How Federal Policies, Industry Shifts Created A Natural Gas Crunch
Link to article
The price of natural gas has increased by as much as fifty percent (50%) recently. This
high price is expected to persist. The causes of the price increase are threefold.
Government policy toward energy providers, the market’s reaction to those policies, and
a very cold winter that was preceded by three warm winters all play a role in causing the
price increase.
The first reason for this price increase is that the Federal Government has been promoting
the consumption of natural gas without promoting an increase in production. Natural gas
is cleaner burning than coal or oil, and safer than nuclear power. Thus, the government
has been developing policies that promote natural gas over these other sources. For
example, in 1993, the Environmental Protection Agency launched broad regulatory
assaults on electric generating plants that used coal. The Department of Energy denied
financial incentives to electric companies that wanted to build nuclear power plants. The
result of these policies is that electric companies made plans to switch to natural gas
burning facilities. Also in 1992, the government disallowed pipelines from buying and
selling natural gas; pipelines were to act solely as a provider of transportation. This move
brought buyers into direct contact with producers. The result was more competition and
lower prices. The lower prices squeezed producers’ profit margins resulting in firms
deciding to shut down, consolidate, or operate at a loss. Such decisions meant that further
exploration was curtailed. Even if natural gas drilling companies wished to increase
exploration, some of the most promising gas fields are closed to drilling for
environmental reasons. Natural gas is abundant in Alaska, but a pipeline to transport the
gas to the mainland would take ten years to build.
In addition to these policies and the market’s reaction, we now face the coldest winter in
four years. As a result of all these factors, the United States must import natural gas from
Canada to make up for the domestic shortage.
The story illustrates many of the topics we will cover this semester. First, we can use the
tools of supply and demand curves to illustrate what has been happening in the natural
gas market. Second, the reaction lags of in the market illustrate the difference between
short-run responses and long-run responses. Third, it was noted in the article that many
drilling companies found it more profitable to operate at a loss rather than shut down.
Finally, the story hints at the general equilibrium impacts of the increase in the price of
gas.
The supply and demand analysis can be seen in Figure 1. P0 is the price that persisted
prior to 1992. The effect of government policy was to cause the demand curve to shift
from D0 to D1. Price increased to P1. Price would have increased to P2 were it not for
imports from Canada. The quantity imported is shown as the difference Q1T minus Q1D.
Regarding reaction lags, in the short run, the number of wells in operation is fixed. Only
in the long run can drilling companies increase the number of wells. Prices will fall when
the supply curve shifts rightward. This will occur in the long run, if at all, but cannot
occur in the short run.
Third, the shut down decision is one that many students find confusing, In the short run,
firms have fixed expenses that must be paid no matter what. If operating would mean a
loss, many people argue that the firm should shut down. This is not the case if the loss
from operating is smaller than the loss that would exist if the firm shut down. In other
words, the firm should forget about fixed costs because these costs must be paid no
matter what. The question about operating then should be: “Does revenue exceed variable
costs?” If so, then operate, even if it means a loss after fixed costs have been included.
Finally, the higher gas prices have impacted other industries that use the fuel. Imperial
Sugar Corporation needed to convert to burning oil instead of natural gas when a bumper
crop of sugar beets forced them to buy natural gas at a price that was twenty times higher
than what they were paying. Kaiser Aluminum laid off 550 workers when it realized that
it could earn a higher profit reselling its energy supplies than by making aluminum.
Figure 1
S
P2
P1
P0
D0 D1
Q0 Q1D Q1T