12 Long-term contracts were commonly used in the U.S. natural gas industry before 1984. But traditional contractual arrangements created rigidity that later impeded competition in the gas market. Producers, interstate pipelines, and local distribution companies were locked into contractual relationships through take-or-pay or minimum obligation clauses that forced them to pay fixed amounts regardless of delivery. Order No. 436 eliminated this rigidity by transforming long-term gas supply contracts into long-term transportation contracts between pipeline companies and their downstream customers. This allowed independent acquisition of natural gas by downstream customers, but left pipeline companies with substantial transition costs because of their large uncovered obligations to producers. Until FERC allowed the distribution of these transition costs among industry participants, interstate pipelines were hesitant to implement the open access regime (box 1).

# **Box 1** The Transition Costs of Order No. 436: Dismantling Long-Term Contract Rigidity

Before 1984, pipeline companies and natural gas producers concluded long-term take-or-pay contracts that required the pipeline companies to buy the contracted volume of natural gas or pay a fixed amount for untaken volumes. The pipeline companies in tum transferred these obligations to their downstream customers. Under a minimum payment obligation clause, pipeline customers paid a fixed charge related to contracted capacity and volume even if they did not take any delivery. All participants, tied by their long-term contracts, were unable to purchase or sell natural gas elsewhere. This Contract rigidity became a substantial impedimen **t** o implementation of the open access regime in interstate pipeline transportation.

The minimum payment provisions gave pipeline companies little incentive to acquire natural gas from producers at the minimum cost, because they passed through producer prices directly to their downstream customers. Regulatory distortions and the oil crisis of the 1970s contributed to a dramatic increase in producer prices in the late 1970s and early 1980s, leading to numerous complaints by consumers. Order No. 380 eliminated minimum payment obligations in 1984. Order No. 436 allowed pipeline customers to purchase gas independently and transformed long-term supply contracts into long-term transportation contracts. Many large customers stopped purchasing natural gas from pipeline companies, which were suddenly left with large take-or-pay obligations to producers.

The burden of these take-or-pay obligations created substantial transition costs for pipeline companies and tumed them against the open access regime. They were unwilling to provide open access to their pipeline systems unless producers and downstream customers took a fair share of the transition costs. These costs were estimated at $20 billion by 1990, compared with a total book value for interstate pipelines of $23.8 billion in 1984 (Pierce 1988). In 1987 Order No. 500 resolved this issue by allowing pipeline companies to transfer up to 75 percent of transition costs to producers and downstream customers. In the end, producers absorbed about $10 billion of the transition costs, local distribution companies $6.5 billion, and interstate pipeline companies $3.7 billion.

_Source:_ Pierce 1988 and U.S. Department of Energy, Energy Information Administration.

_Medium- and short-term Contracts_ As traditional long-term contracting became impractical in the deregulated gas market, market participants developed contracts with a shorter duration of gas supply that would give them the flexibility to adjust natural gas contracting to the frequently changing market environment. Contractual flexibility is important for least-cost acquisition of natural gas in deregulated gas markets affected by changes in weather, economic activity, availability of transportation, and the like.