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November 26,1976 Paying for Gas According to the Federal Power Commission, the nation will suffer a 22-percent shortfall of natural-gas supplies this winter—almost twice the size of the shortfall of two years ago. According to the producers of this popular fuel, the shortfall will continue as long as FPC price con trols continue on the supplies of gas moving in interstate commerce. The FPC this month reaffirmed its earlier approval of a sharp price hike—almost triple—for “ new” gas, which is gas newly discovered or newly sold in interstate commerce after January 1,1975. (New gas ac counts for about 10 percent of in terstate supplies.) This and related price actions over the next year could raise the average price of interstate gas 30 percent or more. Vet producers claim that prices are still far too low to bring forth the increased supplies the nation needs, and they point for proof to the fact that U.S. reserves dropped 22 percent over the past decade even with the addition of new Alas kan supplies. Short-lived program In this situation, it is instructive to examine the means—sometimes very complex means—which the industry has used to finance new natural-gas supplies. One such approach—a significant one despite its eventual regulatory demise—was the system of advanced payments developed last year by the Southern California Gas Co. (SoCal) and At lantic Richfield Co. (ARCO), whereby the utility promised an interest-free development loan to the oil producer in return for first chance at Alaskan oil and gas sup plies. SoCal would have paid $327 million to ARCO for Prudhoe Bay develop ment, and ARCO would have granted SoCal purchase rights to 60 percent of planned production— about 4.2 trillion cu. ft. of gas. Fol lowing up, California's Public Utility Commission (PUC) then approved a schedule of rate increases for So Cal, sufficient to cover its costs. This type of arrangement, where a utility takes over the interest cost of developing reserves in order to gain a share of future gas supplies, was first approved by the Federal Power Commission in 1970. In per mitting such advanced-payment ar rangements, the FPC sought to pro vide incentives for oil and gas com panies to develop more gas re serves. From the very outset, however, consumer groups opposed this fi nancing approach because of the rate increases resulting from such plans. Indeed, the PUC itself was reluctant to approve last year's So Cal arrangement: “The Prudhoe Bay gas producers are attempting to circumvent Federal Power Commis sion regulations by, in effect, offer ing the gas to the highest bidder in an auction in which the sellers are few and the buyers desperate." Several months later, the FPC itself (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. voted to end the advancedpayments program, on the grounds that the program had failed to meet its expressed goal of spurring in creased gas exploration and devel opment. Unusual program Critics of the advanced-payments approach pointed out that oil and gas firms are generally in a better financial position than the hardpressed utilities to borrow money for development. Furthermore, in the case of the SoCal-ARCO ar rangement, SoCal would probably have had to pay taxes on revenues raised for the purpose of financing the ARCO loan— unlike the situa tion if the oil firm had borrowed the money directly. In unregulated industries such contracts are non existent. One critic, Senator John Tunney, argued, "It's like asking a purchaser of furniture to pay five or ten years in advance of getting the furniture.” In view of this harsh criticism, we may well ask how such roundabout financing devices had come to seem so necessary. The utilities are regulated in part because of the very structure of the industry. It is cheaper to provide the customer with gas from a single source in a given geographical re gion, rather than to duplicate facili ties and lose the advantages of economies of scale. In other words, the utility industry provides a classic case of natural monopoly—a mo nopoly created because competi 2 ' tion would raise the prices consum ers pay. To protect the consumer from undue monopoly power, and to insure a "reasonable” electricity rate, regulatory authorities have been established in most localities to pass judgment upon requested rate increases. Insuperable problem Although the existence of natural monopolies leads to the creation of regulatory bodies, regulators face an insuperable problem—the de termination of the correct price. Our economy thus is replete with examples of regulated prices that are either too low or too high— more frequently the latter. When the regulated price is too high, the supplier of the regulated good or service has an incentive to provide added inducements to persuade the consumer to buy. In domestic air transportation, for example, the airlines create an inducement to fly at an above-market price by provid ing such unsolicited services as at tractive flight attendants. The government's ceiling on the price of natural gas, on the other hand, historically has been too low. While there is no way to tell exactly what the competitive price of a monopoly-produced good would be, some broad yardsticks are avail able in the case of natural gas, such as the price of gas sold (without ceilings) in certain intrastate mar kets, and the price of certain com petitive fuels which can be com- pared with gas on a BTU-equivalent basis. In any case, when regulators set a price too low, consumers tend to form lines to obtain the item in question, and they compete with one another in other ways when bidding up the price is not permis sible. In economic jargon, this is called non-price com petition. Simi larly, the producer's behavior, as he allocates the product according to other than price criteria, amounts to non-price rationing. Over the long haul, regulatory agencies have a very difficult time controlling the price of a commodi ty. Non-price competition and non price rationing raise the actual cost of the good above the regulated price, and also, when the price is too low, reduce the quantity of the good available. Pricing below market In the case of the natural-gas indus try, FPC price ceilings create poten tial problems for gas consumers, since at the government-regulated price people want to buy more gas than sellers can profitably provide. This artificially regulated price will create shortages, and more demand for gas than is available at the regu lated price. Gas purchasers may soon (albeit reluctantly) find some legal way of avoiding price regula tions, paying the higher price that gas suppliers require to provide adequate supplies. Although regu 3 lators will eventually perceive this escape from the regulatory intent and move to plug up the gap, their efforts will tend to be frustrated, because the rewards to the pur chaser and seller from avoiding regulations are so much greater than the reward to the regulator of preventing this avoidance. In the end, natural gas might well be pro duced in about the same quantities—and the consumers' sit uation may be the same—as would have been the case if the govern ment had never attempted to regu late the price of gas. A utility's provision of interest pay ments to a producer is one means of paying more than the regulated price for gas, in order to ensure sufficient gas supplies. Indeed, the FPC decision to abolish the advanced-payment program may have been less important than more recent Commission decisions to permit at least some increase in prices. The movement toward prices high enough to equate de mand and supply will be long and tortuous, complicated of course by the difficulties of dealing with a natural monopoly. But clearly the direct payment of the market price to the gas producer is a more effi cient and therefore ultimately a less expensive way of purchasing gas than the alternative—developing round-about financial arrange ments in order to circumvent regu latory attempts to hold the price artificially below market levels. Kurt Dew ucn§umse/v\ • MBM BH • • uoSaJO • epeAaN • oqepi B IU J O J !|B 3 . BUOZUy • *}I|B3 'ODSIDUEJJ UBS ZSL ON llW H d aivd aovisod s n H v w SSV1D JLSNM P® m pTBd® Q BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 11/10/76 + + + + + + + + + + + - Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Government deposits Time deposits—total* States and political subdivisions Savings deposits O ther time deposits^ Large negotiable CD's 90,898 69,629 1,803 22,493 21,046 11,620 8,647 12,622 89,941 26,069 341 62,092 4,798 28,723 26,402 10,294 Weekly Averages of Daily Figures W eek ended 11/10/76 Member Bank Reserve Position Excess Reserves Borrowings Net free(+)/Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions of U.S. security dealers Net loans (+)/Net borrowings (-) + Change from 11/3/76 + 12 0 12 + 366 + 706 361 259 202 175 48 5 91 193 149 785 147 74 49 110 1 74 Change from year ago Dollar Percent + + + + + + + + + - 2,887 3,436 957 287 1,392 1,264 246 303 2,033 1,037 19 1,391 930 7,193 3,628 5,337 W eek ended 11/3/76 + + + + + + + + + + + + - 3.28 5.19 34.67 1.26 7.08 12.21 2.77 2.34 2.31 4.14 5.90 2.29 16.24 33.41 12.08 34.14 Comparable year-ago period 59 0 59 + + 57 0 57 309 + 2,578 81 + 1,843 in c lu d e s items not shown separately. ^Individuals, partnerships and corporations. Editorial comments may be addressed to the editor (William Burke) or to the author. . . . Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. E>|SE| V
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