STAFF REPORT BY THE

OFFICE OF MARKET OVERSIGHT

AND INVESTIGATIONS

FEDERAL ENERGY

REGULATORY COMMISSION

2003 

NATURAL GAS

MARKET

ASSESSMENT
WINTER 2002-03

TABLE OF CONTENTS

The assessment focuses primarily on natural gas. The Office of Market Oversight and

Investigations (OMOI) seeks to identify issues important to customers and market participants

and to signal the areas of greatest concern and vigilance for the Commission at this time. The

Federal Energy Regulatory Commission created the OMOI in April 2002 to focus its efforts in

energy market oversight. Any errors are the responsibility of the OMOI alone and not of the

Commission as a whole.

We encourage readers to provide feedback on this OMOI product by sending comments to 

an e-mail address specifically set up for this report, natural.gas.assessment@ferc.gov, or by

contacting staff referenced in the acknowledgements. They can be reached as follows:

Office of Market Oversight and Investigations

Federal Energy Regulatory Commission

888 First Street, N.E.

Washington, D.C. 20426

202-502-8100

A fair energy marketplace is everyone’s responsibility. Please do your part. If you encounter

inappropriate energy market behavior, contact our Enforcement Hotline toll-free by telephone

at 1-877-337-2446 or via e-mail at hotline@ferc.gov.

Thank you.

WILLIAM F. HEDERMAN

Director

Office of Market Oversight and Investigations

EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . 1

THE ISSUES

1. DETERIORATING FINANCIAL CONDITIONS OF

MARKET PARTICIPANTS . . . . . . . . . . . . . . . . . . . . . . 4

2. MANAGING CREDIT EXPOSURE . . . . . . . . . . . . . . . . 11

3. SHAKEN CONFIDENCE IN PRICE DISCOVERY METHODS . 15

4. CONTINUING NEED FOR EFFICIENT INVESTMENT

IN INFRASTRUCTURE . . . . . . . . . . . . . . . . . . . . . . . 19

5. CONTINUING POTENTIAL FOR MANIPULATION . . . . . . 25

CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . . . . . . 29
The healthy functioning – or distress – of natural

gas markets has profound effects on the overall

economy. In 2001, customers spent $142 billion

on natural gas in the United States,1 about 1.4 percent of the gross domestic product.2 Almost onequarter of the natural gas sold was used by residential customers.3 The average annual natural gas bill for residential customers that year in the contiguous 48 states, stated

in 2002 dollars, was $844.4 Other uses include the generation of electricity and the manufacture of other goods and services and

for transportation fuel.

Competitive forces have created

benefits for natural gas customers.

Reform of natural gas markets in the

United States by Congress and the

Federal Energy Regulatory

Commission generated significant customer benefits over

the past quarter century. Prior to passage of the Natural

Gas Policy Act (NGPA) of 1978,5 the natural gas industry

faced chronic supply shortages arising from uneconomically low regulated wellhead prices.

The NGPA permitted suppressed market forces to

work by phasing out price caps on wellhead natural gas

prices. During the late 1970s and in the early 1980s,

prices rose to meet high interim price caps as an incentive

for drilling for more supply. By the latter half of the

1

JANUARY 2003

2003 NATURAL GAS

MARKET ASSESSMENT

T

The North American natural gas marketplace has shown itself to be remarkably

robust through the many trials of recent years. Nevertheless, wholesale natural

gas markets face challenges as 2003 gets underway. Quick, thoughtful and effective action can address these challenges successfully and can maintain the benefits

of a competitive natural gas industry for customers and the overall economy. 

Wellhead prices 

are prices paid to

producers at the

well, before the gas

enters an interstate

pipeline.

1 OMOI analysis of statistics compiled by the Energy Information

Administration and published in Natural Gas Monthly, December 2002. 2 U.S. Department of Commerce, Bureau of Economic Analysis, National

Accounts Data, "Current-Dollar and ‘Real’ Gross Domestic Product," at

www.bea.gov.

3 Energy Information Administration, Natural Gas Annual 2002, Table 1,

"Summary Statistics for Natural Gas in the United States, 1996-2000," pp. 5-6.

4 Energy Information Administration, Natural Gas Use in American

Households, at www.eia.doe.gov/emeu/consumptionbriefs/recs/natgas/

nat_gas_piece.html. 2002 value was derived from EIA estimate of $10.07

per Mcf residential fuel cost at 1997 residential consumption level of 83

Mcf. OMOI inflated this value using a 1% GDP deflator obtained from

the U.S. Department of Commerce, Bureau of Economic Analysis. 5

15 U.S.C. 3301-3432
2

JANUARY 2003

1980s, prices fell in direct response to

oversupply. That oversupply lasted

through most of the 1990s. Figure 1

tracks prices through this period,

showing how they rose and fell.

Subsequent Commission orders

that addressed evolving market conditions, including Order Numbers 380

(1984), 436 (1985) and 636 (1992),

contributed to the efficient operation

of market forces to benefit customers.

Order 380 enabled utilities to purchase spot market gas, and Orders 436 and 636 provided

for open access on pipelines, ended bundled pipeline

sales service and introduced capacity release and other

innovative rate designs. 

In 2000 and 2001, natural gas prices rose for slightly

more than a year. That price pattern marked the end of

more than a decade of oversupply within the production

segment of the North American gas market, and it was driven by a variety of factors. These market-changing factors

included a tighter supply-demand balance, regional occurrences of pipeline congestion and participant behavior, factors we will discuss in greater detail later in this assessment.

With the exception of the period of the price

plateau, real wellhead prices have remained below those

of the early 1980s. Figure 1 also shows that competitive

markets have brought close to 20 years of moderate

prices for gas delivered to the citygate. Importantly, competitive markets have increased the efficiency of long disThe spot market is

the natural gas market for contractual

commitments that

are short-term (usually a month or less)

and that begin in the

near future (usually

the next day). 

Sources: Energy Information Administration at www.eia.doe.gov; Bureau of Economic Analysis at www.bea.gov

U.S. Consumption

(Annual)
delivery cost of natural gas – the difference between citygate and wellhead prices – has fallen in real terms

about 40 percent between 1984 and

2002, a compound reduction of 2.8

percent per year.

The Commission’s Office of

Market Oversight and Investigations

(OMOI) has prepared this report to

provide the Commission and the

public with an assessment of current

developments, trends and issues in

natural gas markets. In particular,

OMOI explores the effectiveness of competition in natural

gas markets and focuses on industry and government

actions to address any problems or identified threats. This

assessment does not release privileged information related

to current investigations; it does discuss current issues

and industry, regulatory and investigatory efforts to deal

with these issues. 

The Issues

Based on our analysis, OMOI considers the five most

pressing concerns for natural gas markets as of the

winter of 2002-03 to be:

1. Deteriorating financial conditions 

of market participants

Natural gas companies heavily engaged in trading – in a

trend shared with electric traders – are in the forefront of

a traumatic financial shakeout. Many past leaders of energy trading are either out of business or retrenching. 

Their problems have adversely affected other natural gas

companies as well. This serious financial situation could

cause price increases and (in the longer run) delivery

problems for natural gas customers. Thus far this winter,

however, there have been no reports of significant 

delivery problems.

2. Managing credit exposure

Managing credit is one of the most important components

of long-term financial health of energy market participants. Poor risk management of credit exposure contributed to recent financial problems. New approaches to

managing credit that have not been extended to energy

markets in the past are being introduced to natural gas

effective ways will be critical for the successful control of

risk associated with volatile natural gas prices.

3. Shaken confidence in price discovery methods 

Reports of wash trades and intentional false reporting of

transactions and prices by industry sources over the past

half-year have undermined the credibility of published 

natural gas price indexes. Given the importance of these

indexes to customer confidence as well as to the 

functioning of many natural gas contracts, the industry

must respond effectively.

4. Continuing need for efficient investment 

in infrastructure

The natural gas industry requires ongoing investment to

maintain adequate supply, delivery facilities and operational flexibility. As competitive markets for natural gas

have evolved, they have provided a basis for investment

designed to benefit customers and provide adequate

returns from facilities’ market value. Assuring adequate

investment in infrastructure aligned with competitive 

market forces is a critical and continuing need for the 

natural gas industry.

5. Continuing potential for manipulation

The potential for manipulation of energy markets remains

a concern. Without proper monitoring, the likelihood of

successful manipulation could increase under the current

tight supply conditions. Market manipulation can adversely affect the dependability, affordability and competitiveness of gas markets. Solutions require a commitment to

vigilant oversight.

The remainder of this assessment will focus on each of

these challenges. We document the issues and present

highlights of current efforts by industry and the

Commission to resolve them.

OMOI considers the issues facing the effective competitive

functioning of the industry to be manageable. Both industry participants and regulators must seek out and aggressively promote solutions to assure efficient, cost-effective

and reliable natural gas service to all U.S. customers.

3

JANUARY 2003

Citygate prices are

those paid for natural

gas delivered out of

major pipelines at the

gate station, or citygate, where local distribution companies

take control of the gas

from interstate

pipelines.
4

JANUARY 2003

he energy sector faces unprecedented

financial challenges. While initially affecting trading companies, financial stress has

touched electric utilities, pipelines and distributors as well. In response to these new challenges, some companies have abandoned energy

trading. Having fewer, less financially strong

market participants could result in the less-efficient functioning of competitive energy markets.

We will focus on the effects on natural gas markets, though these conclusions could extend to

electricity as well.

The Situation

Financial weakness currently extends across many industries. Every segment of the energy industry important to

the Commission’s jurisdictional markets has recently

experienced difficulties. Figure 2 shows 2002 changes in

stock prices for a group of 111 key market participants in

the energy sector. Financial conditions for the energy 

sector overall deteriorated dramatically in 2002.

Problems for companies heavily engaged in natural

gas trading are even greater than they appear in Figure 2.

While Figure 2 groups companies by service, energy companies often tend to be integrated across fuel and activities. This point deserves a brief discussion. The group of

companies identified as predominantly natural gas distributors has seen almost no reduction in share values, but

these companies have not been at the forefront of natural

gas trading. Pipelines ("mid-stream gas" in Figure 2) and

electric wholesalers ("utility parent w/significant wholesale"), which were far more likely to be active in natural

gas trading, have dropped substantially in value. 

In 2001 and 2002, energy traders revealed a variety

of improprieties in financial reporting and trading activity.

The malfeasance initially associated with Enron, and to

varying degrees with other specific energy trading companies, has led to the financial challenges that now confront

the entire industry. Market discomfort remains, a natural

response to uncovered deceptions and to numerous

ongoing investigations of trading activity by government

agencies.

The difficulties have cascaded to debt-holders,

reducing company credit ratings. Rating downgrades by

the major rating agencies – Standard & Poor’s (S&P),

Moody’s and Fitch – recognize this financial stress and

contribute to the challenge. Figure 3 shows the trend

toward downgrades for energy companies by S&P. 

There is potential for further financial instability

stemming from the amount of energy-company debt scheduled to be renegotiated over the next few years. Figure 4

shows the maturities of long-term debt for selected classes

of energy companies. Overall, about a third of long-term

debt will mature for energy companies over the next five

years, from 2003 through 2007. Short-term debt maturities

will put additional stress on the system. It is likely that

some companies will not be able to manage through these

debt maturities and will fail. Many of these companies are

active participants in the natural gas market.

To manage investor and debt-holder concerns

about viability, many companies either withdrew from or

announced reductions in energy trading activity in late

2001 and in 2002, including:

DETERIORATING FINANCIAL

CONDITIONS OF MARKET

PARTICIPANTS

Issue 1

T

Allegheny 

Energy

American 

Electric Power

Aquila

Calpine

CMS

Dynegy

El Paso Energy

Enron

IdaCorp

Mirant

PG&E

Reliant

TXU

USB Warburg

Williams
5

JANUARY 2003

Source: Standard and Poor’s,

Utilities & Perspectives,

January 20, 2003

Figure 3: Decline in Quality of S&P Energy Company Ratings, 2001–2003

Sources: OMOI groupings.

Analysis of prices based on

quotes from Bloomberg.
6

JANUARY 2003

Deterioration in the financial

condition of energy companies has

many serious implications for natural gas markets, such as:

Companies ceasing natural gas

trading can impair markets and

cause higher prices for consumers. The reduction in the number of energy traders in the marketplace reduces market liquidity – the

ability of a market participant to buy

and sell readily in a marketplace at a

prevailing price.

The reduction in the number

of natural gas traders is particularly

troublesome in the natural gas marketplace because there are so many

regional markets, already somewhat

illiquid due to fragmentation.

Dividing these markets by fewer

traders can give remaining traders

market power, permitting them to

increase above competitive levels the

difference between what they are

willing to pay sellers and demand in

payment from buyers. Some difference in prices paid and charged – 

the bid-ask spread – is necessary for

traders to exist. In particularly thin

markets, however, if a trading 

company increased the bid-ask

spread beyond competitive levels, 

it could be exercising inappropriate

market power. 

Reduced use of agency agreements can shift risk away from

marketers and toward consumers. Through agency agreements (also known as asset management contracts), natural gas traders contract with gas 

purchasing companies such as natural gas distributors

and electric generators to manage their fuel supply 

Market power can

include, but not be

limited to, the ability

of a firm to raise its

price or withhold its

output with the effect

of raising market

prices above competitive levels for a sustained period of time.

Agency agreements

allow traders to manage their customers’

natural gas assets as

agent in exchange for

the additional value

they derive from them. 

Market liquidity

describes the ease

with which a buyer can

buy or a seller can sell

at the prevailing price

in a marketplace.

Bid-ask spread is the

difference in price

between what a buyer

will pay for a commodity and what a seller

charges for it.

Source: OMOI groupings. Analysis of debt projections based on data from Bloomberg.
daily purchases and seasonal supply. These agreements

allow natural gas purchasing companies and their customers to share profits derived from remarketing unused

capacity and supply with the marketer. At the same time,

the marketer assumes some of the associated price risk

and ensures availability.

Competition for agency agreements among marketing companies had, until the recent collapse of the business, been intense. But as merchants abandon wholesale

trading, the number of asset management arrangements

between trading companies and distribution companies is

declining.6 This decline will shift many of the risks the

marketers had been bearing back to their customers, many

of whom may not have the necessary risk management

skills. Depending on the trading ability, planning skills,

regulation and financial incentives of utility staff, price

risks to end-use customers may increase. 

Constrained finances could lead to deferral of necessary infrastructure maintenance, harming reliability. As we have seen, energy companies often are integrated across functions, so energy traders often have

pipelines or electric utilities as affiliated companies. There

are indications – most recently from Williams7 – that trading-related financial problems can cause personnel cutbacks in regulated affiliates. Lack of maintenance could

decrease service or safety.

Constrained finances could lead to deferral of infrastructure builds. The erosion in industry funding may

eventually hinder development of additional energy infrastructure. Recent credit downgrades mean higher interest

rates and costlier projects. Energy companies are finding

it difficult to complete costly new power plant projects.

Delays and cancellations have increased.8 These delays

and cancellations can affect the efficacy of pipeline 

expansion. 

Actions

Both industry and government agencies can help

resolve financial issues related to natural gas companies.

Where possible, market participants are working constructively to address their own deteriorating financial condition as well as manage deterioration in the financial

strength of the companies with which they do business.

These efforts include: 

Improving finances. Natural gas players are cutting

costs, renegotiating debt, selling assets and making 

other adjustments to improve financial strength. Many

have announced asset sales, raising concerns that forced

sales may be under-valuing these assets. However, firms

with strong finances are acquiring good assets. For example, Mid-American Energy Holdings (owned by Berkshire

Hathaway) purchased two large pipelines in 2002,

the Kern River Gas Co., from Williams, and Northern

Natural Gas Pipeline, a former Enron asset, from 

Dynegy.9

Developing best practices for energy trading and

general business behavior. Since late spring 2002,

industry has sponsored several efforts to improve industry

performance in energy trading. These include:

Chief risk officers from more than 30 integrated energy

companies (most of which have energy merchant arms)

formed the Committee of Chief Risk Officers (CCRO) to

develop recommendations for best practices.10 Among the

CCRO’s recommendations are financial disclosures more

informative than the minimum required by the Securities

and Exchange Commission (SEC), enhanced approaches

to managing credit among traders, active use of state-ofthe-art approaches to monitoring the risks taken on by

corporations through energy trading and strict governance

and control procedures.

In June 2002, the Electric Power Supply Association

(EPSA) launched an initiative directed by a high-level 

steering committee to describe and codify ethical standards for the power supply and trading industry. EPSA

will require certification of these standards as a 

condition of membership.11

7

JANUARY 2003

6 OMOI conversations with multiple market participants in fall 2002

and winter 2002-03.

7 "Williams Cutting Jobs at Pipelines Amid Losses at Trading Units,"

Bloomberg News Wire, November 27, 2002.

8 "U.S Energy Sector Has Hit a Credit Crisis, S&P Reports," Rebecca

Smith, The Wall Street Journal, October 14, 2002.

9 Berkshire Hathaway has indicated that it has $10 billion to invest in

energy assets. See "Editor’s Notebook," Jeff Share, Pipeline & Gas

Journal, January 2003. 10 www.ccro.org/bestprac.html. 11 Electric Power Supply Association, "Code of Ethics and Sound

Trading Practices for Electric Power Suppliers," at

www.epsa.org/Positions/index.cfm?section=positions.
8

JANUARY 2003

Association12 to establish best practices and standards of

conduct and to engage in other efforts to help restore

confidence in the energy financial markets.

Increased use of exchanges. Initially, natural gas trading took place between buyers and sellers on telephones.

In 1990, the New York Mercantile Exchange (NYMEX)

introduced natural gas futures trading with a product

associated with an existing liquid cash market at Henry

Hub in Louisiana. Other attempts at exchange-traded

futures contracts for natural gas have failed, but the

Henry Hub contract remains and the terms of its trading

contracts continue to lengthen, indicating greater faith by

participants in this forward market.

NYMEX saw a record year in 2002 for natural gas

futures volumes; more contracts were traded than for any

other physical commodity but oil. The year-over-year

increase in trading natural gas futures contracts was 48

percent, rising to 24.4 million contracts traded. The high

level of trading is a positive sign for natural gas, possibly

from the telephone and toward the visible, secure trading

of a regulated exchange.

Other NYMEX trading data yield mixed signals.

Figure 5 shows the level of open interest in the NYMEX

Henry Hub natural gas market at the

opening of each month in 2001 and

2002. Open interest is a good measure of how actively companies are

participating in the futures market.

Figure 5 shows that open

interest in a month-to-month comparison has been higher in the first

half of 2002 compared to 2001 and

lower in the second half of 2002 compared to 2001. The

pattern suggests that natural gas market participants

began to reduce their activity in April 2002, four months

earlier than the apparently seasonally driven reductions

starting in late 2001. 

In August 2000, a number of active energy traders

launched the IntercontinentalExchange (ICE), which manages trading of a variety of physical natural gas and electric contracts13. ICE reports more than 100 equity partners, including energy and metals traders, brokers and

Source: NYMEX

Figure 5: Recent Relative Decline in Nymex Natural Gas Open Interest

Open interest is the

number of contracts

that are still outstanding at a particular time

for a particular futures

contract. 

12 The seven are Amerex, APB Financial, GFI Group, Natsource,

Prebon Energy, Starsupply Petroleum and TFS Energy. Further information is available at www.energybrokersassoc.org.
installed on more than 6,000 desktops, with the capability

to trade more than 600 products in metals, petroleum,

natural gas and power14. Figure 6 shows the activity in

natural gas volumes traded on ICE. 

Encouraging new entrants. New entrants, mainly financial players, are increasing their energy trading activity to

provide risk management services and liquidity, supplementing the physical deliveries and energy trading of

asset-based marketers. Banks and brokerage firms have

financial stability, good credit ratings and cash, reducing

have hedging and trading experience with other commodities that can be leveraged into diversified energy markets.

Other advantages they bring include experience with regulatory bodies and tight risk control processes. Companies

increasing their activity or entering energy trading include:

American International Group

Bank of America

Centarus Energy

Citadel

ConocoPhilips

Credit Lyonnais 

Goldman Sachs

Louis-Dreyfus

Morgan Stanley

RWE

The positive effects of this new participation do not yet

represent successes that balance the recent failures of trading leaders. OMOI expects that the services provided by

the new entrants will be more expensive than past offer9

JANUARY 2003

13 ICE’s original equity partners included BP Exploration & Oil Inc.,

Deutsche Bank Sharps Pixley Inc., Goldman Sachs Group Inc., MS

Capital Group Inc. (Morgan Stanley), Societe Generale Financial Group,

ST Exchange Inc. (Royal Dutch/Shell Group) and TFE Investment Inc.

(TotalFinaElf). It was later joined by AEP Energy Services, Aquila

Southwest Processing LP, Duke Energy Trading Exchange LLP, El Paso

Merchant Energy Holding Co., Mirant Americas Energy Marketing LP

and Reliant Energy Trading Exchange Inc. ICE acquired London’s

International Petroleum Exchange (IPE) in mid-2001.

14 www.intcx.com/about.html.

Figure 6: Growth in Physical (Day-Ahead Henry Hub) Natural Gas Volumes Traded on ICE Was

Affected by Trading Downturn

Source: www.intcx.com/

Subscriber?operation=gasIndex

Form&hub=All

Note: ICE trades at areas other than

Henry Hub, but because Henry Hub

has existed the longest, OMOI is

using it as a representative point to

illustrate our line of reasoning. 
10

JANUARY 2003

credit risks into prices. Companies such as Enron and

Dynegy were determined to create liquid markets in 

energy necessary for meeting their growth projections

and profitability.

Together, these industry actions indicate a significant

effort to address the financial challenges that natural gas

markets face today. As long as that commitment continues, it provides a positive indication that these issues can

be resolved. 

Commission Actions.

Within the scope of its authority, the Commission seeks to

play a positive role in the resolution of these financial

issues. As the year progresses, the Commission plans the

following actions to address deterioration in the financial

condition of natural gas market players:

The Commission will continue to make policy as necessary to address the ramifications of the deteriorated financial condition of the industry. 

Development of guidance on cash-management 

practices between regulated subsidiaries and their parent

companies. 

Establishment, on a case by case basis, of the creditworthiness standards that interstate pipelines may 

require in their tariffs.

The Commission will continue to monitor the financial health of natural gas companies, with significant consideration of the implications of financial

difficulties on the safe and dependable delivery of

natural gas to customers.

OMOI will continue to monitor the behavior of natural gas markets, with particular concern for the

reduction of market liquidity due to exits from natural gas trading and with attention to the potential

for parent companies that are in financial straits 

to undermine the financial strength of regulated

subsidiaries.
redit management approaches used in

financial markets – approaches not extended to energy markets in the past – are

being adapted and used in natural gas and

electric markets. Given the large cash flows associated with energy contracts, managing credit well is

one of the most important drivers of long-term

financial health of energy traders. Using credit

tools in effective ways will be critical for success.

While generally valuable, some of these new

approaches are not well understood and their

misuse could have unintended consequences. 

In particular, certain uses of credit clearing 

techniques have more limited benefits than is

generally understood by energy-market participants. The first step toward a

better credit management 

structure for the industry is 

better understanding of the

available tools.

The Situation

One novel credit tool is overthe-counter (OTC) credit

clearing. OTC transactions are not

traded on exchanges, but are negotiated between two parties. Table 1 compares over-thecounter trading to exchange and bilateral deals. However,

unlike other contracts negotiated between buyers and sell11

JANUARY 2003

MANAGING CREDIT

EXPOSURE

Issue 2

C Credit clearing is a

mechanism for settling

mutual claims, the

result of which is that

the risk that a company might fail to fulfill

its contract is pooled

among many 

companies.

Bilateral OTC Exchange-Based

Table 1: Characteristics of Types of Trading

Contracts are negotiated directly

between the two contract 

counterparties.

Contracts are often highly 

customized, and of long duration.

Trading counterparties are 

known to each other.

Pricing is opaque

Execution is lengthy and 

expensive.

Credit protections are customized

and negotiated as part of the 

contract.

Contracts are negotiated via a broker

who helps the two parties find each

other and reach agreed terms.

Contract parameters can vary 

significantly, though 

customization is generally 

allowed.

Anonymity of trading varies 

widely.

Pricing is opaque

Execution time and cost can vary 

significantly.

Credit protections are customized

and negotiated as part of the 

contract.

Deals are made through a multilateral

exchange, which provides a managed

marketplace

Contracts are highly standardized.

Trading is anonymous.

Execution is quick and cheap.

Processes often exist to 

safeguard market integrity.

Credit exposure is to the 

exchange member, who is 

protected from other members 

through mandatory credit 

clearing mechanisms.

Source: Office of Market

Oversight and Investigations
12

JANUARY 2003

OTC trades are sufficiently standardized that they can be assigned 

readily to others. 

Until recently, market participants relied on the credit quality of

their counterparties to back each

bilateral transaction. Not many

used contractual provisions to net

transactions between counterparties

to limit financial exposure to 

each other.

Even fewer used a central

clearing entity, or clearinghouse,

to do multilateral netting to further

limit credit exposure, where the

clearinghouse would be backed by an entire group of

financially strong clearing or participating members.15

However, the International Swaps and Derivatives

Association (ISDA), the Edison Electric Institute (EEI) and

other industry groups have recently developed standardized agreements to enable greater use of bilateral netting

across multiple transactions to limit exposures between

two counterparties. 

(EEI) and other industry groups have recently

developed standardized agreements to enable greater use

of bilateral netting across multiple transactions to limit

exposures between two counterparties. 

OTC credit clearing is still in its formative stages in

the United States, having been established by the

Commodity Futures Modernization Act of 2000. Since

early 2002, Nymex and ICE have

offered OTC credit clearing services

for transactions executed in OTC

markets in addition to their

exchange-traded energy services.

According to NYMEX representatives

who spoke with OMOI staff, from

May 31 through the end of 2002,

Nymex cleared more than $5 billion

worth in notional value of transactions that were executed in OTC markets and converted into futures contracts

during the NYMEX clearing process. Similarly, ICE representatives stated that, starting in March, ICE cleared

notional value surpassing $16 billion through year-end.

Start-ups EnergyClear and Virtual Market Assurance Corp.

Table 2 summarizes the main features of these three 

offerings. 

NYMEX and ICE have introduced many new OTC

credit clearing products.17 They include clearing services

for longer-term contracts, energy at a variety of geographical locations and options. The expansion of these services

has the potential to significantly increase the value of tools

available to energy traders and customers to manage 

their risk.

There are several market implications of the introduction of new methods for managing credit exposure 

in the energy industry, such as:

Traditional methods of managing credit exposure

that rely on the credit quality of counterparties are

being supplemented by new methods and increasing

the robustness of credit management in the energy

industry. The traditional method of credit management

failed when many major energy counterparties either

went bankrupt or could no longer meet their obligations

due to debt downgrades. As a result, the quantity of

energy trades has been severely reduced, resulting in a

less-liquid and less-efficient market. New methods for

managing risk can reduce the likelihood of contract failure due to credit failure. In its white paper, CCRO estimated that companies can save 75-90 percent of the collateral required to support transactions by going to this

type of credit clearing from historical approaches embedded in bilateral contracts. The result would increase credit-related transaction capacity several times, allowing for

improved market liquidity.18

Credit clearing mechanisms can serve market participants and markets well but market participants

need to be aware of the limitations of clearing

mechanisms and the differences between the services offered by alternative clearing organizations.

One limitation concerns the limited benefits for nonmembers. A clearinghouse only protects members from the

financial failure of other members. Some clearinghouses

allow nonmembers to conduct business on the clearinghouse through members. If any side of the transaction

experiences financial failure, all sides of the transaction

15 Communication with W.J. Berger, graduate student, Harvard 

Business School.

16 www.energyclear.com, www.vmac.com. 17 www.nymex.com and www.intcx.com. 18 Committee of Chief Risk Officers: Introduction and Executive

Summaries of CCRO Recommendations, Volume 1 of 6, 

November 19, 2002.

Netting: Netting occurs

when market participants are required to

pay (and receive) only

the net amount of their

financial obligations

(that is, amounts owed

by a market participant

are reduced by the

amounts of money that

are owed to that same

market participant).

Notional value of

transactions is the volume of each transaction multiplied by its

price, and then added

over all transactions.
are protected except the nonmember. Consequently,

energy companies using an exchange with clearing by contracting through a clearing member must understand that

they are not protected if the clearing member they are

working with defaults.

Another limitation results from the need to adapt

traditional clearing to energy markets. Traditional clearing

settles transactions purely financially. Energy market participants typically demand physical delivery guarantees.

Clearinghouses are working with market participants to

develop new instruments that mitigate the risks associated

with this mismatch between physical and financial 

delivery.

Actions

The energy industry must become more familiar

with sophisticated credit tools. The Commission

can help by bringing knowledgeable experts together to

discuss these tools.

Industry Actions.

Education. The energy industry is already making use 

of credit clearing mechanisms in its interactions with

NYMEX, ICE, EnergyClear, VMAC and others. Industry

players need to master these tools and report on their use

13

JANUARY 2003

Source: OMOI summary of information from www.nymex.com, www.intcx.com, www.energyclear.com and phone calls between

OMOI and the clearing services.
14

JANUARY 2003

Legal disputes between some of the leaders

(NYMEX and ICE) may hinder progress in this area.

Potential providers of clearing services and energy

market participants still need to clearify market needs and

craft products and services to meet those needs.

Commission Actions.

The Commission is co-sponsoring a technical conference on credit and credit clearing issues with the

Commodity Futures Trading Commission early in

further self-help on the part of energy industry and promote dialogue among energy industry stakeholders. The

conference also will help the Commission assess its future

role in clearing and other credit-management solutions as

they affect the effective functioning of the energy markets.

The Commission will offer its Alternative Dispute

Resolution Services to resolve the NYMEX-ICE dispute.

The Commission also will monitor the use of

new methods for managing credit exposure and

showcase positive developments.
ecent revelations about price indexes and

related false reporting by industry have

contributed to a crisis of confidence in

price discovery. Reports of traders lying

to the energy trade press – which compiles and

publishes numerous price indices – with the

intention of manipulating natural gas prices 

and volumes have undermined confidence in 

the industry. 

No serious alternative to the trade pressdeveloped price index system exists today. 

The trade press has not provided adequate

details about price development to reach a 

public interest standard of use by the

Commission, citing their First Amendment 

constitutional rights. Notably, major players

appear to have been aware of and have provided

for limitations inherent in the price indices.

Smaller players, both buyers and sellers, have

been disproportionately affected by the recent

revelations.

Increasing numbers of natural gas traders

have announced that they will not contribute

price information to the trade press in fear of

lawsuits alleging inaccurate prices.19 This

response is particularly counterproductive

because it does not solve central process problems but does reduce meaningful price information. A critical component of any natural gas

price discovery solution is the broadest possible

participation.

The Situation

A key product of any effective market is accurate

information about the prevailing price in that market. This revelation of price information – price discovery

– helps customers determine the cost of meeting their

needs, helps sellers determine the

value of their investment and, when

working correctly, efficiently allocates resources to the customers

who most value them. 

The energy trade press creates natural gas price indices

through systematic polling of market participants known to each publication. The quality of these indices depends on the quality of the particular processes used by the trade press

when polling participants, as well as the number of active

participants trading at a given price point. A drawback of

the reported approaches are that the traders who traditionally provide the price quotes often have had financial

incentives to influence market prices and behavior. The

trade press attempts to adjust for this conflict of interest

by using median and average prices to compensate for

irregularities or by throwing out outlying price quotes –

those that, without explanation, are significantly different

than other prices gathered – that may be intended to

move the market. 

Confidence in indices has weakened with recent allegations and admissions of false reporting of price and volume information. It is not yet possible to quantify the harm

caused by false price reporting to index publishers or the

extent to which prices might have been distorted. However,

doubt has been cast on available price index results. 

Accurate and credible price indices for natural gas

are crucial because they serve as the basis for many natur15

JANUARY 2003

SHAKEN CONFIDENCE

IN PRICE DISCOVERY

METHODS

Issue 3

R

Price discovery is the

revelation, through

appropriate market

mechanisms, of the

prevailing price in a

marketplace.

19 Foster Electric Report, "Platts Noticeably Absent from Meeting of

Energy Companies and Trade Publications to Devise Appropriate Price

Reporting Guidelines," December 11, 2002.
16

JANUARY 2003

al gas and electric transactions across the United States.

Natural gas price indices are also difficult to monitor for accuracy because there are so many such indices.

There is no one national market for natural gas; there are

many regional markets. These markets contain hundreds

of price points, including many market hubs, some of the

most significant of which are shown in Figure 7. 

Price discovery and pricing at hubs has never been

completely transparent and some pricing points are more

actively used for trading than others. For example, a recent

study completed by Energy and Environmental Analysis on

behalf of several New York natural gas distributors identified only three hubs that meet their definition of adequate

liquidity in the Northeast: Columbia-Appalachian Pool;

Dominion-South Point; and Dawn, Ontario.

The study defined "adequate liquidity" as "more

upstream capacity than downstream, sufficient volumes at

peak periods and year round, more than one pipeline

serving the point, presence of storage and electronic trading at the point, reported price indexes, narrow bid-ask

spread and sufficient volumes and numbers of buyers 

and sellers."20

While we might not define liquidity in exactly the

same way, the point remains broadly valid. Multiple pricing points will tend to challenge liquidity and, therefore,

effective price discovery. On the other hand, as the trade

press states, all price points are included because a sufficient number of market participants asked for that point

to be included in a list of indices.

The implications for the market of decreased 

confidence in natural gas price indices include:

Concerns surrounding price indices may lead to 

the unraveling of existing natural gas contracts. If

parties question the validity of the data upon which their

contracts are based, they may attempt to dissolve contracts. Without an alternative price discovery mechanism,

they would be left without a market basis for determining

prices for new contracts.

Concerns surrounding price indices may affect the

willingness of parties to enter new contracts. If parties are reluctant to enter into new contracts, the efficiency of gas markets and dependent electric markets could

decrease. Disarray in natural gas price discovery could

hinder traders, suppliers and customers from entering the

market and creating liquidity. The result could be a dysfunctional system. 

20 Energy and Environmental Analysis, "Analysis of Natural Gas Market

Liquidity at Points Affecting New York State LDCs," preliminary draft

prepared for the New York Gas Group, November 2002. Final report

expected February 2003.

Source: GASdat map based on Gas Daily pricing points
While the Commission can play a supporting role

here, industry must develop and implement effective

solutions to the current crisis. Both industry and

Commission actions are discussed below.

Industry Actions.

Industry has taken confidence problems with natural gas

price indices quite seriously. The most visibly constructive

efforts include the following: 

Developing best practices for price reporting.

The CCRO is working on best practices for reporting natural gas prices with the hope that recommendations will

be available for adoption by industry participants within

the first quarter of 2003. 

The Coalition for Energy Market Integrity and

Transparency (EMIT), which includes independent natural gas producers, royalty owners, electric generators, energy distributors, consumers and others, has issued a challenge to the industry to produce a list of protocols publishers should follow in reporting and publishing prices.21

Some trade publications themselves are actively

reviewing their price index development procedures to

look for ways to increase confidence.

Shifting transactions to exchanges, where prices are

more transparent. As noted in the discussion of the

financial difficulties of market players, exchange-traded

markets, such as ICE, have added new volume. To the

extent that this creates more price information, it is a

good sign. Price and trading information at NYMEX is

transparent, in part because of its regulation by the CFTC.

The transparency of price and trading information from

ICE is less clear. ICE has begun marketing its price and

volume data online under its brand name "10x." This

pricing service may, in time, compete with the trade press.

Because its regulatory requirements are different from

NYMEX, however, it does not provide the same level of

information to regulators as NYMEX.

Commission Actions.

On January 15, 2003, staff reported concerns

at its open meeting. In addition to reviewing the current situation, staff explained the Commission’s interest in

price index formation, reviewed the public evidence that

raises questions about price index formation, defined the

high-level criteria important to developing trustworthy

price information in the future and proposed some 

next steps.

Specifically, the Commission approves pipeline tariffs that refer to market price data. There are three areas

where these references tend to happen:

Cash-out provisions. On most major pipelines, when

deliveries and receipts of natural gas are not in balance,

the differences may be valued and sold to the shipper or

purchased by the pipeline using market price information.

These cash-out provisions allow the industry to quickly

and efficiently account for and eliminate imbalances.

Penalties. In the determination of pipeline penalties, the

Commission sometimes allows pipelines to use market

prices to deter shipper conduct that could threaten system

operations. 

Basis Differentials. Many negotiated rate transportation

contracts establish transportation rates using the basis differentials between two or more price index trading points.

Staff proposed that in the future, the Commission require

that natural gas price indexes meet certain minimum 

standards before natural gas pipelines are permitted to

use these indexes in new tariffs or for other new 

regulatory purposes. 

Staff proposed that evidence for these new filings

would need to be presented and reviewed to assure that

any referenced price index meet minimum index formation

standards. In particular, the index would need to accurately

reflect the market. For approval, a new tariff containing a

reference to an index would need to demonstrate:

1. Confidence in the accuracy of price reporting – that is,

the ability to verify that reporting is for deals actually

done, not simply aggregate opinions.

2. Adequacy of coverage – that is, the ability to assure the

collection of adequate information to represent prices

across the relevant marketplace.

3. Information about market liquidity or some insight into

17

JANUARY 2003

21 Federal Energy Regulatory Commission, presentation by Arthur 

C. Corbin on behalf of Coalition for Energy Market Integrity and

Transparency, October 25, 2002, at www.ferc.gov/gas/10-25-02-

conf/EMIT-STATEMENT.pdf.
18

JANUARY 2003

order to generate warnings when markets are thin and

confidence when they are liquid.

4. Verifiability – that is, the ability to assure integrity of the

process through independent review by a trustworthy

third party (preferably not by a governmental entity).

Staff suggested that only after assuring the Commission that

these characteristics have been met should a natural gas

price index be approved for use in a new pipeline tariff.

index issues in its Fact-Finding Investigation of

Potential Manipulation of Electric and Natural Gas

Prices in Western Markets (Docket No. PA02-2-000).

On August 13, 2002, Commission staff made the initial

report public. Staff inquired into the characteristics of

publicly-reported price indices, including natural gas spot

prices at California delivery points used in the California

refund proceeding. Staff found significant problems with

published price indices. The Commission response will

depend in part on the findings of its fact-finding investigation. That investigation task force reported a number 

of price index concerns in 2002. The Commission has

announced its intention to conclude this investigation 

in early 2003.

At the direction of the Commission, OMOI has begun

planning a technical conference to address price 

index issues.
espite its current financial problems, the

natural gas industry requires continued

investment to maintain adequate supply,

delivery facilities and operational flexibility and safety. The challenge to the industry is to

maintain adequate, efficient levels of investment

in a competitive environment.

Competitive natural gas markets created

more than a decade of moderate wholesale natural gas prices following the decontrol of significant volumes of wellhead prices in January 1985,

which provided an enormous benefit to natural

gas customers. To achieve these benefits, competitive forces restructured the way the industry

functions. One change has been the direct linkage of investment to market signals. 

In the 1960s and early 1970s, the federally

regulated interstate market combined with the

deregulated intrastate market created a dysfunctional dichotomy that led to shortages of delivered natural gas in the interstate markets in the

mid-to-late 1970s and adequate supplies in major

intrastate markets. That failure to serve interstate customers, especially during the harsh 

winter of 1975-76, became the impetus for

Congressional passage of the Natural Gas Policy

Act of 1978 (NGPA), which provided for the

phased decontrol of the wellhead price of gas,

starting substantially in January 1985.

Natural gas markets since the NGPA was

passed have provided an investment environment

that has benefitted customers and provided adequate returns for the gas industry. Regulatory

policy continues to play a significant role as well,

encouraging investment when necessary. 

For instance, to stimulate investment, the

Commission recently signaled it will set a new

policy in regulating new liquefied natural gas

(LNG) projects where markets are competitive

and other criteria are met.22

The Situation

In this section, we will address the challenge that

current prices pose for developing gas supplies, the

challenge of shifting supply and demand for maintaining

sufficient transmission and delivery infrastructure, and the

need for additional infrastructure as a result of current 

levels of operational flexibility.

The Challenge that Current Prices 

Pose for Developing Gas Supplies

Price levels this winter have increased because of tightened market conditions due to a return of incremental

heating load as compared to last year’s unusually warm

winter (the fifth warmest winter since records began in

the late 1800s).23 Without the threat of a supply shortage,

the sustained early cold of the winter of 2002-03 

created support for natural gas prices in the $4 to low

$5/MMBtu range at Henry Hub. November 2002 was 11

19

JANUARY 2003

CONTINUING NEED FOR

EFFICIENT INVESTMENT

IN INFRASTRUCTURE

Issue 4

D

22 In a preliminary determination on December 18, 2002, to approve

the Hackberry LNG project in Louisiana, the Commission said it would

not require Commission-approved cost-based rates or an open-access

tariff for the new LNG terminal service because its sponsors will bear

the full economic risk of the project and customers will not be adversely affected by the project’s costs. This approach is expected to remove

economic and regulatory barriers to the development of onshore LNG

import terminals (Docket No. CP02-374-000, et al.).

23 www.noaanews.noaa.gov/stories/s878.htm, 
percent colder than November 200l and storage withdrawals this heating season reached 728 Bcf at the end of

2002 (December 31) versus 265 Bcf at the end of 2001.24

As shown in Figure 8, however, market participants

appear not to expect that the current high prices will last.

NYMEX futures prices for delivery of natural gas over the

next three years show prices generally lower each year for

the same month. This is a futures market phenomenon

known as backwardation, which

indicates that support for higher

prices is short term.

The challenge then is for the

industry to continue to invest in natural gas exploration and production

in this shifting price environment.

There is general consensus among

industry observers that gas supply

should be adequate to meet

demand this winter.25 However, there are lingering concerns – and some mixed predictions – about the outlook

for U.S. gas production, imports and total gas supply. 

The Energy Information Administration (EIA) last

November expected dry gas production plus imports to

decline slightly for the fourth quarter of 2002 and first

quarter of 2003 as compared to the same periods in 2001

and 2002.26 By January, however, EIA was predicting

slight increases for those quarters as well as slight but

steady annual increases in production and imports for

2003 and 2004.27 Some financial analysts reviewing quar20

JANUARY 2003

24 Energy Information Administration.

Source: NYMEX

Backwardation is the

situation in futures

markets where prices

for a commodity for

delivery in future

months are lower than

for the near months.

25 Sources of information underlying this broad assessment include the

Energy Information Administration, Short-Term Energy Outlook,

December 2002; Cambridge Energy Research Associates, "CERA

Monthly Briefing: High Anxiety," December 17, 2002; Natural Gas

Supply Association, "NGSA Expects Upward Pressure in the Natural Gas

Market This Winter," press release, September 19, 2002; American Gas

Association, "Natural Gas Supply Fundamentals for Winter 2002-2003,"

October 1, 2002.

26 Energy Information Administration, Short-Term Energy Outlook,

November 2002.
terly filings last fall predicted production declines (yearon-year) of 5 percent to 6 percent, or an annual differential of almost 1.2 to 1.4 Tcf.28 In January, EIA estimated

that 2002 U.S. gas production would be down only 30 Bcf,

or 0.15 percent, from the 2001 level.

Figure 9 shows that the overall number of drilling

rigs searching for natural gas today has increased over

time but decreased recently. This pattern does not raise 

as much concern as it might have in the past given the

increased efficiency in the exploration and production 

sector. Nevertheless, exploration and production activity

deserves continuing attention.

Current price patterns have several implications for

natural gas infrastructure, such as:

Prices in competitive natural gas markets change

more quickly than drilling decisions, resulting in

price cyclicality. Figure 9 shows this tendency, common

to many commodities. Cyclicality of natural gas prices

results from a lag between the time the market signals a

demand increase and the time it takes to increase supply

through drilling and related development. In the short

term, supply remains tight even though demand has risen,

leading to higher prices. Later, as

additional capacity is added, supply

outstrips demand, driving down

prices. As long as natural gas is

considered a basic need, that cyclicality in prices will have a negative

effect on customers’ perceptions of

reliability, price and fairness. 

Competitive natural gas markets

show volatility when demand

and supply are closely balanced.

21

JANUARY 2003

Sources: Baker-Hughes rig count from Bloomberg; Energy Information Administration, "Average Natural Gas Prices: U.S.

Natural Gas Wellhead Price ($/Mcf)," 1976-2002.

Volatility is a measure

of how much uncertainty there is about a

price and is usually

expressed as the rate

of change in a price

over a specified period

of time.

27 Energy Information Administration, Short-Term Energy Outlook,

January 2003.

28 Salomon Smith Barney, "Exploration and Production, Third Quarter

2002 Preview," October 3, 2002, and Lehman Brothers, "Oil & Gas: E&P

(Large Cap)," October 25, 2002.
22

JANUARY 2003

sharp increases in price. In the short term, price spikes

can be painful for customers just as short-term price

drops are painful for producers. In the longer run, 

higher prices result in new supplies being developed.

Customers and producers can manage price volatility by

obtaining fixed prices or engaging in other forms of 

risk management.29

The Challenge of Shifting Supply and

Demand for Maintaining Sufficient

Delivery and Transmission

Infrastructure

The demand for natural gas supply shifts geographically as

load centers grow or shrink in size and industrial and other

uses of natural gas contract or increase. Similarly, the location of natural gas supply can shift over time. For instance,

offshore Gulf of Mexico supply has increased recently while

on and near shore Gulf of Mexico supply has decreased.

These shifts in supply and demand can result in the need

for expanded natural gas transmission capacity. 

Places where delivery capacity is limited generally

signal any tightness through prices. The difference

between prices in different places is a useful indicator of

the value of moving natural gas

from one place to another. These

differences are known as "basis" – a

term that refers to the difference in

prices between any two markets. In

the U.S. natural gas industry, basis

usually refers to geographical differences and typically reflects the value

of gas transmission between those

points (see Figure 7 for some illustrative geographic locations).

Shifts in supply and demand have resulted in several regions that are now short of transmission capacity.

These regions include:

The Rockies, which produces more natural gas than it

uses. Pipeline capacity from the Rockies has not kept pace

with productive capacity. Consequently, prices tend to be

low and drilling incentives reduced. The resulting basis differential for natural gas from the Rockies has encouraged

new pipeline capacity from the Rockies to California,

River with expected completion by

the second or third quarter of 2003

(under a new owner). Northwest

Pipeline is improving its ability to

transport gas to the Northwest to

compete with volumes flowing from

Canada. At least four new and similar

pipelines have been proposed in the

Rockies to move natural gas eastward; however, none has

yet filed at the Commission for certification. 

The New York metropolitan area may need additional capacity to meet its demand. Analysis of capacity

resale, or capacity release for pipelines serving the region,

shows that transportation values have been high in recent

winters, indicating some tightness in capacity.30 To continue to meet potential demand growth, at least one of the

proposed (or similar) pipeline projects into the city

would need to be built. However, annual average basis

differentials from both Chicago and Niagara to New York

City do not yet support the projects. Until the market can

support making the binding capacity commitments necessary for financing a project, the viability and timing of any

proposals remains uncertain.

Other areas in the Northeast may face capacity constraints as well. Tennessee Gas Pipeline Co. declared five

emergency orders during the winter of 2001-02 in its

Northeast market area. Tennessee received requests for

gas flow in excess of available capacity, limiting the availability of interruptible service to New England and New

York City. Analysis of Texas Eastern into New York,

Pennsylvania, New Jersey, Delaware, Maryland and

Virginia shows that capacity release prices were high during the colder-than-normal winter of 2000-2001. This

winter, several pipelines in the Northeast, including

Tennessee, Algonquin, Transco and Texas Eastern, have

30 Staff gathered and analyzed a considerable amount of data on capacity-release transactions over the two-and-one-half year period that the

maximum rate ceiling for short-term releases was waived and published its analysis in a paper posted on the Commission's Website (May

30, 2002). Docket No. PL-02-4-000. The staff paper was intended to

solicit comments regarding the price ceiling for short-term released

capacity. Among the many points raised by commenters, several stated

that the value of released capacity could be an indicator of additional

capacity needs, arguing that releases made above the cap could signal

that capacity is tight in that region at that time. Conversely, these commenters suggested that if capacity is not released above the cap, this

could indicate that sufficient capacity exists during that particular time.

Data on capacity release were downloaded from pipeline databases.

Basis is the difference

in prices between

identical products but

in two different markets; in this report it

refers to different geographical markets.

Capacity release is the

ability for natural gas

transportation service

customers to re-sell

their rights to 

another party.

29 Natural gas price volatility and the use of risk-management techniques to manage it were discussed extensively in General Accounting Office, Natural Gas:

Analysis of Changes in Market Price, December 2002 (Report No. GAO-03-46).
restricted services at times. Restrictions have included little or no authorized overrun service, reduced tolerance

for imbalances and a variety of warnings to shippers to

stay in balance or be subject to operational flow orders.31

Areas in the Southeast, including parts of the

Carolinas, Georgia and Florida, indicate some tightness in

capacity. Analysis of capacity release data for Transco into

the Carolinas and Georgia shows that the values for capacity release were high in the past two winters. In addition,

Transco issued a number of constraint notices last winter

limiting the availability of interruptible transportation service into an area stretching roughly from Alabama through

Northern Virginia. 

Florida, though a summer peaking market for natural

gas deliveries, has experienced winter price spikes due to

a lack of storage on Florida Gas Transmission combined

with the demand for gas to meet heating load in other

downstream markets.

Constrained areas are prone to price spikes and

more susceptible to manipulation than non-constrained areas. Both scarcity-related price spikes

and manipulation can reduce consumer confidence

in markets. The price spikes will continue because of

the high cost of building infrastructure to meet peak

demand rather than some variation of average anticipated

demand. Most customers would not opt to pay the high

premium cost in order to avoid the occasional price spike.

Nevertheless, despite such a rational economic decision,

the presence of price spikes is inefficient for market participants until demand responses are facilitated.

The Need for Additional Infrastructure

as a Result of Current Operational

Efficiently

The same forces that have produced

20 years of moderate natural gas

prices have also rid it of pockets of

excess capacity. Markets tend to

drive just-in-time approaches to

capacity, building facilities that can

pay for themselves through their

value serving markets. The occasional disruption does not produce

enough value to justify the investment required to prevent it.

23

JANUARY 2003

Source: American Gas Association

Just-in-time is an

approach to efficiently

delivering services as

close as possible to

just the amount needed, when it is needed

and where it is 

needed. 31 Multiple trade press references including Gas Daily, Natural Gas

Intelligence and Btu Daily Gas Wire.
24

JANUARY 2003

gas is illustrated by Figure 10 – a graph published by the

American Gas Association in its recent winter assessment.32

Figure 10 tells the story of the end of the oversupply situation

characteristic of the natural gas industry, starting in the early

1980s as a consequence of the NGPA, known as the "gas bubble." Gas production and productive capacity are charted

together. The difference between the two lines is the excess

natural gas production capacity that is available but not used.

Starting in the early 1980s (before the period

included in Figure 10) the natural gas industry used this

flexibility in wellhead production to help manage demand

swings. Production, as long as it remained lower than

capacity, moved up and down in response to relatively

short-term demands. Around 2000, this flexible response

diminished as production neared the ceiling of productive capacity with imports (which tripled between the

mid-1980s and now) making up some of the volume.

The natural gas industry’s experience of managing

operational flexibility from the early 1980s through the late

1990s was made easier by the oversupply situation. The

erratic nature of demand in the natural gas industry did

not disappear in the late 1990s. Consequently, some other

part of the industry has had to handle demand swings. 

Pipeline operations, storage and distribution 

operations play a greater role now in volume management

than when production capacity had surpluses. Price swings

affecting some demand may also play a part. Looking back

at Figure 1, we see that prices rose higher and for longer

after the end of the oversupply situation than they had over

the previous 20 years. The end of the "gas bubble" is not

the only reason for the prices of 2000-01, but the shift in

where supply flexibility must be managed likely contributed.

The implication of the reduced role of production 

as a viable source of operational flexibility is the

increased demand on existing infrastructure to 

provide such flexibility. 

Actions

Industry and government can take actions to assure

adequate investment in gas supplies, constrained

areas and infrastructure needed as a result of reduced

operational flexibility. 

Industry should maintain existing infrastructure.

The extensive facilities required to supply and deliver natural gas to customers make them inherently vulnerable to disruptions. Failure of any part of the system – rigs, pipelines,

compression, storage, distribution facilities – can result in

failure to deliver to certain customers for some period of

time. Consequently, natural gas facilities providers must

monitor and maintain their physical plant, inventories of

replacement parts and safety procedures carefully

Industry should cooperate with improving the performance of price discovery mechanisms. Increased

confidence in price discovery mechanisms can increase confidence in price signals, such as increased basis differentials,

that provide industry with an indication of the value of

investment in new infrastructure such as delivery facilities. 

Industry should work to create viable forward 

markets for capacity. Viable forward markets would

provide the mechanism for customers, producers and

pipelines to invest in new capacity.

Finally, industry needs to make use of risk management services. As discussed, tightening supply, pipeline

constraints and reduced operational flexibility can all

increase short-term price volatility to customers. Industry

focus on stability is critical for customer confidence. Use

of price-risk management techniques, including fixed

prices, and effective investment in infrastructure will be

key to customer satisfaction.

Commission Actions

The Commission has undertaken efforts to improve the

reliability and management of volatility in the natural gas

industry. They include the following:

OMOI will continue to monitor and assess regional

markets and potential capacity constraints and resulting

price and reliability effects.

OMOI believes the Commission should support the

development of forward capacity markets to facilitate gas

infrastructure investment.

The Commission will encourage state regulators to

make rules that allow timely price signals to reach retail

customers and encourage demand-side alternatives,

adding important pricing signals and lower-cost demand

flexibility to the natural gas industry.

32 Energy and Environmental Analysis Inc., "Lower-48 Dry Gas

Production vs. Dry Gas Productive Capacity," presented by the

American Gas Association to the Federal Energy Regulatory

Commission in a briefing titled "Outlook for Natural Gas Market

Conditions," September 6, 2002.
vidence indicates that price manipulation

has occurred in certain natural gas marketplaces, and may be continuing.

Price manipulation accusations and

admissions have had high visibility during this

time of stress on energy markets, resulting in

dramatic losses in confidence by customers and

other participants. To regain lost confidence,

natural gas markets must, going forward, develop

adequate institutions to manage the potential for

manipulation and deter it. 

In addition to recent activity by certain market participants, much evidence of manipulation

right now is likely the result of a high degree of

scrutiny, a natural side effect of building robust

market institutions. Nevertheless, it is likely that

revelations of improper behavior will continue

for some time. The Commission is likely to be

at the forefront of much of this revelation.

The Situation

The fair and effective functioning of energy marketplaces requires robust industry institutions designed

to prevent manipulation and promote customer confidence. To date, the natural gas industry has not adequately developed these institutions. 

The Commission has investigated specific incidences

of aberrant market behavior for some time, and it created

OMOI in 2002 to help the Commission monitor existing

marketplace institutions. OMOI’s charge is to oversee market behavior on an ongoing basis and investigate improper

behavior, such as the manipulation of energy markets.

Manipulation consists of the violation of regulations and

the use of market power and deception to profit from

other market participants.

Since FERC’s Enforcement

Division moved to OMOI in August

2002, we have increased the number

of active natural gas and electric

market-related investigations steadily. Manipulation is more likely

where market liquidity is low, price

discovery is obscure and capacity is

constrained, and this manipulation

may move prices in either direction.

The ongoing reduction in numbers

of wholesale market participants and

reduced liquidity and transparency

at pricing points may increase the

potential for manipulation. Having

fewer traders may reduce the statistical significance of reporting for lessactive trading points, reduce liquidity, increase bid-ask differentials,

increase volatility and increase the

potential for distorted price reporting.

The Commission conducts investigations of natural

gas market participants using the following five broad categories of price manipulation:

Controlling marketplaces through weak liquidity. As

discussed above, the natural gas market consists of many

relatively illiquid marketplaces. In some cases, individual

trading companies dominate these marketplaces, giving

the companies market power. Certain trading companies

appear to have used market power to affect prices. The

Commission, through OMOI and other staff investigations,

is looking at particular situations where use of market

power arising from weak market liquidity appears to have

affected prices.

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CONTINUING POTENTIAL

FOR MANIPULATION

Issue 5

E Manipulation of 

of energy markets can

include, but is not 

limited to, the exercise of market power;

the dissemination of

false or deceptive

information; or other

acts or practices that

may or may not constitute violations of

Commission-filed 

tariffs or Commission

rules, orders or 

other applicable 

requirements.
26

JANUARY 2003

arises from control of facilities to or from areas where

capacity is tight. In the natural gas business, having

capacity generally means having access to transportation,

storage or distribution. The Commission investigates

cases where it is alleged that companies withheld capacity

to the point where a price in a related market was 

affected.

Manipulating physical marketplaces to affect 

prices in associated financial marketplaces.

Companies may be able to use market power to manipulate prices in physical markets in order to affect associated

financial markets.

Communicating market information from pipelines

to their marketing affiliates. The Commission has

strict rules regarding communication of information from

regulated capacity providers – generally pipelines – to

their affiliated marketers. Affiliated marketers could use

information about regulated capacity availability to take

positions in a marketplace more advantageous than 

their competitors. 

Providing false data about prices or volumes to

index publishers. As we discussed more thoroughly

above in the price discovery section, some companies

have admitted lying to the trade press regarding prices.

Lying about commodity prices can be a felony. The

Commission and others have discovered extensive 

evidence of lying about prices to trade publications in 

the past.

This list of categories is not exhaustive, nor does it represent all the potential strategies for manipulating natural

gas prices. Effective market oversight will require the ability to identify, investigate and resolve manipulation quickly, and to distinguish manipulation from price movements

(up or down) resulting from market forces.

Coordinated efforts by industry and government 

can best prevent market manipulation. 

Industry Actions

Participants in natural gas markets may, at times, believe

that their short-term goals can be furthered through 

market manipulation. In the longer term, manipulation

destroys confidence in the industry. In a real sense, 

the current situation in the natural gas industry is the

direct result of certain participants’ failure to consider

the long-term consequences of their unethical and

illegal actions.

Companies active in natural gas trading must 

take responsibility to stop manipulation of markets,

either by their employees or by others. These efforts

fall into two categories:

Establishing and maintaining internal legal and risk

management controls, and

Reporting suspicious behavior to the appropriate

authorities.

OMOI has seen an increasing interest by natural gas

traders in both of these approaches. Some companies

have taken actions to clean house internally in response

to various internal and external investigations. Some

companies have reported suspicious behavior to the

Commission and other responsible governmental 

authorities.

Collective industry efforts have included those

spearheaded by the CCRO related to appropriate controls

and by EPSA related to ethical behavior.

Commission Actions

The Commission has made a strategic commitment

to vigilant oversight of market manipulation in

wholesale natural gas markets. Much of the

Commission’s efforts in this area, those related to

specific investigations, is confidential and cannot 

be mentioned here. However, certain activities 

can be reported:

The Commission formed OMOI in early 2002 

explicitly to coordinate market monitoring and 

investigation capabilities. 
27

JANUARY 2003

developed by OMOI at regular closed meetings since mid2002. Issues reviewed include price movements, financial

conditions, market intelligence, system outages, potential

market manipulations and other observed behaviors.

OMOI is developing a set of gas and electric market

metrics and thresholds designed so that when anomalies

occur, OMOI investigates to determine if the deviations

can be explained by physical market imbalances, by market rule problems or by improper market behavior. 

other regulatory bodies, including the Commodity 

Futures Trading Commission, the Securities and Exchange

Commission, the Department of Justice, state commissions and others.

OMOI operates the Commission’s toll-free

Enforcement Hotline (877-337-2446), which received

about 600 calls in 2002. These calls include inquiries,

complaints and tips about inappropriate market 

behavior.
28

JANUARY 2003

ompetitive forces have created extraordinary benefits for natural gas customers.

However, the competitive wholesale 

natural gas market faces many critical

challenges as 2003 gets underway. These 

challenges include:

Deteriorating financial conditions of market 

participants;

Managing credit exposure;

Shaken confidence in price discovery methods; 

Continuing need for efficient investment in 

infrastructure; and

Continuing potential for manipulation. 

The healthy functioning – or distress – of natural gas markets can have profound effects on the overall economy

because of the gas market’s size, pervasiveness and the

critical needs it meets. 

Operation of a competitive wholesale natural gas

market generated significant customer benefits over the

past quarter-entury. Quick, thoughtful and meaningful

action can address the current challenges and maintain

the benefits of a competitive natural gas industry for its

customers and the overall economy. 

The issues facing the effective competitive functioning of the natural gas market are manageable over time.

Both industry participants and regulators should aggressively seek out and promote solutions to assure efficient,

cost-effective, fair and valuable natural gas service to all

customers in the United States.

Industry actions indicate a significant, responsible

interest in dealing with the challenges that face natural gas

markets today. As long as that interest remains, it provides

a strong positive indication that these issues can be

resolved.

The Commission continues to promote fair, efficient

markets through a clear focus on its strategic initiatives to:

Assure sufficient infrastructure;

Create balanced market rules; and

Maintain vigilant oversight and enforcement.

This Natural Gas Market Assessment has presented how

OMOI is overseeing natural gas markets and enforcing the

Commission’s rules. 

C

CONCLUSION
29

JANUARY 2003

The 2003 Natural Gas Markets Assessment was prepared

by the Office of Market Oversight and Investigations

(OMOI) under the direction of Lisa L. Carter

(lisa.carter@ferc.gov), Acting Director, Division of

Integrated Market Assessment, and Stephen Harvey,

Deputy Director, Market Oversight and Assessment.

OMOI contributors to the report include Stacy Angel, Jim

Caruso, Bob Czarick, Lee Choo, Bryan Craig, Jolanka

Fisher, Robert Flanders, George Godding, Jesse Halpern,

Dan Hedberg, Laurel Hyde, Raymond James, John

Jennrich, Ken Kohut, Thanh Luong, Gary Mahrenholz,

Rafael Martinez, Bill Meroney, Steve Michals, Pat Morris,

Kara Mucha, Camilla Ng, Dennis O’Keefe, Bob Pease, Tom

Pinkston, Steve Reich, Rahul Varma, Eliot Wessler, Carol

White and Charles Whitmore.

Any errors are the responsibility of the OMOI alone.

WILLIAM F. HEDERMAN

Director

Office of Market Oversight and Investigations