Natural Gas Expansion and the Cost Of Congestion

With the emergence of new technologies such as hydraulic fracturing and horizontal drilling, large new deposits of oil and gas are poised to become economically viable. As this happens, substantially increased deliveries will make their way into the market, benefiting both producers and consumers. However, these potential benefits cannot be fully realized with the existing transmission capacity. Limited transmission capacity on key delivery routes creates bottlenecks that drive a wedge between the prices consumers pay and the prices sellers receive, lowering consumer surplus and reducing the incentive to develop the new deposits. A question of some policy relevance is therefore: How large is this wedge? In general, answering this question is quite difficult. Consider the market for natural gas in the United States, illustrated in Figure 1. There are scores of supply sources, and many trading hubs. Hundreds of pipelines connect the various supply sources and trading hubs; the interactions amongst the various supply sources trading hubs and pipelines is, therefore, very complicated. An alternative to evaluating the effect of delivery constraints at the national level is to study a smaller version of the problem—that is, one with fewer sources of supply, fewer trading hubs, and fewer pipelines. In this article, we summarize evidence from such a stripped-down problem involving two trading hubs in the state of Wyoming connected by three pipelines. Gas generally flows from west to east between these two hubs, so that one may interpret the source of supply as represented by the trading hub in the western part of the state (the Opal trading hub) and the source of demand as represented by the trading hub in the eastern part of the state (the Cheyenne trading hub). Our results indicate a persistent difference in prices at the trading hubs, reflecting the cost of transmitting gas between the hubs, in the range of $0.15 per MCF. When scheduled deliveries utilize more than 95% of the available capacity, however, the wedge between the prices at the two trading hubs rises sharply; the tighter are the capacity constraints, the more pronounced is the wedge between the two prices. The conceptual underpinning for this story is straightforward. The spot price at the upstream hub, which in this case is the trading hub, depends upon the supply curve for upstream sellers and the demand curve for downstream buyers. In turn, the price downstream buyers are willing to pay depends upon the price they believe they can obtain for the gas when they sell it, less the cost of transportation between the two trading hubs. This transportation cost reflects the opportunity costs associated with the use of the pipeline, and can be thought of as a form of tax on the transaction. The “incidence” of this tax upon sellers depends upon the elasticities of supply and demand. The magnitude of this “tax”, in turn, is likely to depend positively on the degree to which transmission capacity is constrained; alternatively, it will depend negatively on the amount of unused capacity at a point in time. The key logistical features of our example are illustrated in Figure 2. Most of the natural gas that passes through the Opal trading hub originates in the upper Green River Basin. There, the distribution of the gas is split: some Figure 1: Natural Gas Centers, Hubs, and Major Pipelines. Source: EIA.