U.S. GAS-PIPELINE CONSTRUCTION WILL HELP PRODUCERS AND CONSUMERS

Elbert Johnson Jr.
Booz Allen & Hamilton Inc.
Dallas

Albert J. Viscio
Booz Allen & Hamilton Inc.
San Francisco

Changes currently under way in the U.S. gas-transmission grid will, on balance, benefit both producers and consumers. Wellhead prices will rise and burner-tip prices will fall.

Those are the major results of a study by Booz Allen & Hamilton Inc. of how and to what magnitude producer and city gate prices will be affected by changes in the transmission grid.

This follows an earlier study of the competitive effect of new pipeline capacity on the transmission business (OGJ, Dec. 10, 1990, p. 33).

Some producers and some consumers, however, will be better off than others, the recent study indicates.

Increasing the capacity to move gas between producing basins and markets will allow gas to find higher valued uses, a more optimal market solution.

Producer prices will rise in basins gaining greater access to premium markets and will be lower elsewhere, relative to what they would be without the additional transmission.

Similarly, consumers will see lower prices in markets on the downstream end of new capacity and higher prices elsewhere.

PLANNED CAPACITY INCREASES

More than 6 bcfd of capacity is either under construction or on the drawing board, which well exceeds expected growth in demand. Although not all of these projects will be built, the impact will be felt across the industry.

An examination of several scenarios on both the supply and demand side has yielded the following conclusions:

• Some pipeline corridors will see a significant drop in throughput as their markets gain access to alternative basins and some basins such as the Gulf Coast continue long-term trends of declining deliverability.

• Competition among pipelines in underutilized corridors will lead to discounted transportation prices substantially below regulated rates.

• Buyers and sellers will have a wide range of basin and market options from which to choose, to the benefit of both.

The effects of these new capacity additions will be seen not only in changing utilization rates and competitive dynamics along the existing transmission corridors but will also be reflected in the relative wellhead prices across supply basins and city-gate prices across geographic markets.

The laws of supply and demand work toward different wellhead prices in each basin (Fig. 1). A restructured transmission grid changes the effective supply and demand curve for each basin, thus altering basins' wellhead price differentials.

New projects increase market access for some producing basins. From the producers' perspective, basins that currently are transportation-constrained, such as Alberta, will have more buyers bidding for supplies and fewer producers with shut-in gas when pipeline capacity is increased.

As a result, this increased access to markets will contribute to higher prices in that basin relative to what they would have been without the additional market access.

And prices in other basins will fall as their supplies get displaced.

From the consumers' perspective, markets currently with high city-gate prices that are targeted by new transmission capacity will see prices decline relative to what they would be without access to the additional supply provided by that new capacity.

These markets have relatively high city-gate prices, in part because gas is limited to premium uses. Greater access to supply will allow gas to compete for some less-valued uses such as displacing residual oil.

MARKET DRIVERS

As previously noted, new pipeline projects will significantly change the potential for markets to be met by supply from alternate basins. Greater basin-to-market access will allow both consumers and producers to benefit in aggregate because market forces will drive gas sales to more highly valued uses.

A more efficient transmission system will better match suppliers and consumers. Although producers and consumers are better off in aggregate, however, not all producers nor all consumers will be benefit.

Relative gas prices will change across basins and across consumption regions when new capacity relaxes the constraints on how much gas can flow between individual basins and markets, thus affecting prices.

To assess the impact of new transmission capacity on gas prices, Booz Allen & Hamilton modeled the transmission grid, including a representative set of the new transmission projects (Table 1). The model and the supply/demand assumptions as described in the referenced earlier article were used to quantify the results.

Booz Allen compares basin netbacks and city-gate prices on a before-and-after basis relative to changes in the pipeline grid caused by these new projects.

PRODUCER NETBACKS

From the producer's perspective, the price impact has three components: market mix, transportation cost, and dynamic supply and demand.

Changing the market mix improves netbacks when producers can shift sales to markets with higher city-gate prices, all else being equal.

From an analytical perspective, it can be thought of as producers improving the weighted average city-gate price by shifting toward higher priced markets. Many projects will enable producers to do just that.

For example, several of the new projects are targeting either the California or Northeast markets where prices are higher than in other areas (Fig. 2).

In addition, many of the projects actually increase the distance between basin and market, moving more Alberta gas to U.S. Northeast markets, for example. Transportation costs usually increase because of the investment requirements of building new pipelines.

Thus, although given greater market access, producers must pay a transportation premium, a cost penalty, for the new capacity. One important exception to this could be the situation for Rocky Mountain producers.

The current filing rate for Kern River to transport Rockies' gas to near Bakersfield is slightly less than $0.60/Mcf compared to almost $1 for a typical arrangement to a Midwest market. (Transportation to Northwest markets is less expensive than either of these but capacity is limited.)

As discussed in the earlier article, however, pipeline prices should be market-based with substantial discounting from regulated maximums where warranted by competition.

In addition to these static forces, prices react to dynamic changes in supply and demand. This reaction in the markets results from changes in consumers' access to supply, in effect a shift in the supply curve for that market.

An example is California, with more than 2 bcfd of potential incremental supply. For the market to absorb this volume, end-use prices must decline to the extent that gas can satisfy lower-valued uses which had been squeezed out of the market by those high prices.

Such a price effect does not mean that year-to-year gas prices decline. Rather, it means that prices would be lower with more supply available than they would be if supplies to that particular market were constrained by transmission capacity. In essence, price declines as the market moves down the demand curve to absorb greater volumes.

In a similar way that prices decline in markets which gain greater access to supply, prices rise in those markets which see their current supply reallocated to those higher priced markets which are targeted by the new projects.

The effect of backing gas out of a market to move it to a higher-valued market is to raise prices. Prices rise as gas goes to higher valued uses.

If supply were infinitely elastic, then new production would satisfy demand in markets that gain new transmission capacity. Supply is not highly elastic, however.

Most of the new demand in those Markets targeted by new transmission must be met from supplies serving other markets. These other markets are ones that do not place as high a value on the gas, i.e., prices are lower.

Thus the volume of gas consumed declines in markets that have low valued uses of gas and the mechanism which keeps this market in equilibrium is rising prices. The reallocated supply gets 11 squeezed" out of the market.

EFFECT ESTIMATES

Booz Allen's estimate of these price effects of changing the transmission grid shows a relatively minor impact in 1995 because of the supply "bubble" (Fig. 3a). Volumes of gas are capable of moving to market immediately because in many basins deliverability exceeds demand.

Once the bubble disappears, new transmission capacity results in stronger price effects (Fig. 3b), as measured by larger (and uniformly positive) netback changes in the long term (year 2000) vs. those in the short term (1 year out).

In the long run, producer netbacks increase in the Rockies and Canada. Rockies' gas finds the higher priced California market (which requires price declines to absorb the volume) with Canadian gas going to the Midwest and Northeast markets as well as to California.

It is the reallocation of sales which allows both producers and consumers to benefit from higher prices. Consumers are better off in aggregate because the gains in markets, such as California, outweigh the losses in other markets.

In aggregate, gas sales will shift toward nonswitchable markets and away from switchable markets. Without the new basin-to-market access, California city-gate prices would be $0.59 above the North American average (Fig. 4). With new capacity, that premium is bid down to $0.20.

Thus prices decline in California relative to before the transmission grid expansion but increase on average across North America. A major factor in the average increasing is that the portion of volume going to the premium price market (California) increases from 10.8% to 13.4%.

On average, producer prices increased $0.05 and city-gate prices $0.07. The $0.02 difference could be applied to transportation, although Booz Allen's estimates suggest that transmission companies capture only a small portion of the difference.

The $0.05 netback increase and $0.07 city-gate price increase balance producers' price requirements and consumers' price requirements at the equilibrium volume.

Therefore, the $0.02 is "up for grabs," that is, negotiable. Producers would prefer but do not require an additional $0.02 to supply the market, and consumers would prefer but not require a lower price to consume that level of production.

Booz Allen also tested the netback impact of higher deliverability. A key uncertainty in forecasting future gas-market developments is the deliverability potential of the Rockies and the Midcontinent basins.

To assess the impact on prices of this greater supply potential, Booz Allen developed a scenario in which the Rockies and Midcontinent basins are each assumed to have an additional 1 bcfd of capacity.

As expected, greater supply drove down prices (Fig. 5). Rockies' netbacks had the most negative effects because supply had to serve lower priced markets (moving east) and bear higher transport costs in addition to declining average prices resulting from greater supply.

Midcontinent netbacks had no transportation penalty but felt the effect of more supply driving down prices to raise the level of demand.

GAS PURCHASES

As market conditions change, the types of transactions required by buyers and sellers will also change.

The earlier article showed that corridor flows and utilization rates will change with the construction of several large-scale transmission projects, thus affecting the availability and desirability of spot and contract purchases.

As the utilization rates of certain corridors increase, the availability of reliable spot gas on them will decline.

New transmission capacity out of Alberta and the U.S. Midcontinent should bring excess deliverability rates in better balance across basins as gas from U.S. Gulf of Mexico onshore and offshore is displaced.

The current trend among large gas buyers, such as LDCs, is to buy greater reliability. LDCs are moving away from short-term sales under interruptible transportation and looking for long-term supply options.

The market is not returning to past practices, however. Direct purchases from producers and third-party marketers are expected to grow at the expense of pipeline system supply.

Increased demand for greater reliability, coupled with tighter capacity on some major corridors, should lead to different types of purchase arrangements than those seen today.

For example, Booz Allen would expect to see longer-term and predictable price contracts, some of which might be significantly higher than short-term, spot sales.

As the market tightens and buyers' interest in greater security intensifies, producers will have to decide if, when, and how to lock into these longer-term arrangements.

The range of alternatives is large:

• Prices-fixed, indexed, renegotiable

• Volume-fixed, dedicated reserves, flexibility

• Contracts-swaps, short or long term.

Driving these decisions will be expectations on price trajectories, interfuel price spreads, availability of transportation, and competition from other producers, all of which will differ by basin and market.

The implications for contracting, therefore, are significant.

Both producers and users must decide on long-term vs. short-term contracts and price-adjustment mechanisms. Furthermore, the type of transportation needed, firm vs. interruptible, will depend on how corridor utilizations change and how producer prices and contracts change.

The right answer will be different according to region and how the changes to the transmission grid ultimately play out.

Winners will be those players, producers, and users who properly anticipate these price changes and position themselves properly to take advantage of any discontinuity.

Losers will ride the tide and in some cases be stuck with inappropriate gas contracts, that is, prices that are too high for users or too low for producers in their markets.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.