Increasing Demand and Tight Supply Have Driven Up Prices and Made Extreme Price Spikes Possible

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. 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. The supply of natural gas, however, has not kept pace with the increased  demand. Other factors—such as  market manipulation—may also have affected wholesale prices. Our  ongoing work examining futures trading in natural gas markets will  address this issue later this year. Impact on Consumers of Higher Wholesale Natural Gas Prices Depends on the Extent to Which They Buy from Spot Markets and on Other Factors

How higher wholesale natural gas prices are affecting consumers depends  largely on the degree to which the consumers or their suppliers may have  purchased gas on the spot market—which reflects current wholesale  prices—or may have taken steps to reduce their exposure to these prices. Some consumers, such as low-income residents and certain  industries, are more sensitive to price changes than others. Furthermore, in a few states, some of the  largest natural gas utilities projected they would purchase 70 percent or  more of their natural gas supplies for this winter from the spot market. Participants in the market, such as industrial consumers who purchase gas  directly from the market or natural gas utilities that purchase gas on behalf  of their customers, can hedge against high spot market prices for natural  gas in three main ways: (1) by purchasing and storing gas for use during  times when prices are high; (2) by signing fixed-price contracts for  delivery of the gas in the future; and (3) by purchasing financial  instruments, such as options or derivatives, that increase in value as  natural gas prices rise. Electricity generators are also sensitive to higher prices because of their  dependence on natural gas. A recent  survey by a trade association representing large energy consumers showed  that more than half of 31 member companies surveyed are decreasing their  demand for natural gas an average of 8 percent to 9 percent this winter  compared with last winter, leading the association to conclude that higher  prices have forced industries to curtail production in the United States. However, three federal agencies—FERC, CFTC, and EIA—play key roles  in overseeing and supporting a competitive and informed natural gas  marketplace. FERC’s ability to monitor the natural gas markets has been enhanced in  several regards recently. Since 2002, FERC has settled a number of investigations involving natural  gas market manipulation. In addition, a FERC  administrative law judge found that another company exercised market  power over natural gas prices in California during the 2001-2002 heating  season, and the company subsequently agreed to pay a settlement of $1.6  billion. From 2002 through May 2005, CFTC investigated over 40  energy companies and individuals, filed over 20 actions, and collected over  $300 million in penalties. Most of these actions were related to natural gas.
Why GAO Did This Study

In early December 2005, wholesale natural gas prices topped $15 per million BTUs, more than double the prices seen last summer and seven times the prices common during the 1990s. For the 2005-2006 heating season, the U.S. Energy Information Administration predicts that residences heating with gas will pay 35 percent more, on average, than they paid last winter. This testimony addresses the following: (1) the factors causing natural gas price increases, (2) how consumers are affected by these higher prices, and (3) the roles federal government agencies play in ensuring that natural gas prices are determined in a competitive and informed marketplace. This testimony is based on GAO's 2002 published work in this area, updated through interviews, examination of data, and review of relevant publications. GAO's new work was conducted from December 2005 through February 2006 in accordance with generally accepted government auditing standards.

What GAO Found

Since 1999, wholesale prices for natural gas have trended upward because of expanding demand and supply that has not kept pace. The domestic natural gas industry has been producing at near capacity, and the nation's ability to increase imports has been limited. Tight supplies have also made the market susceptible to extreme price spikes when either demand or supply change unexpectedly. Prices spiked in August 2005 when hurricanes hit the Gulf Coast, disrupting a substantial portion of supply and again later when demand was pushed higher because of, among other reasons, colder-than-expected temperatures in early December. Although prices have dropped, they remain higher than last year. Other factors--such as market manipulation--may also have affected wholesale prices. We are currently examining futures trading in natural gas markets for signs of manipulation and expect to report on our results later this year. While most consumers' gas bills are rising, the degree of the increase depends, in part, on how much of their supply is purchased from wholesale spot markets. Consumers who directly, or indirectly, buy their natural gas mainly from spot markets will see prices that reflect both recent price spikes and the longer-term trend toward higher prices. Our work shows that some of the largest natural gas utilities in a few states expect to buy at least 70 percent of their gas at spot market prices this winter. These companies generally pass these prices on to their customers. On the other hand, consumers and suppliers that have reduced exposure to spot market prices because some of their gas has been purchased through a process called hedging may be insulated from price spikes and may postpone their exposure to even gradual price hikes. In this regard, utilities in more than half the states have hedged at least 50 percent of their supply for this winter by entering into long-term fixed-price contracts and other techniques. This will help stabilize prices for their customers. Nonetheless, high gas prices will hit some consumers hard, including lower-income households and companies that depend heavily upon natural gas, such as fertilizer manufacturers. The Federal Energy Regulatory Commission (FERC) and the Commodities Futures Trading Commission (CFTC) play key roles in ensuring that natural gas prices are determined in a competitive and informed marketplace. Both agencies monitor natural gas markets and investigate instances of possible market manipulation. Since 2002, FERC has settled a number of investigations involving natural gas market manipulation; for example, one company agreed to pay a settlement of $1.6 billion after FERC found it had exercised market power over natural gas prices in California during the 2001-2002 heating season. From 2002 through May 2005, CFTC investigated over 40 energy companies and individuals, filed over 20 actions, and collected over $300 million in penalties, most of which were natural gas related.