The natural gas market is composed of three major components on the supply side; producers,pipelines, and local distribution companies. The price of natural gas paid by consumers is layered,in the sense that the wellhead price paid to producers forms a baseline. Pipeline transportation costsare then added, which yields the city gate price. Finally, local distribution companies add additionalcharges to yield the prices actually paid by consumers. Consumer markets themselves are dividedinto segments, each of which tends to pay a different, in many cases a significantly different, price. Residential consumers pay the highest prices, followed by commercial, industrial, and electricityusers. Table 1 shows the relationship between these prices in recent months. The residential prices presented in Table 1 represent an increase of 7% over residential pricesfor a comparable period in 2003. The most recent EIA natural gas price data available at the timeof this report was August 2004. On the New York Mercantile Exchange (NYMEX), natural gas fordelivery in December 2004 was trading at $6.80 per mcf and January and February 2005 natural gaswas trading at over $7.50 per mcf. (1) Table 1. Natural Gas Prices Source : EIA Natural Gas Price Data, measured as dollars per mcf. Natural Gas Monthly, October,2004, Table 4, p.8. In addition to multiple prices faced by consumers, other prices are key variables for supply and policy decisions. The wellhead price of natural gas, as noted in this report, is competitivelydetermined by market forces. This was not always the case. The process of natural gas pricederegulation began in 1978 when the Natural Gas Policy Act ( P.L. 95-621 ) became law. Under theNatural Gas Policy Act, nearly all price controls were phased out by the end of 1984. (2) The spot price of natural gas is recorded at a transportation hub, the largest in the United Statesbeing Henry Hub in Louisiana, and is generally somewhat higher than the wellhead price becauseit includes some processing and transportation costs. Natural gas futures contract trading on theNYMEX establishes forward prices for natural gas, and allows market participants to hedge shortand medium term price risk. The NYMEX future price is determined by the interaction of traderswho have business interests in the real, physical natural gas market, and financial traders whospeculate on the market. Natural gas is also traded by numerous brokers and other entities forphysical delivery at a number of local markets. Interstate pipeline rates are not directly regulated and their pricing structure largely reflects open access for shippers and market pricing. The Federal Energy Regulatory Commission (FERC)monitors pipeline tariffs to assure "just and reasonable" pricing, and has intervened in a number oftariff situations. The city gate price includes the addition of these pipeline transportation charges. Residential and small commercial consumers buy gas from a local distribution company, which delivers gas from a long-haul pipeline to the customer's premises. Local distribution companies areregulated by state public service commissions, who set distribution charges. The price data in Table1 indicates that residential prices have recently been almost double city gate prices in 2004. Theprice premium paid by residential and commercial consumers reflects the high fixed cost associatedwith distribution of their supply, as well as the added cost of small volume purchases. The EIA defines effective productive capacity as the maximum production available fromnatural gas wells, allowing for limitations in the production, gathering, and transportation systems. (3) The effective capacity utilization rate (ECUR) is the ratio of actual production to effective productivecapacity. Surplus capacity is the difference between effective productive capacity and actualproduction. Figure 1 shows, for monthly data over the period 1987 to 2001, that the average wellheadpricehas stayed below $3.00 per mcf whenever the ECUR was below 90%. The data also show howupwardly volatile natural gas prices can be as the ECUR rises above 90%. The correlation betweenhigh values of the ECUR and high prices suggests that when the ECUR is above 90%, conditionsare in place that are consistent with high, volatile natural gas prices. Figure 2 shows the history of the ECUR, capacity and production since 1985. Several trendsare noticeable in the data. Productive capacity has declined since the late 1980s, but appears to haveremained stable since 1993. Actual production has trended up from 1985 to 1995 and has beenrelatively stable since then. These two trends, taken together, drove the ECUR to 90% or higherlevels for almost all of the past eight years. An ECUR in excess of 90% indicates that available natural gas output is nearly fully allocated to meeting demand. Any further increase in demand, or disruption of supply, can only be metthrough extraordinary draws on existing gas wells, increased draws from storage, or increasedimports. All of these alternatives suggest that prices for the consumer are likely to rise. If thesesources are unavailable for expansion the price could rise dramatically, and supply disruption mightoccur. As part of the market adjustment to higher prices, increased development drilling could take place, but exploration and development does not immediately result in gas on the market. The EIAestimates that there is a lag of between 6 and 18 months between an increase in natural gas pricesand an increase in developmental drilling and ultimately higher production. (4) The decliningproductivity of U.S. fields is also a factor. According to one industry observer, "it takesapproximately 2.5 times more active rig capacity to produce the same amount of gas as just eightyears ago." (5) Alternatively, when the ECUR is below90%, any requirement for additional supply canbe quickly brought to the market by increasing production from existing wells. Source : U.S. Energy Information Administration, derived from data available at http://tonto.eia.doe.gov/dnav/ng/hist/n9190us3A.htm . Figure 3 shows the history of the wellhead price of natural gas from 1973 through 2003. Again, several trends are noticeable. The first run up in prices, from 1973 to the mid 1980s was theresult of price deregulation in a market where supply was not abundant, demand-after years ofregulated prices-was strong, and oil prices were high, as a result of the Arab oil embargo of theUnited States in 1973-74, and the Iranian political upheaval of the late 1970s. Prices declined after1985-as did demand-and the United States entered a decade long period of relatively low, stableprices. During this period, use of natural gas as an abundant, cheap, clean fuel was promoted. Increasing demand, in conjunction with the supply trends shown in Figure 2 ,has resulted in theECUR remaining at, or above, 90% since 1995. These conditions set the stage for the gas priceincreases and price volatility experienced since 2000. An interesting break in the pattern of the Figure 2 data is associated with the sharp price increases of the winter of 2000-01. As can be seen in Figure 2 , the ECUR achieved very highvaluesduring this period. When coupled with the low temperatures of that winter, the result was highprices that set off a boom in exploration and drilling. While only 496 rotary drilling rigs, on average,were drilling for natural gas in 1999, that number increased to 720 in 2000 and rose to 939 for 2001. As the resulting production entered the market in 2002 (6 to 18 months later) the ECUR fell below90% in 2002 and the price of natural gas fell. (6) Thelower price, however, resulted in lowerdevelopmental drilling and set the stage for sharp price increases in the winter of 2002-03. As pricesdeclined in 2002, as seen in Figure 3 , the drilling rig count also declined, to 691. The ECUR,reflecting the lower anticipated increments to production from reduced exploratory drilling, againrose above 90%, and price increases beginning during the winter of 2002-03 followed. Drilling activity may be responding to 2003's higher prices. The EIA reported that the average monthly drill rig count for 2003 was 872, with the count running over 900 per month from June toDecember. The nine month average drilling rig count for 2004 is 1009, and has been on a path ofsteady monthly increases since January 2004. (7) Whether the recent increase in drilling activity resultsin large enough supply increases to allow the price of natural gas to fall depends on the explorationsuccess rate, the size of the fields found, and the degree to which existing producing wells showoutput declines. Any factor that increases demand or decreases supply will increase the ECUR. When theECUR is below 90% extra pressure on the market is likely to result in higher production. Once theECUR rises to 90% or above, timely increases in production are less available and pressure on themarket manifests itself as higher prices. Higher prices create incentives that eventually could causeprice increases to moderate, although new sources may require higher prices to satisfy investmentcriteria. The demand for natural gas exhibits a seasonal pattern even when the weather is normal. Figure 4 shows the typical pattern, which is characterized by seasonal demand peaks. Sinceseasonal patterns are repetitive, suppliers, attempting to accommodate consumers, accumulatequantities of gas in storage facilities in the traditional off-peak season for release during the heatingseason. Source : U.S. Energy Information Administration available at http://www.eia.doe.gov/pub/oil_gas/natural_gas/presentations/2004/searuc/searuc_files/frame.htm If the seasonal demand pattern is accentuated by extreme weather conditions, the stored quantities of natural gas might not be sufficient, setting the stage for price increases if the ECUR ishigh.