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Before the Permanent Subcommittee on Investigations, Committee on 
Homeland Security and Governmental Affairs, United States Senate: 

United States Government Accountability Office: 


For Release on Delivery Expected at 8:30 a.m. CST: 

Monday, February 13, 2006: 

Natural Gas: 

Factors Affecting Prices and Potential Impacts on Consumers: 

Statement of Jim Wells, Director, Natural Resources and Environment: 


GAO Highlights: 

Highlights of GAO-06-420T, a testimony before the Permanent 
Subcommittee on Investigations, Committee on Homeland Security and 
Governmental Affairs, United States Senate: 

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 

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 

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 

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. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Jim Wells at (202) 512-
3841 or 

[End of section] 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss natural gas prices. As you 
know, last fall two powerful and destructive hurricanes, Katrina and 
Rita, tore through the Gulf of Mexico and several states bordering it-
-an important area for the supply of natural gas. By 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 throughout the 1990s. For the 2005-2006 winter heating season, 
the Energy Information Administration estimated in January 2006 that 
residential households heating with natural gas will pay $257 (35 
percent) more, on average, than last winter. Consumers in the Midwest 
are expected to witness even greater increases--paying 41 percent more 
than last winter. 

This is not the first time that natural gas prices have sharply 
increased. In 2000-2001, prices rose steadily and remained high for 
nearly a year. We examined this phenomenon in 2002 and found that 
prices went up mainly because supplies could not keep pace with rising 
demand.[Footnote 1] We also reported that federal agencies responsible 
for overseeing aspects of the natural gas market were actively 
investigating whether market participants had violated market rules or 
manipulated prices. 

Concerned about the recent increases in natural gas prices and the 
implications of these increases on consumers in the United States, you 
asked us to address 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 

Our testimony today is based on our prior reports, interviews, and a 
review of recent reports published by others. Prior related GAO 
products are listed at the end of this statement. To update our 
findings from those reports, we conducted interviews with federal 
agencies that included the Energy Information Administration, the 
Federal Energy Regulatory Commission, and the Commodities and Futures 
Trading Commission. We also interviewed the state commissions that 
oversee natural gas utilities, selected trade associations representing 
the natural gas industry, and other potentially affected industries. 
Further, we examined data on the natural gas industry, including 
prices, consumption, and supplies. In addition, we reviewed relevant 
reports and other documents published by others. We conducted our work 
from December 2005 to February 2006 in accordance with generally 
accepted government auditing standards. 


Since 1999, wholesale prices for natural gas purchased from the short- 
term, or spot, market have trended steadily upward because demand has 
expanded faster than supply. The domestic natural gas industry has been 
producing at near capacity, and, to date, the nation's ability to 
increase imports has reached its limits, given currently available 
infrastructure. Tight supplies have also made the market susceptible to 
extreme price spikes when either demand or supply change unexpectedly. 
Prices spiked in late 2005 when two hurricanes hit the Gulf Coast 
region, disrupting a substantial portion of our natural gas supply. 
This supply disruption was compounded by high demand due to, among 
other reasons, colder-than-expected temperatures in early December. As 
a result, December wholesale prices spiked further. Although prices 
have dropped from these highs, they remain higher than last year 
because some natural gas wells and pipelines damaged by the hurricanes 
remain inoperable and because the margin between demand and supply 
remains narrow. Other factors--such as market manipulation--may also 
have affected wholesale prices. We are examining futures trading in 
natural gas and other energy markets for signs of market manipulation 
and we plan to report on the results of that work later in 2006. 

While the upward trend in natural gas prices is causing higher gas 
bills for most consumers, the degree to which they see their bills rise 
because of high wholesale prices depends on how much of their supply is 
purchased from wholesale spot markets. Consumers who buy most of their 
natural gas from spot markets, or consumers whose suppliers do so on 
their behalf, are likely to see price increases commensurate with both 
recent price spikes and the longer-term trend toward higher prices. 
According to our preliminary work with the state commissions that 
oversee natural gas utilities, some of the largest natural gas 
utilities in a few states expect to buy at least 70 percent of their 
gas this winter at spot market prices. The utilities generally pass 
these prices on to their customers. Gas utilities and consumers that do 
not obtain their gas through utilities can reduce their exposure to 
spot markets through a process called hedging, which includes such 
techniques as buying gas at fixed prices in long-term contracts or 
storing gas purchased when prices are relatively low to be used during 
times when prices are high. While hedging may not guarantee the lowest 
price, it allows consumers to have greater price stability. Our 
preliminary work shows that the natural gas utilities in more than half 
of the states hedged at least 50 percent of their supplies for this 
winter. How consumers are affected by rising natural gas prices also 
depends on the consumer; some consumers are more sensitive to price 
changes than others. For example, lower-income residents may not be 
able to absorb the price increases and may have difficulty paying their 
bills. According to trade associations, industrial consumers that are 
heavily dependent upon natural gas, such as chemical and fertilizer 
manufacturers, may not be able to compete with foreign companies that 
have access to gas at lower prices and therefore may reduce operations 
or close U.S. plants. 

Three federal agencies--the Federal Energy Regulatory Commission 
(FERC), the Commodities Futures Trading Commission (CFTC), and the 
Energy Information Administration (EIA)--play key roles in ensuring 
that natural gas prices are determined in a competitive and informed 
marketplace. FERC is responsible for ensuring that wholesale prices for 
natural gas sold and transported in interstate commerce are determined 
competitively. It carries out this responsibility by, among other 
actions, monitoring the markets in which natural gas is traded and 
investigating 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. Since prices spiked in the fall of 2005, FERC has 
received complaints and identified areas of concern regarding high 
prices. Agency officials told us they investigate such matters where 
appropriate and that regulations governing FERC's activities prevent 
them from disclosing whether any investigations are under way. 
Similarly, CFTC is responsible for ensuring that fraud, manipulation 
and abusive practices do not occur in federally regulated financial 
markets such as the New York Mercantile Exchange (NYMEX), where some 
natural gas contracts are traded. CFTC monitors the markets for 
attempted market manipulation and takes enforcement actions, when it 
deems appropriate, such as initiating legal proceedings and imposing 
financial penalties. From 2002 through mid-2005, CFTC investigated more 
than 40 energy companies or individuals and assessed penalties totaling 
over $300 million, most of which concerned natural gas-related 
settlements. FERC and CFTC recently signed a memorandum of 
understanding in an effort to work together more effectively. EIA 
publishes information about natural gas markets, including aggregate 
estimates of supply and demand and average prices. 


Natural gas is a colorless, odorless fossil fuel found underground that 
is generated through the slow decomposition of ancient organic matter. 
In some cases, the gas, composed mainly of methane, is trapped in 
pockets of porous rock held in place by impermeable rock. In other 
cases, natural gas may occur within oil reservoirs or in coal 
deposits.[Footnote 2] Natural gas is extracted via wells drilled into 
the porous rock. The natural gas is then moved through pipelines and 
processing plants to consumers. 

Historically, domestic natural gas production has occurred largely in 
Texas, Oklahoma, and Louisiana. In more recent years, as older fields 
have been depleted, the Rocky Mountain region, Alaska, and areas 
beneath the deeper waters of the Gulf of Mexico are becoming 
increasingly important in supplying natural gas; however, in many cases 
these supplies are not near pipelines and other infrastructure needed 
for getting the gas to markets, which increases the costs of gas 
obtained from the newer fields. 

Natural gas consumers include: 

* residential users living in houses, apartments, and mobile homes; 

* commercial users such as stores, offices, schools, places of worship, 
and hospitals; 

* industrial users covering a wide range of facilities for producing, 
processing, or assembling goods, including manufacturing, agricultural, 
and mining operations; 

* entities that use natural gas to generate electricity and provide 
that electricity to others, such as regulated electric utilities and 
competitive suppliers of electricity; and: 

* the transportation sector, including pipeline companies, which use 
natural gas to operate the pipeline networks, as well as those using 
natural gas to power cars and buses. 

Most residential and commercial consumers rely on natural gas utilities 
to supply their gas. Industrial consumers and electricity generators 
obtain their gas through a variety of means, including buying it 
directly from spot markets and natural gas utilities. 

The demand for natural gas in the United States has generally been 
seasonal, with peak demand during the winter heating months. From April 
through October, companies typically purchase natural gas and place it 
into underground storage facilities located around the country. Later, 
as the seasonal demand increases, these stored supplies of natural gas 
are used to augment the supplies provided via pipelines. According to 
EIA, natural gas demand during winter months is usually 1.5 times 
greater than monthly natural gas production in other months. 

Over the past 25 years, the wholesale natural gas supply market has 
evolved from a highly regulated market to a largely deregulated market, 
where prices are mainly driven by supply and demand. While the 
regulated market ensured stable prices, it also caused severe gas 
supply shortages because, with artificially low prices, producers had 
no incentive to increase production and consumers had no reason to 
curtail their demand. Before implementation of the Natural Gas Policy 
Act of 1978, which began deregulation of wholesale natural gas prices, 
the federal government controlled the prices that natural gas producers 
could charge for the gas they sold through interstate commerce. Under 
this regulatory approach, producers located natural gas reserves, 
drilled wells, gathered the gas, and sold it at federally controlled 
prices to interstate pipeline companies. After purchasing the natural 
gas, pipeline companies generally transported and sold the gas to local 
distribution or gas utility companies. These companies, under the 
oversight of state or local regulatory agencies, then sold and 
delivered the gas to their consumers, such as homeowners. 

In today's restructured market, the retail prices that consumers pay 
are still regulated in many states and reflect the prices paid by their 
suppliers to acquire the natural gas. However, the federal government 
does not control the wholesale price of natural gas. Since the removal 
of federal price controls, the wholesale price of natural gas decreased 
initially and has become more volatile. Producers still locate and 
gather natural gas, but they now sell the gas at market-driven prices 
to a variety of companies, including marketers, broker/trader 
intermediaries, and a variety of consumers. New market centers have 
emerged, including a market center referred to as the Henry Hub, 
located in Henry, Louisiana. Henry Hub prices are reported on a daily 
basis, and trades made at that market are often used as benchmarks for 
other natural gas trades. 

The various players in the market may sell gas back and forth several 
times before it is actually delivered to the ultimate consumers. In 
some cases--in spot markets, for example--natural gas is sold for 
immediate delivery.[Footnote 3] In other cases, it may be sold for 
delivery in the future, through a variety of what are called futures 
markets. In addition, several types of financial derivatives related to 
natural gas--contracts whose market value is derived from the price of 
the gas itself--can be bought and sold through numerous sources by 
entities that are interested in protecting themselves against increases 
in the price of natural gas. Derivatives include natural gas futures 
and options, and derivative prices typically move in parallel with the 
spot market.[Footnote 4] Derivatives markets include exchanges such as 
the New York Mercantile Exchange, which is regulated by the CFTC; and 
the Intercontinental Exchange, which operates as an exempt commercial 
market without CFTC oversight but over which CFTC has anti-manipulation 
and anti-fraud authority; and off-exchange and over-the-counter (OTC) 
markets, which are not subject to general federal regulatory oversight. 

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 

Trend toward Higher Prices in Recent Years Is Due Largely to Market 

Since 1999, wholesale natural gas prices have risen steadily, as 
demonstrated by the moving average in figure 1. Previously, in the 
early and mid-1990s, prices were generally low, usually ranging from $2 
to $3 per million BTUs, adjusted for inflation. From January 1999 
through July 2005, however, average wholesale prices increased by over 
200 percent, rising from about $2 to $6.75 per million BTUs. 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. 

Figure 1: Wholesale Natural Gas Prices at Henry Hub, in 2004 dollars: 

[See PDF for image] 

[End of figure] 

A combination of market forces has caused the upward trend in wholesale 
natural gas prices since 1999. Demand for natural gas has been growing 
rapidly since the mid-1980s, with total consumption increasing by about 
38 percent from 1986 through 2004. Figure 2 illustrates the extent to 
which consumption of natural gas has risen in the United States over 
the past 2 decades and the relative amounts used by each of the five 
types of consumers: residential, commercial, industrial, electricity 
generators, and transportation. 

Figure 2: Consumption of Natural Gas by Sector, 1986-2004 (with 2004 
Percentage of Total): 

[See PDF for image] 

[End of figure] 

A significant share of the increased demand in recent years has 
resulted from increased use of natural gas to generate electricity. Out 
of concern regarding the supply of natural gas and other factors, 
construction of power plants using oil or natural gas as a primary fuel 
was restricted from 1978, when the Powerplant and Industrial Fuel Use 
Act (Fuel Use Act) took effect, through 1987, when it was repealed. 
After the Fuel Use Act's repeal, use of natural gas by the electric 
generation sector increased by 79 percent from 1987 through 2004. Newer 
gas-powered plants produce low levels of pollutants, compared with many 
existing plants. This characteristic, as well as the long period of low 
prices in the 1990s and other factors, has made natural gas the primary 
fuel in new power plants. 

The supply of natural gas, however, has not kept pace with the 
increased demand. Historically, most of the natural gas used in the 
United States--85 percent in 2003--has been produced here. However, as 
older natural gas fields have been depleted, additional drilling for 
natural gas has been required in order to maintain domestic production. 
This additional drilling has not necessarily resulted in immediate 
additional supplies in part because development of new wells and 
supporting pipeline infrastructure can take time. Overall, from 1994 
through 2003, domestic annual production held steady at about 19 
trillion cubic feet. In 2003, EIA reported that the domestic natural 
gas industry had produced nearly all of the natural gas that could be 
produced on a monthly basis from 1996 through 2001--the most recent 
data then available. Furthermore, EIA reported that at times there was 
virtually no spare capacity in some parts of the country and forecasted 
that these tight supply conditions would continue, despite EIA's 
projection for a significant increase in drilling activity. 

In recent years, imports of natural gas have become increasingly 
important. Net imports of natural gas have increased steadily, rising 
by over 250 percent from 1987 through 2004. In 2004, the United States 
imported about 15 percent of the total natural gas consumed here. 
Nearly all of the imported gas comes from Canada via pipeline, and 
those imports constitute virtually all of Canada's production not used 
in that country. In addition, a small share--about 3 percent of total 
U.S. supply--has been shipped on special ocean tankers as liquefied 
natural gas (LNG) from countries such as Trinidad and Tobago, Nigeria, 
and others. These imports have increased significantly in recent years; 
however, it is not clear if we have the capacity to handle further 
increased shipments, in part because only five facilities in the United 
States are able to receive and process LNG imports. Moreover, because 
of limited international supplies and high prices in other markets, it 
also is not clear how much additional supply is available to the United 

Extreme Price Spikes Resulted from Tight Demand and Supply Conditions: 

The tight demand and supply balance has made the market for natural gas 
more susceptible to extreme price changes when demand or supply changed 
unexpectedly. As we previously reported, prices spikes occur 
periodically in natural gas markets because neither the demand side nor 
the supply side can quickly adjust to changes in the marketplace. On 
the demand side, some customers are able to react to changes in prices. 
For example, some industrial entities may be able to switch fuels or 
reduce their production. However, many other customers, such as 
residential customers, may have few fuel-switching options and little 
firsthand knowledge of spot natural gas prices--and understand the 
costs of their natural gas consumption only when they receive their 
bill. On the supply side, suppliers are slow to respond to price 
changes. For example, they may be delayed in responding to high prices 
because, as noted earlier, existing domestic sources of natural gas are 
already operating at near full capacity--often above 90 percent in the 
United States in recent years, according to EIA. In these 
circumstances, because little excess supply is readily available, it 
must be added, generally by drilling new wells and connecting those 
wells to existing pipelines, which can take time. For example, 
receiving regulatory approval can take a year or more, and the time to 
drill the well and connect it to the pipeline network can take another 
6 to 18 months. Because neither the suppliers nor many consumers can 
react quickly to price changes, even small unexpected increases in 
demand or disruptions in supplies can cause sudden and significant 
price increases. 

High Prices in Late 2005 Resulted from Supply Disruptions Caused by 
Hurricanes Katrina and Rita: 

Most recently, prices rose sharply following the landfall of two 
hurricanes in the Gulf region. It appears that the price spike was 
caused by the unexpected decrease in the supply of natural gas in late 
2005 following Hurricanes Katrina and Rita, exacerbated by factors that 
raised demand. Because of the damage caused to production, processing, 
importing, and transporting infrastructure in the Gulf region, 
wholesale prices climbed to a high of $15 per million BTUs by December 
2005. 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. 

The Gulf region produces about 20 percent of the U.S. natural gas 
supply. The region's extensive natural gas-related infrastructure 
includes about 4,000 platforms that extract natural gas from beneath 
the ocean floor; two of the five terminals that import LNG into the 
United States; plants that remove impurities from natural gas to 
prepare it for sale and use; and an extensive network of pipelines, 
linked by hubs such as the Henry Hub, that transport natural gas to 
other parts of the United States. 

The paths of Hurricanes Katrina and Rita, in relation to Gulf region 
natural gas infrastructure, are shown in figure 3. The hurricanes 
forced operators to evacuate about 90 percent of the oil and gas 
platforms in the Gulf for safety reasons, rendering them unable to 
produce natural gas; shut down one of the two LNG importing terminals 
for about two weeks; damaged processing plants; and damaged several 
pipelines and their connecting hubs, delaying transmission of natural 
gas from supply facilities that were still operational. For example, 
the Henry Hub, a major gas market center, was closed by flooding for a 
total of 11 days following Katrina and Rita. 

Figure 3: Path of Hurricanes Katrina and Rita Relative to Oil and 
Natural Gas Production Platforms: 

[See PDF for image] 

[End of figure] 

As a result of all of these factors, the hurricanes had a significant 
impact on the supply of natural gas. Figure 4 shows the impact of 
Hurricanes Katrina and Rita on the production of natural gas from the 
Gulf region. Hurricane Katrina disrupted about 8 billion cubic feet of 
natural gas production per day immediately following its landfall--
amounting to about 80 percent of daily production from the Gulf and 
about 16 percent of total daily U.S. production of natural gas. Lost 
production from Katrina was in the process of being restored when 
Hurricane Rita struck--again reducing production of natural gas from 
the Gulf region to levels similar to those immediately following 
Katrina. As a result of the severity and timing of these two 
hurricanes, the Gulf region produced less than half its usual amount of 
natural gas for about 9 weeks after Hurricane Katrina struck. By 
comparison, nearly all of the lost production that resulted from 
Hurricane Ivan in 2004 was restored within 9 weeks and amounted to 
about 20 percent of that caused by Katrina and Rita. By the end of 
January, only about 80 percent of the natural gas supplies that had 
been disrupted by Katrina and Rita had been restored, leaving the 
overall market tighter than it was prior to the hurricanes and leaving 
the U.S. vulnerable to future unexpected interruptions in supply or 
increases in demand--either of which could result in higher prices. 

Figure 4: Daily Natural Gas Production from the Gulf of Mexico 
Following Landfalls of Hurricanes Katrina and Rita: 

[See PDF for image] 

[End of figure] 

Prices for natural gas in both the spot and the futures market spiked 
dramatically immediately following the supply disruptions caused by the 
2005 hurricanes. In September 2005, after the second hurricane, natural 
gas spot prices increased to over $15 per million BTUs--roughly twice 
as high as the average price in July 2005 of about $7.60 per million 
BTUs. Futures prices to deliver gas in October also doubled to $14.20 
per million BTUs, reflecting traders' expectations that high spot 
prices could continue into the future. Futures prices closely followed 
spot prices until early November 2005, when spot prices fell to about 
$9 per million BTUs, but prices for December gas futures remained at 
about $12 per million BTUs, reflecting the belief by futures market 
traders that natural gas prices would be high in December. A brief cold 
spell during the beginning of December increased demand for natural gas 
for heating purposes, driving prices up. The arrival of warmer than 
normal temperatures just before the end of the year reduced demand and 
has contributed to the recent reduction in prices. Figure 5 shows the 
spikes in natural gas prices during the months of, and following, the 
2005 hurricanes. 

Figure 5: Prices for Natural Gas in the Spot and Futures Markets, 
August 2005 to January 2006: 

[See PDF for image] 

Note: Because the Henry Hub was closed for one day on August 29, 2005, 
and for 10 days from September 23 through October 6, 2005, prices for 
these dates were based on estimates taken either from a nearby natural 
gas hub or from the previous day's price. 

[End of figure] 

Price Spikes in 2001 and 2003 Were Caused by Unexpected Increases in 

Two other instances of price spikes--caused by unexpected increases in 
demand--have occurred since 1999. First, coincident with the western 
electricity crisis, from mid-2000 through early 2001, wholesale prices 
for natural gas rose substantially and remained relatively high for 
nearly a year. This period witnessed significant increased demand for 
natural gas by the electric generation sector in order to meet 
electricity demand across the West during a year of diminished 
availability of hydroelectricity, a situation compounded by high demand 
through the winter and lower-than-normal storage levels. In a second 
instance, wholesale prices rose sharply in February 2003 during a 
period of high demand because of unusually cold winter temperatures; 
however, prices returned to normal relatively quickly. 

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.[Footnote 5] The effect of higher prices also depends on the 
consumer's sensitivity to price changes. Some consumers, such as low- 
income residents and certain industries, are more sensitive to price 
changes than others. 

Higher Wholesale Prices May Lead to Significant Increases in Energy 
Expenditures for Consumers Exposed to Spot Markets: 

The impact of recent increases in natural gas wholesale prices on 
consumers depends on how much of the natural gas they use is purchased 
in spot markets. Those with the greatest reliance on spot markets are 
hit the hardest when prices rise or spike. For example, some natural 
gas utilities that relied on spot markets are spending significantly 
more on energy this winter, which may translate into higher gas bills 
for residential and commercial consumers. According to our preliminary 
work with the state commissions that regulate natural gas 
utilities,[Footnote 6] 10 states reported that at least some of the 
natural gas utilities they regulate were highly exposed to spot market 
prices. 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. Since the winter of 2000-2001, some 
state public utility commissions (PUCs) have encouraged the natural gas 
utilities they regulate to hedge some part of their gas purchases in 
order to help stabilize prices, according to the American Gas 
Association. According to the state commissions, 27 states reported 
that the utilities they regulate will acquire at least half of their 
expected winter natural gas needs at a known price, generally ranging 
from $7 to $10 per million BTUs. In that regard, last November, 
Commissioner Donald Mason of Ohio told Congress that customers around 
Dayton, Ohio, have saved about $3 per million BTUs as a result of 
hedging, including use of long-term, fixed-price contracts. Gas 
utilities are also taking other approaches to keep down or stabilize 
their customers' costs. For example, in some states, utilities offer 
"level" payment programs and show customers how to use energy wisely 
through energy-efficient appliances. In Minnesota, in 2005, all state- 
jurisdictional gas utilities are required to spend at least 0.5 percent 
of their gross operating revenues on conservation improvement efforts 
such as weather audits, weatherization, and rebates for purchases of 
energy-efficient appliances. While some gas utilities have made efforts 
to reduce their exposure to spot prices by increasing their use of 
hedging, as some did after the price spike in 2000-2001, some states 
and municipalities still discourage the use of hedging, according to 
the association that represents the public utility commissioners. 

While hedging allows consumers to obtain greater price stability, it 
has costs and risks, and utilities may lack incentives to undertake it. 
Storing gas for later use, for example, entails up-front costs such as 
the cost of placing it into and keeping it in storage. Market 
participants face risks if, for example, they purchase gas in advance 
under a fixed-price long-term contract and prices drop. For that 
reason, some natural gas utilities may be reluctant to enter into long- 
term contracts when prices are relatively high, according to a trade 
association that represents municipal gas utilities. Furthermore, 
absent specific PUC guidance to hedge purchases, gas utilities may have 
few incentives to hedge since they are generally able to pass along 
increased costs associated with purchases of natural gas. Moreover, 
some state regulators may not allow gas utilities to financially 
benefit from using hedging but hold them financially responsible if the 
hedge proves unnecessary. Furthermore, while under some circumstances 
hedging can reduce or eliminate the impact of a price spike, it may 
offer little benefit during prolonged periods of price changes. For 
example, a utility that signed a 5-year commitment to purchase natural 
gas at a predetermined price may witness no change in the cost of 
acquiring the natural gas during the period of the contract but would 
again face market prices (either higher or lower) when it came time to 
replace this gas supply at the end of the contract. In this sense, 
hedging may serve to delay until the contract term ends, but not 
prevent, the effect of higher or lower prices on consumers. 

Some Consumers Are More Sensitive to Price Changes: 

Because energy costs account for a relatively large share of overall 
costs for some consumers or because they are heavily dependent on 
natural gas, any price increases can present significant difficulties. 
In particular, low-income residential consumers and some highly energy 
intensive industries appear likely to encounter the greatest impact. 

The effect of high natural gas prices has already been especially 
severe on low-income individuals. According to representatives from a 
trade association representing publicly owned natural gas utilities, a 
utility in Philadelphia, Philadelphia Gas Works, has billed $42 million 
more than they have collected so far this winter, representing an 
increase of 2 percent in uncollectible heating bills this winter 
compared with last winter. In Kentucky, utilities this winter have 
witnessed the highest number of complaints and the greatest number of 
problems faced by customers. Furthermore, federal assistance to low- 
income households in meeting heating expenditures provides only limited 
assistance. According to the National Association of State Energy 
Officials, the Low Income Home Energy Assistance Program 
(LIHEAP)[Footnote 7] currently serves only 20 percent of the eligible 
population, with average payments of $311 per family designed to help 
families pay projected natural gas heating expenditures of $1,568 this 
winter. Additionally, despite several years of increases, LIHEAP 
funding in fiscal year 2005 is only 67 percent of what it was in fiscal 
year 1982, adjusted for inflation.[Footnote 8] However, some states 
have increased funding for low-income individuals recently. For 
example, in December, Minnesota began distribution of an additional 
$13.4 million in funding designed to assist an additional 26,000 
households in paying for heating. 

Electricity generators are also sensitive to higher prices because of 
their dependence on natural gas. This is true especially in the eastern 
United States, where, according to FERC, electricity generators rely 
heavily on natural gas. Furthermore, the region has many of the newer 
gas-fired electric power plants that have less flexibility to switch to 
other fuels, such as oil-based fuels, according to the National 
Petroleum Council and others. As a result, some consumers may see 
higher electricity bills. 

High natural gas prices are also adversely affecting industrial 
consumers. As we reported in 2003, some industrial consumers shut down 
production facilities[Footnote 9] because of higher energy costs in 
2000 and 2001. Industry representatives expect recent high prices to 
have a similar effect. 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. The 
association expects that further cutbacks will occur if prices remain 
high this year. 

According to an association that represents industrial consumers, high 
natural gas spot prices have been particularly detrimental to specific 
industries in the United States that rely on natural gas, such as 
fertilizer and chemical manufacturers, that compete in international 
markets. As we reported in 2003,[Footnote 10] natural gas expenses can 
account for 90 percent of the total cost of manufacturing nitrogen 
fertilizer. The high cost of domestic natural gas has made it difficult 
for U.S. producers of nitrogen fertilizer to compete with foreign 
nitrogen fertilizer producers, who can buy natural gas at lower prices 
and export their products to the United States. For example, in 2004, 
Trinidad and Tobago was the largest supplier of anhydrous 
ammonia,[Footnote 11] a type of nitrogen fertilizer, to the United 
States. Prices of natural gas are sharply lower in Trinidad and Tobago, 
where, according to the Fertilizer Institute, prices were about $1.60 
per million BTUs in 2005. The U.S. fertilizer industry, which typically 
supplied 85 percent of its domestic needs from U.S.-based production 
during the 1990s, now relies on imports for nearly 45 percent of 
nitrogen supplies, according to a trade association representing 
fertilizer companies. Furthermore, other industries can be affected. In 
the fertilizer industry, according to a trade association representing 
fertilizer companies, costs are passed on to U.S. farmers, which have 
witnessed a dramatic increase in the cost of nitrogen fertilizers. The 
prices paid by farmers for the major fertilizer materials reached a 
record during the spring of 2005--on average, 8 percent higher compared 
with the same period in 2004, according to a trade association 
representing fertilizer companies. 

The Federal Government Has a Limited, but Important, Role in Overseeing 
Natural Gas Markets: 

In today's restructured market, the federal government does not control 
the price of natural gas or directly regulate most wholesale prices. 
However, three federal agencies--FERC, CFTC, and EIA--play key roles in 
overseeing and supporting a competitive and informed natural gas 

FERC's Oversight Activities: 

Under federal law, FERC is responsible for regulating the terms, 
conditions, and rates for interstate transportation by natural gas 
pipelines and public gas utilities to ensure that wholesale prices for 
natural gas, sold and transported in interstate commerce, are "just and 
reasonable." FERC's jurisdiction over retail natural gas sales is 
limited to domestic gas sold by pipelines, local distribution 
companies, and their affiliates. The commission does not prescribe 
prices for these commodity sales. FERC's regulatory authority applies 
to the physical markets for energy commodities, such as natural gas, 
and not to futures markets. 

In December 2002, we reported that as energy markets were restructured, 
FERC had not adequately revised its regulatory and oversight approach 
to respond to the transition to competitive energy markets. FERC agreed 
that its approach to ensuring just and reasonable prices needed to 
change: from one of reviewing individual companies' rate requests and 
supporting cost data to one of proactively monitoring energy markets to 
ensure that they are working well to produce competitive prices. That 
year, the commission established the Office of Market Oversight and 
Investigations to actively monitor energy markets and, when necessary, 
undertake investigations into whether any entity had or was attempting 
to manipulate energy prices. As we previously reported, in 2002, FERC 
staff undertook several studies and investigations to determine whether 
there had been attempts to manipulate upward prices for natural gas 
delivered to California during 2000-2001. 

FERC's ability to monitor the natural gas markets has been enhanced in 
several regards recently. First, the Energy Policy Act of 2005, passed 
last September, contains several enforcement provisions that increase 
the commission's ability to punish wrongdoers that harm the public. In 
particular, the act provides FERC with the authority to impose greater 
civil penalties on firms that commit fraud. In addition, FERC has taken 
steps to strengthen its efforts to protect energy consumers. These 
actions include establishing a telephone hotline that individuals can 
call to report market abuse or other problems. FERC also has begun 
actively monitoring natural gas markets to determine whether price 
movements are the result of market manipulation or market fundamentals. 
The staff reviews market activity for any possible manipulation that 
might also affect prices and performs a detailed review of natural gas 
prices and market activity on a daily basis with the intent of 
identifying areas of possible manipulation. If the staff identifies 
price anomalies that are not explained by market fundamentals, they 

Since 2002, FERC has settled a number of investigations involving 
natural gas market manipulation. For example, 10 companies agreed to 
pay settlements totaling approximately $84 million. 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. FERC officials told us that, since early fall of last 
year, it has received complaints, expressions of concern, and requests 
to investigate with respect to high natural gas prices through its 
enforcement hotline and from public officials and the general public. 
Additionally, FERC has identified areas of concern through its daily 
market oversight process. FERC officials told us that all complaints 
and concerns are taken seriously and actively investigated, where 
appropriate. However, since ongoing investigations are considered 
nonpublic under FERC's regulations, officials said they could not 
comment further on any ongoing investigations of the natural gas 

CFTC Oversight of Related Financial Markets: 

A large part of CFTC's mission is to protect market users and the 
public from fraud, manipulation, and abusive practices related to the 
sale of commodity futures and options, including natural gas. CFTC does 
this for federally regulated exchanges such as NYMEX, and it has 
limited authority over certain other futures markets. It does not have 
general regulatory authority for other over-the-counter markets, 
including some used for trading natural gas futures or 
options.[Footnote 12] In fulfilling its regulatory role, CFTC conducts 
market surveillance to identify situations that could amount to 
attempted or actual futures market manipulation and to initiate 
appropriate preventive actions. For instance, to protect the futures 
market from excessive speculation that could cause unwarranted price 
fluctuations, CFTC or an exchange impose limits on the size of the 
transactions that may be held in futures or options of a commodity. In 
the natural gas futures market, these transaction limits are placed on 
trading that occurs during the spot month.[Footnote 13] To monitor 
these transaction limits, the commission has about 45 market 
surveillance staff and economists to do policy and economic analysis of 
energy trading issues. 

As part of its regulatory role, CFTC also enforces various laws 
prohibiting fraud, manipulation, and abusive trading practices. CFTC's 
enforcement group investigates and prosecutes alleged violations of the 
Commodity Exchange Act. 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. For example, in July 2004, Coral Energy 
Resources, L.P. (Coral), a Houston-based firm that marketed gas to 
consumers across the United States, was ordered to pay a civil monetary 
penalty of $30 million. The penalty was imposed because the CFTC found 
that Coral knowingly provided false, misleading, or inaccurate 
information concerning its natural gas transactions from January 2000 
to September 2002. During that time, CFTC found that Coral employees 
also attempted to manipulate the price of natural gas in interstate 
commerce or for future delivery. Natural gas traders report their 
market information to firms like Natural Gas Intelligence, who in turn 
compile pricing and volume indexes, for instance, that are used by 
market participants to settle their transactions. Submitting incorrect 
information could affect the price of natural gas in interstate 
commerce and could affect the futures or options prices of gas. 

FERC and CFTC Taking Action to Better Coordinate Oversight Efforts: 

FERC and CFTC have recently signed a memorandum of understanding to 
create a more effective and efficient working relationship between the 
two agencies. The agreement covers the sharing of information and the 
confidential treatment of proprietary energy-trading data. FERC 
officials told us that if either agency needs information about trading 
within the other agency's jurisdiction, then the other agency must 
provide it. The understanding is to contribute to better coordination 
of enforcement cases. 

EIA Collects, Disseminates, and Analyzes Information about the Market: 

The Energy Information Administration (EIA) is charged with collecting 
information about energy markets, including natural gas. The 
information reported by this agency is important in promoting efficient 
natural gas markets and public awareness of these markets. In our 2002 
analysis of natural gas markets, we identified that most elements of 
EIA's natural gas data collection program inadequately reflected some 
of the changes in the market. For example, with some exceptions, EIA's 
current natural gas data collection program remains primarily an annual 
effort to obtain comprehensive information on natural gas volumes and 
prices, while markets have evolved to require more timely and detailed 
data. However, beginning in the spring of 2002, EIA began to provide 
more real time market information that traders and other gas industry 
analysts use as an indicator of both supply and demand. For example, on 
May 9, 2002, EIA began releasing weekly estimates of natural gas in 
underground storage for the United States and three regions of the 
United States. According to EIA, these data are valued by market 
participants and are a key predictor of future natural gas price 
movements. EIA has also undertaken efforts to better understand 
derivatives markets and the effectiveness of energy derivatives to 
manage price risk. In addition, EIA's weekly natural gas data releases 
are published each Thursday, and according to EIA officials, these 
releases have been well received by natural gas market participants. 

Concluding Observations: 

Natural gas has become an essential element in our national energy 
picture. Ironically, however, natural gas markets may be suffering from 
the growing popularity of this versatile fuel. Rising demand and 
tightening supply appear to have contributed to both the general rise 
in prices over the past several years as well as the price spikes, such 
as that following the hurricanes in 2005. Moreover, the stage seems set 
for future price spikes if either demand is higher than expected or 
supplies are unexpectedly interrupted. 

To the extent that the higher prices persist and price spikes are 
possible, natural gas markets could pose significant challenges for our 
country. Many people may have to pay a larger percentage of their 
income for home heating and other uses of natural gas, such as 
electricity--not just this year, but every year. Some may not be able 
to afford it. Further, because some key industries have historically 
relied on low natural gas prices to be competitive, we may lose some of 
these industries along with the jobs that they provide. 

These are weighty issues that require concerted actions reaching across 
not just the natural gas industry but also across the energy sector and 
related financial markets. The American consumer wants secure, 
affordable, reliable, and environmentally sound energy. Meeting this 
demand will be a challenge. This hearing offers another important step 
in the process of overseeing the regulators--FERC and CFTC--charged 
with ensuring these markets operate as intended. 

Mr. Chairman, this concludes my prepared statement. I would be pleased 
to respond to any questions that you or other Members of the 
Subcommittee may have at this time. 

Contact and Staff Acknowledgments: 

If you have any questions about this testimony, please contact me at 
(202) 512-3841 or Other major contributors to this 
testimony include Karla Springer (Assistant Director), Lee Carroll, 
Michael Derr, Patrick Dynes, Elizabeth Erdmann, Philip Farah, John 
Forrester, Mark Gaffigan, Mike Hix, Chester Joy, Jon Ludwigson, Kristen 
Sullivan Massey, Cynthia Norris, Frank Rusco, Jena Sinkfield, Rebecca 
Spithill, John Wanska, and Kim Wheeler-Raheb. 

[End of section] 

Related GAO Products: 

Meeting Energy Demand in the 21st Century: Many Challenges and Key 
Questions. GAO-05-414T. Washington, D.C.: March 16, 2005. 

Natural Gas: Domestic Nitrogen Fertilizer Production Depends on Natural 
Gas Availability and Prices. GAO-03-1148. Washington, D.C.: September 
30, 2003. 

Energy Markets: Additional Actions Would Help Ensure That FERC's 
Oversight and Enforcement Capability Is Comprehensive and Systematic. 
GAO-03-845. Washington, D.C.: August 15, 2003. 

Natural Gas: Analysis of Changes in Market Price. GAO-03-46. 
Washington, D.C.: December 18, 2002. 

Energy Markets: Concerted Actions Needed by FERC to Confront Challenges 
That Impede Effective Oversight. GAO-02-656. Washington, D.C.: June 14, 


[1] GAO, Natural Gas: Analysis of Changes in Market Price, GAO-03-46 
(Washington, D.C.: Dec. 18, 2002). 

[2] Natural gas occurring within oil deposits is referred to as 
"associated natural gas." Natural gas found in coal deposits is 
referred to as "coal-bed methane." 

[3] According to the American Gas Association, the term spot market 
refers to a market in which natural gas is bought and sold for 
immediate or very near-term delivery, usually for a period of 30 or 
fewer days. 

[4] A futures contract is an agreement to buy or sell a commodity for 
delivery in the future at a price, or according to a pricing formula, 
that is determined at initiation of the contract. An obligation under a 
futures contract may be fulfilled without actual delivery of the 
commodity by, for example, an offsetting transaction or cash 
settlement. An option gives the buyer the right, but not the 
obligation, to buy or sell a commodity at a specific price on or before 
a specific date. 

[5] Other costs reflected in consumers' retail bills, such as 
transportation and pipeline maintenance, compose a substantial part of 
the final retail bill but are relatively stable. 

[6] The preliminary work is part of a larger effort that we will 
complete later this year. 

[7] LIHEAP is a federally funded program that helps low-income 
households with their home energy bills. The federal government does 
not provide energy assistance directly to the public, generally 
providing funding to state-run programs. State-run LIHEAP programs may 
offer bill payment assistance, weatherization, and energy-related home 
repairs or other types of assistance. 

[8] Data reflect LIHEAP and weatherization appropriations, supplemental 
or emergency appropriations, and REACH funding. 

[9] GAO, Natural Gas: Domestic Nitrogen Fertilizer Production Depends 
on Natural Gas Availability and Prices, GAO-03-1148 (Washington, D.C.: 
Sept. 30, 2003). 

[10] GAO-03-1148. 

[11] Anhydrous ammonia is the source of nearly all nitrogen fertilizer 
produced in the world. Nitrogen fertilizer is composed of three basic 
components--nitrogen, potassium, and phosphorus--and of these 
components, nitrogen is the most important component of fertilizer. 
Natural gas is a key component in the production of nitrogen, and the 
cost of natural gas can account for up to 90 percent of nitrogen 
fertilizer production costs. 

[12] Under the Commodity Exchange Act, transactions in exempt 
commodities, which include over-the-counter energy derivatives, are 
exempt from most provisions of the act, although the antimanipulation 
and certain antifraud provisions are applicable and can be enforced by 
CFTC. To qualify for the exemption, the markets must be limited to 
institutional participants, and if a market should function like an 
electronic exchange, the exemption requires that the exchange limit 
transactions to participants trading for their own accounts, notify the 
commission of their activities, keep records, submit to CFTC's subpoena 
authority and information requests, and publicly report trade data when 
the products begin to serve a significant price discovery function. 

[13] The "spot month" is defined in many different ways, but generally 
refers to the nearest futures month beginning on a date near the first 
business day of the month in which the futures expires or on a date 
near the first day that delivery notices can be tendered. Some spot- 
month limits apply to both hedge and speculative positions.