Today’s Friday Focus highlights the role of Local Distribution Companies (LDCs) in the domestic natural gas market. There are over 2,000 natural gas distribution companies that serve approximately 90 percent of the daily natural gas needs of residential and commercial customers in the United States. These LDCs maintain and manage over 2 million miles of pipe that ensure homes and business are able to receive fuel for heating requirements, and to a much lesser extent the requirements of industrial and commercial consumers located inside of LDC territories. In addition, LDCs comprise approximately 30% of U.S. natural gas storage capacity.
Functionally, these physical assets provide for reliable and safe access to affordable natural gas supply to residential and commercial consumers. LDC storage capacity coupled with a liquid forward natural gas curve (NYMEX) theoretically prevents excessively volatile supply costs.
With reliability and safety being paramount, Local Distribution Companies provide two primary functions that are critical for the consumption of a hydrocarbon with explosive attributes:
Safety – Local distribution companies must maintain high safety standards to ensure system reliability, and to prevent deadly or destructive accidents. Safety measures include: leak detection, pressure management, safety education programs, on call technicians, emergency preparedness, and user focused call centers.
Natural gas hookups for new customers – The process of installing pipes, meters, and safety equipment between LDC mainlines and distribution lines, also called the ‘last mile’
Beyond the above noted primary functions, LDCSs provide a number of other functional and regulatory structures which serve to facilitate the consumption of natural gas by consumer. However, before taking a deeper dive we thought it relevant, particularly for those less conversant in natural gas terminology, to first broadly define the 4 primary components/participants involved in the process of providing natural gas service to residential and commercial consumers in the U.S.:
Producers – Focused of the extraction and processing of natural gas
Interstate/Intrastate Pipelines – Responsible for the transportation of refined natural gas from producing fields, and non-LDC storage, to Local Distribution Companies
Local Distribution Companies – Responsible for the reliable delivery of natural gas from interstate/intrastate pipelines to end users
Gas Suppliers – Entities dedicated to selling natural gas to consumers through the coordination of all pieces of the delivery system
Before moving on to the current environment, and how LDCs presently function as a critical component of the U.S. natural gas market, we will first provide a very brief explanation of how a consumer’s access to natural gas supply through LDCs has evolved. As regulated utilities, LDCs are tasked with the reliable delivery of natural gas to consumers within a specific geographic area. Prior to the 1990’s, LDCs offered only ‘bundled’ services for customers that combined the acquisition cost of natural gas molecules, transportation services, and last mile distribution, into one price. Over the past two decades there has been an increasing trend of ‘unbundling’, whereas consumers are able to choose a supplier of choice in numerous markets throughout the U.S. The advent of partial de-regulation has provided more market-based pricing options directly to the consumer, versus a reliance on quasi-governmental bodies annually setting prices.
Allowing consumers the choice to directly transact with 3rd party suppliers of natural gas at the residential and commercial level has not diminished the importance of LDCs in terms of reliable delivery of natural gas supply. The term ‘choice program’ is often used to describe the process by which a state approved (PUC or Public Utility Commission) supplier can be engaged by a consumer to set the price at which a full-requirements natural gas supply service can be negotiated between one of these 3rd parties and a consumer. The LDCs role in such de-regulated natural gas markets becomes centered on the reliability component.
In order to ensure reliable delivery, an LDC will require of the aforementioned 3rd party providers several assurances, and it will also set defined guidelines which must be followed (including costly penalties for violating the guidelines). Included in these assurances and guidelines are parameters for gas quality, guaranteed access to enough supply to meet peak demand needs, and strict thresholds for the management of on-system storage. This final component, storage management, is an area of particular importance to the broader U.S. natural gas market.
In theory, all natural gas storage would be constantly managed on an economic basis, whereas it would be injected when near term prices are ‘low’, and withdrawn when prices are ‘high’. However, there are differing attributes of various storage fields which dictate the ability to inject or withdraw on a moments notice, and many other factors which contribute to the decision making process of storage management. In the sphere of LDC storage one of the most notable factors is defined storage ratchets. These are minimum and maximum storage levels which must be maintained by all parties responsible for delivery of natural gas to consumers and typically set on month end intervals.
As a result of these ratchets, the LDC themselves or 3rd party participants must either inject or withdraw at certain levels throughout the year in order to maintain both reliable access to supply, and storage system integrity. We are admittedly omitting a great deal of information on the nuances of system integrity, and the varied process of calculating peak demand needs. Turning back to storage ratchets, there are a few important effects to note. First, there is the effect of excess on-system storage when flowing supply is greater than market demand. This can occur as a result of excess natural gas production, or more often when weather patterns materially reduce on-system demand. Alternatively, there is the effect of insufficient on-system storage + flowing supply. This obviously occurs when the prior noted factors are inverted, specifically when weather driven demand + production levels collectively create an imbalance between gas needs and availability.
Now, tying all of the above to the present environment there are some interesting dynamics at play which may temporarily obscure underlying market conditions over the next several months. With the winter withdrawal season having seen minimal weather driven demand, and U.S. production having virtually flat-lined, the amount of natural gas still held in LDC storage is somewhat elevated. As storage ratchets require the draw down of LDC storage over the next couple of months there could be a pricing headwind in day-ahead or even month-ahead markets. These should not be construed as an indicator of fair value for MMBtus for the remained of 2021, much less beyond. Additionally, colder weather is expected in the first half of February. The location, duration, and intensity of the cold has the capability of both impacting demand (heating needs) and supply (freeze-off). Although LDC storage levels have not been materially eroded so far this winter, persistent late winter cold can quickly lead to jarring upside price risk if LDC storage is tapped to fill a flowing supply shortfall.
While the primary function of LDCs is reliability and safety, they are always a key component of market pricing dynamics particularly from late winter through the first two months of injection season.
Zane has been with Mobius Risk Group since February of 2016. His primary responsibility is a fundamental analysis of the North American natural gas market. Additionally, he assists in the valuation of gathering, processing, transportation, and physical sales agreements. His experience in energy has been focused on natural gas, however, as the North American hydrocarbon value chain has become a more integrated system his knowledge has expanded to crude oil, petroleum products, and seaborne LNG. Prior to joining Mobius, Zane spent 6.5 years with a Houston based hedge fund (Goldfinch Capital) with AUM of approximately $750M. In his time with Goldfinch Capital, Zane was tasked with developing detailed models of the North American natural gas market, including 1st derivative components such as power generation by fuel source, supply side impacts of liquids focused drilling, etc. Zane is a graduate of Rice University, and a former member of his alma mater’s baseball program as both a player and coach.