NRRI 16-04 Vertical Arrangements for NG Procurement.pdf

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Recent interest in long-term hedging

Both electric and gas utilities purchase large amounts of natural gas as part of their business operations. Prior to the 1980s, a feature of the natural gas industry was contracts of long durations, often over 20 years at fixed prices, for both producer-pipeline transactions and pipeline-gas utility transactions.
Starting around 1985, trading arrangements within the natural gas industry became dramatically more short-term and flexible, in both price and terms and conditions, compared to prior periods. This trend occurred throughout the sector, from gas procurement, gas storage, and retail transactions to capacity contracting for pipeline services. It was a result of a more open and restructured natural gas market, among other things. This market includes buyers and sellers consummating trades with minimal transaction costs. Other developments favoring shorter-term contracts since the mid-1980s include a highly developed financial market for gas hedging and the evolution of short-term electricity markets. In fact, a major motivator of the restructuring of the U.S. natural-gas industry was the high social costs from rigid multi-year contractual arrangements as the industry transitioned to a more liberalized structure. Overall, competitive pressures have made long-term commitments a more expensive proposition for utilities as well as other market participants by increasing risk.
Over the past few years, utilities and gas producers have given increased attention to long-term commercial commitments under a vertical arrangement. Utilities have publicly stated that these commitments complement their current hedging initiatives that mostly today are short term in nature, one to two years.
This interest in long-term transactions hinges on the U.S. gas market having ample supplies over the next several decades, resulting in more stable and predictable prices than seen over the first half of this century. Other factors include low natural gas prices, gas operator cash-flow problems, and a buyer’s market. Evolving conditions in the natural gas market have made long-term commitments more palatable and potentially mutually beneficial for both gas operators and utilities.
Proposals for vertical arrangements
This paper focuses on utility long-term commitment in the form of utility ownership of gas reserves (UOGR) or a joint venture with an affiliate exploration and production (E&P) company. Under the first arrangement, a utility would acquire a non-operating interest in gas reserves; the utility becomes a partner with the operating entity. The utility typically pays upfront capital expenditures to fund reserves development and typically a portion of the operating costs. In return, the utility acquires an interest in gas reserves located in specific gas fields. The length of an agreement ranges from five years to multi-decade.
All of the utilities proposing UOGR and joint venture arrangements calculate expected gas cost savings for their customers based on inf rma n a a ab e at t e me for example, a comparison of gas production costs with market price forecasts n add t n t ng‐term hedging/price stability benefits and a more secured gas supply. Common features of vertical arrangements for gas procurement include: (1) Cost of service pricing of gas, (2) expected gas-cost savings and stabilized prices to utility customers, (3) for UOGR, rate basing of gas reserves, and (4) imbalanced risk allocation to utility customers.
In their proposals for joint ventures, utilities’ forecasts of gas prices 10-40 years out are highly speculative, illogical, and practically meaningless for making decisions. Justification for vertical arrangements must therefore derive from other than forecasted gas savings over time to utility customers. One possible benefit, and one that seems most plausible, if not tenable, is price stability or hedging on a long-term basis. Utilities have different options for hedging. Whether UOGR or another vertical arrangement is a preferred approach to purchasing natural gas from independent entities in the wholesale gas market requires thorough review driven by facts and utility-specific conditions.
Economic theory and commercial structures Transaction cost economics (TCE) predicts the market conditions under which vertical integration is a preferred institutional arrangement over long-term contracting and spot market transactions. When asset specificity, sunk costs, and a high degree of complexity (e.g., the buyer requires a product to have exact specifications of a high technical nature) characterize a trade, vertical integration can be the most efficient alternative. As the contractual process becomes highly complex, for example, a firm might rationally decide to supply a required input internally rather than purchasing it in the marketplace to avoid the high transaction costs associated with contracting.
The benefits from vertical integration to customers, as specified in the economics literature and realized in actual experiences just seem doubtful for gas procurement by utilities. Vertical integration by electric utilities with coal mines, for example, is consistent with TCE because of asset specificity that makes contracting with an independent entity highly costly. Its rationale for gas procurement seems dubious.
Firms should be less vertically integrated as the cost of using the marketplace to purchase a good or service decreases. Overall, each commercial structure has its strengths and weaknesses. Buying all gas on the spot market, for example, can lead to volatile prices for utilities and their customers. The question for regulators is whether UOGR or utility purchase of gas from an E&P affiliate is compatible with conditions conducive to vertical integration.  The uncertainty of long-term hedging benefits
Utilities proposing vertical arrangements are implicitly assigning a high value to long-term hedg ng. T s a ue may n t ref ect cust mers’ percept n f benef ts. The large hedging losses experienced by utilities in recent years, if anything, suggest a cutback on hedging, rather than expanding hedging on a long-term basis. In evaluating proposals for vertical arrangements, regulators should have some understanding of the value that utility customers place on stable prices. Hedging is not a costless activity, so the utility should provide evidence, other than conjecture, that customers are willing to pay something for more stable prices over the long term. The vertical arrangements discussed in this paper are all complex, involving substantial utility costs in negotiating, executing, and enforcing and monitoring. Regulators should determine as best they can that these costs are justifiable from the perspective of utility customers.
Perhaps the most fundamental question comes down to how long-term commitments under a vert ca arrangement f t w t n a ut ty’s gas-procurement portfolio. Gas procurement is a multi-objective endeavor where the utility tries to balance reasonable cost, price stability and secured gas supplies. For example, a balanced portfolio of gas supplies might combine different commercial transactions, including long-term and short-term contracts. Most gas and electric utilities apply a portfolio approach to gas procurement, which involves purchasing gas under different durations and other terms and conditions. A motivator for a portfolio approach is the hedging of natural gas prices to customers. Whether a vertical arrangement is compatible with an optimal, balanced gas-procurement strategy requires the attention of regulators in evaluating utility proposals.

The hazards of vertical arrangements

Vertical arrangements raise a number of questions for state public utility regulators. One argument in support of utility ownership is that it would provide utilities with a secured supply of natural gas at stable prices over several years. Although this outcome would be a positive development, regulators have to ask whether other commercial arrangements would be preferred. Some of the utility ownership arrangements, either in place or being proposed, would enable utilities to rate base their gas-reserves assets. Their structure almost always involves little risk to utilities relative to the risk borne by their customers. The benefits to customers from long-term gas cost savings and hedging (i.e., how much customers are willing to pay for more stable prices) come across as highly speculative and devoid of accurate quantification.
Another issue touches on regulatory oversight in which utility-ownership of gas reserves or a joint venture arrangement involves a utility and an affiliate. One major distinction between market transactions and vertical integration is the self-dealing aspect of the latter that can pose tricky problems for regulators, necessitating their oversight and other vigilant actions. A regulator would have to monitor this relationship, for example, to ensure utility customers are not overpaying for natural gas purchased by the utility from its affiliate. The regulator might also need to establish codes-of-conduct rules that explicitly prohibit self-dealing abuses by restricting certain actions. Ring fencing or structural separation would help to avoid cost shifting from the unregulated affiliate to the regulated utility, but not necessarily eliminate it.

To protect its interest, utilities need to be vigilant in monitoring their gas operator partner. Under UOGR, utilities have to make important decisions about choosing a partner and gas basins or wells, and the pricing of gas reserves. Effective utility management in contracting or non-operating ownership includes evaluating and selecting a supplier or partner, and negotiating, executing and administrating contractual agreements. The gas operator may lack strong incentives for cost efficiency, especially with a cost-plus pricing scheme and asymmetric information favoring the gas operator. Incomplete contract provisions can also lead to pp rtun sm r “bad be a r” by t e gas perat r n m ca t ut ty nterests.
Dubious customer benefits
For various reasons, this paper is skeptical about vertical arrangements in benefiting utility customers. It raises the question of what economic gains accrue to utility customers from long-term hedging. We have seen large losses in recent years from short-term hedging by both electric and gas utilities. Multi-decade hedging would seem to pose yet higher risk to utility customers. These risks translate into inflated utility bills for customers. It seems ironic that the major apparent reason for vertical arrangements is to reduce upside price risk to utility customers but, in the process, utilities are asking customers to take on new risks. Although an empirical question, it is conceivable that utility customers could face higher risk from a vertical arrangement involving UOGR or a utility affiliate than from the absence of long-term hedging. A review of the vertical arrangement plans suggests that customers could very well bear higher risk from an action that purports to protect those same customers from risk.
From the perspective of utility customers, vertical integration seems to be a high-risk strategy for hedging. Under most proposals and actual plans, utility customers would shoulder much more risks than utility shareholders or holding companies. Vertical arrangements create several risks. They relate to: (1) gas-production operating cost, (2) level of gas reserves and production (dry holes), (3) liability and incomplete contractual agreement (leaving room for opportunism or, more generally, bad behavior, (4) counterparty risk and (5) for utilities, regulatory-induced risks from less-than-full commitment, regulators knowing little about the upstream side of the gas business and having to evaluate complex contract provisions.
After reviewing different vertical-arrangement plans, it is evident that customer risk is excessive relative to utility or holding company risk. Customer risk comes largely from a low market price, and unanticipated, unfavorable events in gas operation or production from reserves. Commissions entertaining UOGR and other vertical arrangements, or long-term hedging in general, should consider balancing the risks between utility shareholders and customers. The main objective would be to protect utility customers from inaccurate forecasts, which are likely given the long-term nature of the vertical arrangements.
More definitive benefits to utilities and their affiliates
Benefits to utilities and affiliates from vertical arrangements are much more certain. One benefit is higher utility earnings from the rate basing of gas-reserves assets. A utility affiliate could also realize higher profits from selling to the utility instead of the open market. Thus, on the surface expected benefits are larger and more certain for utilities and their affiliates than their customers. Liquid wholesale gas markets (minimizing gas supply risk) plus highly speculative forecasts of long-term gas prices dramatically weaken the argument for UOGR and affiliate transactions. In fact, in one sense the vertical arrangements proposed by utilities resemble more of a speculative than hedging activity. The utilities are betting that future natural gas prices will increase based on highly imperfect information, and then structure a long-term plan designed to achieve gas-cost savings. In sum, utilities should have a strong burden of proof showing that vertical arrangements are good for their customers in the long term.

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