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. 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. 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. 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.