NGSA Background Materials: History of Natural Gas Wellhead Price Controls

NATURAL GAS SUPPLY ASSOCIATION

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History: Natural Gas Wellhead Price Controls

Imposition of Wellhead Controls

For most of the 20th century, the natural gas industry--like the telecommunications, railroad, and electricity industries--was viewed as a "natural monopoly" that needed government regulation to protect consumers.

Public consensus held that, to create a market large enough to encourage a company to invest in the pipeline grid necessary to get the gas to the customer, local municipalities had to grant exclusive licenses to natural gas distributors or create municipally-owned gas distribution companies. Similarly, investments in the interstate pipeline construction necessary to get gas from production areas to market areas was also viewed as likely only if competition were limited and rates of return were guaranteed; the federal government extracted a price from companies responding to these benefits by imposing controls on transmission rates.

Natural gas prices at the wellhead remained uncontrolled by federal or state governments until the early 1950s, when the state of Wisconsin sued Phillips Petroleum Co. over the company's plan to raise the price of natural gas from three to four cents per thousand cubic feet. As a result, in 1954, the Supreme Court determined that the federal government could regulate natural gas back to the wellhead, at least for natural gas traded interstate. (The price of intrastate gas--sold in the state that produced it, such as Louisiana or Texas--remained unregulated until 1978.)

The Initial Effect of Wellhead Price Controls

For the first two decades of controls, wellhead prices remained low and supplies remained high. Supply was driven, however, not by the profit available in selling natural gas, but by the fact that companies drilling for oil kept finding natural gas instead of or associated with oil. Putting this gas into the marketplace provided more income than failing to do so.

General economic conditions in the 1950s and '60s also tended to support the practice of companies' producing their gas rather than leaving it in the ground. First, there was very little general price inflation; the consequent low interest rates encouraged companies and their stockholders to accept the modest returns on gas investments. Second, during this period, the industry was not in as significant competition for capital in global markets; thus, putting capital into gas production facilities (gathering systems and processing plants, for instance) did not detract from capital available to invest in more profitable business areas.

Wellhead Price Controls as Economic Conditions Changed

The federal government's imposition of low wellhead prices began to exert a depressing force on the industry as economic conditions changed. Inflation rose during the Viet Nam War; and the economies of Europe and the Far East, largely devastated during World War II, began to grow, draining available capital away from low-return but capital-intensive natural gas production. As producers had to choose between gas production and more lucrative investments, resources started to move away from gas production. In market areas, however, demand continued to increase, however, because of low prices.

These conditions would clearly have led to a supply/demand imbalance at some point. That imbalance manifested itself during several exceptionally cold winters in the mid-'70s. Gas continued to be available to customers in the producing states because, without price controls, supply and demand were able to come into balance. However, the controls on interstate gas caused a shortage in non-producing states.

Adjusting Wellhead Price Controls

The federal government's initial reaction to the "shortage" was to raise the price of natural gas--not via market forces but instead by developing a system of controls designed to encourage exploration. The result was the 1978 Natural Gas Policy Act, which created 26 categories of natural gas subject to varying degrees of price control. The Act assigned high prices to natural gas produced in the most expensive ways--deep wells or hard-to-produce reservoirs such as "tight sands." Readily-available natural gas, however, continued to have low regulated prices.

Producers responded by putting on the market the higher-priced, hard-to-get-at natural gas, leaving more easily found natural gas in the ground. The average price of natural gas rose significantly. But demand dropped precipitously.

The "Take-or-Pay" Problem

The initial consequences of the new supply/demand imbalance were experienced initially not by producers but by pipelines. Under then-existing industry regulations, pipelines contracted for natural gas supply from producers, "bundled" it with services such as transmission and storage, and sold it to distributors.

In the months immediately following passage of the Natural Gas Policy Act in 1978, pipelines contracted for enough gas to meet then-current demand, but at the new, higher prices demanded under regulation. These supply contracts frequently had "take-or-pay" clauses requiring the pipelines to pay for the gas whether or not they actually took and sold it. As demand began to fall in response to higher prices, pipelines began to fill with unsold gas, forcing pipelines to refuse to pay for gas they could not sell. As the situation worsened, severe financial damage or even bankruptcy appeared to threaten some pipelines--pipelines that had been built under regulations guaranteeing them a rate of return on investment.

With strong government encouragement, producers and pipelines renegotiated many of the supply contracts, reducing the threat to the pipelines. However, producers now faced a situation in which they had made investments to produce far more gas than could be absorbed by the market--a situation termed the "gas bubble." Low prices, financial difficulties, and corporate cut-backs resulted.

End of Controls

While the Natural Gas Policy Act initially exacerbated the supply/demand imbalance, it also contained the nucleus of relief--a plan for a partial decontrol of natural gas prices beginning in 1985.

As 1985 approached, there were many predictions that the wellhead gas price--which averaged $2.66 in 1984 would "fly up" once controls were relaxed. In fact, the opposite occurred. As market forces were permitted to influence the industry, prices started to drop.

The positive effects of allowing market forces to set natural gas prices were clear enough that in 1989, Congress passed the Wellhead Decontrol Act to speed up the demise of price controls, which ended finally on January 1, 1993.

Marketplace Effects

On an average, gas customers (residential, commercial, and industrial) saw prices drop 30 percent between 1984 and 1991. For residential customers, the drop represented an annual saving of over $250 on natural gas bills for the average American family.

During the same period, demand began gradually to increase--from 17.95 trillion cubic feet (tcf) of consumption in 1984 to 19.05 tcf in 1991. By 1992, production capacity figures of the Natural Gas Supply Association indicate that supply and demand began to come into balance.

Effects on the Perceived Natural Gas Resource Base

In 1978, the U.S. Geological Survey predicted that the U.S. had only 25 years of natural gas supply left. This misperception appears to have been based on the belief that market shortages resulted from a short supply of natural gas.

Today, both industry and government accept that the cause of the shortage was regulation, not short supply. According to the National Petroleum Council's report to the U.S. Secretary of Energy in 1992, there are approximately 60 years-worth of conventional supply in the lower 48 states (at current rates of consumption). Additionally, U.S. consumers have access to strong Canadian natural gas reserves. Should demand increase, there are significant resources in Alaska as well as several thousand years' supply of natural gas in such unconventional supply sources as deep brines and hydrates.

September 1996

NOTE: Statistics are those of the Energy Information Administration, U.S. Department of Energy, unless otherwise noted.

This page was last updated August 31, 1997.