Natural Gas Prices and Market Fundamentals

Publication Date: December 2004

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics; Energy

Type:

Abstract:

Intermittently high, volatile natural gas prices since 2000 have raised concern among all types of consumers. Residential customers have seen gas bills increase dramatically during the heating season. Industrial consumers have seen costs increase, which reduces their competitiveness. Because the price of natural gas at the consumer level is a mixture of market forces and regulation, explaining the behavior of price can be difficult.

Debate in the 108th Congress concerning the energy bill (H.R. 6), considered provisions which are intended to improve long term natural gas supplies in the United States. Other issues are likely to be brought before the 109th Congress for consideration. This paper analyzes the short term forces which influence the natural gas market.

The Energy Information Administration has developed a metric called the effective capacity utilization rate as a framework for analyzing the economics of the natural gas market. This measure has been shown to be correlated with the price of natural gas. When as the effective capacity utilization rate attains high levels (90% and above) it becomes increasingly likely that tight market conditions will yield high prices.

As a result of the Natural Gas Policy Act of 1978 (P.L. 95-621) and subsequent legislation in 1989 and 1992 (P.L. 101-60 and P.L. 102-486) the wellhead price of natural gas is market determined. Pipeline rates are federally monitored and distribution charges are regulated at the state level. Price variability centers on the wellhead price as well as the price determined in futures markets.

Price spikes have occurred in two of the past three heating seasons. Whether severe weather causes price increases depends on the tightness of the market as measured by the effective capacity utilization rate. The same level of demand could lead to very different price results if the effective capacity utilization rate is high or low.

A variety of factors can affect the effective capacity utilization rate. Since short run supply adjusts to meet demand, the weather will be an important determinant. The relationship between natural gas prices and investment in exploration, development and production is an important factor in determining productive capacity. The availability of stored gas and imported gas become vital to price stability as the effective productive capacity exceeds 90%.

In the very short term there appears to be little that can be done from a policy perspective to alter the fundamental economics of the natural gas market. In the longer term, policies that slow demand growth and/or encourage the growth of supply, either from domestic or foreign sources could be effective.

This report will be updated as events warrant.