Natural Gas: Factors Affecting Prices and Potential Impacts on Consumers
Published: 2006-02-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In early December 2005, wholesale natural gas prices topped $15 per million BTUs, more than double the prices seen last summer and seven times the prices common during the 1990s. For the 2005-2006 heating season, the U.S. Energy Information Administration predicts that residences heating with gas will pay 35 percent more, on average, than they paid last winter. This testimony addresses the following: (1) the factors causing natural gas price increases, (2) how consumers are affected by these higher prices, and (3) the roles federal government agencies play in ensuring that natural gas prices are determined in a competitive and informed marketplace. This testimony is based on GAO's 2002 published work in this area, updated through interviews, examination of data, and review of relevant publications. GAO's new work was conducted from December 2005 through February 2006 in accordance with generally accepted government auditing standards.
section_title: What GAO Found
paragraphs: Since 1999, wholesale prices for natural gas have trended upward because of expanding demand and supply that has not kept pace. The domestic natural gas industry has been producing at near capacity, and the nation's ability to increase imports has been limited. Tight supplies have also made the market susceptible to extreme price spikes when either demand or supply change unexpectedly. Prices spiked in August 2005 when hurricanes hit the Gulf Coast, disrupting a substantial portion of supply and again later when demand was pushed higher because of, among other reasons, colder-than-expected temperatures in early December. Although prices have dropped, they remain higher than last year. Other factors--such as market manipulation--may also have affected wholesale prices. We are currently examining futures trading in natural gas markets for signs of manipulation and expect to report on our results later this year. While most consumers' gas bills are rising, the degree of the increase depends, in part, on how much of their supply is purchased from wholesale spot markets. Consumers who directly, or indirectly, buy their natural gas mainly from spot markets will see prices that reflect both recent price spikes and the longer-term trend toward higher prices. Our work shows that some of the largest natural gas utilities in a few states expect to buy at least 70 percent of their gas at spot market prices this winter. These companies generally pass these prices on to their customers. On the other hand, consumers and suppliers that have reduced exposure to spot market prices because some of their gas has been purchased through a process called hedging may be insulated from price spikes and may postpone their exposure to even gradual price hikes. In this regard, utilities in more than half the states have hedged at least 50 percent of their supply for this winter by entering into long-term fixed-price contracts and other techniques. This will help stabilize prices for their customers. Nonetheless, high gas prices will hit some consumers hard, including lower-income households and companies that depend heavily upon natural gas, such as fertilizer manufacturers. The Federal Energy Regulatory Commission (FERC) and the Commodities Futures Trading Commission (CFTC) play key roles in ensuring that natural gas prices are determined in a competitive and informed marketplace. Both agencies monitor natural gas markets and investigate instances of possible market manipulation. Since 2002, FERC has settled a number of investigations involving natural gas market manipulation; for example, one company agreed to pay a settlement of $1.6 billion after FERC found it had exercised market power over natural gas prices in California during the 2001-2002 heating season. From 2002 through May 2005, CFTC investigated over 40 energy companies and individuals, filed over 20 actions, and collected over $300 million in penalties, most of which were natural gas related.

section_title: Letter
paragraphs: I am pleased to be here today to discuss natural gas prices. As you know,  last fall two powerful and destructive hurricanes, Katrina and Rita, tore  through the Gulf of Mexico and several states bordering it—an important  area for the supply of natural gas. By early December 2005, wholesale  natural gas prices topped $15 per million BTUs, more than double the  prices seen last summer and seven times the prices common throughout  the 1990s. For the 2005-2006 winter heating season, the Energy  Information Administration estimated in January 2006 that residential  households heating with natural gas will pay $257 (35 percent) more, on  average, than last winter. Consumers in the Midwest are expected to  witness even greater increases—paying 41 percent more than last winter.
This is not the first time that natural gas prices have sharply increased. In  2000-2001, prices rose steadily and remained high for nearly a year. We  examined this phenomenon in 2002 and found that prices went up mainly  because supplies could not keep pace with rising demand. We also  reported that federal agencies responsible for overseeing aspects of the  natural gas market were actively investigating whether market participants  had violated market rules or manipulated prices.
Concerned about the recent increases in natural gas prices and the  implications of these increases on consumers in the United States, you  asked us to address the following: (1) the factors causing natural gas price  increases, (2) how consumers are affected by these higher prices, and (3)  the roles federal government agencies play in ensuring that natural gas  prices are determined in a competitive and informed marketplace.
Our testimony today is based on our prior reports, interviews, and a  review of recent reports published by others. Prior related GAO products  are listed at the end of this statement. To update our findings from those  reports, we conducted interviews with federal agencies that included the  Energy Information Administration, the Federal Energy Regulatory  Commission, and the Commodities and Futures Trading Commission. We  also interviewed the state commissions that oversee natural gas utilities,  selected trade associations representing the natural gas industry, and  other potentially affected industries. Further, we examined data on the  natural gas industry, including prices, consumption, and supplies. In  addition, we reviewed relevant reports and other documents published by  others. We conducted our work from December 2005 to February 2006 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Natural gas is a colorless, odorless fossil fuel found underground that is  generated through the slow decomposition of ancient organic matter. In  some cases, the gas, composed mainly of methane, is trapped in pockets of  porous rock held in place by impermeable rock. In other cases, natural gas  may occur within oil reservoirs or in coal deposits. Natural gas is  extracted via wells drilled into the porous rock. The natural gas is then  moved through pipelines and processing plants to consumers.
Historically, domestic natural gas production has occurred largely in  Texas, Oklahoma, and Louisiana. In more recent years, as older fields have  been depleted, the Rocky Mountain region, Alaska, and areas beneath the  deeper waters of the Gulf of Mexico are becoming increasingly important  in supplying natural gas; however, in many cases these supplies are not  near pipelines and other infrastructure needed for getting the gas to  markets, which increases the costs of gas obtained from the newer fields.  residential users living in houses, apartments, and mobile homes;   commercial users such as stores, offices, schools, places of worship, and  industrial users covering a wide range of facilities for producing,  processing, or assembling goods, including manufacturing, agricultural,  and mining operations;   entities that use natural gas to generate electricity and provide that  electricity to others, such as regulated electric utilities and competitive  suppliers of electricity; and the transportation sector, including pipeline companies, which use natural  gas to operate the pipeline networks, as well as those using natural gas to  power cars and buses.
Most residential and commercial consumers rely on natural gas utilities to  supply their gas. Industrial consumers and electricity generators obtain  their gas through a variety of means, including buying it directly from spot  markets and natural gas utilities.
The demand for natural gas in the United States has generally been  seasonal, with peak demand during the winter heating months. From April  through October, companies typically purchase natural gas and place it  into underground storage facilities located around the country. Later, as  the seasonal demand increases, these stored supplies of natural gas are  used to augment the supplies provided via pipelines. According to EIA,  natural gas demand during winter months is usually 1.5 times greater than  monthly natural gas production in other months.
Over the past 25 years, the wholesale natural gas supply market has  evolved from a highly regulated market to a largely deregulated market,  where prices are mainly driven by supply and demand. While the regulated  market ensured stable prices, it also caused severe gas supply shortages  because, with artificially low prices, producers had no incentive to  increase production and consumers had no reason to curtail their demand.  Before implementation of the Natural Gas Policy Act of 1978, which began  deregulation of wholesale natural gas prices, the federal government  controlled the prices that natural gas producers could charge for the gas  they sold through interstate commerce. Under this regulatory approach,  producers located natural gas reserves, drilled wells, gathered the gas, and  sold it at federally controlled prices to interstate pipeline companies. After  purchasing the natural gas, pipeline companies generally transported and  sold the gas to local distribution or gas utility companies. These  companies, under the oversight of state or local regulatory agencies, then  sold and delivered the gas to their consumers, such as homeowners.
In today’s restructured market, the retail prices that consumers pay are  still regulated in many states and reflect the prices paid by their suppliers  to acquire the natural gas. However, the federal government does not  control the wholesale price of natural gas. Since the removal of federal  price controls, the wholesale price of natural gas decreased initially and   has become more volatile. Producers still locate and gather natural gas,  but they now sell the gas at market-driven prices to a variety of companies,  including marketers, broker/trader intermediaries, and a variety of  consumers. New market centers have emerged, including a market center  referred to as the Henry Hub, located in Henry, Louisiana. Henry Hub  prices are reported on a daily basis, and trades made at that market are  often used as benchmarks for other natural gas trades.
The various players in the market may sell gas back and forth several  times before it is actually delivered to the ultimate consumers. In some  cases—in spot markets, for example—natural gas is sold for immediate  delivery. In other cases, it may be sold for delivery in the future, through a  variety of what are called futures markets. In addition, several types of  financial derivatives related to natural gas—contracts whose market value  is derived from the price of the gas itself—can be bought and sold through  numerous sources by entities that are interested in protecting themselves  against increases in the price of natural gas. Derivatives include natural  gas futures and options, and derivative prices typically move in parallel  with the spot market. Derivatives markets include exchanges such as the  New York Mercantile Exchange, which is regulated by the CFTC; and the  Intercontinental Exchange, which operates as an exempt commercial  market without CFTC oversight but over which CFTC has anti- manipulation and anti-fraud authority; and off-exchange and over-the- counter (OTC) markets, which are not subject to general federal  regulatory oversight.
section_title: Increasing Demand and Tight Supply Have Driven Up Prices and Made Extreme Price Spikes Possible
paragraphs: Since 1999, wholesale prices for natural gas have trended steadily upward  due to expanding demand—largely for electricity production—and supply  that could not expand as quickly because the industry is already operating  at near capacity. This tightness in the demand and supply balance has also  made the market susceptible to extreme price changes in times when  either demand or supply change unexpectedly. One such period of  extreme price changes occurred in late 2005, when two hurricanes hit the  Gulf Coast region, disrupting a substantial portion of the domestic supply  of natural gas. Prices spiked to high levels and, although they have since  dropped, they remain unusually high today.
subsections: section_title: Trend toward Higher Prices in Recent Years Is Due Largely to Market Forces
paragraphs: Since 1999, wholesale natural gas prices have risen steadily, as  demonstrated by the moving average in figure 1. Previously, in the early  and mid-1990s, prices were generally low, usually ranging from $2 to $3  per million BTUs, adjusted for inflation. From January 1999 through July  2005, however, average wholesale prices increased by over 200 percent,  rising from about $2 to $6.75 per million BTUs. Most recently, in the last  half of 2005, prices rose to over $15 per million BTUs, sevenfold higher  than prices seen in the early 1990s.
A combination of market forces has caused the upward trend in wholesale  natural gas prices since 1999. Demand for natural gas has been growing  rapidly since the mid-1980s, with total consumption increasing by about 38  percent from 1986 through 2004. Figure 2 illustrates the extent to which  consumption of natural gas has risen in the United States over the past 2  decades and the relative amounts used by each of the five types of  consumers: residential, commercial, industrial, electricity generators, and  transportation.
A significant share of the increased demand in recent years has resulted  from increased use of natural gas to generate electricity. Out of concern  regarding the supply of natural gas and other factors, construction of  power plants using oil or natural gas as a primary fuel was restricted from  1978, when the Powerplant and Industrial Fuel Use Act (Fuel Use Act)  took effect, through 1987, when it was repealed. After the Fuel Use Act’s  repeal, use of natural gas by the electric generation sector increased by 79  percent from 1987 through 2004. Newer gas-powered plants produce low  levels of pollutants, compared with many existing plants. This  characteristic, as well as the long period of low prices in the 1990s and  other factors, has made natural gas the primary fuel in new power plants.
The supply of natural gas, however, has not kept pace with the increased  demand. Historically, most of the natural gas used in the United States—85  percent in 2003—has been produced here. However, as older natural gas  fields have been depleted, additional drilling for natural gas has been  required in order to maintain domestic production. This additional drilling  has not necessarily resulted in immediate additional supplies in part  because development of new wells and supporting pipeline infrastructure  can take time. Overall, from 1994 through 2003, domestic annual  production held steady at about 19 trillion cubic feet. In 2003, EIA  reported that the domestic natural gas industry had produced nearly all of  the natural gas that could be produced on a monthly basis from 1996  through 2001—the most recent data then available. Furthermore, EIA  reported that at times there was virtually no spare capacity in some parts  of the country and forecasted that these tight supply conditions would  continue, despite EIA’s projection for a significant increase in drilling  activity.
In recent years, imports of natural gas have become increasingly  important. Net imports of natural gas have increased steadily, rising by  over 250 percent from 1987 through 2004. In 2004, the United States  imported about 15 percent of the total natural gas consumed here. Nearly  all of the imported gas comes from Canada via pipeline, and those imports  constitute virtually all of Canada’s production not used in that country. In  addition, a small share—about 3 percent of total U.S. supply—has been  shipped on special ocean tankers as liquefied natural gas (LNG) from  countries such as Trinidad and Tobago, Nigeria, and others. These imports  have increased significantly in recent years; however, it is not clear if we  have the capacity to handle further increased shipments, in part because  only five facilities in the United States are able to receive and process LNG  imports. Moreover, because of limited international supplies and high  prices in other markets, it also is not clear how much additional supply is  available to the United States.
section_title: Extreme Price Spikes Resulted from Tight Demand and Supply Conditions
paragraphs: The tight demand and supply balance has made the market for natural gas  more susceptible to extreme price changes when demand or supply  changed unexpectedly. As we previously reported, prices spikes occur  periodically in natural gas markets because neither the demand side nor  the supply side can quickly adjust to changes in the marketplace. On the  demand side, some customers are able to react to changes in prices. For  example, some industrial entities may be able to switch fuels or reduce  their production. However, many other customers, such as residential  customers, may have few fuel-switching options and little firsthand  knowledge of spot natural gas prices—and understand the costs of their  natural gas consumption only when they receive their bill. On the supply  side, suppliers are slow to respond to price changes. For example, they  may be delayed in responding to high prices because, as noted earlier,  existing domestic sources of natural gas are already operating at near full  capacity—often above 90 percent in the United States in recent years,  according to EIA. In these circumstances, because little excess supply is  readily available, it must be added, generally by drilling new wells and  connecting those wells to existing pipelines, which can take time. For  example, receiving regulatory approval can take a year or more, and the  time to drill the well and connect it to the pipeline network can take  another 6 to 18 months. Because neither the suppliers nor many  consumers can react quickly to price changes, even small unexpected  increases in demand or disruptions in supplies can cause sudden and  significant price increases.
subsections: section_title: High Prices in Late 2005 Resulted from Supply Disruptions Caused by Hurricanes Katrina and Rita
paragraphs: Most recently, prices rose sharply following the landfall of two hurricanes  in the Gulf region. It appears that the price spike was caused by the  unexpected decrease in the supply of natural gas in late 2005 following  Hurricanes Katrina and Rita, exacerbated by factors that raised demand.  Because of the damage caused to production, processing, importing, and  transporting infrastructure in the Gulf region, wholesale prices climbed to  a high of $15 per million BTUs by December 2005. Other factors—such as  market manipulation—may also have affected wholesale prices. Our  ongoing work examining futures trading in natural gas markets will  address this issue later this year.
The Gulf region produces about 20 percent of the U.S. natural gas supply.  The region’s extensive natural gas-related infrastructure includes about  4,000 platforms that extract natural gas from beneath the ocean floor; two  of the five terminals that import LNG into the United States; plants that  remove impurities from natural gas to prepare it for sale and use; and an  extensive network of pipelines, linked by hubs such as the Henry Hub, that  transport natural gas to other parts of the United States.
The paths of Hurricanes Katrina and Rita, in relation to Gulf region natural  gas infrastructure, are shown in figure 3. The hurricanes forced operators  to evacuate about 90 percent of the oil and gas platforms in the Gulf for  safety reasons, rendering them unable to produce natural gas; shut down  one of the two LNG importing terminals for about two weeks; damaged  processing plants; and damaged several pipelines and their connecting  hubs, delaying transmission of natural gas from supply facilities that were  still operational. For example, the Henry Hub, a major gas market center,  was closed by flooding for a total of 11 days following Katrina and Rita.
As a result of all of these factors, the hurricanes had a significant impact  on the supply of natural gas. Figure 4 shows the impact of Hurricanes  Katrina and Rita on the production of natural gas from the Gulf region.  Hurricane Katrina disrupted about 8 billion cubic feet of natural gas   production per day immediately following its landfall—amounting to  about 80 percent of daily production from the Gulf and about 16 percent of  total daily U.S. production of natural gas. Lost production from Katrina  was in the process of being restored when Hurricane Rita struck—again  reducing production of natural gas from the Gulf region to levels similar to  those immediately following Katrina. As a result of the severity and timing  of these two hurricanes, the Gulf region produced less than half its usual  amount of natural gas for about 9 weeks after Hurricane Katrina struck. By  comparison, nearly all of the lost production that resulted from Hurricane  Ivan in 2004 was restored within 9 weeks and amounted to about 20  percent of that caused by Katrina and Rita. By the end of January, only  about 80 percent of the natural gas supplies that had been disrupted by  Katrina and Rita had been restored, leaving the overall market tighter than  it was prior to the hurricanes and leaving the U.S. vulnerable to future  unexpected interruptions in supply or increases in demand—either of  which could result in higher prices.
The high natural gas prices that followed the Katrina and Rita supply  disruptions came at a time when demand for natural gas was already high.  Higher-than-average late-summer temperatures in August had led to  increased demand for natural gas to generate electricity, particularly in the  South. As a result of this high level of demand, existing supplies were  stretched thin and overall price levels were high. In addition, the  hurricanes struck as companies were filling their storage of natural gas in  preparation for the winter heating season.
Prices for natural gas in both the spot and the futures market spiked  dramatically immediately following the supply disruptions caused by the  2005 hurricanes. In September 2005, after the second hurricane, natural  gas spot prices increased to over $15 per million BTUs—roughly twice as  high as the average price in July 2005 of about $7.60 per million BTUs.  Futures prices to deliver gas in October also doubled to $14.20 per million  BTUs, reflecting traders’ expectations that high spot prices could continue  into the future. Futures prices closely followed spot prices until early  November 2005, when spot prices fell to about $9 per million BTUs, but  prices for December gas futures remained at about $12 per million BTUs,  reflecting the belief by futures market traders that natural gas prices  would be high in December. A brief cold spell during the beginning of  December increased demand for natural gas for heating purposes, driving  prices up. The arrival of warmer than normal temperatures just before the  end of the year reduced demand and has contributed to the recent  reduction in prices. Figure 5 shows the spikes in natural gas prices during  the months of, and following, the 2005 hurricanes.
Two other instances of price spikes—caused by unexpected increases in  demand—have occurred since 1999. First, coincident with the western  electricity crisis, from mid-2000 through early 2001, wholesale prices for  natural gas rose substantially and remained relatively high for nearly a  year. This period witnessed significant increased demand for natural gas  by the electric generation sector in order to meet electricity demand  across the West during a year of diminished availability of hydroelectricity,  a situation compounded by high demand through the winter and lower- than-normal storage levels. In a second instance, wholesale prices rose  sharply in February 2003 during a period of high demand because of  unusually cold winter temperatures; however, prices returned to normal  relatively quickly.
section_title: Impact on Consumers of Higher Wholesale Natural Gas Prices Depends on the Extent to Which They Buy from Spot Markets and on Other Factors
paragraphs: How higher wholesale natural gas prices are affecting consumers depends  largely on the degree to which the consumers or their suppliers may have  purchased gas on the spot market—which reflects current wholesale  prices—or may have taken steps to reduce their exposure to these prices.  The effect of higher prices also depends on the consumer’s sensitivity to  price changes. Some consumers, such as low-income residents and certain  industries, are more sensitive to price changes than others.
subsections: section_title: Higher Wholesale Prices May Lead to Significant Increases in Energy Expenditures for Consumers Exposed to Spot Markets
paragraphs: The impact of recent increases in natural gas wholesale prices on  consumers depends on how much of the natural gas they use is purchased  in spot markets. Those with the greatest reliance on spot markets are hit  the hardest when prices rise or spike. For example, some natural gas  utilities that relied on spot markets are spending significantly more on  energy this winter, which may translate into higher gas bills for residential  and commercial consumers. According to our preliminary work with the  state commissions that regulate natural gas utilities, 10 states reported  that at least some of the natural gas utilities they regulate were highly  exposed to spot market prices. Furthermore, in a few states, some of the  largest natural gas utilities projected they would purchase 70 percent or  more of their natural gas supplies for this winter from the spot market.
Participants in the market, such as industrial consumers who purchase gas  directly from the market or natural gas utilities that purchase gas on behalf  of their customers, can hedge against high spot market prices for natural  gas in three main ways: (1) by purchasing and storing gas for use during  times when prices are high; (2) by signing fixed-price contracts for  delivery of the gas in the future; and (3) by purchasing financial  instruments, such as options or derivatives, that increase in value as  natural gas prices rise. Since the winter of 2000-2001, some state public  utility commissions (PUCs) have encouraged the natural gas utilities they  regulate to hedge some part of their gas purchases in order to help  stabilize prices, according to the American Gas Association. According to  the state commissions, 27 states reported that the utilities they regulate  will acquire at least half of their expected winter natural gas needs at a  known price, generally ranging from $7 to $10 per million BTUs. In that  regard, last November, Commissioner Donald Mason of Ohio told  Congress that customers around Dayton, Ohio, have saved about $3 per  million BTUs as a result of hedging, including use of long-term, fixed- price  contracts. Gas utilities are also taking other approaches to keep down or  stabilize their customers’ costs. For example, in some states, utilities offer  “level” payment programs and show customers how to use energy wisely  through energy-efficient appliances. In Minnesota, in 2005, all state- jurisdictional gas utilities are required to spend at least 0.5 percent of their  gross operating revenues on conservation improvement efforts such as  weather audits, weatherization, and rebates for purchases of energy- efficient appliances. While some gas utilities have made efforts to reduce  their exposure to spot prices by increasing their use of hedging, as some  did after the price spike in 2000-2001, some states and municipalities still  discourage the use of hedging, according to the association that represents  the public utility commissioners.
While hedging allows consumers to obtain greater price stability, it has  costs and risks, and utilities may lack incentives to undertake it. Storing  gas for later use, for example, entails up-front costs such as the cost of  placing it into and keeping it in storage. Market participants face risks if,  for example, they purchase gas in advance under a fixed-price long-term  contract and prices drop. For that reason, some natural gas utilities may  be reluctant to enter into long-term contracts when prices are relatively  high, according to a trade association that represents municipal gas  utilities. Furthermore, absent specific PUC guidance to hedge purchases,  gas utilities may have few incentives to hedge since they are generally able  to pass along increased costs associated with purchases of natural gas.  Moreover, some state regulators may not allow gas utilities to financially  benefit from using hedging but hold them financially responsible if the  hedge proves unnecessary. Furthermore, while under some circumstances  hedging can reduce or eliminate the impact of a price spike, it may offer  little benefit during prolonged periods of price changes. For example, a  utility that signed a 5-year commitment to purchase natural gas at a  predetermined price may witness no change in the cost of acquiring the  natural gas during the period of the contract but would again face market  prices (either higher or lower) when it came time to replace this gas  supply at the end of the contract. In this sense, hedging may serve to delay  until the contract term ends, but not prevent, the effect of higher or lower  prices on consumers.
section_title: Some Consumers Are More Sensitive to Price Changes
paragraphs: Because energy costs account for a relatively large share of overall costs  for some consumers or because they are heavily dependent on natural gas,  any price increases can present significant difficulties. In particular, low- income residential consumers and some highly energy intensive industries  appear likely to encounter the greatest impact.
The effect of high natural gas prices has already been especially severe on  low-income individuals. According to representatives from a trade  association representing publicly owned natural gas utilities, a utility in  Philadelphia, Philadelphia Gas Works, has billed $42 million more than  they have collected so far this winter, representing an increase of 2  percent in uncollectible heating bills this winter compared with last  winter. In Kentucky, utilities this winter have witnessed the highest  number of complaints and the greatest number of problems faced by  customers. Furthermore, federal assistance to low-income households in  meeting heating expenditures provides only limited assistance. According  to the National Association of State Energy Officials, the Low Income  Home Energy Assistance Program (LIHEAP) currently serves only 20  percent of the eligible population, with average payments of $311 per  family designed to help families pay projected natural gas heating  expenditures of $1,568 this winter. Additionally, despite several years of  increases, LIHEAP funding in fiscal year 2005 is only 67 percent of what it  was in fiscal year 1982, adjusted for inflation. However, some states have  increased funding for low-income individuals recently. For example, in  December, Minnesota began distribution of an additional $13.4 million in  funding designed to assist an additional 26,000 households in paying for  heating.
Electricity generators are also sensitive to higher prices because of their  dependence on natural gas. This is true especially in the eastern United  States, where, according to FERC, electricity generators rely heavily on  natural gas. Furthermore, the region has many of the newer gas-fired  electric power plants that have less flexibility to switch to other fuels,  such as oil-based fuels, according to the National Petroleum Council and  others. As a result, some consumers may see higher electricity bills.
High natural gas prices are also adversely affecting industrial consumers.  As we reported in 2003, some industrial consumers shut down production  facilities because of higher energy costs in 2000 and 2001. Industry  representatives expect recent high prices to have a similar effect. A recent  survey by a trade association representing large energy consumers showed  that more than half of 31 member companies surveyed are decreasing their  demand for natural gas an average of 8 percent to 9 percent this winter  compared with last winter, leading the association to conclude that higher  prices have forced industries to curtail production in the United States.  The association expects that further cutbacks will occur if prices remain  high this year.
According to an association that represents industrial consumers, high  natural gas spot prices have been particularly detrimental to specific  industries in the United States that rely on natural gas, such as fertilizer  and chemical manufacturers, that compete in international markets. As we  reported in 2003, natural gas expenses can account for 90 percent of the  total cost of manufacturing nitrogen fertilizer. The high cost of domestic  natural gas has made it difficult for U.S. producers of nitrogen fertilizer to  compete with foreign nitrogen fertilizer producers, who can buy natural  gas at lower prices and export their products to the United States. For  example, in 2004, Trinidad and Tobago was the largest supplier of  anhydrous ammonia, a type of nitrogen fertilizer, to the United States.  Prices of natural gas are sharply lower in Trinidad and Tobago, where,  according to the Fertilizer Institute, prices were about $1.60 per million  BTUs in 2005. The U.S. fertilizer industry, which typically supplied 85  percent of its domestic needs from U.S.-based production during the  1990s, now relies on imports for nearly 45 percent of nitrogen supplies,  according to a trade association representing fertilizer companies.
Furthermore, other industries can be affected. In the fertilizer industry,  according to a trade association representing fertilizer companies, costs  are passed on to U.S. farmers, which have witnessed a dramatic increase  in the cost of nitrogen fertilizers. The prices paid by farmers for the major  fertilizer materials reached a record during the spring of 2005—on  average, 8 percent higher compared with the same period in 2004,  according to a trade association representing fertilizer companies.
section_title: The Federal Government Has a Limited, but Important, Role in Overseeing Natural Gas Markets
paragraphs: In today’s restructured market, the federal government does not control  the price of natural gas or directly regulate most wholesale prices.  However, three federal agencies—FERC, CFTC, and EIA—play key roles  in overseeing and supporting a competitive and informed natural gas  marketplace.
subsections: section_title: FERC’s Oversight Activities
paragraphs: Under federal law, FERC is responsible for regulating the terms,  conditions, and rates for interstate transportation by natural gas pipelines  and public gas utilities to ensure that wholesale prices for natural gas, sold  and transported in interstate commerce, are “just and reasonable.” FERC’s  jurisdiction over retail natural gas sales is limited to domestic gas sold by  pipelines, local distribution companies, and their affiliates. The  commission does not prescribe prices for these commodity sales. FERC’s  regulatory authority applies to the physical markets for energy  commodities, such as natural gas, and not to futures markets.
In December 2002, we reported that as energy markets were restructured,  FERC had not adequately revised its regulatory and oversight approach to  respond to the transition to competitive energy markets. FERC agreed that  its approach to ensuring just and reasonable prices needed to change:  from one of reviewing individual companies’ rate requests and supporting  cost data to one of proactively monitoring energy markets to ensure that  they are working well to produce competitive prices. That year, the  commission established the Office of Market Oversight and Investigations  to actively monitor energy markets and, when necessary, undertake  investigations into whether any entity had or was attempting to manipulate  energy prices. As we previously reported, in 2002, FERC staff undertook  several studies and investigations to determine whether there had been  attempts to manipulate upward prices for natural gas delivered to  California during 2000-2001.
FERC’s ability to monitor the natural gas markets has been enhanced in  several regards recently. First, the Energy Policy Act of 2005, passed last  September, contains several enforcement provisions that increase the  commission’s ability to punish wrongdoers that harm the public. In  particular, the act provides FERC with the authority to impose greater  civil penalties on firms that commit fraud. In addition, FERC has taken  steps to strengthen its efforts to protect energy consumers. These actions  include establishing a telephone hotline that individuals can call to report  market abuse or other problems. FERC also has begun actively monitoring  natural gas markets to determine whether price movements are the result  of market manipulation or market fundamentals. The staff reviews market  activity for any possible manipulation that might also affect prices and  performs a detailed review of natural gas prices and market activity on a  daily basis with the intent of identifying areas of possible manipulation. If  the staff identifies price anomalies that are not explained by market  fundamentals, they investigate.
Since 2002, FERC has settled a number of investigations involving natural  gas market manipulation. For example, 10 companies agreed to pay  settlements totaling approximately $84 million. In addition, a FERC  administrative law judge found that another company exercised market  power over natural gas prices in California during the 2001-2002 heating  season, and the company subsequently agreed to pay a settlement of $1.6  billion. FERC officials told us that, since early fall of last year, it has  received complaints, expressions of concern, and requests to investigate  with respect to high natural gas prices through its enforcement hotline and  from public officials and the general public. Additionally, FERC has  identified areas of concern through its daily market oversight process.  FERC officials told us that all complaints and concerns are taken seriously  and actively investigated, where appropriate. However, since ongoing  investigations are considered nonpublic under FERC’s regulations,  officials said they could not comment further on any ongoing  investigations of the natural gas market.
section_title: CFTC Oversight of Related Financial Markets
paragraphs: A large part of CFTC’s mission is to protect market users and the public  from fraud, manipulation, and abusive practices related to the sale of  commodity futures and options, including natural gas. CFTC does this for  federally regulated exchanges such as NYMEX, and it has limited authority  over certain other futures markets. It does not have general regulatory  authority for other over-the-counter markets, including some used for  trading natural gas futures or options. In fulfilling its regulatory role,  CFTC conducts market surveillance to identify situations that could  amount to attempted or actual futures market manipulation and to initiate  appropriate preventive actions. For instance, to protect the futures market  from excessive speculation that could cause unwarranted price  fluctuations, CFTC or an exchange impose limits on the size of the  transactions that may be held in futures or options of a commodity. In the  natural gas futures market, these transaction limits are placed on trading  that occurs during the spot month. To monitor these transaction limits,  the commission has about 45 market surveillance staff and economists to  do policy and economic analysis of energy trading issues.
As part of its regulatory role, CFTC also enforces various laws prohibiting  fraud, manipulation, and abusive trading practices. CFTC’s enforcement  group investigates and prosecutes alleged violations of the Commodity  Exchange Act. From 2002 through May 2005, CFTC investigated over 40  energy companies and individuals, filed over 20 actions, and collected over  $300 million in penalties. Most of these actions were related to natural gas.  For example, in July 2004, Coral Energy Resources, L.P. (Coral), a  Houston-based firm that marketed gas to consumers across the United  States, was ordered to pay a civil monetary penalty of $30 million. The  penalty was imposed because the CFTC found that Coral knowingly  provided false, misleading, or inaccurate information concerning its  natural gas transactions from January 2000 to September 2002. During that  time, CFTC found that Coral employees also attempted to manipulate the  price of natural gas in interstate commerce or for future delivery. Natural  gas traders report their market information to firms like Natural Gas  Intelligence, who in turn compile pricing and volume indexes, for instance,  that are used by market participants to settle their transactions.  Submitting incorrect information could affect the price of natural gas in  interstate commerce and could affect the futures or options prices of gas.
section_title: FERC and CFTC Taking Action to Better Coordinate Oversight Efforts
paragraphs: FERC and CFTC have recently signed a memorandum of understanding to  create a more effective and efficient working relationship between the two  agencies. The agreement covers the sharing of information and the  confidential treatment of proprietary energy-trading data. FERC officials  told us that if either agency needs information about trading within the  other agency’s jurisdiction, then the other agency must provide it. The  understanding is to contribute to better coordination of enforcement  cases.
section_title: EIA Collects, Disseminates, and Analyzes Information about the Market
paragraphs: The Energy Information Administration (EIA) is charged with collecting  information about energy markets, including natural gas. The information  reported by this agency is important in promoting efficient natural gas  markets and public awareness of these markets. In our 2002 analysis of  natural gas markets, we identified that most elements of EIA’s natural gas  data collection program inadequately reflected some of the changes in the  market. For example, with some exceptions, EIA’s current natural gas data  collection program remains primarily an annual effort to obtain  comprehensive information on natural gas volumes and prices, while  markets have evolved to require more timely and detailed data. However,  beginning in the spring of 2002, EIA began to provide more real time  market information that traders and other gas industry analysts use as an  indicator of both supply and demand. For example, on May 9, 2002, EIA  began releasing weekly estimates of natural gas in underground storage  for the United States and three regions of the United States. According to  EIA, these data are valued by market participants and are a key predictor  of future natural gas price movements. EIA has also undertaken efforts to  better understand derivatives markets and the effectiveness of energy  derivatives to manage price risk. In addition, EIA’s weekly natural gas data  releases are published each Thursday, and according to EIA officials,  these releases have been well received by natural gas market participants.
section_title: Concluding Observations
paragraphs: Natural gas has become an essential element in our national energy  picture. Ironically, however, natural gas markets may be suffering from the  growing popularity of this versatile fuel. Rising demand and tightening  supply appear to have contributed to both the general rise in prices over  the past several years as well as the price spikes, such as that following  the hurricanes in 2005. Moreover, the stage seems set for future price  spikes if either demand is higher than expected or supplies are  unexpectedly interrupted.
To the extent that the higher prices persist and price spikes are possible,  natural gas markets could pose significant challenges for our country.  Many people may have to pay a larger percentage of their income for home  heating and other uses of natural gas, such as electricity—not just this  year, but every year. Some may not be able to afford it. Further, because  some key industries have historically relied on low natural gas prices to be  competitive, we may lose some of these industries along with the jobs that  they provide.
These are weighty issues that require concerted actions reaching across  not just the natural gas industry but also across the energy sector and  related financial markets. The American consumer wants secure,  affordable, reliable, and environmentally sound energy. Meeting this  demand will be a challenge. This hearing offers another important step in  the process of overseeing the regulators—FERC and CFTC—charged with  ensuring these markets operate as intended.
Mr. Chairman, this concludes my prepared statement. I would be pleased  to respond to any questions that you or other Members of the  Subcommittee may have at this time.
section_title: Contact and Staff Acknowledgments
paragraphs: If you have any questions about this testimony, please contact me at (202)  512-3841 or wellsj@gao.gov. Other major contributors to this testimony  include Karla Springer (Assistant Director), Lee Carroll, Michael Derr,  Patrick Dynes, Elizabeth Erdmann, Philip Farah, John Forrester, Mark  Gaffigan, Mike Hix, Chester Joy, Jon Ludwigson, Kristen Sullivan Massey,  Cynthia Norris, Frank Rusco, Jena Sinkfield, Rebecca Spithill, John  Wanska, and Kim Wheeler-Raheb.
section_title: Related GAO Products
paragraphs: Meeting Energy Demand in the 21st Century: Many Challenges and Key  Questions. GAO-05-414T. Washington, D.C.: March 16, 2005.
Natural Gas: Domestic Nitrogen Fertilizer Production Depends on  Natural Gas Availability and Prices. GAO-03-1148. Washington, D.C.:  September 30, 2003.
Energy Markets: Additional Actions Would Help Ensure That FERC’s  Oversight and Enforcement Capability Is Comprehensive and  Systematic. GAO-03-845. Washington, D.C.: August 15, 2003.
Natural Gas: Analysis of Changes in Market Price. GAO-03-46.  Washington, D.C.: December 18, 2002.
Energy Markets: Concerted Actions Needed by FERC to Confront  Challenges That Impede Effective Oversight. GAO-02-656. Washington,  D.C.: June 14, 2002.
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