Consumers are sometimes surprised when they open their natural gas bills. The rate that their local utility charged this month could be 25 percent higher than it was just last month. That same rate, however, could at the same time be 30 percent lower than it was last year. This leads some consumers to wonder what is going on at the utility. The fact is that natural gas price changes are driven by several different factors, some of which the utility has control over, and others it does not. Some of these costs are subject to regulatory oversight while others are not. Some of these factors change infrequently and in small increments, while others swing widely from month to month. Still others vary by the season.

	What causes natural gas price changes?
	What is the wellhead price?
	Why is the commodity price so unstable?
	What do utilities do to insulate customers from volatility?
	What are interstate pipeline costs?
	Are pipeline rates constant from season to season?
	How does increased winter usage affect pipeline capacity costs?
	Are there other reasons that a natural gas rate changes?
	What are local distribution service rates?

Changes in natural gas prices are caused by five principal factors. Natural gas rates change when there are:

The price of gas at the site of production is referred to as the commodity price or wellhead price. Of all the cost components, natural gas commodity prices are by far the most unstable and the least predictable. The Figure 1 shows monthly wellhead prices of natural gas from 1992 to 1998. It is clear that these prices move around quite a bit from month to month and from year to year. Natural gas price volatility is among the highest of all commodities that are traded on major market exchanges. The price can unexpectedly double in a matter of months. It can also tumble by 50 percent just as fast.

The natural gas commodity price is so volatile because it is a market price, not a regulated price. Market forces reflect the underlying supply and demand situations. Since there is no regulatory oversight a sudden unexpected cold snap can send prices soaring. Conversely, an unexpected decline in the price of competing fuels, such as oil, can cause industrial customers to use much less gas than expected and the price of natural gas can decline precipitously. The figure shows monthly prices. The daily prices are even more volatile.

Figure 1

Utilities buy gas in the off-season and store it for winter use The principal method is to buy gas in the off-season and store it for winter use. The principal reason that storage services are used is because the pipeline system in our part of the country was designed so that a stored gas inventory is required if the utility is to satisfy its customers’ total demand. The resulting price hedging impact is, therefore, more of an ancillary benefit from the use of storage rather than the primary reason for using it.) If gas is put in storage in the summer and withdrawn in the winter, the cost of gas charged to consumers in the winter will be a blend of the current market price and the cost incurred when buying in the summer. This blending tends to have a limiting effect on the price volatility to some extent. It is far from perfect insulation, however. When natural gas prices rise or fall dramatically, consumers will still see noticeable changes in their gas rates. Since on any given day Wisconsin gas utilities can meet only a fraction of their gas demands with supplies from storage, they are always buying relatively large amounts of gas at market prices. Therefore, even if storage services are used to their maximum capacity, market price changes always filter through to the prices paid by the ultimate consumers if no other action is taken.

Utilities use financial instruments The other action than can be taken to reduce price volatility is a more recent development in natural gas markets. Futures, options, and swap contracts for natural gas traded on the New York Mercantile Exchange provide means of hedging natural gas prices. Proper use of these contracts allows the utilities to lock in prices or to put ceilings on prices, for example, which limits the volatility of gas costs that flow through to consumers. Most Wisconsin utilities have not used this approach, with Wisconsin Gas Company being the notable exception. The goal of using financial instruments is generally to control price volatility, not to reduce gas costs. If consumers do not mind the price volatility, then hedging with financial instruments is not useful. The utility’s cost of administering the hedging program is passed on to consumers so that, over a long period of time, a hedged gas supply portfolio will produce slightly higher gas prices than if the portfolio were not hedged. The prices will, on the other hand, be more stable and more predictable. Whether the increased cost justifies the reduced volatility is a matter of personal opinion. Since it is not always clear how consumers feel about this trade-off, most utilities have not ventured into this arena.

Interstate pipeline costs represent the space (capacity) on the pipes, that transport natural gas. Pipeline costs are much more stable than are commodity prices. The overall level of pipeline charges changes very little from year to year. Occasionally, the FERC sets new pipeline rates that must be flowed through to consumers, but in most years the pipeline rates are fairly constant.

Generally no. The PSC requires most of the state’s gas utilities to recover more of its charges for pipeline service in the winter than in the summer. Why does the Commission do this? Increased demand in the winter, not the summer, determines whether the utility must contract for new pipeline capacity. There is plenty of space available on the pipeline in the summer so that even if everyone installs natural gas fired grills for summer barbecues, the utility simply runs more gas through its space on the pipe. So customers who increase usage in the summer cause the utility to incur commodity costs, but not pipeline capacity costs.

The same cannot be said of customers who increase their winter usage. If numerous customers convert from, say, fuel oil to natural gas for home heating, the utility must make sure that it has enough space on the pipeline to meet the increased demand. If it does not, it will have to arrange for more space on the pipe. Who should pay for the increased pipe capacity, the customers who installed gas grills for summer usage or the customers who installed gas furnaces? Those that installed the furnaces clearly caused the need for the new capacity, so from a cost-causer / cost-payer perspective, those customers should pay for that capacity. To link cost-causer with cost-payer, the PSC requires utilities to use a seasonal pricing approach to collect pipeline costs. The concept is shown in Figure 2 below. The winter period runs from November through either March or April, depending on the utility. The important point to note is that pipeline charges increase by about $0.10 per therm on November 1. This is a hefty increase for most consumers. This means that even if commodity costs are stable from October to November, gas bills are likely to rise noticeably once October ends.

Figure 2

Natural gas rates can change due to reasons that occur irregularly. For example, in recent years several Wisconsin utilities were required to pass back to customers a refund of pipeline costs. Other utilities might be allowed to or required to pass on to consumers slight surcharges or credits based on their performance under gas cost incentive mechanisms. It is difficult to know when and if these types of costs might be incurred. In any event, they tend to be quite small relative to the commodity, interstate pipeline, and distribution service costs.

These rates reflect the utility's cost of maintaining and operating its local system for distributing natural gas to homes and business. It is surprising to many consumers that the portion of the business fully regulated by the PSC, namely the basic distribution business, is usually not the culprit when it comes to significant natural gas price changes. These costs are, like interstate pipeline rates, fairly stable from year to year. Unlike interstate pipeline rates, however, local distribution rates do not vary by season. >These rates change only when the PSC has a formal rate proceeding for the utility. In most cases, these rates are not changed more frequently than once every two years.

**There are many factors that cause natural gas price changes
We hope that it has been clear that there are numerous forces acting on natural gas prices. Some are market forces. Others are institutional forces such regulatory decisions by the PSC or FERC. The combination of all these determines the price that Wisconsin consumers pay for natural gas service.