Natural Gas
Factors Affecting Prices and Potential Impacts on Consumers
Gao ID: GAO-06-420T February 13, 2006
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.
Since 1999, wholesale prices for natural gas have trended upward because of expanding demand and supply that has not kept pace. The domestic natural gas industry has been producing at near capacity, and the nation's ability to increase imports has been limited. Tight supplies have also made the market susceptible to extreme price spikes when either demand or supply change unexpectedly. Prices spiked in August 2005 when hurricanes hit the Gulf Coast, disrupting a substantial portion of supply and again later when demand was pushed higher because of, among other reasons, colder-than-expected temperatures in early December. Although prices have dropped, they remain higher than last year. Other factors--such as market manipulation--may also have affected wholesale prices. We are currently examining futures trading in natural gas markets for signs of manipulation and expect to report on our results later this year. While most consumers' gas bills are rising, the degree of the increase depends, in part, on how much of their supply is purchased from wholesale spot markets. Consumers who directly, or indirectly, buy their natural gas mainly from spot markets will see prices that reflect both recent price spikes and the longer-term trend toward higher prices. Our work shows that some of the largest natural gas utilities in a few states expect to buy at least 70 percent of their gas at spot market prices this winter. These companies generally pass these prices on to their customers. On the other hand, consumers and suppliers that have reduced exposure to spot market prices because some of their gas has been purchased through a process called hedging may be insulated from price spikes and may postpone their exposure to even gradual price hikes. In this regard, utilities in more than half the states have hedged at least 50 percent of their supply for this winter by entering into long-term fixed-price contracts and other techniques. This will help stabilize prices for their customers. Nonetheless, high gas prices will hit some consumers hard, including lower-income households and companies that depend heavily upon natural gas, such as fertilizer manufacturers. The Federal Energy Regulatory Commission (FERC) and the Commodities Futures Trading Commission (CFTC) play key roles in ensuring that natural gas prices are determined in a competitive and informed marketplace. Both agencies monitor natural gas markets and investigate 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. 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 which were natural gas related.
GAO-06-420T, Natural Gas: Factors Affecting Prices and Potential Impacts on Consumers
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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:
GAO Highlights:
Highlights of GAO-06-420T, a testimony before the Permanent
Subcommittee on Investigations, Committee on Homeland Security and
Governmental Affairs, United States Senate:
Why GAO Did This Study:
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.
What GAO Found:
Since 1999, wholesale prices for natural gas have trended upward
because of expanding demand and supply that has not kept pace. The
domestic natural gas industry has been producing at near capacity, and
the nation‘s ability to increase imports has been limited. Tight
supplies have also made the market susceptible to extreme price spikes
when either demand or supply change unexpectedly. Prices spiked in
August 2005 when hurricanes hit the Gulf Coast, disrupting a
substantial portion of supply and again later when demand was pushed
higher because of, among other reasons, colder-than-expected
temperatures in early December. Although prices have dropped, they
remain higher than last year. Other factors”such as market
manipulation”may also have affected wholesale prices. We are currently
examining futures trading in natural gas markets for signs of
manipulation and expect to report on our results later this year.
While most consumers‘ gas bills are rising, the degree of the increase
depends, in part, on how much of their supply is purchased from
wholesale spot markets. Consumers who directly, or indirectly, buy
their natural gas mainly from spot markets will see prices that reflect
both recent price spikes and the longer-term trend toward higher
prices. Our work shows that some of the largest natural gas utilities
in a few states expect to buy at least 70 percent of their gas at spot
market prices this winter. These companies generally pass these prices
on to their customers. On the other hand, consumers and suppliers that
have reduced exposure to spot market prices because some of their gas
has been purchased through a process called hedging may be insulated
from price spikes and may postpone their exposure to even gradual price
hikes. In this regard, utilities in more than half the states have
hedged at least 50 percent of their supply for this winter by entering
into long-term fixed-price contracts and other techniques. This will
help stabilize prices for their customers. Nonetheless, high gas prices
will hit some consumers hard, including lower-income households and
companies that depend heavily upon natural gas, such as fertilizer
manufacturers.
The Federal Energy Regulatory Commission (FERC) and the Commodities
Futures Trading Commission (CFTC) play key roles in ensuring that
natural gas prices are determined in a competitive and informed
marketplace. Both agencies monitor natural gas markets and investigate
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. 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 which were natural gas related.
www.gao.gov/cgi-bin/getrpt?GAO-06-420T.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Jim Wells at (202) 512-
3841 or wellsj@gao.gov.
[End of section]
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.[Footnote 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.
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.[Footnote 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:
* residential users living in houses, apartments, and mobile homes;
* commercial users such as stores, offices, schools, places of worship,
and hospitals;
* industrial users covering a wide range of facilities for producing,
processing, or assembling goods, including manufacturing, agricultural,
and mining operations;
* 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:
* 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.
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.[Footnote 3] 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.[Footnote 4] 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.
Increasing Demand and Tight Supply Have Driven Up Prices and Made
Extreme Price Spikes Possible:
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.
Trend toward Higher Prices in Recent Years Is Due Largely to Market
Forces:
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.
Figure 1: Wholesale Natural Gas Prices at Henry Hub, in 2004 dollars:
[See PDF for image]
[End of figure]
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):
[See PDF for image]
[End of figure]
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:
[See PDF for image]
[End of figure]
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:
[See PDF for image]
[End of figure]
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:
[See PDF for image]
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.
[End of figure]
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.[Footnote 5] 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,[Footnote 6] 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.
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)[Footnote 7] 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.[Footnote 8] 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.
High natural gas prices are also adversely affecting industrial
consumers. As we reported in 2003, some industrial consumers shut down
production facilities[Footnote 9] 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,[Footnote 10] 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,[Footnote 11] 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.
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.[Footnote 12] 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.[Footnote 13] 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.
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 wellsj@gao.gov. 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.
[End of section]
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.
FOOTNOTES
[1] GAO, Natural Gas: Analysis of Changes in Market Price, GAO-03-46
(Washington, D.C.: Dec. 18, 2002).
[2] Natural 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."
[3] According 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.
[4] A 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.
[5] Other 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.
[6] The preliminary work is part of a larger effort that we will
complete later this year.
[7] LIHEAP 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.
[8] Data reflect LIHEAP and weatherization appropriations, supplemental
or emergency appropriations, and REACH funding.
[9] GAO, Natural Gas: Domestic Nitrogen Fertilizer Production Depends
on Natural Gas Availability and Prices, GAO-03-1148 (Washington, D.C.:
Sept. 30, 2003).
[10] GAO-03-1148.
[11] Anhydrous 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.
[12] Under 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.
[13] The "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.