U. S. INDEPENDENTS FACE NEW AGE FOR GAS UNDER FERC ORDER 636

Everett S. Gibbs
Arthur Andersen & Co.
Houston

The U.S. Federal Energy Regulatory Commission's Order 636 opens the doors to a potential new age for independent producers and others in the gas industry.

Rather than defining new winners and losers, it creates the same opportunity for every competitor: a significant new role in the marketing of natural gas.

But it is not for the faint of heart, the uneducated, or those who have not identified their goals, strategies, and parameters within which they intend to compete. For, in today's new world, there is no place for yesterday's rigid regulatory mindset; participants must be willing to alter their paradigm.

IRREVERSIBLE CHANGE

Although Order 636 has been in existence for 6 months and anyone active in the natural gas industry is familiar with at least its basic tenets, some naturally remain inclined to assume the "wait and see" approach which has historically been appropriate for many FERC orders (Fig. 1).

Without fanfare, let me say, "Don't do it." This order is here to stay. It has already weathered rehearing: Order 636-A was issued on Aug. 3. With minor modifications, it effectively derailed any quick congressional action.

Although it is undergoing certain legal challenges, it has been cynically but accurately observed that, with the order's compressed implementation schedule, it will be difficult for the courts to turn back the clock regardless of their decisions.

In short, independent producers need to be approaching their decisions with a sense of urgency.

We are, in a matter of months, going to alter and restructure contractual relationships that have taken years to build and establish. By now, the first compliance filings have been made. By yearend, all interstate pipelines will have completed their filings, reflecting how they and their new customers intend to allocate and distribute costs of pipeline capacity.

With such a mandated timetable, even inactivity becomes a decision of significance.

MAJOR RAMIFICATIONS

There is no need to embellish on Order 636's already well documented details. However, as a foundation for discussing the opportunities it presents, it is helpful to outline the significance of each major facet. The order:

Requires pipelines to provide open access transportation service on a basis that is equal in quality for all gas supplies.
Unbundles transportation service from sales service.
Authorizes pipelines to sell gas on a basis similar to unregulated sellers and to earn whatever incremental returns the market permits.

The commission giveth and the commission taketh. Collectively, these three mandates of Order 636 form the foundation of permanent change in the gas market.

They guarantee that pipelines will effectively operate as common carriers. Further, they embrace the concept of "equal quality of service," which translates into a requirement that producers and marketers be provided sufficient pipeline access so that customer choices are not impacted by the pipeline's facility and service infrastructure.

The ramifications are apparent. Producers and marketers will enjoy greater access to markets, and local distribution companies (LDCs) and endusers will have greater access to reserves.

There will be mechanical problems, but as a matter of strategy independents should assume complete-pipeline accessibility. Without question, they also should assume prices will be more transparent and more volatile.

The tradeoff, of course, is that pipelines will be permitted to participate in this new market and to reap the rewards and misfortunes of marketing natural gas. As discussed later, not all pipelines are desirous of playing in this game.

ADDITIONAL REQUIREMENTS

Order 636 includes several additional requirements that will be significant in shaping the emerging new market. The order:

Requires pipelines to provide a new optional "no-notice" firm transportation service. The availability of this transportation service option assures that a participating customer on any day can receive up to its firm entitlement without penalty. This was the compromise to achieve LDC acceptance of unbundling of all services. It is the commission's version of an insurance policy and provides a pipeline backup obligation in the event other parties fail to supply the contracted gas or the LDC fails to nominate sufficient quantities.
Encourages creation of "market centers" and "pooling points" by prohibiting tariff provisions that would inhibit their development. Market centers and pooling points enable users to compete with pipeline marketing affiliates by aggregating their gas on the system.
The order also requires flexible receipt and delivery points (within certain constraints), which will further facilitate market penetration by producers.
Requires that storage be provided to customers on an open access basis. This is an essential step to assure sufficient flexibility for users of the pipeline grid.
Adopts the principles of capacity assignment, a controversial aspect of the order. Envisioned to provide flexibility for firm transportation subscribers and as a means to recover costs of unutilized capacity, this provision permits resale of excess capacity through a complicated and cumbersome bidding process facilitated by electronic bulletin boards operated by the pipelines.

Upon rehearing, the commission omitted the posting and bidding requirement for assignments under 30 days' duration. While in theory capacity assignment would displace interruptible transportation (IT), the unwieldy system may result in the resale of all but the most desirable space at sufficient discounts to make it virtually IT by a different name.

Requires pipelines to provide all shippers with equal and timely access to all information by maintaining electronic bulletin boards.
Provides pregranted abandonment of expired sales, IT, and short term firm transportation contracts. This is designed to permit pipelines to shed nontransportation contractual obligations.
Requires pipelines to adopt a straight fixed-variable rate design for transportation rates. The straight fixed-variable rate design recovers most pipeline costs through a demand charge to customers, thereby minimizing the incremental charge to transport gas. It is argued that this facilitates tariff comparisons, increases netbacks, and enables domestic gas to compete more favorably with Canadian gas.
Entitles pipelines to recover 100% of the transition costs, which bodes well for the producers. The rule permits pipelines to recover transition costs including unrecovered purchase gas cost, cost of altering supply contracts, and the physical cost to change and improve their systems to meet demands of Order 636. The respective recoupment methodologies are direct billing, demand surcharges, and inclusion of system improvement and obsolescence cost in rate base in future rate filings.

The recovery of transition costs and the straight fixed-variable rate design perhaps reflect some recognition by the FERC that many pipelines could not withstand another regulatory change that weakened their financial stability. However, both measures also received strong producer support.

COST RECOVERY EFFECTS

Two points should be made about the implications of cost recovery efforts under the order.

First, initial compliance information filed by 15 interstate pipelines-which as a group accounted for 80% of the natural gas delivered last year-placed transition costs associated with Order 636 at more than $2.5 billion. While the manner of recoupment will spread these costs over a number of years, the costs of Order 636 will be impacting the marketplace concurrent with the implementation of new accounting methods for post-retirement benefit obligations and additional environmental costs.

The combination of these costs will be significant even if passed through uniformly to all customers.

Second, the magnitude of these costs will clearly impact LDC and enduser decisions on the role of natural gas as their future fuel of choice. The collective impact on LDCs could diminish what has been a growing demand for natural gas over the last 4 years.

Therefore, while both pipelines and producers should be elated that at least the initial orders grant them the right to recover the cost of altering their contracts (therefore, hopefully avoiding another take-or-pay debacle) there is certainly plenty of incentive for the parties to minimize these costs to increase their odds of maintaining market share.

DEVELOPING STRATEGIES

Essentially, Order 636 has created a California gold rush environment, with industry participants in a race to realize the abundant opportunities generated by it.

By mandating that pipelines be common carriers and placing all gas suppliers on equal footing in the marketplace, the FERC has established a new starting line. All participants should initially be evaluating opportunities to fill the role of supply aggregation for LDCs and end-users, which the pipelines previously handled.

As a result, at the starting gate everyone's goals are identical: Determine how your company wants to address its opportunity to buy, sell, aggregate, and disseminate natural gas volumes throughout a now-accessible pipeline grid.

Some would argue this transition has already started (Fig. 2). Indeed, volumes of gas transported by interstate pipelines represented 84% of total throughput in 1991. By contrast, 5 years ago carrier gas accounted for less than 30% of interstate pipeline throughput.

In similar fashion, reserves dedicated to interstate natural gas pipeline companies have markedly declined. Whereas 10 years ago they represented close to 70% of U.S. production, today they are less than 20% (Fig 3).

Clearly, the interstate pipelines, in an effort to resolve their take-or-pay problems, have substantially reduced their gas merchant activity. Most industry participants would readily concede that the FERC-legislated void has become a reality.

Unfortunately, because of the substantial oversupply of gas in recent years, there has been little incentive to fill this void. Further, because the FERC had not completed the unbundling of pipeline services until its issuance of Order 636, there has been little pressure on LDCs and end-users to make long term gas portfolio choices.

In short, they have enjoyed the luxury of playing the field for cheap gas while maintaining the pipeline supply commitment in the event of an emergency. This has given rise to many complaints by producers and gas marketers that the market was interested in only short term contractual relationships.

Order 636 effectively eliminates the pipeline safety net. LDCs and endusers must decide the source, longevity, and price of future gas supply. They must also decide whether to establish a supply procurement department, which, in effect, is the mirror image of the producer's decision.

Recognizing the plethora of marketing strategies available, industry participants must establish their priorities before throwing resources and personnel at today's market. This means establishing realistic goals. Strategies to meet these goals can then be developed, along with detailed implementation and design of controls. Fig. 4 outlines steps to building such an infrastructure.

PROVIDER QUESTIONS

Among the questions a producer or marketer must investigate in establishing goals and strategies are the following:

What market do I desire to serve?
What are the geographic area limitations?
What services do I intend to offer?
What length of contractual commitments am I willing to entertain?
What portion of my assets am I willing to tie up in fixed-price contracts?
How do I wish to conduct my gas activities (gas marketer, aggregator, or only producer)?
What resources (back office, policies, systems) are needed to meet these goals?

Companies that have already determined their goals and strategies can use mandated pipeline restructuring meetings to develop implementation approaches for their strategies. These meetings, which are being held by each pipeline to negotiate details of it's compliance filing, are actually working sessions in which the pipelines and their future customers are establishing the new rules of the game.

Producers and marketers who have identified the carriers they intend to use can potentially be comparing prices with competing lines, evaluating capacity availability, seeking information about future capacity assignment possibilities, and evaluating the probability of available interruptible transportation capacity.

Based on the information gained in this process, some companies may decide only to market major portions of their reserves, and to utilize existing marketers and other aggregators for their less significant reserves.

SORTING STRATEGIC OPTIONS

Among the common strategic evaluations facing producers as they prepare for the post-636 world are:

Stratifying reserves. Once goals are established, companies frequently find that the reserves available for sale must be stratified into groups. As an example, major offshore reserves or large onshore concentrations of reserves strategically are more marketable than smaller dispersed pockets of reserves. Additionally, pipeline accessibility will often dictate strategy, as may capacity availability.
Risk profile. Clearly, goals adopted by a producer should also contemplate how much the producer wants to lock in prices or sell into future index-based arrangements. The appropriate risk profile to future price changes is a key strategic decision for the producer.
Long term contracts can reduce or increase risks for a producer. The key is proper understanding of the effects of new contracts on a producer's risk profile. Therefore, a strong background in basic risk management techniques is essential, including an understanding of the financial instruments in common use.
Gas balancing. Other barriers to implementation that producers must address include revision of contractual arrangements to provide for operational methods of gas balancing. Agreements are essential to avoid the legal entanglements of gas imbalances that have plagued the pipeline industry over the past 5 years and the imbalance penalties in today's marketplace.
State taxes. New players in the gas marketing arena should investigate state tax considerations associated with their strategies. Generally, whenever there is a change in operations by corporations, there are state tax ramifications. Thus, consideration must be given to the potential effects of gross receipts, sales, and income taxes. Contracts must consider issues such as where title to the gas passes to a utility and whether a different corporate structure that separates production and selling activities would reduce tax exposure.
Supply reliability. Those embarking into the world of natural gas marketing need to recognize its demands to be innovative, creative, and particularly sensitive to traditional sales issues such as reliability. A recent survey performed by Arthur Andersen indicated that reliability of suppliers is one of the most critical factors to LDCs and end-users.
Flexibility. Each provider will be endeavoring to differentiate himself by tailoring his contracts to meet perceived market demand. Already this is happening in the diversity of contractual instruments marketers are introducing. Today's gas contracts may track spot prices for a period, be indexed to a combination of measures, and ultimately evolve to a netback arrangement when cogeneration facilities with matching power contracts are in existence. The net effect is a complex instrument designed to meet a specific user need.
Operating costs. In analyzing strategies and implementation options, the costs of each alternative will certainly impact decisions. One of the larger costs is qualified personnel. Another is back office support-will new activities require more people and, if so, how many and when? Does the producer's marketing area have experience in nominating gas, finding the lowest cost transportation, and arranging storage to protect against shut-ins and imbalance?
Capital costs. Some of the capital expenditure decisions associated with an effective marketing program revolve around selecting between investments to gather gas or create transportation alternatives; adding new measuring equipment; and providing systems to electronically interact with pipelines to monitor gas measurement, track imbalances, and account for gas portfolio and contractual positions.
In evaluating whether to deploy resources, companies should consider what alternatives exist in the marketplace. Often, it may be more economical to outsource or purchase the service, particularly some of those more naturally handled by others. Pipelines have begun to offer an impressive array of new services, such as marketing of capacity released by shippers. Producers and marketers may desire to utilize these services piecemeal in a mix-and-match philosophy that achieves the most economical solution (Fig. 5).
Credit. Credit evaluations are critical in the long term arena. Committing resources and reserves to an arrangement can be devastating if the counterparty cannot perform over the long term.

STARTING POSITIONS

Logically, the best positioned players to resume market aggregation are pipelines. They already have most of the expertise and familiarity with the system and consumer needs.

However, being the actual recipients of Order 636, most pipelines have their hands full simply responding to its demands and therefore may be less able to channel some of their innovative juices to developing a separate gas merchant function.

Based on the limited announcements to date, it is obvious that pipelines do not feel compelled to rush into this void.

Two pipelines have declared their intent not to retain a merchant function, and others have indicated their merchant activities will be substantially reduced.

Interestingly enough, LDCS, marketers, and producers all seem to agree that pipeline affiliates will have a substantially reduced role in market aggregation (Fig. 6).

PRODUCERS' POSITION

By contrast, many of the features of Order 636 provide producers with an opportunity to take control of their destiny (Fig. 7). Why?

Producers have the chance to control firm transportation to the customer either through cooperation with end-users, the capacity release program, or by direct capacity acquisition.
Price signals will not be confused by the clutter of varying transmission prices.
Potential customer targets can be LDCs or even end-users such as major commercial and industrial companies.

What producing companies lack in knowledge of customer needs will be compensated for by their control of the product and their ability to pool gas on the transmission grid, which, with the granting of flexible receipt and delivery points, assures them of the ability to aggregate gas to meet market demands.

However, to accomplish these objectives, producers must get out of the starting blocks quickly. Building on the steps in their Order 636 strategies, producers need to perform initial self-evaluations to ascertain their abilities to compete in this market. Particular emphasis needs to be on:

Infrastructure and strategy in place.
Personnel knowledgeable about pipeline systems.
Marketing tools and familiarity with today's diversified products and the bid/ask curve concept.
Contractual arrangements to resolve gas imbalances.
Systems to track and bill gas and transportation.
Contract portfolio management tools.

Such an evaluation should help companies decide whether they are prepared to initiate company-wide strategies or should establish phase-in plans.

For example, some producers are initiating their goals and strategies for major reserve pools at major pipeline delivery points in the short term and maintaining all other arrangements through short term or evergreen contractual arrangements until they can phase in or complete their strategic planning elsewhere.

Such a limited strategic implementation recognizes that inactivity will lose the pole position just as effectively is a poor strategy.

MARKETERS' POSITION

The position of gas marketers as a result of Order 636 is a more difficult call.

They have historically thrived on interruptible transportation, the availability of which may be substantially reduced under Order 636. Therefore, marketers are faced with capacity release programs or making firm transportation arrangements. Their strategic decision must also include an evaluation of whether additional hard assets such as gathering systems, reserves, or processing plants facilitate their ability to aggregate gas.

Lastly, marketers have traditionally made their money on price volatility, poor pricing signals, and identifying markets unknown to others. Order 636 should increase the market's access to pricing information and the accessibility to end-users.

This will increase the pressure on margins unless marketers are serving niche markets, have special customer relationships, or differentiate their products through characteristics like reliability, contract flexibility, or ability to serve.

LDCS' POSITION

Producers need to recognize that Order 636 grants LDCs the same new opportunities it grants them.

In short, LDCs can, through contractual relationships, establish a supply portfolio custom-made for their businesses, and effectively utilize the no-notice service to mitigate much of the deliverability exposure. Many LDCs are ready and capable of operating in these markets. However, all are constrained by the existing state regulatory environment.

Currently, LDCs receive no reward for taking risk and lowering gas cost. Nevertheless, a primary motivation for LDCs to become active marketers/gas suppliers may be the desire to minimize the rate shock associated with the many new costs potentially coming if they do not manage the business and to mitigate potential bypass issues with their customers.

Certainly, the absence of encouragement from state regulators for LDCs to minimize gas cost will not help them make their strategic decisions.

So who has the pole position? It's difficult to tell but may not matter. In this race the companies who make the best strategic decisions during the next few laps will find themselves positioned in the lead for years to come.