August 24, 2004 - From the August, 2004 issue

Sempra's Rick Morrow On The Local Natural Gas Market, Beyond The Energy Crisis

How does the recent run-up on oil prices impact the market for natural gas? What is the future of liquefied natural gas in Southern California? MIR is pleased to present this interview with Rick Morrow, Vice President of Customer Service-Major Markets for the Southern California Gas Company, in which he elaborates on the evolving natural gas market in the Southern California region.

Rick Morrow

Rick, to meet our region's need for gas, discussions abound re what additional pipelines might be needed to help California out with its energy needs. Can you update our readers on the prospects for a Phoenix-El Paso line? What capacity alternatives should be on the infrastructure agenda of this region's civic and political leadership?

Let me step back and address the broader gas supply picture for California and the region. Right now, we have a number of pipelines that have been in service to California, including El Paso's infrastructure, for 40 years or more. This service is based on long-term contracts with suppliers. As the markets have evolved over the years, demand has gone up especially in the areas east of California. At the same time, North American natural gas production from traditional supply basins is declining. So we need to diversify our supplies from the traditional supply areas, and ensure that California has access to alternative sources of natural gas supplies, which would be a great benefit to our California consumers.

Today, a number of companies, including El Paso, are proposing expansions. Couple this with the fact that there are at least five liquefied natural gas (LNG) projects that are on the drawing board creates the potential for a highly diverse supply mix. We believe that these new supplies will help to lower the gas prices dramatically, protect California against potential future supply shortages, and would be a real benefit for California. When we last spoke three years ago, gas prices were about $2.50 per million BTU. Today, the price is between $5 to $6 at the California border and holding fairly level. Absent new supplies coming into California, the price is unlikely to significantly decrease.

Elaborate on your remarks. In the summer of 2000 and winter of 2001, gas prices spiked quite high. What happened and have any lessons been learned?

During that period, gas prices were driven higher by an unprecedented combination of extreme circumstances. A 1-in-75 year drought cut to a trickle the Pacific Northwest hydro energy imports California historically relied upon, and created tremendous additional demand from in-state gas-fired generators. Warm weather created a lot of air-conditioning load in the summer, and some nuclear power plants were down, most notably San Onofre, also increasing demand for gas-fired generation.

Reductions in interstate capacity resulting from a rupture of the El Paso pipeline at Carlsbad, New Mexico in August of 2000, and a series of maintenance outages on El Paso and other pipelines serving California, combined with chronic scheduling cuts on the El Paso system, further limited supplies reaching California and put upward pressure on gas prices. Unusually cold weather substantially increased core demand during the winter, The decision by noncore holders of firm gas storage capacity to withdraw gas from storage and not refill it before the winter in response to market signals also had a significant impact on gas prices. The situation with high natural gas prices was not limited to California. Nationally, natural gas prices were elevated due to high demands.

During the 2000-2001 time period, the Gas Company did a very good job buying gas for our core customers. We stored sufficient gas to meet the needs of the core market and we effectively used the interstate capacity we had under contract to transport the gas purchased in producing basins to our system in California.

This high demand required the most gas deliveries in the history of this company. Although our system was very heavily utilized, and our deliveries were at record highs, we didn't curtail any customers. As a result of the heavy demand, we quickly began construction on four projects that added 375 million cubic feet per day (MMcf/d) of additional receipt point capacity by May of 2002.

So what lessons have we learned?

There are a few lessons, but it is also important to note that the current and forecast natural gas price increases result from an entirely different set of factors-specifically the North American production decline from traditional supply basins. As we move forward in this environment, having adequate infrastructure in place will be critical. We believe the transmission system have about 15-20% of slack capacity to meet customer needs over a wide variety of market conditions and to ensure diversity of supply sources that are available to California.

We cannot get complacent and assume that one year is going to be exactly the same as the next. The CPUC previously decided that noncore customers should be responsible for their own fuel supply decisions. The year prior to 2000 was very mild year. Many customers stored gas in 1999 and ended up not needing it. In 2000-2001, the year of very high demand, the non-core storage levels were very low. Although there was ample gas in storage to meet the needs of core customers, there was no reserve base on the system to serve the heavy demands that were being experienced by non-core customers. The 2000-2001 period was just totally anomalous in that the demand and the supply went in opposite directions. We muscled through it, but unfortunately our customers were faced with extremely high natural gas prices.

You/we may have muscled through the energy crisis, but prices spiked six times before leveling off at about double what they were three years ago.

After the crisis, natural gas prices declined, people started looking at the natural gas market a little bit closer. They found that, from a supply side perspective, 2000-01 was a precursor of what was to come. In general, the supplies from traditional suppliers are getting tighter. More and more forecasters are now predicting that traditional supply basins are running thin and new discoveries are not keeping pace with production. If you look at the long-term trends, the amount of new discoveries from our traditional supply areas has not been keeping pace with demand. Although there is still a reserve base, those that are looking at the long term are saying we need to supplement or diversify away from traditional supply sources. We need to look into some of the more promising frontiers, such as expanding access into the Rocky Mountains, getting more gas from the world markets, and encouraging the development of LNG-type projects to tap the world's gas supply market. Including these sources in the supply mix will help to dampen the otherwise increasing price of natural gas.

How does the LNG project proposal for Long Beach and other like regional locations play into your company's planning for energy reliability and the possibilities of alternative sources of energy supply for Southern California?


There are a number of LNG projects pending. Sound Energy Solutions, a subsidiary of Mitsubishi, is proposing an LNG project in Long Beach. There are two projects being proposed in the Oxnard/Ventura area, and two more proposals to build LNG terminals in Mexico. At this point, we don't know which project(s) are going to be built. But these are not projects in which the utility has a financial interest. We certainly welcome the new supplies, but we are not actively involved in any specific project nor do we endorse one project over the other. In order to protect our customers against the potential impacts of the looming North American production decline, we have proposed that we add receipt point capacity on our transmission system by up to a billion cubic feet or more to accept those new supplies. By today's standards, that's about one-third of our daily demand. Based on our consultants' forecasts on the potential for these new LNG projects, if we invest about $200 million in infrastructure, the annual benefit to our customers in lower delivered costs could range between $200 million and $1 billion a year. So, we want new supplies and supply diversity is important.

Gov. Schwarzenegger's Energy Department has an Energy Action Plan under consideration? Is their work promising re development of new capacity and supplies for the state?

So Cal Gas has taken a leadership position in the CPUC's Gas Market rulemaking proceeding to identify new supply options, such as LNG, and to improve the existing natural gas transportation framework. The Public Utilities Commission is currently evaluating these proposals. Hopefully, in the next month or so the Commission will issue decisions in the proceeding. When these decisions are made we will have a clearer picture about the policy framework. The Energy Action Plan unveiled earlier in the year covers a lot of important topics including energy efficiency, development of renewable energy sources and ensuring that there is a reliable supply of reasonably priced natural gas. The plan is definitely on the right track.

MIR did an interview with you in 2001. We were obviously in the midst of a market frenzy post energy deregulation. Your concern then was that we didn't need any more laws, but what we needed was more sanity in the market. There is a bill, AB 2006, now moving through the Legislature to again deal with retooling energy deregulation. What should our readers be paying attention to re this bill? What lessons from experience should be applied?

During the electricity crisis, a lot of the problem was due to not having sufficient electric generation and transmission in place coupled with a flawed market design. In recent years, a lot of work that has gone into developing additional generation capacity in the state of California, but much is left to be done, and investments are not being made as they should due to regulatory and market uncertainty. Having adequate infrastructure in place is absolutely critical. In the electric industry, a general consensus is developing to the effect that a properly designed "resource adequacy mechanism" is necessary to stimulate the generation capacity construction that will be needed to meet California's reliability needs. Unfortunately the mechanism that is being proposed in AB2006 would not cover all of the state's needs and would not solve the problem that existed during the energy crisis. This is not encouraging.

MIR's June issue, included an interview with So. Cal. Edison's Bob Foster. In that interview, Mr. Foster offered, "The premise on which every deregulated market is based is that you will be able to produce adequate supplies in electricity-we would call it reliability-through markets. That premise was sorely tested during California's energy crisis and we haven't fully learned that lesson." Is this the lesson what you make reference to?

In the electricity market, California made a huge mistake in relying only on short-term markets-price signals demonstrating the need to construct additional capacity have to be recognized at least three years before the actual need for capacity so the needed generation can be built. A properly designed resource adequacy mechanism would accomplish this. On the gas side, we are currently seeing the market respond to higher prices-LNG proposals are being made across the country and rig counts are up. Markets do respond to price signals. During the 2000-2001 time period, SoCalGas also responded quickly by building additional gas transmission capacity. As we look to the LNG supplies coming in at some point in time, we think it's very appropriate to have additional gas transmission capacity available to give customers the ability to obtain those supplies. Having a policy and a framework in place now that will set the construction policy for building that infrastructure is very critical.

And is the implementation of such a policy framework likely?

I think the CPUC is trying to get there, but the regulatory decision must address the issue of who pays. The question frequently raised when you want to do a construction project like this is, "who is going to pay?" Rate advocates will argue that customers of the utilities should not have to pay for these kind of expansions because either they don't feel they are needed now or they argue others should pay for the project components. Various customer classes will argue that a separate customer class benefits so they ought to pay. We get stuck in these debates about which customers ought to pay, and as we have those debates, valuable time passes. The last thing I want to do is continue this debate if another crisis is looming. You want to be prepared with the infrastructure and framework in place and not arguing who should fund it. If the benefits of an investment exceed the costs we believe the costs should be rolled into rates because of the customers benefits.

What are the consequences for California, direct and indirect, of a barrel of oil being in the $39-40+ range?

When you have oil prices that high, it has a tendency to pull up natural gas prices because some customers have the ability to switch to different types of fuel stocks based on economics, and these prices can affect natural gas demand. So what does it mean for California industry and growth? Higher energy prices in general slow down growth in California. If a customer is looking at building a facility in California versus other countries, they will look at energy costs and figure out what makes the most sense for their business. But I really want to emphasize that when it comes to high natural gas prices, California is not alone in that natural gas market. Nationally, natural gas prices are generally higher than they were back prior to 2000 when prices were about $2.50 per million British thermal units (MMbtu). The reason is simply that supplies are more scarce than they once were. People can't necessarily get a better deal on their natural gas prices by moving to Arizona. However, they will get a better deal on electricity prices because we are still dealing with the fallout from the energy crisis. Electricity and natural gas costs are key factors for companies that are looking at expansion, particularly manufacturing companies that are energy intensive. While it is currently "at the end of the pipe," California is not necessarily at a disadvantage when it comes to natural gas, if we are able to attract alternative sources of supply that could actually move California to the beginning of the pipe.

Rick, one last question. If you were governor of California, or mayor of a city like Los Angeles with its own utility, why wouldn't you prioritize moving away from a reliance on oil and natural gas and onto more reliable alternative energy sources?

The Governor is doing a good job in focusing a big part of his agenda on renewable resources. It's important for us to focus on renewable opportunities, global energy opportunities and energy conservation. We need to look at all of the options we have on that side within economic reason. But at the same time, you have to look at how you are going to supplement renewable resources with traditional sources to meet the growing energy demands of this region, state and country since renewable projects generally have long lead times. It is a high priority of the Governor's, and something that will be seeing some increasing focus on in the next two years. Those undertaking critical new supply projects need to decide whether they are going to construct new facilities in California, and the framework needs to be in place so that they can make their business decisions wisely. Also, we continue to encourage that energy efficiency be given a high priority and that customers use natural gas wisely.


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