Supply Chain Management Review

Robert A. Rudzki

Supply Chain Components of Natural Gas Cost – IV
July 1, 2008

Today’s guest blogger is Peter Franolic, who heads the Energy practice at Greybeard Advisors LLC. Pete is the former Director of Energy Affairs for one of the largest energy users in North America, where he managed all aspects of energy, including energy procurement, risk management and hedging, conservation, and regulatory matters, before joining Greybeard. Pete can be reached at: Franolic@GreybeardAdvisors.com

This is the fourth in a multi-part series.

Pipeline Transportation (continued from the last posting)

When a contract is executed with a pipeline for the movement of gas, the costs are defined by tariff and must be adhered to during the term of the contract. Pipeline transport rates are regulated and fixed, usually within a range. Pipeline rates usually are proportional with the distance between receipt and delivery points. In the financial market, the difference between market hubs or points on the pipeline system is referred to as “basis.” Basis is variable and is not regulated. Basis is often significantly different from the contractually fixed rates in the physical market.

The pipelines offer a variety of transportation services, predominately segregated by the degree of interruption risk a transporter is willing to take.

Most natural gas that moves on the interstate pipeline system is delivered to a Local Distribution Company (LDC).

Distribution

Distribution is the final step in delivering natural gas to end users. While some large industrial, commercial, and electric generation customers receive natural gas directly from high capacity interstate and intrastate pipelines (usually contracted through natural gas marketing companies), most other users receive natural gas from a local distribution company (LDC).

Local distribution companies typically transport natural gas from delivery points along interstate and intrastate pipelines through thousands of miles of small-diameter distribution pipe. Delivery points to LDCs, especially for large municipal areas, are often termed 'citygates', and are important market centers for the pricing of natural gas. Typically, LDCs take ownership of the natural gas at the citygate, and deliver it to each individual customer's location of use. This requires an extensive network of small-diameter distribution pipe; it has been estimated that there are over one million miles of existing distribution pipe in the United States.

Because of the transportation infrastructure required to move natural gas to many diverse customers across a reasonably wide geographic area, distribution costs typically make up the majority of natural gas costs for small volume end users. While large pipelines can reduce unit costs by transmitting large volumes of natural gas, distribution companies must deliver relatively small volumes to many more different locations. In fact, according to the Energy Information Administration (EIA), for the typical small volume residential natural gas consumer, distribution costs can represent up to 47 percent of the natural gas bill. For larger industrial consumers, the percentage can be much less, but still represents a significant portion of the overall cost. In the best case, the commodity portion of the total natural gas cost represents about 65 to 70 percent of the price.

Summary

It is evident from the discussion of the natural gas supply components that natural gas cost is not just the commodity price that we have all become familiar with. There are components in the natural gas supply chain that add cost to the gas that are usually fixed and there is little that can be done to influence them. This is true of the gathering and processing costs. Other component costs such as the pipeline transport and LDC delivery costs are subject to regulatory control and can be influenced through intervention in the price setting process or through prudent selection of the level of transport or delivery service that is adequate for a particular end use.

Information about the individual component cost can be cumbersome and difficult to get.   Most of what is reported is still considered just the commodity component of the total price. If it is considered at the output of the processing plant it may represent as little as 34 percent of the total cost to a residential consumer.

Components of Residential Natural Gas Price, Source: EIA

The message is that it is necessary to pay close attention to all the parts of the supply chain and seek opportunity to control portions of the total price beyond just the commodity risk. The pipelines and LDCs offer many different services levels at a variety of pricing that can result in significant cost reduction to the end consumer who is willing to tolerate some prudent risk taking.

In future segments of our natural gas supply chain review, we will discuss ways to manage the pricing volatility as well as take advantage of cost reduction opportunities that may exist in specific situations.

Posted by Robert A. Rudzki on July 1, 2008 | Comments (0)