized point for natural gas spot and
futures trading in the United States. The New York Mercantile Exchange
(NYMEX) uses the Henry Hub as the point of delivery for its natural gas
futures contract. NYMEX deliveries at the Henry Hub are treated in the
same way as cash-market transactions. Many natural gas marketers also use
the Henry Hub as their physical contract delivery point or their price
benchmark for spot trades of natural gas.
4According to the American Gas Association, the term spot market refers to
a market in which natural gas is bought and sold for immediate or very
near-term delivery, usually for a period of 30 or fewer days.
5A futures contract is an agreement to buy or sell a commodity for
delivery in the future at a price, or according to a pricing formula, that
is determined at initiation of the contract. An obligation under a futures
contract may be fulfilled without actual delivery of the commodity by, for
example, an offsetting transaction or cash settlement. An option gives the
buyer the right, but not the obligation, to buy or sell a commodity at a
specific price on or before a specific date.
Increasing Demand and Tight Supply Have Driven Up Prices and Made Extreme Price
Spikes Possible
Trend toward Higher Prices in Recent Years Is Due Largely to Market Forces
Figure 1: Wholesale Natural Gas Prices at Henry Hub, in 2004 dollars
A combination of market forces has caused the upward trend in wholesale
natural gas prices since 1999. Demand for natural gas has been growing
rapidly since the mid-1980s, with total consumption increasing by about 38
percent from 1986 through 2004. Figure 2 illustrates the extent to which
consumption of natural gas has risen in the United States over the past 2
decades and the relative amounts used by each of the five types of
consumers: residential, commercial, industrial, electricity generators,
and transportation.
Figure 2: Consumption of Natural Gas by Sector, 1986-2004 (with 2004
Percentage of Total)
A significant share of the increased demand in recent years has resulted
from increased use of natural gas to generate electricity. Out of concern
regarding the supply of natural gas and other factors, construction of
power plants using oil or natural gas as a primary fuel was restricted
from 1978, when the Powerplant and Industrial Fuel Use Act (Fuel Use Act)
took effect, through 1987, when it was repealed. After the Fuel Use Act's
repeal, use of natural gas by the electric generation sector increased by
79 percent from 1987 through 2004. Newer gas-powered plants produce low
levels of pollutants, compared with many existing plants. This
characteristic, as well as the long period of low prices in the 1990s and
other factors, has made natural gas the primary fuel in new power plants.
The supply of natural gas, however, has not kept pace with the increased
demand. Historically, most of the natural gas used in the United States-85
percent in 2003-has been produced here. However, as older natural gas
fields have been depleted, additional drilling for natural gas has been
required in order to maintain domestic production. This additional
drilling has not necessarily resulted in immediate additional supplies in
part because development of new wells and supporting pipeline
infrastructure can take time. Overall, from 1994 through 2003, domestic
annual production held steady at about 19 trillion cubic feet. In 2003,
EIA reported that the domestic natural gas industry had produced nearly
all of the natural gas that could be produced on a monthly basis from 1996
through 2001-the most recent data then available. Furthermore, EIA
reported that at times there was virtually no spare capacity in some parts
of the country and forecasted that these tight supply conditions would
continue, despite EIA's projection for a significant increase in drilling
activity.
In recent years, imports of natural gas have become increasingly
important. Net imports of natural gas have increased steadily, rising by
over 250 percent from 1987 through 2004. In 2004, the United States
imported about 15 percent of the total natural gas consumed here. Nearly
all of the imported gas comes from Canada via pipeline, and those imports
constitute virtually all of Canada's production not used in that country.
In addition, a small share-about 3 percent of total U.S. supply-has been
shipped on special ocean tankers as liquefied natural gas (LNG) from
countries such as Trinidad and Tobago, Nigeria, and others. These imports
have increased significantly in recent years; however, it is not clear if
we have the capacity to handle further increased shipments, in part
because only five facilities in the United States are able to receive and
process LNG imports. Moreover, because of limited international supplies
and high prices in other markets, it also is not clear how much additional
supply is available to the United States.
Extreme Price Spikes Resulted from Tight Demand and Supply Conditions
The tight demand and supply balance has made the market for natural gas
more susceptible to extreme price changes when demand or supply changed
unexpectedly. As we previously reported, prices spikes occur periodically
in natural gas markets because neither the demand side nor the supply side
can quickly adjust to changes in the marketplace. On the demand side, some
customers are able to react to changes in prices. For example, some
industrial entities may be able to switch fuels or reduce their
production. However, many other customers, such as residential customers,
may have few fuel-switching options and little firsthand knowledge of spot
natural gas prices-and understand the costs of their natural gas
consumption only when they receive their bill. On the supply side,
suppliers are slow to respond to price changes. For example, they may be
delayed in responding to high prices because, as noted earlier, existing
domestic sources of natural gas are already operating at near full
capacity-often above 90 percent in the United States in recent years,
according to EIA. In these circumstances, because little excess supply is
readily available, it must be added, generally by drilling new wells and
connecting those wells to existing pipelines, which can take time. For
example, receiving regulatory approval can take a year or more, and the
time to drill the well and connect it to the pipeline network can take
another 6 to 18 months. Because neither the suppliers nor many consumers
can react quickly to price changes, even small unexpected increases in
demand or disruptions in supplies can cause sudden and significant price
increases.
High Prices in Late 2005 Resulted from Supply Disruptions Caused by Hurricanes
Katrina and Rita
Most recently, prices rose sharply following the landfall of two
hurricanes in the Gulf region. It appears that the price spike was caused
by the unexpected decrease in the supply of natural gas in late 2005
following Hurricanes Katrina and Rita, exacerbated by factors that raised
demand. Because of the damage caused to production, processing, importing,
and transporting infrastructure in the Gulf region, wholesale prices
climbed to a high of $15 per million BTUs by December 2005. Other
factors-such as market manipulation-may also have affected wholesale
prices. Our ongoing work examining futures trading in natural gas markets
will address this issue later this year.
The Gulf region produces about 20 percent of the U.S. natural gas supply.
The region's extensive natural gas-related infrastructure includes about
4,000 platforms that extract natural gas from beneath the ocean floor; two
of the five terminals that import LNG into the United States; plants that
remove impurities from natural gas to prepare it for sale and use; and an
extensive network of pipelines, linked by hubs such as the Henry Hub, that
transport natural gas to other parts of the United States.
The paths of Hurricanes Katrina and Rita, in relation to Gulf region
natural gas infrastructure, are shown in figure 3. The hurricanes forced
operators to evacuate about 90 percent of the oil and gas platforms in the
Gulf for safety reasons, rendering them unable to produce natural gas;
shut down one of the two LNG importing terminals for about two weeks;
damaged processing plants; and damaged several pipelines and their
connecting hubs, delaying transmission of natural gas from supply
facilities that were still operational. For example, the Henry Hub, a
major gas market center, was closed by flooding for a total of 11 days
following Katrina and Rita.
Figure 3: Path of Hurricanes Katrina and Rita Relative to Oil and Natural
Gas Production Platforms
As a result of all of these factors, the hurricanes had a significant
impact on the supply of natural gas. Figure 4 shows the impact of
Hurricanes Katrina and Rita on the production of natural gas from the Gulf
region. Hurricane Katrina disrupted about 8 billion cubic feet of natural
gas
production per day immediately following its landfall-amounting to about
80 percent of daily production from the Gulf and about 16 percent of total
daily U.S. production of natural gas. Lost production from Katrina was in
the process of being restored when Hurricane Rita struck-again reducing
production of natural gas from the Gulf region to levels similar to those
immediately following Katrina. As a result of the severity and timing of
these two hurricanes, the Gulf region produced less than half its usual
amount of natural gas for about 9 weeks after Hurricane Katrina struck. By
comparison, nearly all of the lost production that resulted from Hurricane
Ivan in 2004 was restored within 9 weeks and amounted to about 20 percent
of that caused by Katrina and Rita. By the end of January, only about 80
percent of the natural gas supplies that had been disrupted by Katrina and
Rita had been restored, leaving the overall market tighter than it was
prior to the hurricanes and leaving the U.S. vulnerable to future
unexpected interruptions in supply or increases in demand-either of which
could result in higher prices.
Figure 4: Daily Natural Gas Production from the Gulf of Mexico Following
Landfalls of Hurricanes Katrina and Rita
The high natural gas prices that followed the Katrina and Rita supply
disruptions came at a time when demand for natural gas was already high.
Higher-than-average late-summer temperatures in August had led to
increased demand for natural gas to generate electricity, particularly in
the South. As a result of this high level of demand, existing supplies
were stretched thin and overall price levels were high. In addition, the
hurricanes struck as companies were filling their storage of natural gas
in preparation for the winter heating season.
Prices for natural gas in both the spot and the futures market spiked
dramatically immediately following the supply disruptions caused by the
2005 hurricanes. In September 2005, after the second hurricane, natural
gas spot prices increased to over $15 per million BTUs-roughly twice as
high as the average price in July 2005 of about $7.60 per million BTUs.
Futures prices to deliver gas in October also doubled to $14.20 per
million BTUs, reflecting traders' expectations that high spot prices could
continue into the future. Futures prices closely followed spot prices
until early November 2005, when spot prices fell to about $9 per million
BTUs, but prices for December gas futures remained at about $12 per
million BTUs, reflecting the belief by futures market traders that natural
gas prices would be high in December. A brief cold spell during the
beginning of December increased demand for natural gas for heating
purposes, driving prices up. The arrival of warmer than normal
temperatures just before the end of the year reduced demand and has
contributed to the recent reduction in prices. Figure 5 shows the spikes
in natural gas prices during the months of, and following, the 2005
hurricanes.
Figure 5: Prices for Natural Gas in the Spot and Futures Markets, August
2005 to January 2006
Note: Because the Henry Hub was closed for one day on August 29, 2005, and
for 10 days from September 23 through October 6, 2005, prices for these
dates were based on estimates taken either from a nearby natural gas hub
or from the previous day's price.
Price Spikes in 2001 and 2003 Were Caused by Unexpected Increases in Demand
Two other instances of price spikes-caused by unexpected increases in
demand-have occurred since 1999. First, coincident with the western
electricity crisis, from mid-2000 through early 2001, wholesale prices for
natural gas rose substantially and remained relatively high for nearly a
year. This period witnessed significant increased demand for natural gas
by the electric generation sector in order to meet electricity demand
across the West during a year of diminished availability of
hydroelectricity, a situation compounded by high demand through the winter
and lower-than-normal storage levels. In a second instance, wholesale
prices rose sharply in February 2003 during a period of high demand
because of unusually cold winter temperatures; however, prices returned to
normal relatively quickly.
Impact on Consumers of Higher Wholesale Natural Gas Prices Depends on the Extent
to Which They Buy from Spot Markets and on Other Factors
How higher wholesale natural gas prices are affecting consumers depends
largely on the degree to which the consumers or their suppliers may have
purchased gas on the spot market-which reflects current wholesale
prices-or may have taken steps to reduce their exposure to these prices.6
The effect of higher prices also depends on the consumer's sensitivity to
price changes. Some consumers, such as low-income residents and certain
industries, are more sensitive to price changes than others.
Higher Wholesale Prices May Lead to Significant Increases in Energy Expenditures
for Consumers Exposed to Spot Markets
The impact of recent increases in natural gas wholesale prices on
consumers depends on how much of the natural gas they use is purchased in
spot markets. Those with the greatest reliance on spot markets are hit the
hardest when prices rise or spike. For example, some natural gas utilities
that relied on spot markets are spending significantly more on energy this
winter, which may translate into higher gas bills for residential and
commercial consumers. According to our preliminary work with the state
commissions that regulate natural gas utilities,7 10 states reported that
at least some of the natural gas utilities they regulate were highly
exposed to spot market prices. Furthermore, in a few states, some of the
largest natural gas utilities projected they would purchase 70 percent or
more of their natural gas supplies for this winter from the spot market.
Participants in the market, such as industrial consumers who purchase gas
directly from the market or natural gas utilities that purchase gas on
behalf of their customers, can hedge against high spot market prices for
natural gas in three main ways: (1) by purchasing and storing gas for use
during times when prices are high; (2) by signing fixed-price contracts
for delivery of the gas in the future; and (3) by purchasing financial
instruments, such as options or derivatives, that increase in value as
natural gas prices rise. Since the winter of 2000-2001, some state public
utility commissions (PUCs) have encouraged the natural gas utilities they
regulate to hedge some part of their gas purchases in order to help
stabilize prices, according to the American Gas Association. According to
the state commissions, 27 states reported that the utilities they regulate
will acquire at least half of their expected winter natural gas needs at a
known price, generally ranging from $7 to $10 per million BTUs. In that
regard, last November, Commissioner Donald Mason of Ohio told Congress
that customers around Dayton, Ohio, have saved about $3 per million BTUs
as a result of hedging, including use of long-term, fixed- price
contracts. Gas utilities are also taking other approaches to keep down or
stabilize their customers' costs. For example, in some states, utilities
offer "level" payment programs and show customers how to use energy wisely
through energy-efficient appliances. In Minnesota, in 2005, all
state-jurisdictional gas utilities are required to spend at least 0.5
percent of their gross operating revenues on conservation improvement
efforts such as weather audits, weatherization, and rebates for purchases
of energy-efficient appliances. While some gas utilities have made efforts
to reduce their exposure to spot prices by increasing their use of
hedging, as some did after the price spike in 2000-2001, some states and
municipalities still discourage the use of hedging, according to the
association that represents the public utility commissioners.
6Other costs reflected in consumers' retail bills, such as transportation
and pipeline maintenance, compose a substantial part of the final retail
bill but are relatively stable.
7The preliminary work is part of a larger effort that we will complete
later this year.
While hedging allows consumers to obtain greater price stability, it has
costs and risks, and utilities may lack incentives to undertake it.
Storing gas for later use, for example, entails up-front costs such as the
cost of placing it into and keeping it in storage. Market participants
face risks if, for example, they purchase gas in advance under a
fixed-price long-term contract and prices drop. For that reason, some
natural gas utilities may be reluctant to enter into long-term contracts
when prices are relatively high, according to a trade association that
represents municipal gas utilities. Furthermore, absent specific PUC
guidance to hedge purchases, gas utilities may have few incentives to
hedge since they are generally able to pass along increased costs
associated with purchases of natural gas. Moreover, some state regulators
may not allow gas utilities to financially benefit from using hedging but
hold them financially responsible if the hedge proves unnecessary.
Furthermore, while under some circumstances hedging can reduce or
eliminate the impact of a price spike, it may offer little benefit during
prolonged periods of price changes. For example, a utility that signed a
5-year commitment to purchase natural gas at a predetermined price may
witness no change in the cost of acquiring the natural gas during the
period of the contract but would again face market prices (either higher
or lower) when it came time to replace this gas supply at the end of the
contract. In this sense, hedging may serve to delay until the contract
term ends, but not prevent, the effect of higher or lower prices on
consumers.
Some Consumers Are More Sensitive to Price Changes
Because energy costs account for a relatively large share of overall costs
for some consumers or because they are heavily dependent on natural gas,
any price increases can present significant difficulties. In particular,
low-income residential consumers and some highly energy intensive
industries appear likely to encounter the greatest impact.
The effect of high natural gas prices has already been especially severe
on low-income individuals. According to representatives from a trade
association representing publicly owned natural gas utilities, a utility
in Philadelphia, Philadelphia Gas Works, has billed $42 million more than
they have collected so far this winter, representing an increase of 2
percent in uncollectible heating bills this winter compared with last
winter. In Kentucky, utilities this winter have witnessed the highest
number of complaints and the greatest number of problems faced by
customers. Furthermore, federal assistance to low-income households in
meeting heating expenditures provides only limited assistance. According
to the National Association of State Energy Officials, the Low Income Home
Energy Assistance Program (LIHEAP)8 currently serves only 20 percent of
the eligible population, with average payments of $311 per family designed
to help families pay projected natural gas heating expenditures of $1,568
this winter. Additionally, despite several years of increases, LIHEAP
funding in fiscal year 2005 is only 67 percent of what it was in fiscal
year 1982, adjusted for inflation.9 However, some states have increased
funding for low-income individuals recently. For example, in December,
Minnesota began distribution of an additional $13.4 million in funding
designed to assist an additional 26,000 households in paying for heating.
Electricity generators are also sensitive to higher prices because of
their dependence on natural gas. This is true especially in the eastern
United States, where, according to FERC, electricity generators rely
heavily on natural gas. Furthermore, the region has many of the newer
gas-fired electric power plants that have less flexibility to switch to
other fuels, such as oil-based fuels, according to the National Petroleum
Council and others. As a result, some consumers may see higher electricity
bills.
8LIHEAP is a federally funded program that helps low-income households
with their home energy bills. The federal government does not provide
energy assistance directly to the public, generally providing funding to
state-run programs. State-run LIHEAP programs may offer bill payment
assistance, weatherization, and energy-related home repairs or other types
of assistance.
9Data reflect LIHEAP and weatherization appropriations, supplemental or
emergency appropriations, and REACH funding.
High natural gas prices are also adversely affecting industrial consumers.
As we reported in 2003, some industrial consumers shut down production
facilities10 because of higher energy costs in 2000 and 2001. Industry
representatives expect recent high prices to have a similar effect. A
recent survey by a trade association representing large energy consumers
showed that more than half of 31 member companies surveyed are decreasing
their demand for natural gas an average of 8 percent to 9 percent this
winter compared with last winter, leading the association to conclude that
higher prices have forced industries to curtail production in the United
States. The association expects that further cutbacks will occur if prices
remain high this year.
According to an association that represents industrial consumers, high
natural gas spot prices have been particularly detrimental to specific
industries in the United States that rely on natural gas, such as
fertilizer and chemical manufacturers, that compete in international
markets. As we reported in 2003,11 natural gas expenses can account for 90
percent of the total cost of manufacturing nitrogen fertilizer. The high
cost of domestic natural gas has made it difficult for U.S. producers of
nitrogen fertilizer to compete with foreign nitrogen fertilizer producers,
who can buy natural gas at lower prices and export their products to the
United States. For example, in 2004, Trinidad and Tobago was the largest
supplier of anhydrous ammonia,12 a type of nitrogen fertilizer, to the
United States. Prices of natural gas are sharply lower in Trinidad and
Tobago, where, according to the Fertilizer Institute, prices were about
$1.60 per million BTUs in 2005. The U.S. fertilizer industry, which
typically supplied 85 percent of its domestic needs from U.S.-based
production during the 1990s, now relies on imports for nearly 45 percent
of nitrogen supplies, according to a trade association representing
fertilizer companies. Furthermore, other industries can be affected. In
the fertilizer industry, according to a trade association representing
fertilizer companies, costs are passed on to U.S. farmers, which have
witnessed a dramatic increase in the cost of nitrogen fertilizers. The
prices paid by farmers for the major fertilizer materials reached a record
during the spring of 2005-on average, 8 percent higher compared with the
same period in 2004, according to a trade association representing
fertilizer companies.
10GAO, Natural Gas: Domestic Nitrogen Fertilizer Production Depends on
Natural Gas Availability and Prices, GAO-03-1148 (Washington, D.C.: Sept.
30, 2003).
11 GAO-03-1148 .
12Anhydrous ammonia is the source of nearly all nitrogen fertilizer
produced in the world. Nitrogen fertilizer is composed of three basic
components-nitrogen, potassium, and phosphorus-and of these components,
nitrogen is the most important component of fertilizer. Natural gas is a
key component in the production of nitrogen, and the cost of natural gas
can account for up to 90 percent of nitrogen fertilizer production costs.
The Federal Government Has a Limited, but Important, Role in Overseeing Natural
Gas Markets
In today's restructured market, the federal government does not control
the price of natural gas or directly regulate most wholesale prices.
However, three federal agencies-FERC, CFTC, and EIA-play key roles in
overseeing and supporting a competitive and informed natural gas
marketplace.
FERC's Oversight Activities
Under federal law, FERC is responsible for regulating the terms,
conditions, and rates for interstate transportation by natural gas
pipelines and public gas utilities to ensure that wholesale prices for
natural gas, sold and transported in interstate commerce, are "just and
reasonable." FERC's jurisdiction over retail natural gas sales is limited
to domestic gas sold by pipelines, local distribution companies, and their
affiliates. The commission does not prescribe prices for these commodity
sales. FERC's regulatory authority applies to the physical markets for
energy commodities, such as natural gas, and not to futures markets.
In December 2002, we reported that as energy markets were restructured,
FERC had not adequately revised its regulatory and oversight approach to
respond to the transition to competitive energy markets. FERC agreed that
its approach to ensuring just and reasonable prices needed to change: from
one of reviewing individual companies' rate requests and supporting cost
data to one of proactively monitoring energy markets to ensure that they
are working well to produce competitive prices. That year, the commission
established the Office of Market Oversight and Investigations to actively
monitor energy markets and, when necessary, undertake investigations into
whether any entity had or was attempting to manipulate energy prices. As
we previously reported, in 2002, FERC staff undertook several studies and
investigations to determine whether there had been attempts to manipulate
upward prices for natural gas delivered to California during 2000-2001.
FERC's ability to monitor the natural gas markets has been enhanced in
several regards recently. First, the Energy Policy Act of 2005, passed
last September, contains several enforcement provisions that increase the
commission's ability to punish wrongdoers that harm the public. In
particular, the act provides FERC with the authority to impose greater
civil penalties on firms that commit fraud. In addition, FERC has taken
steps to strengthen its efforts to protect energy consumers. These actions
include establishing a telephone hotline that individuals can call to
report market abuse or other problems. FERC also has begun actively
monitoring natural gas markets to determine whether price movements are
the result of market manipulation or market fundamentals. The staff
reviews market activity for any possible manipulation that might also
affect prices and performs a detailed review of natural gas prices and
market activity on a daily basis with the intent of identifying areas of
possible manipulation. If the staff identifies price anomalies that are
not explained by market fundamentals, they investigate.
Since 2002, FERC has settled a number of investigations involving natural
gas market manipulation. For example, 10 companies agreed to pay
settlements totaling approximately $84 million. In addition, a FERC
administrative law judge found that another company exercised market power
over natural gas prices in California during the 2001-2002 heating season,
and the company subsequently agreed to pay a settlement of $1.6 billion.
FERC officials told us that, since early fall of last year, it has
received complaints, expressions of concern, and requests to investigate
with respect to high natural gas prices through its enforcement hotline
and from public officials and the general public. Additionally, FERC has
identified areas of concern through its daily market oversight process.
FERC officials told us that all complaints and concerns are taken
seriously and actively investigated, where appropriate. However, since
ongoing investigations are considered nonpublic under FERC's regulations,
officials said they could not comment further on any ongoing
investigations of the natural gas market.
CFTC Oversight of Related Financial Markets
A large part of CFTC's mission is to protect market users and the public
from fraud, manipulation, and abusive practices related to the sale of
commodity futures and options, including natural gas. CFTC does this for
federally regulated exchanges such as NYMEX, and it has limited authority
over certain other futures markets. It does not have general regulatory
authority for other over-the-counter markets, including some used for
trading natural gas futures or options.13 In fulfilling its regulatory
role, CFTC conducts market surveillance to identify situations that could
amount to attempted or actual futures market manipulation and to initiate
appropriate preventive actions. For instance, to protect the futures
market from excessive speculation that could cause unwarranted price
fluctuations, CFTC or an exchange impose limits on the size of the
transactions that may be held in futures or options of a commodity. In the
natural gas futures market, these transaction limits are placed on trading
that occurs during the spot month.14 To monitor these transaction limits,
the commission has about 45 market surveillance staff and economists to do
policy and economic analysis of energy trading issues.
As part of its regulatory role, CFTC also enforces various laws
prohibiting fraud, manipulation, and abusive trading practices. CFTC's
enforcement group investigates and prosecutes alleged violations of the
Commodity Exchange Act. From 2002 through May 2005, CFTC investigated over
40 energy companies and individuals, filed over 20 actions, and collected
over $300 million in penalties. Most of these actions were related to
natural gas. For example, in July 2004, Coral Energy Resources, L.P.
(Coral), a Houston-based firm that marketed gas to consumers across the
United States, was ordered to pay a civil monetary penalty of $30 million.
The penalty was imposed because the CFTC found that Coral knowingly
provided false, misleading, or inaccurate information concerning its
natural gas transactions from January 2000 to September 2002. During that
time, CFTC found that Coral employees also attempted to manipulate the
price of natural gas in interstate commerce or for future delivery.
Natural gas traders report their market information to firms like Natural
Gas Intelligence, who in turn compile pricing and volume indexes, for
instance, that are used by market participants to settle their
transactions. Submitting incorrect information could affect the price of
natural gas in interstate commerce and could affect the futures or options
prices of gas.
13Under the Commodity Exchange Act, transactions in exempt commodities,
which include over-the-counter energy derivatives, are exempt from most
provisions of the act, although the antimanipulation and certain antifraud
provisions are applicable and can be enforced by CFTC. To qualify for the
exemption, the markets must be limited to institutional participants, and
if a market should function like an electronic exchange, the exemption
requires that the exchange limit transactions to participants trading for
their own accounts, notify the commission of their activities, keep
records, submit to CFTC's subpoena authority and information requests, and
publicly report trade data when the products begin to serve a significant
price discovery function.
14The "spot month" is defined in many different ways, but generally refers
to the nearest futures month beginning on a date near the first business
day of the month in which the futures expires or on a date near the first
day that delivery notices can be tendered. Some spot-month limits apply to
both hedge and speculative positions.
FERC and CFTC Taking Action to Better Coordinate Oversight Efforts
FERC and CFTC have recently signed a memorandum of understanding to create
a more effective and efficient working relationship between the two
agencies. The agreement covers the sharing of information and the
confidential treatment of proprietary energy-trading data. FERC officials
told us that if either agency needs information about trading within the
other agency's jurisdiction, then the other agency must provide it. The
understanding is to contribute to better coordination of enforcement
cases.
EIA Collects, Disseminates, and Analyzes Information about the Market
The Energy Information Administration (EIA) is charged with collecting
information about energy markets, including natural gas. The information
reported by this agency is important in promoting efficient natural gas
markets and public awareness of these markets. In our 2002 analysis of
natural gas markets, we identified that most elements of EIA's natural gas
data collection program inadequately reflected some of the changes in the
market. For example, with some exceptions, EIA's current natural gas data
collection program remains primarily an annual effort to obtain
comprehensive information on natural gas volumes and prices, while markets
have evolved to require more timely and detailed data. However, beginning
in the spring of 2002, EIA began to provide more real time market
information that traders and other gas industry analysts use as an
indicator of both supply and demand. For example, on May 9, 2002, EIA
began releasing weekly estimates of natural gas in underground storage for
the United States and three regions of the United States. According to
EIA, these data are valued by market participants and are a key predictor
of future natural gas price movements. EIA has also undertaken efforts to
better understand derivatives markets and the effectiveness of energy
derivatives to manage price risk. In addition, EIA's weekly natural gas
data releases are published each Thursday, and according to EIA officials,
these releases have been well received by natural gas market participants.
Concluding Observations
Natural gas has become an essential element in our national energy
picture. Ironically, however, natural gas markets may be suffering from
the growing popularity of this versatile fuel. Rising demand and
tightening supply appear to have contributed to both the general rise in
prices over the past several years as well as the price spikes, such as
that following the hurricanes in 2005. Moreover, the stage seems set for
future price spikes if either demand is higher than expected or supplies
are unexpectedly interrupted.
To the extent that the higher prices persist and price spikes are
possible, natural gas markets could pose significant challenges for our
country. Many people may have to pay a larger percentage of their income
for home heating and other uses of natural gas, such as electricity-not
just this year, but every year. Some may not be able to afford it.
Further, because some key industries have historically relied on low
natural gas prices to be competitive, we may lose some of these industries
along with the jobs that they provide.
These are weighty issues that require concerted actions reaching across
not just the natural gas industry but also across the energy sector and
related financial markets. The American consumer wants secure, affordable,
reliable, and environmentally sound energy. Meeting this demand will be a
challenge. This hearing offers another important step in the process of
overseeing the regulators-FERC and CFTC-charged with ensuring these
markets operate as intended.
Mr. Chairman, this concludes my prepared statement. I would be pleased to
respond to any questions that you or other Members of the Subcommittee may
have at this time.
Contact and Staff Acknowledgments
If you have any questions about this testimony, please contact me at (202)
512-3841 or [email protected]. Other major contributors to this testimony
include Karla Springer (Assistant Director), Lee Carroll, Michael Derr,
Patrick Dynes, Elizabeth Erdmann, Philip Farah, John Forrester, Mark
Gaffigan, Mike Hix, Chester Joy, Jon Ludwigson, Kristen Sullivan Massey,
Cynthia Norris, Frank Rusco, Jena Sinkfield, Rebecca Spithill, John
Wanska, and Kim Wheeler-Raheb.
Related GAO Products
Meeting Energy Demand in the 21st Century: Many Challenges and Key
Questions. GAO-05-414T . Washington, D.C.: March 16, 2005.
Natural Gas: Domestic Nitrogen Fertilizer Production Depends on Natural
Gas Availability and Prices. GAO-03-1148 . Washington, D.C.: September 30,
2003.
Energy Markets: Additional Actions Would Help Ensure That FERC's Oversight
and Enforcement Capability Is Comprehensive and Systematic. GAO-03-845 .
Washington, D.C.: August 15, 2003.
Natural Gas: Analysis of Changes in Market Price. GAO-03-46 . Washington,
D.C.: December 18, 2002.
Energy Markets: Concerted Actions Needed by FERC to Confront Challenges
That Impede Effective Oversight. GAO-02-656 . Washington, D.C.: June 14,
2002.
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