[why has the Fed suddenly cut rates? One possible answer is because current
atronomically-high natural gas prices have created a huge shift of disposable income
from the US big seaboard cities, to the natgas producing areas. This unexpected
delfationary force may be the straw that is finally snappiong the spine of the New
Economy. Mark]
Now Is the Winter of Our Discontent - 4
Pete warned you last May that it was going to be bad (that is, that the energy
delivery system couldn't handle a normal weather winter if too much gas was used to
generate electricity in the summer), but he didn't realize how bad the situation
might become, even after a record hot summer mid-continent. He only warned of $7
natural gas, back when it was in the $2's, but gas seems to have hit $10 last week
while Pete was away. He warned you that deregulation in California wasn't working
out because of structural flaws, but he didn't foresee that December blackouts and
the bankruptcy of two of the largest utilities in the country were possibilities.
So it has become worse than he thought. The question is how much worse will it get?
The first part of the answer is financial. President-elect Bush will take over
right in the middle of a truly large* redistribution of wealth. Money will quite
literally be pouring out of the cities of the east coast, mid-west and west coasts
and pouring into Texas, Louisiana and the other gas producing regions. This is what
elections are all about, you may suppose. But you'd be wrong. No matter how much
oil interests may have supported his election, the new president will be facing
awesome deflationary forces, and he'll certainly wish to avoid the possible economic
consequences of sharp declines in consumer demand. Consumer demand will be
adversely affected, but the real threat is to the rest of the industrial sector for
reasons to be explained in a minute. The Fed, slow to recognize the magnitude of
what has taken place, has yet to ease up on interest rates, but it will have to do
so soon.
Selling natural gas for prices above $9/mmBtu is not unprecedented, but past
precedents have little relevance. The incremental cost of gas might have exceeded
$9 very briefly in the early 1980's, but that was only for a very tiny fraction --
less than 5% -- of the total volume of gas being sold. Most of the gas was locked
up in long-term contracts subject to obscure but very potent "market out" clauses,
which basically said that the buyers could pull the plug if they couldn't sell the
gas. They did pull the plug, and it took the domestic gas production industry a
decade to recover, it having turned out that a contract is not always a contract and
that otherwise legal prices may constitute fraud and abuse in retrospect.
But the year 2000 problem is that almost the entire winter's gas requirement is
moving at these extremely high prices. There are few long-term contracts these
days, and there are no price controls except, curiously, where electricity has been
deregulated. We've learned in California that the "market" price for incremental
supply can go to $60 mmBtu under the LaLaLand rules where consumers are temporarily
protected by price controls but their utilities are not. So everyone plays games
for a few months until the price controls are scrapped and consumers are made to pay
for the sins of the regulators. Once again, it will be FERC out of Washington, DC
that imposes this, and Bush will take the blame even though he won't deserve it.
The reason why the rest of the industrial sector is at risk, at least until the
spring, is that natural gas service to satisfy residential and small commercial load
is not a luxury but a necessity. Prices can go to $80 and consumers will still need
to heat their homes. True, they can use less gas, but not that much less. The
driving force is the severity of the winter, not price sensitivity. To indulge for
a moment in thinking the unthinkable, what happens if the local distributor can't
satisfy residential load? The answer is that, unlike losses of either electric or
heating oil load, you can't just fix the problem and throw the switch (or start
making more heating oil deliveries), you have to send a qualified technician to each
house and turn on the gas on properly. If homeowners try to do it and do it wrong,
air bleeds back into the supply lines and explosions may occur. So each time a
local distributor goes down (and that's only happened once or twice in 50 years), an
army of technicians from every gas utility for 200 miles is needed to reestablish
service. In the meanwhile, if it's cold, you suffer the consequences of having the
urban/suburban population without heat. For these reasons, when supplies become low
enough, you have to cut off all non-essential uses, which means industrial uses.
This used to happen regularly in the late 1970's when interstate gas supplies were
low. There were voluminous FERC regulations explaining how it was done. Industrial
customers had alternative sources of supply, usually No. 2 (i.e. heating/diesel oil)
or No. 6 (residual) fuel oil, and just switched to that.
So, if this winter doesn't start getting a lot warmer soon, the new president may
well have to consider reimposing some form of controls to protect residential and
commercial customers. This is probably not what he thought he was coming to
Washington to do. But he may have to get going on it pretty soon, or take a really
huge gamble with the heath and safety of literally tens of millions of people. And,
either way, he'll discover that there's not exactly a lot of No. 2 oil available for
industry right now. This means that the industrial sector may face operating
disruptions later this winter, no matter what happens to monetary or fiscal policy.
*On the order of $350 per household for 56 million residential gas users. This, of
course, does not cover the transfer caused by oil price increases.
http://qv3.com/PolicyPete/policypete.htm
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