U.S. producers scramble for shares of evolving domestic gas markets
A.D. Koen
Senior Editor-News
Reinvention is the watchword as U.S. gas producers seek ways to attain the critical mass needed to compete in domestic markets.
Facing producers is a market in which the average wellhead price of gas in real terms has plunged 50% in the past decade.
In the 1980s, gas surpluses depressed wellhead prices. In the 1990s, many believe, the problem of low wellhead prices has persisted mostly because of the federal government's attempts to boost gas industry efficiency by allowing competition in markets.
When it issued Order 636 in 1992, the Federal Energy Regulatory Commission said it was the last big regulatory step needed to create an environment in which producers could begin selling gas directly to end users.
Order 636 required interstate pipe-line companies to unbundle their gas services and charges. The order allowed the pipelines to provide gas transportation, storage, and related services, but prohibited them from owning gas for resale.
For the first time, players in U.S. interstate gas markets were allowed to decide which combination of transportation, storage, or other pipeline services they wanted in order to move shipments from wellhead to burner tip.
The gas industry implemented Order 636 in the winter of 1993-94.
Boosting efficiency
Most in the gas industry agree that the sum of FERC's recent gas regulations has indeed increased the industry's efficiency.
By combining lower costs upstream with improved flexibility achieved through system enhancements, gas suppliers in the first two winter heating seasons under 636 served domestic markets without a hitch. In some end use markets, gas prices even declined.
However, there also is evidence that FERC's new gas regulatory scheme has not fully achieved its main goal of encouraging gas industry competition. Some contend the gas industry still is adjusting to Order 636, and the full competitive effects of new federal regulations have yet to be felt all the way to the burnertip.
Observers with that view separate the domestic gas industry into three segments - production, midstream transmission/storage, and distribution - through which deregulation is proceeding at uneven rates.
As John A. Strom, president of Tejas Power Corp. (TPC), Houston, points out, by the time FERC began promulgating Order 636, a free market was already a reality at the wellhead. Congress decontrolled U.S. gas wellhead prices in 1989, subjecting producers to intense competitive pressures to curb costs.
"Producers as a group have done an outstanding job of wringing costs out of their business and becoming more efficient," Strom said. "If you look at wellhead prices over the past 10 years, you'll see it's been a pretty incredible job."
In Strom's view, Order 636 provided merely the regulatory framework to allow competition to flourish in midstream and distribution sectors. As a commercial reality, competition there is just beginning.
Independents' view
How Prices of U.S. Natural Gas Compare
Many independent gas producers in the U.S. take issue with the idea that Order 636 enhanced gas industry competition.
To the contrary, many argue, the new rule wrenched control of interstate markets from a handful of interstate pipelines only to give to a handful of large gas marketers. In their view, most independent producers can't compete in U.S. gas markets because the market is set up to reward big players and discourage small ones.
Independents fault Order 636 for giving rise to large gas marketing organizations, who as brokers and gas service providers are allowed to aggregate supplies, capture end use markets, and deal in gas futures and other gas related financial marketsall with few restrictions.
Interstate pipelines and marketers under Order 636 allow incentive rates for shipping or storing large blocks of gas. However, federal antitrust law prevents small producers from aggregating gas supplies, barring them from assembling gas shipments large enough to qualify for incentive rates.
Because they must pay full costs for gas services, independents maintain that low wellhead prices effectively lock them out of domestic markets.
In addition, producers charge that speculators and traders are encouraging price volatility on U.S. gas markets because they profit from margins achieved in buying and selling forward gas supplies.
"Gas marketers, pipelines, and traders all love the volatility, and we're sitting down here wondering how we deal with our bankers," said a Houston independent. "The pricing volatility that has occurred since gas became a commodity has been a disaster for all of us."
Perhaps still more disturbing to producers of all sizes is the appearance that, while gas prices have declined substantially at the wellhead, the producing sector has borne the brunt of the relatively nominal decline of burnertip prices.
Energy Information Administration data show U.S. wellhead prices in 1989 averaged $1.69/Mcf and city gate prices $3.01/Mcf. Comparative prices in 1994 were $1.83/Mcf and $3.08/ Mcf.
The average cost of gas to residential customers in 1994 was $6.41/Mcf, 77/Mcf more than in 1989. Commercial customers last year on average paid $5.43/Mcf for gas, up 69/Mcf since 1989.
Meantime, the average cost of gas to industrial customers increased only 9/Mcf to $3.05/Mcf, largely because of direct sales allowed by earlier FERC orders. Electric utilities faired best of all classes of gas customers over that time span, as their gas cost in 1994 averaged $2.28/Mcf, 15/Mcf less than in 1989.
Call for gas co-ops
Spurred mainly by gas price volatility, Apache Corp., Houston, early this year proposed changing U.S. law to allow producers to form gas cooperatives (OGJ, Feb. 27, p. 22).
Apache Chairman and Chief Executive Officer Raymond Plank charged that three large marketing companies, which together accounted for more than 60% of gas futures contract trading on the New York Mercantile Exchange, were earning more than half their income not by marketing gas but by speculating on wide and frequent futures price swings.
Plank said giving producers a bigger voice in U.S. gas markets would help restore order. Gas co-ops could help by aggregating members' supplies into pools, then selling only enough gas to meet demand.
In rallying support for their cause, Apache and other gas co-op proponents noted that gas prices since January 1993 have been more than twice as volatile as those of any nonhydrocarbon commodity.
Gas co-op backers also say gas price volatility discourages development of gas supplies and markets. Producers are less willing to spend money to replace production, and consumers are less likely to invest in gas fueled facilities, both because of the difficulty involved in estimating fuel costs to calculate investment performances.
Apache estimates show the cost of moving gas from wellhead to city gate varies widely, depending on identity of the shipper.
For example, a large producer, marketer, or end user, taking advantage of high volume discounted transportation and storage tariffs, typically would spend about 59/Mcf to deliver gas to the city gate, Apache said. By contrast, companies too small to amass the volumes needed to qualify for discounts would spend about $1.36/Mcf to serve the same market.
With wellhead prices of $1.40/Mcf, less about 35/Mcf for taxes and royalty payments, Apache figured that an independent producer trying to serve the market would lose more than 30/ Mcf.
Gas producers also have lost ground beyond the city gate.
Apache said that a decade ago, the cost of gas at the wellhead on average accounted for about 41% of the cost of gas to a residential customer. Last year, the wellhead price on average amounted to only 27% of residential gas prices.
"From the independent producer's perspective, the situation actually has been worse than it would appear," Roger B. Plank, Apache vice-president of corporate planning, told members of the Colorado Oil & Gas Association in early August. "Because the numbers were annualized, they masked tremendous volatility within individual years."
Gas co-op legislation
Independents this summer found receptive ears for their gas co-op message in two U.S. congressmen from Texas.
Lamar S. Smith, a Republican, and John Bryant, a Democrat, in mid-September in the House of Representatives introduced H.R. 2342, the Natural Gas Competitiveness Act of 1995 (NGCA). The seven page bill asks for producers of gas and natural gas liquids the right to form associations with or without capital stock to aggregate supplies for sale on intrastate, interstate, or foreign markets.
Under NGCA, independent gas co-ops would be allowed to collectively produce and gather gas and NGL. Gas co-ops also could process production streams and store and market products on their own accounts or through common marketing agents.
NGCA would allow gas co-ops to deal in nonmembers' gas and NGL, but in volumes no more than half the volume of member-produced gas handled by the group. In no calendar year would the bill allow a co-op to handle a volume of gas and NGL amounting to more than 20% of the previous year's U.S. gas and NGL production.
The bill would ensure the public and private sectors the right to stop gas co-op activities that monopolize or restrain trade. NGCA empowers the U.S. attorney general to serve a cease order and investigate any co-op believed to be unduly affecting gas or NGL prices.
Apache says gas marketing co-ops likely would generate these benefits for independent producers:
- The co-op structure would enable independents to achieve economies of scale and scope otherwise attainable only through mergers.
- Competition across the market would improve because independents would be likely to form many co-ops throughout the U.S.
- Because independents could aggregate and market larger packages of gas, as well as gas services, gas purchasers would have more choices.
- With the ability to better manage gas inventories and make their own decisions, fewer U.S. independents would be forced to leave the business.
Marketing intricacies
Typical U.S. Gas Market Charges
Gas industry participants all along the supply chain, including some of the largest U.S. marketers, support producers' need to find ways to assemble large enough packages of gas to compete for market share.
But many hasten to add that even a successful gas marketing co-op won't necessarily boost wellhead prices.
In fact, gas co-ops might not be the most effective way for independents to become more competitive in U.S. gas markets. And even if larger gas packages improve producers' competitive positions in the markets, large volumes alone do not ensure a producer will be able to capture pieces of the premium markets.
Ken Randolph, senior vice-president and general counsel of NGC Corp., Houston, said it would be very hard for producers to organize a gas co-op at a cost low enough to compete with simply trying to strike the best deals with the 10-15 large marketing companies already in the market.
"It's true that independent producers account for about 60% of the gas produced in the U.S.," he said. "But putting a co-op together capable of aggregating a 10 bcf pool of gas, the volume being discussed, would be very difficult."
Randolph said one thing NGC has learned from its marketing activities is independent producers like choices.
"I'm not convinced that independent producers are going to appreciate a bureaucratic co-op making their choices for them any better than the choices they have today," he said. "From the standpoint of a small independent producer, it would give him less choice in the market."
Where the money is
Randolph is similarly skeptical of a co-op's ability to quickly master the ins and outs of successfully selling gas on interstate markets.
"Gas marketing is a low margin, high volume, high cost, complex business that requires lots of personnel to participate on a nationwide scale," Randolph said. "A company has to be active in all the different regional markets in order to get the best prices."
In addition, he says, gas marketers must:
- Take part in futures trading, option swaps, and all the other hedging instruments available in the market.
- Use all the electronic bulletin boards supporting electronic data interchange.
- Learn everything possible about intrastate and interstate transportation and storage capacities, as well as how pipeline systems fit together in key production and marketing areas.
- Learn as much as possible about the array of service options available under Order 636.
To be an effective marketer, a co-op would have to become adept in all logistical areas and understand how they interrelate.
Most important, it must learn how to rebundle available supplies and tools into competitive packages. That would be no small feat in a business where several strong independent and producer and pipeline affiliated marketing companies provide such services for as little as 1-6/Mcf.
"With midstream margins like that, a co-op is not going to be very much help to a producer who is getting $1.25/Mcf for his gas," Randolph said.
He pointed out that most of the cost of gas at the burnertip is added after the gas reaches the city gate, as much as $3-4/Mcf depending on the customer.
"When I look at that value chain, I have difficulty seeing how a co-op can add anything more to the value of members' gas than a marketing company unless the co-op can somehow line up residential customers behind the city gate," he said.
Lack of storage
In the view of TPC's Strom, perhaps the greatest disadvantage facing producers in U.S. gas markets is their lack of storage capacity.
An advocate of using new technology to reduce the cost of delivering gas when and where customers want it, TPC develops high deliverability salt cavern gas storage facilities.
The company currently has 4 bcf of working gas capacity at its Egan storage facility in Acadia Parish, La. By the end of this month, working gas capacity at its Moss Bluff salt cavern in Liberty County, Tex., is to jump to 9 bcf.
In addition, TPC in 1994 marketed 150-160 bcf of gas in the U.S. The company last week closed a $154.8 million acquisition of offshore pipeline and gathering assets in the Gulf of Mexico and onshore gas processing and condensate stabilization equipment from a group led by Seagull Energy Corp., Houston. That deal boosted TPC's yearly gathering capacity to more than 300 bcf.
TPC also offers gas market information services.
As Strom sees it, gas is one of the few commodities for which essentially none of the commodity producers has storage. Players in a commodity market can use storage as a tool to help control price risks.
If a market participant on a given day thinks the commodity price is too high, he can refrain from buying until prices decline. Conversely, if demand boosts prices to acceptable levels, a player with a commodity in storage can sell into the market, then replace the volume sold later when prices decline.
In U.S. gas markets, wholesale buyers, mainly local distribution companies, control most of the storage. Some capacity they own outright, and the rest was inherited under Order 636 through existing contracts.
Because buyers have all the storage, Strom said, they have all the flexibility. That flexibility becomes of prime importance in U.S. gas markets each month during bid week.
Strom estimates that prices of 70-80% of the gas sold in the U.S. each month are set according to cash indices in referenced deals. Producers sell the rest in spot market cash transactions, thereby establishing the cash index on which many referenced contract prices are based.
"So gas sold during bid week each month establishes the cash prices reported by the trade press, which in turn become the basis of prices paid for most of the other gas in the market," Strom said.
Because wholesale buyers have most of the flexibility in U.S. gas markets, they have the most influence on the price they pay to acquire supplies. Because the producer has no flexibility in such situations, he often must accept whatever price is offered. As buyers trim the price of gas offered in spot market transactions, they exert downward pressure on all gas in the market.
Whether or not a producer co-op could help members gain access to economic gas storage capacity, Strom said, most producers have made little use of such tools.
"All our storage capacity sales have been to marketing companies and affiliates of distribution companies," he said.
Reinventing an edge
Whatever the possible benefits from producer gas marketing co-ops, companies involved all along the U.S. gas supply chain are recombining assets and operations to take advantage of opportunities created by the new interstate regulatory regime.
Even among the largest players, the effort to increase participation in midstream and distribution activity is apparent.
A good example surfaced last week, when Shell Oil Co. and Tejas Gas Corp., Houston, formed Coral Energy Resources LP to market mainly Shell produced gas through the combined operations of the two companies. Coral intends to combine the reliability of Shell's gas reserves and production with flexible delivery options and swing capacity available through Tejas Gas's pipeline and storage assets.
Tejas Gas and TPC are not affiliated.
The Coral combine is supported with risk management services provided through a contract with Bankers Trust.
Murry Gerber, Coral's new chief executive officer, said the company on its first day of business expected to rank among the top five gas marketers in the U.S., with about 3.7 bcfd of sales. Coral will aim to provide high quality service and a broader array of product lines than was available through the parent companies' marketing operations.
"In addition, we plan to expand into other energy businesses related to gas, including electricity," Gerber said.
By forming an alliance like Coral that blends their advantages, Shell and Tejas Gas expect to improve their competitive positions in the market. Each will derive part of its improved competitive position by tapping into information sources of the other.
Combining their market information and client bases will help bolster Coral's ability to provide gas services and market and deliver gas to customers as cheaply and efficiently as possible.
Attractiveness of alliances
Gerber said forming alliances like Coral is attractive to companies trying to keep pace with changes on U.S. gas markets because they offer a fast way to assemble new skills and strengths.
"With respect to the trading skills we believe Tejas brings-even if only in intrastate markets now-and the financial skills of Bankers Trust, capabilities like that don't just fall out of a tree," Gerber said. "We felt that to rapidly get into this business-and I think speed is important here-an alliance was the fastest way for us to achieve those capabilities."
Having Bankers Trust's insights about how to structure risk management opportunities for customers contributes to the value of deals.
"Bankers Trust deals in metals, in oil, and in all kinds of other commodities," Gerber said. "What it learns in other trading operations helps its gas trading. That's just a core capability of the company, and Shell doesn't have that and neither does Tejas Gas."
Among the activities in which it expects to become involved, Coral envisions helping arrange financing of third company projects that would enhance its gas and power businesses.
Upstream, that could include projects that help Coral develop a greater supply of gas, including production payments or even slightly riskier developments where Shell's expertise might be tapped to help evaluate a proposal.
Midstream, Coral could help finance pipeline construction, again in areas where its parent companies have some inherent expertise.
Further downstream, Coral might help build gas fired power plants or convert existing plants to gas fuel.
The key in each instance would be to support projects that in turn would support Coral's gas and power businesses.
"That's really what we're looking to target," Gerber said.
More and more, he added, companies are finding it difficult to foster new strategic capabilities in-house.
"Particularly with respect to timing, we felt it was necessary to do this with a couple of partners," Gerber said.
When producers benefit
Strom said bad timing has contributed to gas marketing woes of independent producers. But that should change as the effects of Order 636 move through the gas industry from wellhead to burnertip.
When Order 636 was implemented, he said, most pipelines had portfolios of contractual commitments with wholesale distribution companies that didn't expire until 1996 or later.
Order 636 ended pipelines' merchant roles and allowed producers, marketers, and end users to compete for the commodity portion of the value chain. But contractual commitments prevented full competition in transportation and storage services historically provided by pipelines.
"Beginning in 1996 and progressively out through 2001, all those contracts at various times are going to roll out and change," Strom said. "As each contract expires, many more opportunities will become available for companies to market city gate delivered services, as well as storage services in competition with pipelines."
As deregulation and competition continue to move through the gas industry value chain, demand will increase for more efficient products and services.
Strom said producers trying to develop strategies that would help them establish a midstream or downstream marketing presence should try to convince FERC and state agencies to end cost based tariff structures. Instead, he said, rates in areas where competition exists should be market based. Rates in areas with little or no competition should be incentive or performance based.
Cost of service rates reward shareholders when companies invest capital in facilities, "not for being smart," Strom said. They also promote midstream and downstream inefficiency and "end up artificially keeping the burnertip price high."
Competitive pressures will force costs out of the industry's midstream and downstream businesses, along with cost based tariffs. Midstream and downstream cost decreases will effectively lower the price of gas at the burnertip. But Strom said that doesn't mean the wellhead price of gas will fall, too.
"Producers have paid their dues," he said. "But if we can lower the burnertip cost of gas by taking costs out of midstream and downstream businesses, gas will continue to be competitive with other forms of energy like fuel oil and electricity.
"Eventually, producers will benefit from the process because lower burnertip prices will stimulate demand for gas."