COMMENT ANATOMY OF FERC ORDER 636: WHAT'S OUT, WHAT'S IN

Jeffrey J. Leitzinger
Executive Vice President
Micronomics
Los Angeles

Adapted from a paper given at a seminar sponsored by Jones, Day, Reavis & Pogue, Dallas.

Federal Energy Regulatory Commission Order 636 requires an unbundling of U.S. gas pipeline sales and transportation service.

It is often described as an industry restructuring provision designed to foster broad competition in gas supply from a host of potential new suppliers, marketers, and transporters. My view is that the gas industry of the 1970s is a blueprint for the industry in the post-Order 636 1990s.

This view springs from an examination of the effects of Order 636 from three standpoints:

How it will change the players in the industry.
How it will change the product.
Implications for winners and losers as the industry moves forward into the 1990s.

DEREGULATION PROCESS

The U.S. natural gas industry of the 1960s and 1970s was largely an integrated, highly concentrated business. That was not because regulation or government interference forced it to be so, but because there were strong underlying economies that made bundling of transportation and gas sales service on a large scale economically efficient.

In a very real sense, the piecemeal deregulation of the industry during the last 6 years has driven a temporary artificial wedge through the heart of the gas supply business. In the process, some activities are still held within the regulated sphere of the industry, but others are forced into the unregulated marketplace.

That fragmentation is not the natural order of things.

By completing the transition to deregulation-and Order 636 will accomplish just that-the artificial wedge is removed.

As a result, the underlying economies that drove the industry prior to the mid-1980s will once again be free to shape its activity. As they do, there will be a shift back to bundled delivered gas service and emergence of large, efficient providers of that service who will become to the natural gas industry what American, United, and Delta are to the U.S. airline industry.

INDUSTRY PLAYERS

After a long, valiant struggle, it finally can be said the patient has died. Regulated pipelines will be out of the merchant business. As a result of Order 636, regulated pipelines will be out of the business of trying to market transportation service altogether.

Consider in this regard the effect of straight-fixed/variable ratemaking.

The pipeline recovers its depredation, profit, and taxes in the fixed payment-the demand charge-it charges customers for reservations to use space on the pipeline system. The pipeline gets almost nothing-just fuel and variable operating costs from the use of that space.

Accordingly, one shouldn't expect pipelines to be in the business of trying to figure out how best to use space or where to find customers for space that sits unused.

In the post-Order 636 world, pipelines will be solely in the business of selling reservations.

One can compare the post-Order 636 pipeline with building developers. They bring together the assets to construct a facility and capacity needed to provide office services. They sell that capacity in fixed price leases, the profitability of which don't depend on either how well particular lessees use the space or on the terms at which lessees are able to arrange temporary subleases during periods when they don't require the space.

The developer may be responsible for day to day operation and maintenance of the building. But that's a nonmoney making mechanical function, not an important dimension of the developer's business activity.

After Order 636, pipelines will be responsible for bringing together the capacity to provide transportation service.

The transaction that culminates that activity is leasing of that capacity -the sale of firm transportation rights. Once that is accomplished, the main role for the pipeline will be the mechanical job of operating the system and making sure its lessees don't run into maintenance or other operational problems.

In the business of selling transportation service, the most important player in the industry in the 1990s will be a new breed of marketing middlemen who can be thought of as "supply aggregators."

As a group, they will be the firms that acquire firm capacity rights put on the block by pipelines under the dictates of Order 636. It will fall to them to decide how to take those rights, translate them into a gas transportation service, then market that service.

The main surviving role of regulation will be to control terms under which capacity is leased.

In a very real sense deregulation is complete. All the business of deciding how to package and sell gas and transportation service will reside downstream of the initial lease of firm capacity rights, downstream of the point where regulation will stop.

Despite some opposition to bypass expressed by pipelines, I expect to see pipelines sell capacity rights in blocks that run to and from pooling points or marketing centers along their systems. The logic follows the same design and efficiency principles that have made "hub and spoke" the dominant organization of airline transportation routes.

By blocking out transportation space around market pooling points, the space will be more valuable in the marketplace.

THE PRODUCT

In the post-Order 636 environment, the product offered by the aggregator/lessees of pipeline capacity rights will be a bundled product.

Transportation won't be resold to gas buyers and sellers as a stand alone service. There are several reasons for that conclusion.

Foremost are operational benefits that flow from organizing the coordination of supply and transportation through internal decisions rather than external contracts.

Providing the ultimate product-on-demand peak gas supply-requires flexibility to respond quickly to changing market and weather conditions in ways that may depend on concurrent operational conditions on the system. An integrated, internally organized, transportation/supply service allows that kind of response.

It is hard to imagine that a series of stand alone service contracts arranged between each customer and respective suppliers of gas, storage, gathering, transportation, and balancing service could do so nearly as well.

Such contracts would have to be extremely complex in options and contingencies they contained. They would be costly to craft and negotiate. Perhaps most important, they would be nearly impossible to coordinate when stacked one on top of another for each customer on a pipeline system.

That same logic applies to one important tool pipelines always have used with great success in their traditional merchant business. The magic word of course, is displacement.

The ability to use displacement of gas supply across place and time as a means of effectively transporting gas is one very important means to accomplish supply management.

And while pipelines have in the end become "supporters" of Order 636, potential efficiency losses that caused them to question the wisdom of unbundling gas supply and transportation are real. The desire to build a better mousetrap and reap associated rewards should lead supply aggregators to pursue the same efficiencies with bundled service.

WINNERS AND LOSERS

What about winners and losers? A better description of the future of the industry under Order 636 will be winners and big winners.

First, despite the shift in their importance in the mainstream of the industry, pipelines will be winners. They will escape gas supply problems and the freeriding that has occurred by customers who have retained rights to secure peak gas delivery service without the need to pay the true cost of that service.

To the extent that pipelines have abilities, interests, and business designs that take them beyond this more limited role to aggregation, they will be able to do so under Order 636 through the simple expedient of affiliated, unregulated aggregators.

Because supply aggregators will be free-and pushed by the competitive process-to explore opportunities for innovative services and cost savings, the real cost of providing the aggregation service will be pushed down over time. That will benefit both customers and producers.

The smaller the aggregation cost, the greater the remaining part of the pie to be shared between producers and end users. Lower costs of aggregation will allow higher producer prices and lower delivered prices to consumers.

The big winners will be the supply aggregators. I mean "big" here in several senses.

The first is size. Successful supply aggregators will be large, national firms.

The other reason there will be big winners in aggregation involves potential rewards.

This will be an unregulated activity. Firms that can provide the service at lower costs than their competitors will be able to retain some or all of that savings in the form of bottom line profit.

As firms grow larger and expand the base of their business the developing economies will compound the profit effects. Results, certainly in comparison with performance in the industry during the past 10 years or so, will be nothing short of astounding.

With two simple lines (see chart) one can see the essence of the aggregation problem. The pattern of delivery customers want is seasonal, high in the winter low in the summer. The pattern of supply producers want is flat with constant cash flow, constant production conditions, and optimally sized well investment year round.

The essence of the aggregator's role is to reconcile those two patterns.

One way is through operational devices such as storage, which permits the pattern of delivery to differ from the pattern of receipt.

A second possibility is to flatten the delivery pattern out of the system by pooling customers with noncoincident peaks to smooth deliveries during the year.

A third possibility is to build a gas supply portfolio that embodies flexible takes, doing so in a way that minimizes the cost of that flexibility.

AU of those tools benefit from economies of scale.

WHEN WILL IT HAPPEN?

As a result of 636, pipelines are out, aggregators are in. Stand alone transportation service-firm or interruptible-is out, bundled delivered gas is in.

Pooling points will be the organizing factor for firm transportation rights. And, when all is said and done, bigger will be better-lower cost, more efficient, more responsive, and more profitable.

When will this all take place?

There's an adage among economic forecasters that says if you want to be right in your forecast, be positive in your projection, clearly identify whether things will go up or down, even provide a specific target if you have to, but never ever say when.

With an eye on that tongue in cheek advice, let me say only that this view of the future of the industry reflects the likely result of strong market forces unleashed by Order 636.

How long it will take to play out is difficult to say. Considering the rewards to be had by being there first and the consequences likely to result from being there last, I expect these changes to occur sooner rather than later.