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Chicago Fed Letter
Natural gas prices—National and regional issues
by Lynne Kiesling, director of economic policy, Reason Foundation, and senior lecturer of economics, Northwestern University;
and Richard Mattoon, senior economist, Federal Reserve Bank of Chicago

Why are U.S. natural gas prices currently at the high end? What are the implications of
recent regulatory changes and changes in market fundamentals? This article explains
the boom and bust nature of natural gas prices and some ways to reduce this volatility
going forward.

Current natural gas prices in the U.S. are
high—more than double their historical trend over the last five years—and
futures prices indicate that natural
gas supplies are likely to continue to
be tight for at least the near term.
High and volatile fuel prices are the
consequence of both
changing market
1. Natural gas consumption per capita, 2001
fundamentals and
regulatory decisions.
Residential Commercial Industrial Vehicle Electricity Total
( - - - - - - - - - - - - - - - - - cubic feet in thousands - - - - - - - - - - - - - - - - - )
Accordingly, the interplay of these effects
could have substanIowa
tial consequences,
Wisconsin 23.36
both nationwide and
in the Midwest.1 This
Chicago Fed Letter deSOURCE: Consumption data from the U.S. Department of Energy, Energy Information
Agency; population data from U.S. Department of Commerce, Bureau of the Census;
scribes conditions that
and authors' calculations.
have put pressure on
gas prices and suggests some potential
strategies that might mitigate gas price
volatility in the future.
Domestic market

Natural gas markets have been deregulated for the most part since the late
1970s, when the Federal Energy Regulatory Commission first allowed competitors to enter the natural gas pipeline
industry. This deregulation movement
broke the vertically integrated structure
of the natural gas industry, which had
arisen from federal interstate regulation

dating back to early in the twentieth
century. Deregulation opened up previously unrealized value creation opportunities that benefited most consumers
and some producers. As a result, by the
1990s natural gas was widely available
at very low prices, so low, in fact, that
some producers went out of business
or confined their extraction to existing
deposits. Low prices reduce exploration,
and high prices encourage it, resulting
in a boom and bust cycle, which has historically been a feature of the industry.
Another development that has followed
deregulation in the natural gas industry has been the creation of liquid, sophisticated financial markets for natural
gas. The development of a wide range
of financial instruments has enabled
risk spreading in natural gas markets.
The resulting ability to hedge risk across
time and across different market conditions has substantially decreased the
volatility in natural gas prices associated with the boom and bust cycle that
characterizes extractive industries like
natural gas.
So, why the recent spike in natural gas
prices? The price increase has been
fairly sudden, but not unpredictable.
In fact, natural gas prices have been
edging up since the late 1990s. Still,
while the current and expected price
increases are the consequence of the

interaction of demand, supply, and other
forces that shape the market, supply
issues seem to be a particularly important factor.
Many analysts and energy industry experts have, correctly, pointed to regulatory restrictions as the prime cause
of the rigidity of natural gas supply.
In particular, they argue that limitations on drilling on federal lands, in
consideration of the environmental
amenities attached to those lands, have
greatly limited exploration options.
Approximately 40% of known natural
gas reserves in the U.S. are off limits
to exploration and production.
Another potentially abundant source of
supply is imported liquefied natural gas
(LNG) from such places as the Middle
East, Russia, China, West Africa, and
the countries around the Caspian Sea.
However, the industry still has some work
to do to convince the U.S. public that
long-distance transportation of LNG is
safe. And, even if the industry succeeds
in this effort, it then has to build the
necessary infrastructure to facilitate LNG
imports onshore. LNG off-loading and
storage at port requires specific technology in the terminals. Few such terminals
exist in North America, and they take a
long time to build. Construction of new
LNG terminals can take up to a decade,
taking into account siting and environmental regulatory processes. Accordingly, LNG terminal construction and
imported supply is a long-term, though
important, response to the current
market imbalance.
Constrained supply is not the only cause
of high natural gas prices. Environmental regulation of U.S. air pollutants was
predicated on the assumption of abundant natural gas as a substitute fuel.
Specifically, natural gas is a clean (and
formerly cheap) fuel for electricity generation, particularly relative to bituminous coal. Improvements to existing
power plants that have occurred in the
past 30 years have overwhelmingly used
natural gas to comply with the new
source review regulations introduced
in the early 1970s. And air quality regulations have led to a situation in which
the only economical way to build new

power plants is to fuel
the facilities with natural gas. For example,
93% of new electricity
generation capacity
that will come online
in the next two years
will use natural gas to
fuel generation.

2. City gate gas prices, 3-month moving average
index, U.S.=100



This emphasis on natural gas as the way to
achieve air quality improvements without
dramatically increasSep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan
ing power generation
costs has had the unIllinois
foreseen consequence
of reducing the resilIowa
iency of natural gas
SOURCE : U.S. Department of Energy, Energy Information Administration, natural gas
rates for states database.
markets. Regulatory
mandates have reduced our ability to
warned that tight natural gas supplies
apply the lessons of portfolio diversifiwould translate into a 20% jump in home
cation to our energy choices. This is a
heating bills in the Midwest for the comvery high price to attach to the environmental amenities of improved air quali- ing winter.3 This would mean that the
average heating bill for the November
ty, air quality that could conceivably have
been achieved through other means if through March “official heating season”
would rise to $915. Even more worrisome
environmental regulations had not
is that such an estimate is based on norspecified natural gas as the fuel input.
mal weather conditions. A colder than
The potential implementation of the
normal winter would drive demand and
Kyoto Treaty exacerbates this costly balprices even higher.
kanization of fuel portfolios. Even if the
U.S. does not ratify the treaty, Canada’s Since the Secretary’s announcement,
natural gas conditions have improved.
implementation of it would have a sigThe combination of increased drilling
nificant impact on the U.S. market as
activity, mild summer weather, and some
well. Canadian electricity generators
demand decreases and fuel switching
would have to substitute into natural
by large industrial users have improved
gas as they reduce their use of coal to
the supply balance, allowing for signifimeet the carbon dioxide reduction
cant injections of natural gas into untargets. If Canadian demand for natuderground storage. By mid-July, estimates
ral gas increases to fuel its own power
of working gas in storage stood at about
needs, then barring a substantial and
13% below the previous year.4 However,
unlikely increase in Canadian drilling
a return of warm weather could reverse
and recovery, there will be much less
this trend toward replenishing stocks if
Canadian natural gas available for exgas is needed for electricity generation.
port to the U.S. Most of our imported
Similarly, gas prices as reflected by the
natural gas comes from Canada, both
futures contract on the New York Mernationally and in the Midwest, so the
cantile Exchange have fallen 25% since
dislocation to the U.S. natural gas
early June highs to around $5 per milmarket would be acute.
lion Btus (British thermal units).
Natural gas and the Midwest

At a June 26, 2003, conference sponsored by the U.S. Department of Energy,
Secretary of Energy Spencer Abraham

However, the Secretary’s analysis points
to one of the fundamental differences
between the use of natural gas as a fuel

in the Midwest versus the rest of the
nation. While much of the gas supply
problem during the summer has been
blamed on the increasing use of natural
gas to fuel electricity generation, in the
Midwest, natural gas is disproportionately used for residential service and
particularly home heating. As figure 1
(p. 1) demonstrates, per capita residential use of natural gas for the Seventh
District is nearly twice the U.S. average.
Thus, high gas prices will become particularly noticeable to Midwest consumers with the onset of winter. Also notable
is the heavy usage of natural gas for industrial purposes in Indiana and Iowa.
Many analysts have suggested that natural gas used for industrial purposes
will be among the first to feel the effects
of higher prices. Industrial customers
are often more exposed to wholesale
prices, and price spikes often lead to
plants reducing activity or shutting down
altogether. Industries such as aluminum,
petrochemicals, plastics, and fertilizers
are particularly vulnerable and, with the
exception of aluminum, these industries
do have a significant presence in the
Midwest. As increasing natural gas prices
raise production costs, some of these
costs are likely to be reflected in the prices of fertilizers, chemicals, plastics, metals, and the products that use them as
inputs, such as agricultural products.
The one limited positive for the Midwest
is the relative under-utilization of gas
for power generation. As figure 1 shows,
gas use for electricity per capita in the
region is less than one-third the U.S.
average. The region’s historical use of
coal and nuclear fuel for power generation has tended to limit the use of
natural gas for electricity. Given this historical investment in other generation
assets, spikes in natural gas prices during
the summer months will have less of
an impact on consumer electricity prices
in the region. But the seasonal effect
of winter weather on natural gas prices
in the Midwest remains important, because Midwest consumers rely heavily
on natural gas for heating.
Gas prices in the Midwest

Gas prices (as measured by price paid
in dollar per thousand cubic feet at

the city gate) have exhibited considerable volatility both nationally and locally.
However, with a few notable exceptions,
Midwest gas prices tended to be lower
than the U.S. average during the period September 2000 to October 2002
(see figure 2.) The region has benefited from its relatively lower reliance on
natural gas in the summer months, and
in 2001–02 a relatively mild winter
lowered demand.
Storage and transmission

Storage capacity is an issue in some
of the Midwest states. For example,
Wisconsin has virtually no storage capacity, and storage capacity in Indiana
amounts to only 43 days of average
usage. Storage capacity is greater in
Illinois (165 days of average usage), Iowa
(242 days), and Michigan (264 days—
however, by February 2003 Michigan’s
storage level had fallen to 51% of capacity). Michigan needs a significant
level of storage capacity because interstate pipeline capacity is limited, with
the existing pipelines running at 95%
of capacity. Without significant storage,
out of state gas may be unavailable because of pipeline limitations. Available
pipeline capacity is better in Illinois
(75%), Iowa (55%), and Wisconsin
(60%). Storage is a significant concern
in Indiana, where pipeline capacity runs
at 91% and current storage capacity is
slim.5 The last major pipeline expansion
in the region was the addition of the
Alliance pipeline between British
Columbia, Canada, and Joliet, Illinois,
in 2000. Since then most additional
pipeline capacity has focused on moving natural gas from the Chicago hub
to markets in southern Wisconsin and
northeastern Illinois.

Further deregulation that would make
energy markets more robust and resilient would help stabilize natural gas
prices and provide some certainty to
Midwest businesses and homes that consume natural gas. One frequently cited
recommendation this summer has been
to remove existing obstacles to fuel substitution and to the importation of LNG.
In fact, retooling existing petroleum terminals to take some small LNG imports

would be a low-cost first step toward creating integrated global natural gas markets. Imported LNG is more realistically
seen as a long-run move, furthering
the resiliency and global integration
of natural gas markets.
Regulatory obstacles that constrain supply, including limitations on LNG terminal construction, exploration and
drilling on federal lands, and offshore
exploration and drilling, should be evaluated and subjected to a thorough cost–
benefit analysis. This test would ensure
that the combined environmental benefits of the regulations and the fuel
supply benefits would outweigh the
costs, including the opportunity costs
of the foregone environmental and
fuel supply benefits.
On the natural gas demand side, our
approach to air quality regulation relies too heavily on natural gas. Too much
air quality regulation mandates inputs,
such as the use of natural gas or a particular coal emission scrubbing technology. An air quality regulatory framework
that stipulates air quality objectives and
enforcement technologies that regulators will employ would provide better
incentives to apply technological change
in decreasing both emissions and fuel
use. Setting outcome-based air quality
performance standards and introducing a transparent means of evaluating
and enforcing performance would provide polluters with the flexibility to

Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, team leader, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834, tel. 312-322-5111 or fax 312-322-5515.
Chicago Fed Letter and other Bank publications
are available on the World Wide Web at http://
ISSN 0895-0164

improve and innovate to find better
ways of meeting the performance standard. This innovation would reduce
costs and produce new technologies.
New knowledge could enhance our
ability to achieve higher air quality and
make available different fuels at prices
we are willing to pay.
Another constructive action governments could take to make energy markets more resilient would be to change
state-level electricity regulations to allow retail competition and demandside bidding in retail markets. An active
demand in retail electricity markets
would not only discipline the ability of
suppliers to raise prices, it would also
equip consumers with their most effective energy conservation tool. Demand
response, particularly in large industrial and commercial customers, can
send signals to power producers of how
much investment in generation they
should undertake. Conservation and
shifting of demand away from costly

peak hours can actually decrease the
amount of required investment in generation capacity, as well as reducing
overall fuel use.
Price increases, such as those seen recently in natural gas, transmit valuable
information to consumers. That information enables them to decide when it
is worth it to them to conserve. Price
increases serve as the most effective inducement to conservation, because they
signal to consumers large and small
that the relative value of natural gas
has increased. They also tell suppliers
when it is worth bringing more to market and when to invest in more capacity, and through this interaction across
time and place, fuel portfolios become
more certain and prices become more
stable. Most importantly, timely price
information can help fashion appropriate (cost–benefit) public policies with
respect to the environment, infrastructure, and regulation.


The Midwest is defined here as the states
of the Seventh Federal Reserve District—
Illinois, Indiana, Iowa, Michigan, and


In 2001, 99.5% of all imported natural
gas to the U.S. by pipeline originated in
Canada. This represented 109.2 billion
cubic meters or roughly 18% of U.S. consumption (BP Statistical Review of World
Energy, June 2002).


Melita Marie Garza, 2003, “Energy chief
warns of 20% jump in Midwest heating
bills,” The Chicago Tribune, June 27, available at


Energy Information Administration,
2003, Weekly Natural Gas Storage Report,
July 18.


Underground gas storage capacity and
pipeline capacity, December 2001.