By LINDA VOGT

Take equal parts complex regulations, supply uncertainties, soaring rates and consumer confusion; heat to an angry, rapid boil. What have you brewed? A mulligan stew of confusing natural gas rates. The pipelines and the prices they pay for natural gas are at issue, but solutions must consider the complexity and vastness of the industry, large financial investments, and long-term supply, plus the consumer's need for heat. Illinois has proposed one plan to Congress, and the pressure is building for some kind of action. At press time in late April, one of the major pipelines, Panhandle Eastern, announced it was making efforts to reduce its rates in Illinois

IN OCTOBER 1982, Panhandle Eastern announced the delivery of imported liquified natural gas from Algeria at over $7.00 per thousand cubic feet. At this news, Illinois consumers erupted with the force of a natural gas explosion, causing all parties involved to reevaluate the pricing mechanisms of natural gas. Not only have gas prices risen by 20 to 40 percent over the 1982-83 heating season, but there is a surplus of natural gas in this country and cheaper gas is available than what is being transported by pipelines and paid for by consumers.

But the blame for higher prices cannot be placed on any one action. For years, natural gas prices have been brewing in a stew of regulatory policies and supply uncertainties. That stew is now boiling over.

The intricacies of deregulation of natural gas prices under the Natural Gas Policy Act of 1978 set the stage for wellhead price increases, the price that producers charge to the pipeline. Distribution shortages of natural gas during the early 1970s caused pipelines to enter into long-term contracts, both foreign and domestic, that have resulted in the substitution of expensive gas for cheaper gas. And behind all the pricing and supply mechanisms is the stark fact that natural gas is a depletable and therefore increasingly expensive resource.

Natural gas pricing has become a problem because of the effects higher prices have had on consumers. When asked about the situation, Illinois Commerce Commission Chairman Philip O'Connor said, "It's bad. Prices are putting a lot of people, both middle-and low-income, in a very tight squeeze. They are causing job loss as businesses close because they can't pay all of the bills." In January Central Illinois Light Company, a utility whose customers have experienced some of the highest price increases, reported that one in five of its customers had fallen behind on their bills. Not only that, but around 17,000 households in Illinois went into the winter without any heat, disconnected by their utility because they weren't able to pay their bills from the previous winter.

The complexity of the pricing problem is reflected in the complicated nature of the industry itself. The natural gas journey begins with the producer, who extracts it from a well and sells it to a pipeline company. Pipelines, of which there are nine supplying Illinois, carry and sell the gas to distributors, better known as utility companies. The major pipeline in Illinois is Natural Gas Pipeline Company of America, which transports gas to Northern Illinois Gas, Peoples Gas, the Northern Indiana Public Service Company and Northshore Gas Company. Panhandle Eastern, via two of its subsidiaries, Trunkline Gas Company and Panhandle Eastern Pipeline Company, supplies natural gas to utilities in central and downstate Illinois, as well as other Midwestern states. Central Illinois Light Company (CILCO), Central Illinois Public Service Company (CIPS) and Illinois Power are three of Panhandle's major Illinois customers. These utilities then distribute the gas to consumers, who use it for heat in residences and businesses and as fuel for manufacturing processes.

'It's bad. Prices are putting a lot of people, both middle- and low-income, in a very tight squeeze' — IlCC Chairman O'Connor

The journey is also a well-regulated one, both in price and pathway. The Federal Energy Regulatory Commission (FERC), an independent agency within the Department of Energy, has regulatory jurisdiction over interstate natural gas operations, which includes pipelines. At the state level, the Illinois Commerce Commission (I1CC) regulates natural gas utilities in Illinois. Influencing the entire process, of course, is the invisible hand of the federal Natural Gas Policy Act (NGPA) of 1978, which raised the ceiling prices charged by producers for different categories of natural gas and which continues to allow prices to rise in carefully modulated steps.

Readers of Illinois Issues will be familiar with the history of deregulation (see "Natural Gas: What's in the pipeline for Illinois?" February 1982). The NGPA of 1978 did not simply deregulate the price of gas; it gave us a multiplicity of prices and about 24 categories of gas. In order to understand present pricing difficulties, these categories can be reduced to old gas, new gas and deep gas. Old gas, which is largely from wells producing prior to 1977, remains under price controls until 1985, when it will be allowed to rise at a rate slightly higher than inflation. New gas, from wells that have been producing since 1977, was allowed to rise in price and will be totally deregulated in 1985. The last category, deep gas, has not been regulated since 1979; it is usually found 15,000 feet below the earth's surface and therefore expensive to drill.

June 1983/Illinois Issues/11

In 1978, the reasoning for the new pricing regulations was perfectly clear. Prices had been set at artificially low levels, relative to other fuels, and producers had no incentive to drill new and deeper wells to augment dwindling supplies. The new pricing structure

Customers of CILCO, which is supplied by Panhandle Eastern Pipeline, have experienced rate hikes of 72 percent, almost all of which is due to pipeline increases

Another inexorable but minor factor in price increases has been the normal depletion of old gas. Ken Costello, senior economist at the IlCC, estimated that higher priced new gas replaces old gas at the rate of 10 to 15 percent per year because the old gas is simply used up. And it's the reality of natural resource depletion that put the fear of supply shortfalls into the pipelines and caused some of them to go seeking their salvation in foreign lands.

The year 1968 was a key year for supply predictions. At that time, estimates of proved reserves, those natural gas supplies that producers know are in the ground and recoverable under present economic conditions, began to decline. By 1975, the American Gas Association, which represents gas utilities, was predicting that proved reserves amounted to a 10-year domestic supply — an estimate thought to be too low by some geologists. At the same time, immediate supply shortfalls were experienced in Midwestern states because of regulatory pricing mechanisms. Consumers were asked to conserve, new hookups were forbidden, and some industries experienced disruptions in gas service. That put the fear of the cold into consumers. Meanwhile, Panhandle Eastern, through its subsidiary Trunkline LNG, was negotiating a gas contract with Algeria; and while blizzards raged in the winter of 1977, the contract was approved by the Federal Power Commission (predecessor to the Federal Energy Regulatory Commission). The I1CC and utilities such as CILCO and CIPS supported the contract at the time.

Since that decision, but not completely because of it, natural gas prices have soared skyhigh. For instance, over the past two years, customers of CILCO, which is supplied by Panhandle Eastern Pipeline, have experienced rate hikes of 72 percent, almost all of which is due to pipeline increases. Natural Gas Pipeline's price rises have been more moderate, in the area of 18 percent, and its rates are now among the cheapest in the nation. Past policies of the two pipelines have differed: While Panhandle was negotiating with Algerian suppliers, Natural Gas made a commitment to develop domestic reserves and has avoided much of the controversy that Panhandle's decision ignited.

Algerian LNG controversy

In addition, eight members of the Illinois congressional delegation cosigned a letter to FERC, noting the disastrous effects price rises were having on consumers. But to no avail. If consumers were having trouble, Panhandle was also in a precarious position. The take-or-pay contract that its subsidiary, Trunkline LNG, had made with Algeria specified that Truckline LNG had to pay for the gas whether it took delivery or not. Trunkline LNG had invested $577 million in import facilities at Lake Charles, Ga., which were completed in 1981. Although this cost can be passed on to consumers even if the facilities aren't actually used, the company cannot earn a full rate of return on them if no gas is flowing through. In addition, two American tankers were built in 1980 for $480 million to transport the liquified gas from Algeria. Their financing was a private venture carried out by Lachmar, a U.S. corporation. However, Panhandle had formed a subsidiary, Pelmar, which holds a 40 percent partnership in Lachmar. Because it is a private venture, the tanker costs cannot be recovered through the rate base (where they would be passed on to consumers) if tankers are not used. With such large investments at stake, Panhandle, like any other business, did not want to take a loss. And while complying with regulations, it also sought the highest possible rate of return.

12/June 1983/Illinois Issues

In responding to the IlCC complaints, Panhandle's subsidiaries, Trunkline Gas and Trunkline LNG, argued that FERC had no authority to revoke the importation certificate. In addition, in spite of the 1981 interruption cited by the IlCC, LNG was now being imported according to the contract. Panhandle also accurately observed that the opponents of the LNG project were its supporters in 1977, when the contract was approved. The present opposition, Panhandle argued, stemmed from short-term market conditions, which would eventually correct themselves.

FERC utlimately ruled in Panhandle's favor by dismissing the complaints, and Panhandle's pipelines were allowed to pass on the costs of Algerian gas to consumers. Although FERC judged that it probably could not revoke the import certificate, it sidestepped the issue by saying there was no need to determine the extent of its authority. If revocation were possible, FERC said it would require "a compelling showing" that the conditions under which the certificate was issued had undergone fundamental longterm changes, a showing which the judges did not find. Although FERC concurred that the Algerian gas was not needed now, "no one has demonstrated that this gas. . .will not be needed over the duration of the gas supply contract." Furthermore, Sonatrach was now delivering Algerian LNG as specified in the contract, and the gas was considered marketable because its high price had been "rolled in," or averaged, with lower priced gas. In recognition of the high cost of the LNG, FERC did ask in its ruling that the Algerian contract be renegotiated at a lower price, but final action on that was not expected for several months. Another area of concern for FERC was the effect of higher-priced Algerian gas on utilities. Since price increases that pipelines pay to producers are automatically passed on to utilities, and then to consumers, demand for the utilities' services can go down. A new concern for natural gas utilities is that they may lose some of their industrial customers who can switch to lowerpriced coal or fuel oil. For example, since the hearings, CILCO has lost two industrial customers to coal. CILCO also estimated that, in the future, it could lose as much as 20 percent of its total load due to fuel switching. Not considered as an issue in the FERC proceedings was the effect of the higher-priced gas on the average household rate-payer.

What was at issue, claimed Stan Wallace, spokesperson for Panhandle Eastern, was "the integrity of the regulatory process." In other words, FERC concluded that Panhandle had not only followed the full regulatory process in the Algerian contract, but that the massive investments made in the project required secure long-term contracts. Wallace said, "Lenders should be able to act with a degree of certainty, and the commission focused on the legal and financial underpinnings of the industry."

Algerian gas is now being shipped to central and downstate Illinois. But virtually unnoticed during the Algerian controversy was the importation of Canadian gas, which is shipped to nearly all consumers in Illinois. Last October, when charges for Canadian gas began to show up in consumer bills, the price at the Canadian border was $4.94 Mcf. Moreover, since the venture required a new pipeline, the fixed costs of transporting it, at $1.87 Mcf, were extremely high. For comparison, it costs around $.40 Mcf to transport gas from Kansas. Thus, total costs to the Illinois utilities for Canadian gas amounted to almost $7.00 Mcf. This price is further complicated because the Canadian charge of $4.94 Mcf is a uniform border price, charged at all points of entry into the United States. Since most Canadian gas is developed in the western provinces, the uniform border price, which includes transportation to the border, means that Illinois consumers are subsidizing transportation costs to customers in New England. Although Canada recently announced an 11 percent price cut in gas shipped to the U.S., and Natural Gas Pipeline is now buying Canada's gas at lower prices, it is still more expensive than some domestic gas.

Take-or-pay dilemma

But underlying the controversy over imported gas is a far more basic, industrywide problem: the take-or-pay contracts have hurt everyone except producers. Take-or-pay contracts became the fashion between 1973 and 1978 as pipelines sought to ensure their supply. Because gas prices were regulated at low levels and pipelines could not obtain gas by merely offering a higher price, they instead bid up the amount of gas they would take from a field. At the time, pipelines agreed to take up to 90 percent of the gas and guarantee payment whether it was delivered in the year it was purchased or not. Domestic prices for this gas ranged from $.53 Mcf to $1.92 Mcf, depending upon when the contract was made. Many contracts also contained indefinite escalation clauses, which tied price increases to the price of No. 2 fuel oil. Although the gas which has been paid for may still be taken for a number of years, the price for it may go up in the meantime, and the pipeline would have to pay the difference upon delivery.

June 1983/Illinois Issues/13

The irony of these contracts was that, when demand dropped 12 percent as it has over the last several years, pipelines were stuck with purchase agreements for gas they couldn't sell. "Then it was a choice of what gas do we [the pipelines] not take," said Lemon of the IlCC. "If we don't take the more expensive gas, we benefit our consumers, but we lose money corporation-wise. If we don't take our cheap gas, our consumers pay a little bit more, but our corporate treasury is not quite so adversely affected."

For example, Natural Gas Pipeline in 1982 made prepayments on take-or-pay contracts of about $50 million. While consumers in Illinois were paying an average price of $2.33 Mcf, the gas not taken was selling for about $.70 Mcf. From a consumer's point of view, the decision seems questionable. However, if Natural had "shut in," or not taken, the more expensive gas, its prepayments to the producers could have totaled around $300 million, according to the IlCC. Money for prepayments is borrowed by the pipelines, and the interest is considered part of carrying costs. Because the gas is not used, pipelines have no assurance at present that these costs can be recovered in the rate base. Therefore, Natural chose to take the expensive gas and not lose the interest on the larger sum of money which would be borrowed for prepayments on the higher priced gas. Trunkline Gas, Panhandle's subsidiary pipeline which serves downstate Illinois, is in far worse condition, anticipating up to $600 million worth of prepayments to producers for gas it cannot take because there is no market for it.

"Under established FERC regulations, it's not necessarily imprudent to do what Natural did," concluded IlCC economist Lemon, ". . .but it's interesting that the surplus of gas that we [the consumers] benefited from under the Natural Gas Policy Act has led the pipelines to alter their purchasing price so that we're even paying a higher price than what we need to."

In fact, the take-or-pay contracts are getting much of the blame for price rises, where expensive gas has been substituted for cheap gas, and federal regulatory policies are getting the blame for both the take-or-pay contracts and for the higher ceiling prices.

Yet another way of looking at the situation is provided by Lemon: "Federal ceiling prices permit those high prices, but they don't make the pipelines necessarily pay those high prices." In other words, paying the highest price allowed under NGPA is not called for by either regulations or market conditions.

The Illinois plan

Lowering the price of gas by various methods has been the subject of a flurry of bills being introduced into Congress. The most radical proposal comes from Illinois, in an unprecedented merging of efforts of the IlCC and the Illinois congressional delegation. Called the Consumer Access Plan, bills have been introduced into both houses of Congress to change the nature of business as usual for the pipelines. In the House, the bill is sponsored by Tom Corcoran (R-14, Ottawa). In a rare bipartisan effort, the Senate bill is cosponsored by both Illinois senators, Democrat Alan J. Dixon and Republican Charles H. Percy. Developed by the Illinois Commerce Commission, the plan would change the status of pipelines from a business that buys and sells gas to that of a mere transporter of gas, and the utility companies could purchase gas directly from the producer, not the pipeline. Oil pipelines are presently under this system, called common carriage. If the plan passes, all existing contracts between utilities and pipelines could be voided, paving the way for the utilities to negotiate lower-priced contracts.

A key element behind the Illinois proposal is the current excess supply of gas. Assuming that about 15 percent of the total volume of gas available is presently shut in, or not being sold, the plan would make this gas available to utilities to purchase, thereby displacing higher-priced gas. More buyers would also create a more competitive market. Not everyone agrees with this reasoning, however. Some economists contend that more buyers cause the price of a commodity to rise, to which the IlCC responds that total demand for natural gas would not be changed. In testimony presented before a subcommittee of the U.S. House Committee on Energy and Commerce, IlCC Chairman O'Connor said, "On the day this Consumer Access Plan is passed, consumer gas bills will be reduced as much as 25 percent." The reduction would actually vary depending upon what pipeline serves what utility. For example, IlCC projections show that Chicago may experience a 4 percent reduction, while Springfield's gas prices may go down by 16.9 percent. The legislation would also authorize Congress to set transportation tariff rates for the pipelines, which may in turn provide additional savings for customers of Panhandle Eastern Pipeline and Trunkline Gas.

The proposal does not address the take-or-pay contracts themselves. The IlCC theory is that making cheaper gas available to utilities would make the expensive contracted gas unmarketable and that the change in public policy would provide sufficient reason to renegotiate the contracts.

An area to be studied under the plan, which may pose a problem in direct utility/producer dealings, is the vertically integrated nature of the natural gas industry. Pipelines often have subsidiary producers. In fact, another reason for the price rises was a 1982 FERC order which provides that, under NGPA, a pipeline is allowed to pay its

14/June 1983/Illinois Issues

production affiliates the price that it paid to one other producer. Previously, the pipeline had been able to pay only the cost of service, or developing the gas, plus a rate of return. "This ruling permitted the pipelines to make money they hadn't anticipated making," said IlCC economist Lemon. Chairman O'Connor would not predict any specific problems with vertical integration, however, saying that "common carriage would break the most anti-competitive link. It is hard to make a decision about vertical integration unless that link is broken and then we see what happens."

While stopping short of saying Panhandle is against the Illinois proposal, spokesperson Stan Wallace responded to the plan by saying it is "a shorthand conclusion" drawn from a temporary aberration in the industry. He argues that price trends are responding to the market. For example, some deep gas in 1981 was selling at $9.00 Mcf; it is now under $4.00 Mcf. Given time, Wallace believes, the present system will prove itself to be economically efficient. In addition, he says, the proposal does not address several points.

For one, the natural gas industry has built extensive physical facilities to transport gas. Under the proposed system, it would be difficult to allocate the fixed costs of these facilities in a fair way if utilities bought gas from outside of the pipeline's present territory. The Illinois proposal, according to Wallace, does not address this situation. Wallace's second point deals with emergency situations. In buying gas, Panhandle has a number of producers to call upon in an emergency, such as a frozen well. If the Illinois plan were adopted, utilities would need to compensate for this diversity of supply sources in their own trading in order to assure themselves of uninterrupted supply.

Most importantly, however, longterm supply remains a question for Wallace, since pipelines operate on a 15-year timeframe, and Panhandle thinks that the Illinois proposal does not adequately allow for the time and investment needed for the development of new supplies for the U.S. Wallace pointed out that from 1970 to 1982, proved domestic reserves have declined by 35 percent. Furthermore, he said, drilling in the U.S. has recently declined sharply, from 4,500 to 1,800 working rigs, largely due to the current excess of supply.

The Illinois proposal for common carriage is one of about 20 bills that have been introduced into Congress to either recontrol or decontrol natural gas prices. Co-sponsors Corcoran, Dixon and Percy say that the proposal has a good chance of being an amendment to any bill on gas prices worked out by both houses of Congress. Certainly, consumer attitudes are such that the politicans feel compelled to act.

But action will require laborious work and generate heated debate. Predictions of price increases and decreases are as numerous as the number of proposed solutions, and regulators and industry experts only agree that the natural gas situation is not natural. Moreover, in this extensively regulated industry, the rules — however well-intentioned — have operated so far to the detriment of the consumer. What complicates the matter is that solutions depend on accurately predicting the nation's energy future, and the difficulty of that task is well-documented historically. In 1978, when NGPA was formulated, predictions of supply were not based on a prolonged economic recession, the amount of conservation that has occurred or the effects of the rapid rise and fall of oil prices. Predictions are equally problematic today. Panhandle justifies many of its actions on its fear of supply shortages in the next 20 years, while the I1CC claims that domestic reserves are adequate for the next 20 years. Given lower-priced alternatives, the I1CC sees no sense in importing Algerian or Alaskan LNG (predicted to come in at $18 Mcf in the 1990s) for the rest of the century. Under the common carriage plan, the I1CC argues, utilities can say "No" to gas not priced according to market conditions.

But while the economists, the politicians, the regulators and industry management debate, the consumer is paying the high prices and feels unjustly burdened by them. Thus, gas prices have become a political issue, with Illinois politicians becoming consumer advocates, and the fate of the industry is now in congressional hands. □

Linda Vogt is a public affairs associate for energy studies at Sangamon State University, where she is also completing a master's degree in environmental studies.

June 1983 | Illinois Issues | 15