Utility investment in upstream natural gas reserves backed by ratepayer funds has been promoted as a means to procure gas at lower and more stable prices, but a new analysis by a utility ratemaking expert has found "dubious customer benefits" of such arrangements in some cases.
Hedging the cost of gas supply by taking positions in the upstream sector is becoming more popular and is particularly attractive today because of depressed natural gas prices and overextended producers needing cash flow. However, under such arrangements, it is utility ratepayers who usually bear an unfair share of the risks involved, according to the National Regulatory Research Institute's Ken Costello, principal researcher for energy and the environment.
"It seems ironic that the major apparent reason for vertical arrangements is to reduce upside price risk to utility customers but, in the process, utilities are asking customers to take on new risks," Costello wrote in the research paper. "Although an empirical question, it is conceivable that utility customers could face higher risk from a vertical arrangement involving UOGR [utility ownership of gas reserves] or a utility affiliate than from the absence of long-term hedging. A review of the vertical arrangement plans suggests that customers could very well bear higher risk from an action that purports to protect those same customers from risk."
Costello noted that UOGR by utilities -- natural gas and electric -- has grown in popularity as a long-term hedging tool "with the secondary benefit of saving their customers fuel costs over time." Only "a handful of utilities" have these arrangements and the relative amount of gas supplied is small. However, interest is likely to increase, Costello said, because UOGR offers utility companies a new source of revenue.
One utility company cited by Costello is South Dakota-based Black Hills Corp. and its cost of service gas program for electric customers in Colorado, Iowa, Kansas and Nebraska. The same is proposed for gas and power customers in South Dakota and Wyoming (see Daily GPI, Feb. 5; Shale Daily, Nov. 5, 2015). Black Hills owns its own gas reserves.
Another program, in effect since 1981, is that of Questar Gas in Utah and Wyoming, which has a joint agreement with exploration and production affiliate Wexpro (see Daily GPI, Nov. 30, 2015). "Questar Gas simply receives a monthly invoice from Wexpro that flows through the utility's balancing account just like all other gas purchases," Costello wrote. "In essence, the cost-based price Questar Gas pays for gas resembles the traditional regulated cost-of-service model used to regulate utilities.
About four years ago, the Montana Public Service Commission approved a request by NorthWestern Energy to include in rate base natural gas production properties and allowed for the recovery of costs associated with the acquisition of producing properties. After a deal to acquire assets of Devon Energy (see Daily GPI, May 30, 2013), owned gas reserves meet about 30% of the company's annual gas supply requirement, Costello said, adding that plans are to increase this to 50%.
Florida Power & Light has an ownership interest in upstream reserves through a joint venture with a non-affiliated company (see Daily GPI, June 18, 2015; Dec. 19, 2014; June 25, 2014). Customers, in effect, become investors in the upstream natural gas business, Costello said.
And in 2011, the Oregon Public Utility Commission approved a five-year, $250 million joint venture of Northwest Natural Gas Co. and Encana Oil & Gas to develop reserves in Wyoming (see Daily GPI, May 2, 2011).
In arguing for participation in the upstream sector, utilities have asserted that such vertical integration arrangements offer them the "only feasible long-term hedge," Costello wrote. Utilities have argued that long-term, fixed-price gas supply contracts are not available in the market and also that credit/counterparty risk makes such agreements less attractive, Costello said.
"One argument in support of vertical arrangements is that the time is now ripe for utilities to exploit a buyer's market; they may be able to lock in gas supplies at an attractive price," Costello wrote. "Gas producers may find it advantageous to sign favorable deals from the buyer's perspective because of current financial problems triggered by low gas prices."
Another argument favoring utility action in the upstream is that drilling for shale natural gas has become a relatively low-risk activity as there are few dry holes encountered. "...UOGR could eliminate the 'middleman' profits (e.g., marketers)," Costello wrote. "From the utility perspective, UOGR can also offer utilities higher earnings and tax benefits."
Other factors also argue for benefits in the trend toward utility participation in the upstream, but Costello wrote that vertical integration "seems to be a high-risk strategy for hedging," at least from the perspective of utility customers.
"After reviewing different vertical-arrangement plans, it is evident that customer risk is excessive relative to utility or holding company risk," Costello wrote. "Customer risk comes largely from a low market price, and unanticipated, unfavorable events in gas operation or production from reserves. Commissions entertaining UOGR and other vertical arrangements, or long-term hedging in general, should consider balancing the risks between utility shareholders and customers."