The Cost of Natural Gas
Authors: Sherwin S.F. 
Published: December 2007

Three principal methods of cost determination have been proposed to the Federal Power Commission as a basis for pricing natural gas at the wellhead:

the cost of service; the expenditure approach; and the inventory cost approach.

Each of these approaches has severe limitations, partly due to the approach itself and partly, due to the presence of joint costs, which renders the resulting unit cost of gas subject to the vagaries of inherently arbitrary methods of allocation. Although some progress has been made in narrowing the gap between proponents of different allocation methods, the cost of gas can only be determined within relatively wide ranges, which do not furnish a sufficient degree of reliability to serve as a basis for pricing.

Introduction

The purpose of this paper is to review and appraise the principal methods of cost determination which have been proposed to the Federal Power Commission as the basis for pricing natural gas at the wellhead. I must caution that there is no such thing as "the" cost of natural gas; there may be "a" cost of natural gas, but even it cannot be determined with the degree of reliability and accuracy characteristic of scientific inquiry. In some degree, all cost determinations of gas are a fiction. There are several reasons for this inaccuracy and unreliability. A first obstacle arises from the difficulty of relating costs to the quantity of reserves found or produced. Thus, there is uncertainty over whether the supplies reported as found in a particular period were found as the result of expenditures in that period. The reported reserve additions consist of (1) discoveries and (2) extensions and revisions. Even if we assume that the reported discoveries of a particular period are the result of expenditures during that period - an assumption of questionable validity due to the time lags involved in the various phases of exploration-the extensions and revisions are to a considerable, though unknown, extent the result of exploratory expenditures in a prior period.

A second obstacle stems from the elusive nature of hydrocarbons, which makes an accurate measurement of reserves impossible until after the reservoirs have been depleted. This obstacle is not only encountered when costs are related to reserves added, but also when costs are related to production, because costs include capital recovery charges which in turn are typically based on the relation between annual production and ultimate reserves.

A third difficulty is the virtual impossibility of determining the cost for a gas supply other than for existing reserves. This difficulty stems both from the variability in productivity as well as the fact that an extractive industry tends to be an increasing-cost industry. These problems are particularly serious in determining cost for pricing, since the purpose of such a determination is partly to determine the expenditures necessary to discover supplies adequate to meet future demand, and the necessary supplies may exceed those that happen to have been found. An estimate of dollar expenditures required for an additional supply is difficult and uncertain, because it hinges on an estimate of the future productivity of drilling. A fourth obstacle stems from the fact that over 90 per cent of all gas is found and produced in conjunction with either oil or condensate liquids. The costs of finding and developing gas are therefore joint costs, subject to methods of allocation which are inherently discretionary and arbitrary. Hence, allocated costs are never in fact costs, but merely a reflection of individual judgments, which vary to such an extent that the results frequently vary 100 per cent between the low and the high. The fact that the cost of finding gas cannot be accurately determined does not mean that all cost studies are equally fictitious. Some fictions have more basis in reality than others. The extent to which cost determinations are fictitious is directly related to the degree to which the results are dependent upon allocation. This leads us to the important distinction between the cost of nonassociated and the cost of associated gas.

Costing Nonassociated Gas

In determining the cost of nonassociated gas, it is possible to directly identify the cost of drilling and equipping successful wells, as well as the cost of producing the gas. These items account for approximately half of total costs. This leaves the cost of dry holes, lease acquisitions, geological and geophysical as joint costs, which require allocations between oil reservoirs and gas reservoirs. During the last two years, considerable progress has been made in this area. Most experts who have presented costs of nonassociated gas at FPC proceedings agree that these joint costs should be allocated in proportion to either the cost of successful wells or the number of successful feet drilled.

JPT

P. 133ˆ