S. P. A. Brown

English

Research Papers in Economics

No. 8411
NATURAL GAS PIPELINES: RENT REVEALED
S. P. A. 8rown*
October 1984
Research Paper
Federal Reserve Bank of Dallas
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) N0.8411
NATURAL  GAS  P]PELINES:  RENT  REVEALED
S. P. A. B  rown  *
0ctober  1984
*  Economist,  Federal  Reserve  Bank  of Dallas.  The  views  expressed  are
those  of the author  and  should  not be attributed to any  par! of the
Federal  Reserve  System. The  author is gr"ateful  to 19ichael  J.  Barror.,
David  Green,  John  Kent  Hill,  Gerald  P. 0'Driscoll and  James  E. Pearce
for  he'lpfu1  comments  and  to Joseph  Haslag  for nesearch  assistance.I
NATURAL  GAS  PJPELINES:RENT  REVEALED
After 1984,  the wellhead  prices for most  sources  of natural gas  wjll  be
deregulaLed.  Nevertheless,  under  current law, significant quantities of
natural gas  will  remain  under  price controls far beyond  1984. In fact,
during the first  half  of 1984,  47 percent  of the domestically  produced  gas
that was  purchased  by interstate pipeline companies  came  from  resefves  that
are currently scheduled  to remain  under  price controls indefinitely.
Consumer  opposition  to further decontrol  remains  a formidable  obstacle
to any  new  legislaLion that would  completely  deregulate  natura'l  gas  prices
at the wellhead. This opposition  Lo decontrol  appears  largely based  on the
feaf that consumer  prices for natural gas  would  rise.  This fear could  be
misplaced,  however,  because  the total  decontrol  of wellhead  prices could
result  in lower  consumer  prices for natural gas.
Binding  ceilings on the wel  ihead  prices for  some  sources  of natural gas
have  accorded  economic  rent to its  purchasers. Econometric  evidence
suggests  that despite federal regulation  of the interstate transport of
natural gas, lhis  rent has  been  retajned  at least in part by interstate
pipeline companies--and  has  not been  shifted forward  Lo consumers--widening
the gap  between  wellhead  and  delivered  prices.  The  decontrol  of wellhead
prices would  narrow  thjs  gap, possib'ly  yielding both a higher  average
wellhead  price and  lower  consumer  prices for  natural gas.REGULATION  AND  RENTS  AFTER  i984
The  regulation  of the wellhead  prices of gas  from  some  producLion
categorjes  under  the Natural  Gas  Policy Act of 1978  (NGPA)  accords  economic
rent to the purchasers  of gas  with controlled prices.  The  way  in which
this  reni is distributed detefmines  what  effect a total  deregulalion  of
wellhead  natural gas  prices would  have  on the delivered  price of gas, the
wellhead  price of gas  and  the total  quantity of natural gas  produced.
To uncover  the effect of price controls, it  is useful to examjne  the
case  in which  there are no price regulations.  In the absence  of price
controls, the welthead  supply  of natural gas  would  be the sum  of rro1d,"
"new"  and  'rhjgh  cost" gas  brought  fort,h  at every  wel'lhead  price (shown  as
S, in fi gure  1):1/
= qo(pn) + qn(pn)
whi  ch
(1)
n  .i<  +h6  +^-it  ^,,.niil-y  of gas  supplied. -s
qo  is the quantity of old gas  suppljed.
qn  is the quantity of new  and  high cost gas  supplied.
pn  is the vvel  lhead  price of new  gas, which  \rould  be the
wel  lhead  price of all  gas  in the absence  of price
control  s.
Del  jvered supply  (Sr1) ecuals  wellhead  supply  plus the efficient  cost
required  by natural gas  nriddlemen  to co11ect,  transport and  distribute the
0
in3
gas.  Given  consumer  demand,  a market-clearing  price and  quantity of
del  ivered  gas  i  s obtai  ned  (at P'  Q1).
With a bindjng  price ceiling (po*) on old gas, wellhead  supply  is
either shifted inward  (Sr) or outward  (56) from  its  free market
construction  (S1).  The  direction of the shift  depends  on who  obtains
rent that is accorded  to purchasers  of o1d  gas.  The  rent received  by
purchasers  of o1d  gas  is the djfference between  the ceiling price on
gas  and  the price that producers  of unregulated  new  and  high cost gas
the
o'l  d
can
command  when  old gas  is regulated.  If  this  rent is wholly retained  by
natural gas  middlemen,  the supply  curve  shifts  inward.  If  this  rent is
shifLed  completely  forward  to consumers,  the supply  curve shifts  outward.
If  natural gas  middlemen  were  competitive  and  did not face government
regulation  of their profits,  they would  reta'in  the rent arising from
wellhead  price control  s and  total  wellhead  supply  would  simply  reflect the
cost of jncremental  gas, comprised  of new  and  high cost gas:
Qr=9o*+qn(pn);
in which
(2)
Con  sequently,  supply  would  be
If  Lhe  regul  at  ion of old
of  oas risps  (+.o  P-)  rnci lilg
^f  ^1,.1 -..  -,,^^li^.1  .*  +h6  nFi.6  noilinn u,  u,u  go>  )uPP,rEu  c,,  ,-,,c  p,  ,LE  sL'  |,,,r
price  of  new  and high cost gas-
shifted inlard (to S^). 'z'
gas  shifts  supply  inward,  the del  ivered  price
total  quantity of gas  consumed  fal  I  s (to Q2).
pn
is Lhe  quanti  ty
po*.
i  s the wel  I  head4
The  price received  by producers  of new  and  high cost gas rises somewhat  (to
pnn)  and  thejr  production  of gas  is  stimulated  (to qnn).
L"l.
The  rent is  shifted forward  to consumers,  however-,  if  federal
regulation is  successful  in restricting  the tarjff  charged  by middlemen  Lo
a normal  profit  plus the cost of collecting, transporting  and  distributing
natural gas.  Under  these  regulations it  is generally  presumed  that
middlemen  se11  gas  to consumers  at the average  wellhead  price plus a
competjtive  co1lection, transportation  and  distribution charge:
PO  = t  + (po* qo* + pn qn) /  (qo* + qn)  (3)
in which
P,  is  the  oelivcrprJ  nrirc  of  oas 'd
t  is the competitive  collection, transportation  and
dj  stri buti  on charge.2/
Under  an average  cost pricing of natural gas  and  commonly  assumed
elasticities  of supply,  the produc!ion  increase  in new  and  high cost gas  is
greater than the decrease  in o1d  gas  production. As a result,  supply  is
shi  fted outward  (to Sr^).3,/ u' -
The  outward  shift  in supply  results in a lower  price for del  ivered  gas
(Pn) and  a greater  quantity of gas  consumption  (Q") than  would  result in a - u'  '  '  u'
free market.  New  and  high cost gas  would  receive  a much  higher  price (ln6)
than if  middlemen  retained  the renL  and, consequently,  its  production  is
greatly expanded  (to qn"). .  U'MIDDLEIV1EN  I.4AY  RETAIN  RENT
DESPITE  REGULATION
Because  their market  activities  include  buying  natural gas  from
producers  and  selling it  to consumers--and  are not confined  to collecting,
transp0rting  and  distributing  natural gas--natural  gas  middlemen  are in a
position to capture  the rent resu'lting  from  the control of wellhead  prices.
Because  the rent need  not appear  as accounting  prof.it on the books  of the
companies,  federal and  state regulation  of collection charges,  pipeline
transportation  tariffs  and  distribution charges  may  prove  ineffective in
shifting Lhe  rent forward  to natural gas  consumers.  Rent  may  be retained
as profits  in other companies  owned  by the companyrs  corporate  parent,
djssipated  through  simple  inefficiency or consumed  in the costs of
obtainjng  and  protecting  ownership  of the rent.
Vertical integration  wiLh  unregulated  activities  is one  way  in which
this  renL  can  be captured. 0nce  a company  is vertically  integrated,
transactions  can  be  made  "at-less-!han-armrs-lengthrr  that enhance  Lhe
profitability  of unr"egulated  companies  under  the same  corporate  banner.
Higher  than market  prices may  be paid for unregulated  natura'l  gas  from  lhe
corporationrs  producLion  company,  and  lower  than  markeL  prices may  be
recejved  from  gas-using  companies  owned  by the corporation.  The  validity
of this  argument  is casually supported  by the number  of pipeline companies
that have  vertically  integrated  through  holding  companies.
Not all  lhe economic  rent captured  by natural gas  middlemen  will
necessarily  become  corporaLe  profits.  Richard  Posner  [1975]  and  Gordon
Tullock [1967]  have  pointed  out that obtainjng  and  protecting  the ownershipof economic  rent can  consume  that
rents, middleman  companies  can  be
ownershjp  that could  cost as much
defendi  ng the nent.4/
6
rent.  In addition to competing  to obtain
pxnpctcd  tD raise a defense  of their  rent
as the expected  value  of successful  ly
Lobbying  is one  form  of rent protection.5/  Financial  contrjbutions  of
the pipeline and  gas  utility  industries to lobbying  o  r  g  a  n  i  z  a  t  i  o  n  s  -  -  s  u  c  h as
the American  Gas  Association  and  the Interstate Natur"al  Gas  Association  of
America--that  oppose  the complete  decontrol  wel  lhead  natural gas  prices
provide  some  casual  evidence  that rent is being  earned.
A TEST  FOR  PIPELINE
COMPANY  RETENTION  OF  RENT
As suggested  above,  economjc  rent may  not be evident in the accounting
profits  of middleman  companies.  Nonetheless,  if  the rent accorded
purchasers  of oid gas  is  retained, dissipated  or consumed  by the activities
of middlemen,  the rent should  remajn  evident  in the difference  between  the
del  ivered  and  wellhead  prices of gas.  If  natural gas  middlemen  generally
face competition  with oil  products  jn their  final  del  ivery markets,  those
middlemen  fi rms  endowed  with greater  access  to low cost natural gas  should
evidence  a greater markup  than those  with poorer  access  if  they retain the
rent associated  with access  !o lov/  cost gas.
Passage  of the NGPA  endowed  pipeljnes companies  with varying
contractual  rights to buy  pri  ce-control  1ed  gas.  Differences  jn these
endowments  have  contributed  t.o  a varjation in the average  wellhead  price of
gas  across  pipeline companies.6/  Thjs variation in average  welIhead  prices7
can  be exploited to test for pipeline company  retention of rent.  If
pipel  ine companies  retain the rent assocjated  with purchases  of
price-control  led gas, there  will  be an inverse  relationship across  firms
between  the markup  for transporting  the gas  to market  and  the average
purchase  cost of its  gas  that is  independent  of the djffjculty  jn
transporting  that gas  Lo market.  Ev.idence  of this  relationship  was
revealed  in a linear regression  that used  data pooled  across  31 companjes
and  four years following imp'lementation  of the NGPA:
NlARKUP  i
=  .?747  + .0159  D81-  + .0822
(5.11)  (.s1)  (2.50)
-  .1083  AvlP.  + 2.4559  TRANS.
(-3.26)  (2.73)
D82'  + .1409  083-
(4.20)
-  .4277  PGP.  + e. 'Il
(-3.11.)Z/  R?=.Zs
in which
I,4ARKUP. 'l 'i  s the difference between  the average  real price aL
which  a pipel  ine sold gas  to distribution  companies
and  other pipeline companies  in a given  year and  the
average  real price it  paid for gas  in that year.8/
'i  s the average  real price that a company  paid for gas
in a given  year.  It  includes  wellhead  purchases,
purchases  from  other companies  (including other
subsidiaries  of its  corporate  parent) and  imports.
is a measure  of the difficulty  that the pipeline
faces  jn transporting  the gas  to market. The  gas
consumed  jn transmjssion  per unit of total  gas  sold
by the pipeline company  served  as a proxy  for
tran  sportati  on  di  ffi cul  ty.
AuIP. 'I
TRANS.
I8
PGP.  js the percentage  of total  gas  obtained  by a pipeline
I
that is produced  from  reserves  that the pipeline
company  jtself  owns. Thjs variable does  not include
purchases  of gas  from  production  companies  oh,ned  by
lhe pipeliners corporate  parent.9/
D8l.  is a dummy  variable for observations  in 1981. 'I
D82.  is a dummy  varjable for observatjons  in 1982. 'I
D83.  is a dummy  varjable for observations  in 1983. 'I
It  should  be noted  thal this  econometric  test has  a bias against
finding evidence  of pipeljne rent retention.  The  data used  djd not permit
the indentification of gas  purchased  from  production  companies  owned  under"
the same  corporaLe  banner  as lhe purchasing  pipeline.  This data ljmjLation
prevents  direct consideration  of one  means  in which  pipeline companies
could  retain and  hide rent.
Nevertheless,  evjdence  of pipel  ine rent retention was  found.  The
coefficient on  AWP.  is negative  and  significant at better than the 99 'I
percent  1eve1  .  In addition, the transportation  Variable  is  significant at
hetter  than  t.he 99 nprr^ont lovcl  nrovidinn  r^nnfidpncp +haf. the  rpores.iOn
differentiates between  rent and  efficiently  costly transportation.
Furthermore,  the yearly dummy  variables indicate that the real markup  on
natural gas  has  increased  over time, perhaps  indicating thal pipeline
companies  have  increasingly  avajled themselves  of the rent.CONCLUS]ON
Federal  control of wellhead  prices for natural gas  yields economic  rent
to the purchasers  of the p  r  i  c  e  -  c  o  n  t  r  o  I  1  e  d gas.  For  a number  of reasons
government  regulation  of natural gas  middlemen  may  not be effectjve in
shifting this  rent forward  to consumers.  Econometric  evidence  indicates,
in fact,  that some  of this  rent is retained  by pipe'l  ine companies.
Collection  and  distribution  companies  may  also retain some  of the rent.
l'ljddleman  retention of the rent created  by natural gas  price control  s
serves  to widen  the gap  between  the del  jvered  and  wellhead  prices of
nalural gas.  The  complete  deregulation  of wellhead  natural gas  prices
would  narrow  this  gap.  The  delivered  price of natural gas  cou'ld  fall  while
the average  wellhead  price rose.
|l/ellhead  deregulation  may  not be sufficient  to assure  lower  consumer
prices and  higher  wel  l  head  prices, however. Pipel  ine companies  own
government  franchises  to transport gas  along  specific rouLes  and  lhey ac!
as marketing  agents  (buying  and  reselling most  gas).  As a result of their
franchises,  pipeline companies  have  monopsony  buying  power  in some
production  regions  and  monopoiy  selling power  jn some  consumpLjon  regions.
In addition, gas  utilities  own  government  franchjses  to distribute natural
gas i  n parti  cu'l  ar regi  ons  or I  ocal  es.  Addi  ti onal competi  ti on coul  d be
'i  ntroduced  by shifting pipeline and  dislribution  companies  into contract
carriage  or by allowing  the free entry of new  companies  along  existing
pipeline routes  and  in existing distribution  regions.3.
2.
1.
10
NOTES
When  enacted,  the NGPA  created  over 20 pricjng categories  of natural
gas  to which  differenl  ceiling pr.ices  were  applied.  For purposes  of
analysis, these  categories  are I  umped  jnt.o  two groups:  "o1d  gas"  and
"new  plus high cost gas.rr (See  Lable  1.)  After 1984,  the wellhead
price of o1d  gas  will  remain  controlled and  the wellhead  prices of new
and  hjgh cost gas  will  be  deregulated.
Note  that SO  is  constructed  from  51.
With  a sufficiently  greater  elasticity  of o1d  gas supply,  a
suf  f  icient'ly lower  elastjcity  of new  and  high cost 9as  supply,  or a
combination  of both, SO  could lie  above  Sr.  NeverLheless,  in such  a
case,  S, would  stjll  1ie above  SO.
4.  The  efforts  of natural gas  producers  to eliminate  the ceilings on the
price of old gas  would  also conrribute  to the social cost of the price
control  s.
6.
Federal  regulation and  long-standing  contracts  inhibit  competition  to
obtain the p  r  i  c  e  -  c  o  n  t  r  o  I  I  e  d gas, perhaps  limiting  thi s means  of
converti  ng rent to costs.
0f cout'se  transportation  costs also contribute Lo the variation in
wellhead  prices.  In a competitive  market,  natural gas  that is  farther
from  its  consumption  market  than  a competing  source  of gas  can  be
expected  to have  a higher  transportation  cost and  lower  purchase  price
than the competing  source  of gas.
7.  Figures  shown  in parenthesis  are t  statistics.  An  F statistic  of.36
(with 9, 108  degrees  of freedom)  justifies  pooling  the data across
years.
8.  Inquiry was  limited to sales  for  resale to avoid  the consideration  of
distribution  cosLs  for a pipe'l  ine companies  that have  retaiI  customers.
9.  With the exception  of price deflators, annual  data for all  varjables
for each  company  were  compiled  from Federal  Energy  Regulatory
Commission  (FERC)  Form  No. 11, rrNatural  Gas  Pipeline  Company  l"lonthly
Statement.  "  Prices  were  deflated  with the the implicit  GNP  deflator.
RE  FER  EN  C  ES
Posner,  Richard  A.,  I'The  Social Costs  of lt4onopoly  and  Regulation,rr  Journal
of Pol  jtical  Economy,  83 (August  I975):807-27  .
Tullock, Gordon,  rrThe  Wel  fare Costs  of Tariffs,  Monopol  ies and  Theft,rl
l{estern  Economic  Journal  , 5 (June  1,967):224-32.
5.Tabl  e 1
NATURAL  GAS  PURCHASES
OF  I'4AJOR  INTERSTATE  PIPELINE  COI'lPANIES
DURING  THE  F]RST  HALF  OF  1984
Average
wel  I  h  ead
price
per
thousand
cubi  c fe  et
New  + high
A1  1 ga  s*
1.2.07
22.77
1  .41
J. YJ
2.76
"As a resul  t  of
agree.
roundi  ng  error,  total  doe  s not
Analysi  s
Ca  Lego  ry
Purchases
(bi1lions
of cubi  c
feet
er day;
t
=
t
F
F
I
-
-
l
_
-
-
-
T
-
-
-
-
-
-
-
-

Natural gas pipelines: rent revealed

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Natural gas pipelines: rent revealed

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