Though it will go largely unnoticed, this October 31 is an anniversary of some significance to those who work in the energy sector, and to energy consumers generally. Twenty-five years ago, on October 31, 1985, the federal government of Brian Mulroney, together with the provinces of Alberta, British Columbia and Saskatchewan, announced the Agreement on Natural Gas Markets and Prices. The so-called "Hallowe'en Agreement" initiated the deregulation of natural gas pricing and the move toward a free market for the energy commodity.
At the time of the Agreement, natural gas supply was highly regulated and highly integrated. The price of gas in interprovincial trade was regulated by federal-provincial agreement, and included a large measure of taxes. TransCanada PipeLines bought gas from Alberta producers at the regulated price under long-term contracts, transported the gas to the east, and then sold the gas to the local utilities, also at the regulated price under long-term contracts. About 96% of the gas flowing to eastern Canadian markets flowed under these arrangements. The utilities sold the gas to end-users at costs equal to the sum of the regulated transmission and distribution costs plus the cost of gas set by the federal government.
In order to get a licence to export gas from Canada, producers had to show that they had 25 years of gas supply available to meet domestic demand (that is, their reserves had to equal 25 times their annual production).
The Hallowe'en Agreement, at least notionally, gave end-users the opportunity to deal directly with producers and marketers of gas, and strike their own deal for the price of the commodity (hence the origin of the term "direct purchase"). The Agreement provided for a one-year transition to the new market, and required that existing contracts must be honoured. But while changes began almost immediately, there were many significant hurdles to overcome before a functioning market could evolve.
For example, end-users who wanted to enter into a direct purchase arrangement needed access to pipeline capacity to get their gas from Alberta to the east. All the capacity was under contract between TransCanada and the utilities. A process had to be developed to allow the transfer of capacity to the end-users, without a negative financial impact on TransCanada or the utilities.
TransCanada had to create from scratch a gas marketing business to sell the commodity, distinct from the regulated pipeline. In the late 1970's and early 1980's, TransCanada had entered into a number of gas supply contracts with producers that required TransCanada to take all the gas the producer could supply, or if TransCanada did not take it, it had to pay for it anyway (a "take-or-pay" contract). These contracts were entered into at a time of perceived gas shortages, when TransCanada had the role of being essentially the sole buyer of Alberta gas to supply eastern Canada. However, the recession of 1981-82 and high regulated prices for natural gas in the early '80's had significantly reduced gas demand, while those same high prices had driven producers to find a lot of gas. At the advent of deregulation, TransCanada had a lot of gas it had to take, just as its assured market was about to be opened to competition. A mechanism had to be developed to deal with this "stranded asset".
The requirement for producers to have 25 years of supply inventory prior to deregulation meant that there was a significant supply overhang when the market opened. As the new market took hold, prices fell to about 40% of the price level prior to deregulation. This placed tremendous hardship on Alberta producers, reduced cash flow, and choked back drilling activity. The Alberta treasury was hard hit from reduced royalties due to lower prices, and reduced land sales due to the reduction in drilling activity. But while the Alberta government applied some regulatory manoeuvres to try to mitigate the fall in prices, they were powerless to completely stop the tide. The Hallowe'en Agreement was an agreement among several governments, and no single government could reverse it or stop the process once started.
The "gas bubble" of excess supply persisted until the early 1990's, by which time a period of slow reserves growth and rapidly growing Canadian exports - beginning with increased exports to California - helped to better balance the market. While Canadian gas production declined by about 15% from 1975 to 1985 (a period of regulated prices), from 1986 to 1996 production rose almost 60%. Over that time, various marketing entities sprang up to help fill the gap between end-users who needed gas, and the exploration and production companies in Alberta. Some marketers were capable and well-financed. Others, less so.
At the start of the market, price discovery and liquidity were poor. There were no price screens or price indexes. Direct sellers generally had to accept a discount for their commodity, since buyers didn't know them and perceived their supply to be potentially less secure. Over time, with experience, it became clear who the responsible operators were and buyer confidence in the market grew.
It took a while for the utilities to extricate themselves from the process of buying and selling gas, to get to the point where Western Gas Marketing (representing TransCanada's traditional supply) was on an equal footing with other sellers in how its gas got to the end-user.
In the 1990's, the market came of age. Price indexes came into use, there were many sellers competing, and the market was more balanced. Natural gas prices began to show some volatility in response to unexpected factors such as a colder winter. In 1990, the New York Mercantile Exchange established its futures contract in natural gas, and the commoditization of natural gas began in earnest.
The 1990's also saw a surge in pipeline expansion and extension projects. Price signals illustrated where there was surplus supply and excess demand, and when a pipeline proposed to connect these points, buyers and sellers were motivated to contract for capacity. A spin-off benefit was that the pipeline grid became more of a network, increasing reliability by diversifying away from reliance on a single basin or source of supply.
Canadian exports grew substantially, while the proven reserves to production ratio declined from 25 years toward 10 years as producers were free to use their assets more efficiently. In 2009, Canada's proven reserves to production ratio stood at 8.7.
In the 25 years since the move to natural gas deregulation began, we've seen prices fall below $1/GJ and rise above $14/GJ. It is striking that for most of the last 25 years, governments, provincial and federal, have managed to stay away from any action to manage or control the market price of natural gas, choosing to leave that to market forces. As a result, we've seen rational responses by both suppliers and buyers in response to these price signals. Buyers have availed themselves of an array of market mechanisms available to control their price risk. Suppliers have innovated to reduce finding and production costs, bringing on new sources of supply and investing in ways to get that supply to market.
At the time of the Hallowe'en Agreement, the regulated price for gas at the Alberta border was $2.79804/GJ, or about $5.60/GJ in 2010 dollars. In contrast, gas at Empress for a one-year term from November 1, 2010 can be purchased at the time of writing for about $3.32/GJ, or about 40% less than its 1985 value.
The deregulation of the gas market has been a significant energy policy success. It opened markets for producers and lowered costs for consumers. The deregulated nature of the market is now taken for granted by most but, in fact, the transition and development of the current market took time and there were dislocations and complexities to be resolved before the benefits could be enjoyed. Working through those challenges took patience, policy consistency and a long-term focus by the governments of the day.
October 31, 1985 Agreement on Natural Gas Markets and Prices Read more »
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