Reasons for Not Extending the Contract Abrogation Provision of S. 615 to Contracts for Sales by Producers to End Users

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1 April 15, 1983 MEMORANDUM Reasons for Not Extending the Contract Abrogation Provision of S. 615 to Contracts for Sales by Producers to End Users S. 615, the Administration's natural gas bill, allows either party to a contract for the first sale of natural gas to terminate the contract during calendar year The contract abrogation provision, section 3O3, is part of a package of provisions intended to' move the market for gas-producer sales to free-market conditions while providing protection to consumers. As drafted, section 303 includes within its reach not just first sales by producers to pipelines, but also first sales by producers directly to end users. Contract abrogation is an extraordinary measure. If government intervention to abrogate contracts is to be justified, it can be only for the most compelling policy reasons. The reliability of contracts is simply too important to our national commerce to violate in other circumstances. Since, as described below, neither the purposes of the bill nor any other sound policy objective would be advanced by abrogating contracts for sales by producers to end users, the abrogation provision of S. 615 should not extend to such contracts. This memorandum first describes the nature and historical background of direct producer sales to end users. It then describes the rationale of the contract abrogation provisions of

2 - 2 - the bill and shows why that rationale does not apply to long-term direct producer sales contracts. Finally, the memorandum responds directly to the contentions which have been made by the producers to justify their desire to obtain legislative relief from their contract obligations to end users. I. Background All but a small percentage of the gas sold by producers is purchased by interstate and intrastate pipeline companies for resale. The pipelines buy gas from many sources and resell the gas to their own customers. The pipelines.have a mix of old and new contracts, under which they purchase a mix of high-priced and low-priced gas. Pre-NGPA sales by producers to interstate pipelines are sales for resale in interstate commerce and were subject to federal price regulation under the Natural Gas Act. Controls on those sales were continued by the NGPA ( 104). A small percentage of first sales by producers are made directly to industries and electric utilities for their own use. A 1978 survey by the Energy Information Agency found that contracts for direct sales to end users occurred in 24 different states.^/ Purchasers under such contracts buy gas for use in their own facilities rather than for resale to others. A number of long term direct sale contracts were entered into between producers and end-users in the 1960's. In some cases, the terms I/ Intrastate and Interstate Supply Markets under the Natural Gas Policy Act (Table 2), October 1981.

3 - 3 - under these contracts extend beyond 1985 at prices which appear favorable by today's standards JL/ Direct long-term sales by producers to industrial or electric utility purchasers will account for only about three to five per cent of hat Ibrial consumption i5l_lj???.r~ I At the time the long-term direct sales contracts were entered into by the producers with the end users, the producers were searching for markets for their gas. Louisiana producers, in fact, had.been flaring unmarketable associated gas from oil wells until they were able to create the direct industrial market for the gas. In order to create a market for their gas, the producers solicited the construction near their producing wells of new petrochemical facilities and other industrial plants with large natural gas requirements. To induce the contruction of those plants, the producers guaranteed firm supplies of natural gas at stated prices over long terms. The negotiations between the producers and their long term industrial customers took place at arms length in an unregulated environment. Direct sales between producers and end users were not regulated under the Natural Gas Act. Although federal regulation of the interstate market existed in the I960 1 s, wellhead price ceilings imposed in that market remained at or _2/ Direct sales to end users by producers should not be confused with "direct main line sales" made by pipelines directly to end users. The latter represent the resale of gas by the pipelines from their system supply and are not "first sales" within the meaning of the NGPA. 3/ Estimates supplied by Foster Associates, based on EIA data.

4 _ 4 - above market-clearing levels and therefore had no distorting effect on the intrastate market.-!/ The price under at least some of the long-term direct sale contracts was established at levels above the prevailing rate in either the intrastate or the interstate market at that time. The higher contract price was agreed to by the purchasers/ in part, in exchange for the security provided by the long term of the contracts. The results of the direct sale negotiations were contracts from which both sides benefitted. The producers gained a secure market for their gas at prices which they believed to be fair and which, in some cases, were at a premium above market. Where oil and gas were co-produced, the producers were enabled to produce oil more readily and efficiently because they had found a market for the gas. For their part, the industries received assurance of a long term supply at a guaranteed price. In reliance on that assurance, the industries made investment decisions and constructed plants. Both sides freely accepted the market risks inherent in any long-term contractual arrangement for the purchase of a commodity whose price is subject to market fluctuations. In the post-ngpa environment, where pipeline companies were bidding the price of gas to unrealistic levels, there was no advantage to an industrial user in entering into a long term direct sale contract with a producer. Thus, while some direct See "Department of Energy Analysis of Natural Gas Consumer Regulatory Reform Legislation" Feb. 28, 1983.

5 sale contracts were entered into after the NGPA was enacted, few, if any, such post-ngpa contracts would extend beyond II* The Policy Goals Which the Administration's Contract Abrogation Provision Seeks to Serve Proponents of the Administration's contract abrogation proposal justify it as necessary in order to remove the distortions in contracting practices which were created by federal price controls under the Natural Gas Act and the NGPA. The arguments made, however, apply only to pipeline contracting practices. They are irrelevant to long-term arms length contracts entered into between producers and end users. The distorted market conditions which have given rise to the proposal to abrogate contracts are these: 1. Pipeline companies which purchase gas from many sources have used their low cost old gas as a "cushion" to bid up the price of unregulated gas above a market price. Companies with little or no cushion have been disadvantaged in competing to buy gas. 2. Interstate pipelines, emerging from the curtailment of the early and mid 1970's, used their, cushion to offer not only higher current prices but also unrealistic escalator provisions for the future. The contracting practices of the pipelines in the distorted market conditions created by the NGPA have caused the average purchased gas cost of pipelines to rise to and above market clearing levels. The escalator provisions will operate to carry the cost of still more gas above market clearing

6 - 6 - levels after additional decontrol (of Section 102 gas) occurs in The consumer does not receive a price benefit from a pipeline's low cost gas because the "cushion" created by the low cost gas is used to subsidize high cost purchases by the same pipeline. 4. Low prices in contracts tied to production from particular wells or fields cause gas to be left in the ground because it is uneconomic to upgrade the wells or to do additional drilling in order to produce maximum recoverable volumes from the fields. III. The Irrelevance of Long-Term Direct Producer Sales Contracts to the Accomplishment of the Administration's Goals The long-term direct sales by producers to end users are irrelevant to the contract problems and market conditions the abrogation provision of the Administration's bill is intended to address. They were unaffected by price regulation when they were negotiated, and they do not distort today's market. 1. The pre-ngpa direct sales contracts between producers and end users were never regulated by the federal government. They are not the product of either NGPA or Natural Gas Act distortions. (As described above, pre-ngpa contracts account for the great bulk, if not all, of the direct producer sales contracts extending past 1984.) 2. Unlike pipelines, industrial users and electric utilities do not purchase gas from many sources of supply.

7 - 7 - In most cases, the direct purchaser is dependent on a single source. Abrogation of a low cost contract of an industrial user will not be balanced by the abrogation of a high cost contract. The only beneficiaries of the abrogation of end user contracts will be a few large producers. They will receive the unanticipated windfall of being allowed unilaterally to break the contract obligations they willingly assumed, when they have already received the benefit of a stable market for their gas during a period when they needed it. 3. A low-cost contract between a producer and an industrial user does not act as a cushion permitting the industrial user to bid prices of other gas above market-clearing levels. Because the industrial user does not have multiple sources of supply, it is forced by economic considerations to offer only realistic prices for long term supplies. 4. Much of the direct sale gas is sold under general corporate obligation contracts which require the producer to make available specified quantities of gas at a specified price. Such contracts, even at low prices, will not adversely affect the incentive of producers to maximize production from their wells. If anything, such contracts increase rather than decrease incentives to produce, because the producer must produce in order to meet the contract obligations. IV. Responses to Specific Claims Those producers that would benefit from abrogating direct- sale contracts with end users have advanced several claims in

8 purported justification of allowing them to do so. None of those claims withstands scrutiny. 1. "A particular group of customers would be singled out for favorable contract treatment." As discussed above, the purposes and rationale of abrogation extend only to certain sales: those made by producers for resale. Contract abrogation is an extraordinary measure justifiable only for compelling public policy reasons. In the absence of any sound policy reason to abrogate direct-sale producer contracts, those contracts should remain in force. The burden of persuasion is on those who seek to nullify the contracts rather than on those who seek to preserve them. The intended overall effect of the abrogation provision, as stated by Secretary Hodel, will be to reduce the average cost of gas purchased by pipelines, and thus to decrease prices to the consumers they supply. If abrogation is extended to direct contracts between purchasers and end users, the latter will be the only class of gas consumers who, under the Administration's projections, will be guaranteed to end up with significantly higher burner-tip prices as a result of the bill. 2. "It is inconsistent to support natural gas decontrol and, at the same time r to support the protection of long-term direct producer sale contracts." The stated purpose of the Administration's decontrol proposal is to allow the operation of a free market in natural gas. One of the essential characteristics of a free market is that parties may freely enter into contracts with the expectation

9 - 9 - that those contracts will be honored. It is those few producers that would have the government intervene to abrogate their freely-negotiated contracts whose arguments are inconsistent with the concept of a free market. 3. "Failure to abrogate low-cost, long-term producer sale contracts creates a subsidy for economic inefficiencies.* a. Only in a theoretical economic model are the effects of contracts considered to be a distortion of the market or to promote inefficiency. Many other fungible commodities (coal, for example) are sold under long term contracts. Long term contracts may result in prices that are above or below the spot market price at any given moment, but those differences are not viewed as granting an unfair advantage or disadvantage to the contracting parties. Price differentials between contract prices and spot prices will always exist. It is precisely to guard against the risk of changes in spot prices, whether up or down, that parties enter into long term contracts. b. When parties enter into long-term contracts, they freely assess the risks and benefits of the mutual obligations undertaken, and they make business decisions in reliance on them. The length of the contract term, as well as the price provisions, reflect the economic trade-offs made in negotiations. Such negotiations are the mechanism by which the most efficient allocation of resources over the long term is achieved. In the case of the industries and utilities whose gas purchase contracts are at issue, economic efficiency was served by the creation of a market for a resource which otherwise would

10 not have been sold. Part of the economic consideration for the transaction was the undertaking by the producers that they would make gas available at a specified price over a specified period of time. c. It is a perverse use of economic theory to argue that a low contract price "subsidizes" an "inefficient" industry. In a free market economy, all firms seek the most advantageous supply contracts they can obtain. The companies which constructed plants in reliance upon contracts with certain producers took large entrepreneurial risks. Their corporate management made correct and economically "efficient" decisions. The "subsidy" argument suggests nothing less than a prohibition against any contract that deviates from a spot-market price. 4. "Preserving long-term direct producer sale contracts to end-users provides an unfair competitive advantage to parties which benefit from those contracts." Companies which negotiated long-term fixed price contracts many years ago will neither "benefit" nor suffer from legislation which does not disturb their contracts; they will merely retain the benefits and the burdens of the bargains previously struck. The contract abrogation provision, according to Secretary Hodel and FERC Chairman Butler, is intended to benefit natural gas consumers: lower prices to end users served by pipelines, as stated above, is a key purpose of allowing pipelines to abrogate. A decision not to extend abrogation to direct producer sales contracts would simply allow the purchasers to maintain the price arrangements they now have, while their competitors, served

11 by pipelines, may receive a significant reduction in rates as a result of renegotiation induced by contract abrogation. Whatever benefit exists to purchasers under direct contracts will last only until the contracts expire by their terms. By the end of 1990, according to EIA data, the contracts covering more than 80% of the pre-ngpa direct sales volumes will have expired j 5. "Producer sales to end users cannot be distinguished from pre-ngpa sales by producers to intrastate pipelines, which were also unregulated at the time they were made." Viewed from the standpoint of the bill's effects and purposes, the producer sales to end users are radically different from pre-ngpa unregulated sales by producers to intrastate pipelines. Intrastate pipeline purchasers will benefit from the contract abrogation provision, as high cost contracts as well as low cost contracts are abrogated. The industrial or electricutility direct purchaser, not having had roll-in capability, does not have high cost supply contracts subject to abrogation. For that purchaser, abrogation leads prices in only one direction (up), notwithstanding the bill's purpose of lowering burner-tip prices. J5/ Intrastate and Interstate Supply Markets under the Natural Gas Policy Act, October 1981 (Table 4) (Calculation excludes sales under well-life contracts and contracts with missing or erroneous termination dates.)

12 Second, unlike old lower cost contracts of pipelines, the industrial users 1 contracts do not provide a "cushion" to support market-distorting purchases of high cost gas. Finally, a pipeline's decision to contract for gas at unduly high costs, if allowed to stand, penalizes not just the pipeline, but the residential, commercial and industrial users it supplies. In contrast, the consequences of prudent or imprudent direct contracting between an industrial buyer and a producer are essentially limited to those two parties. They may, therefore, fairly be expected to stand by their bargains, and there is no general public interest to be served by abrogating their contracts. 6. "Producer sales to end users cannot be distinguished from post-ngpa unregulated sales or from post-ngpa sales made under contracts with unregulated escalator provisions." Unlike prices paid under post-ngpa unregulated pipeline contracts, the prices paid by the industrial and electric utility direct purchasers from producers were not distorted by the existence of any cushion. It is extremely unlikely that any contracts with end users exist under which an industrial customer would agree to pay above-market prices for any significant volume of gas for a term extending beyond While pipelines have readily entered into such agreements, an industrial purchaser sensitive to profit margins (and without the protection of guaranteed cost passthrough) would be unlikely to sign such a contract.

13 "The unregulated producer-to-end-user sales were affected by federal price controls even though the prices were not directly regulated; thus they should be subject to abrogation. 1* The pre-ngpa long-term direct sales by producers to users were wholly unaffected by government regulation of wellhead rates. In fact, in many cases, there was no market at all for the gas the users purchased before the producers began inducing industrial customers to build new plants in the producing region. The contract price was the price which was established in arms length bargaining between two parties of relatively equal negotiating power. More generally, as Secretary Hodel testified on March 9 before the Senate Committee on Energy and Natural Resources, during the 1960's, when most of the long-term industrial contracts were entered into, intrastate prices did not differ significantly from interstate prices. This relationship does not, however, indicate that the intrastate prices were driven by the interstate prices. Rather, it demonstrates that the FPC under the Natural Gas Act was establishing interstate prices at levels that approximated the free-market price. If it had not, a disparity between the regulated and unregulated prices would have developed (as it did in the 1970s). As DOB has stated: "During most of the 1960's, the wellhead price ceilings [under the Natural Gas Act] were at or above market clearing levels and,

14 therefore, had little effect on the [gas] industry."^/ NGPA prices, when set in 1978, were well above the contract levels of long-term direct sales contracts. The prices under existing long term contracts between producers and end users have thus not intersected with federally-set price ceilings. 8. "Royalty owners would be unfairly prejudiced if low- cost direct producer sale contracts are not abrogated." The royalty owners stand in the same position as the producers. They enjoyed the benefits and assumed the risks of long term gas marketing arrangements. Any benefits to state treasuries from abrogating long term contracts would be offset by loss of tax revenues and employment in the states affected if contract abrogations result in plant shutdowns. JS/ "Analysis of Natural Gas Consumer Regulatory Reform Legislation, February 28, 1983 (at page 2).