Natural Gas Market Monitoring and Recent Price Increases

1. Natural Gas Market Monitoring andRecent Price Increases William F. Hederman, DirectorOffice of Market Oversight and Investigations Federal Energy Regulatory Commission Presented to:NARUC Joint PanelConsumer Affairs/Gas CommitteesWashington, DCMarch 9, 2004 WH-3/9/04

2. Outline • FERC’s Overall Strategy • Market Monitoring (OMOI) • Current Challenges • Confidence building -- February 2003 price spike investigation -- Price index/reporting initiative -- Winter 2003-04 price ramp-up • Conclusion

3. FERC has a 3-pronged strategy. Infrastructure Effective Rules Competitive Markets Just & Reasonable Outcomes Strategic Approach Rules Enforcement

4. Market Oversight:the Necessary Feedback Loop • Why a Feedback Loop is Essential - Markets not perfect - Companies are paid to find advantage - Leads to dynamic forms of efficiency – and market power - Stakes are unusually high • What a Feedback Loop Needs to Be and Do - Lead to changes in market structure and rules - Uncover and respond to abuse - Find problems in details of the market - Also find problems in inter-connections of markets • The Bottom Line: Good Walls make Good Neighbors => Good Regulators make Good Markets

5. Office of Market Oversight and Investigations (OMOI) - Knowledge/Skillsets • Planning • Perf. Mgmt. • Budgeting • Facilitation • Speaking • Knowledge of • industry • Partnering • Career Dev. • HR • Recruiting • Contracting • Writing/Editing • Web design • Graphics • Presentation • development Division of Management & Communication Director Deputy Director Market Oversight & Assessment Deputy Director Investigations & Enforcement Market Scanning Hotline • Public Speaking • ADR • Phone answering • Strategic Analysts • Library Science Division of Energy Market Oversight Division of Financial Market Assessment Division of Integrated Market Assessment Division of Information Development Division of Enforcement Division of Operational Investigations Division of Technical Investigations • Forensic Auditors • Analytic ability • Statistical sampling • Documentation • Industry experience • Investigators • Examiners • Gas Engineer • Electric Engineer • Mechanical Engineer • Quantitative Economist • Electrical Engineers • Pipeline Engineers • Economists • Deep Industry • Expertise • Information Analysis • Modeling • Operations Research • Market Design & • Operation • Financial Analysts • Accountants • Understanding of • Investment • Derivatives Markets • Energy Trading • Engineers • Economists • Broad Industry • Experience (Cross- • Industry, Scenario, • Regulatory Analysis; • Market Microstructure • Issues) • Operations Research • Writing/Presentation • Skills • Policy Analysts • Information Analysis • Energy Industry • Expertise • Software Applications • (Large databases, • Data Analysis, • Statistical, • Presentations • (including Mapping) • Web Experience • Questionnaire & Survey • Design • Statistical Analysis • Attorneys • Litigation • Investigation • Knowledge of • financial markets • Enforcement • ADR Training • Paralegal

6. Natural Gas & Electric Market Space Nat Gas & Electric Derivatives Nat Gas & Electric Clearing Trading Venues Futures (NYMEX) Electronic Platforms Physical Nat Gas Phys Electric Power Voice Brokers Bilateral Trading RTO’s & ISO’s Generation Gas Supply Players Transmission & Pumped Storage Pipelines & Storage • Price Contributors • Fixed price • buyers & sellers • Speculators Price Takers -Indexed price buyers & sellers Delivered Market Delivered Market Gas to fuel power generation Source: FERC-OMTR&OMOI

7. The natural gas market has entered a period of stress. • Production flexibility declined significantly • Demand has changed significantly - significant generation load growth - significant industrial load decrease • Fuel switching potential is less well understood than in the past but appears to be small

8. Perceptives about market conditions are sometimes confused. 2000 2001 2002 2003 2004 Prices Increase Market Manipulation Manipulation Investigations Refunds/settlements

9. FERC, through OMOI, is working hard to improve market integrity and confidence in market integrity. • February 2003 Price Spike Inquiry/Investigation (with CFTC) • Price index/reporting initiative • Winter 2003-04 Price Inquiry/Investigation (with CFTC)

10. Withdrawals of 154 Bcf and 176 Bcf for the weeks ending Feb. 3,500 21 and Feb. 28, respectively 3,000 2,500 Volume (Bcf) 2,000 1,500 1,000 500 0 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Month 1998-2002 range 2002-03 2001-02 Re-building confidence in markets: February Gas Price Spike Investigation National storage levels Source: AGA through 4/26/03; EIA from 5/3/02 through week ending 3/28/03.

11. Re-building confidence in markets: February Gas Price Spike Investigation • FERC OMOI/CFTC subpoenaed information from exchanges and brokerages • FERC OMOI/CFTC team examined more than 16,000 transactions, 130,000 bids/offers • Findings: --relatively few active buyers and sellers at the time (liquidity problem) --weather influence (cold front + sustained cold earlier + well freeze-offs) --low storage levels --tight production capacity --markets related to one another effectively --no evidence of manipulation from data, hotline, or trader interviews • Trade Press response: “the size, speed, and depth of the (FERC OMOI/CFTC team) would have made an SEC ‘tiger team’ proud.” (The Desk, July 25, 2003, page 5.)

12. Price Index Background • Sharp reduction in energy trading in 2002 • Instances of index manipulation led to FERC and CFTC scrutiny • Many companies decided not to “risk” reporting • Fewer fixed price deals, more “at index” • Price index developers had less data to create indices • Indices still essential component of markets for pricing deals; setting royalty payments; tracking prices; settling futures contracts; hedging gas transportation costs; pricing cash-outs or penalties in tariffs; and benchmarking prudent transactions • Need to restore confidence in indices—they must be accurate, reliable, and transparent

13. Essentials in the Policy Statement • Focuses on near-term improvements to existing system of voluntary reporting • Outlines standards expected of both index developers and price reporters • Embraces “safe harbor” approach to encourage more reporting • Prospectively requires indices in gas tariffs (i.e., for cash-outs) to meet standards and “reflect adequate liquidity” • Directs Staff to monitor and report developments under Policy Statement • Notes that failure of industry to respond could result in mandatory price reporting

14. Standards for Price Index Developers • Code of conduct and confidentiality • Completeness—maximum information and liquidity measures • Data verification, error correction, and monitoring • Verifiability—process audit • Accessibility—for customers and FERC

15. Standards for Reporting Prices • Code of conduct—on trading and reporting • Source of data—independent from traders • Data reported—each bilateral physical trade, with price, volume, buy/sell indicator, delivery/receipt location, date and time, term • Error resolution process • Data retention and review—3 year retention, independent audit

16. Safe Harbor • Companies that establish processes to follow reporting standards are presumed to be reporting in good faith, and will not be penalized for inadvertent errors • Presumption is rebuttable, FERC will pursue (or refer to other federal agencies) actions that manipulate, misinform, or mislead

17. Monitoring the Policy Statement • OMOI is engaging in proactive monitoring, sending message to industry that FERC is impatient to see improvement • Status report given to FERC at October 22 meeting • Survey of industry on trading and reporting before and after issuance of Policy Statement conducted in October • OMOI is meeting with trade associations to get input and encourage members to report trades • OMOI is meeting with index developers to review adherence to standards • Workshop on liquidity held at FERC in November

18. Survey • Sent to 266 companies—producers, generators, traders, LDCs, utilities, industrial users • Covers trading and reporting practices before and after Policy Statement—ten questions: Do you trade? What do you trade? Do you report? What portion of trades are reported? Are trades reported to one or to more than one index developer? Do you report through exchanges or to publications? What transaction details to you report? Who submits the report? Do you have an audit process? Do you have a code of conduct for trading and/or reporting?

19. Liquidity Issues • Index used in gas tariff must meet standards and “reflect adequate liquidity” at the relevant location • Economic literature on liquidity not helpful • OMOI must report to FERC on index publishers and liquidity January 2003 • Workshop on how to measure adequate liquidity held at FERC in November

20. Winter 2003-04 Price Inquiry • 3 Elements: - National price increases - Northeast price spike - New England generator behavior • Joint efforts - with CFTC (successful) - with Connecticut state agencies (Less successful)

22. Conclusion • Gas supply system likely to encounter additional stress unless weather cooperates • Market suspicions continue and FERC/OMOI examines any credible allegations • OMOI will continue extensive oversight of important market moves