Natural gas pipelines after field price decontrol : a study of risk, return and regulation

Abstract

This is a study of a regulated industry undergoing rapid change. For the first time in its history, following the partial decontrol of field prices in 1978, natural gas is being priced at a level which places it in direct competition with competing fuels, chiefly oil. This change is placing considerable stress on the established institutional relationships in the gas industry and is the source of what has been and will continue to be a protracted public policy debate on the subject. It is the chief purpose of this study to interpret the effect of this change on the gas pipeline segment of the industry and its regulation.

A second purpose is to explore the use of information from the capital market's valuation of natural gas pipeline securities, both as a means of characterizing the industry transition in the terms of financial economics and of evaluating the financial performance of the pipelines (and thus indirectly their regulators) during the transition. As such, the continuing decontrol of field prices constitutes a convenient "natural experiment" that allows us to characterize the likely nature of the gas industry of the future and ultimately to evaluate the various proposals for changing it.

To accomplish these purposes, the study is divided into five parts. After describing the principal structural characteristics, transactional arrangements and regulatory procedures in the industry, the study investigates the origins and historical evolution of these features. This history is important in establishing the role of natural gas field price and pipeline regulatory policy and market conditions in determining the nature of the transactional arrangements prevalent today in the industry. This section closes with some conventional measures of the extent of the post-1978 transition and the disequilibrium that now exists between gas market conditions, regulatory policy and industry transactional arrangments.

In the next two chapters the tools of modern financial economics are used to characterize the effects of the industry transition on the systematic risk borne by gas pipeline industry investors. A significant secular increase in pipeline industry risk is found to persist during the transition period after 1978, an increase that is found to be directly associated with the partial decontrol of field prices. Other sources of risk are examined including what is termed "contractual leverage"--the leverage induced by rigid pipeline contractual relationships. These results are used to evaluate pipeline financial (and thus regulatory) performance during the transition. A significant deterioration in gas pipeline profitability is detected during this period.

The study closes with an examination of the industry's transactional arrangements as they serve to allocate these risks under regulatory service obligations. It is observed that the current regulatory regime ratifies the longstanding transactional arrangements which bundle rights to gas reserves with rights to pipeline capacity. A substantial exogenous change in the risk conditions in the industry may require a regulatory regime which allows for more flexibility in gas supply transactions. It is suggested that to achieve this flexibility it may be necessary to unbundle the two types of rights, allowing a separate, unregulated market for gas reserves and production to form. This could lead to the formation of a liquid spot and futures market for gas, with consequential informational advantages for the rest of the market. This unbundling might be achieved with pipeline deregulation or a system of common carriage, the feasibility of which is examined in a preliminary manner.