Presented to: NARUC Joint Panel Consumer Affairs/Gas Committees Washington, DC March 9, 2004 Natural Gas Market Monitoring and Recent Price Increases William F. Hederman, Director Office of Market Oversight and Investigations Federal Energy Regulatory Commission 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 price ramp-up Conclusion

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

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 Director Office of Market Oversight and Investigations (OMOI) - Knowledge/Skillsets Division of Management & Communication Division of Management & Communication Planning Perf. Mgmt. Budgeting Facilitation Speaking Knowledge of industry Partnering Career Dev. HR Recruiting Contracting Writing/Editing Web design Graphics Presentation development Deputy Director Market Oversight & Assessment Deputy Director Market Oversight & Assessment Deputy Director Investigations & Enforcement Deputy Director Investigations & Enforcement Hotline Division of Energy Market Oversight Division of Energy Market Oversight Division of Financial Market Assessment Division of Financial Market Assessment Division of Integrated Market Assessment Division of Integrated Market Assessment Public Speaking ADR Phone answering Attorneys Litigation Investigation Knowledge of financial markets Enforcement ADR Training Paralegal Division of Enforcement Division of Enforcement Division of Operational Investigations Division of Operational Investigations Division of Technical 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 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 Market Scanning Market Scanning Strategic Analysts Library Science Division of Information Development Division of Information Development Financial Analysts Accountants Understanding of Investment Derivatives Markets Energy Trading

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

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 Market Manipulation Prices Increase 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 Price Inquiry/Investigation (with CFTC )

Re-building confidence in markets: February Gas Price Spike Investigation ,000 1,500 2,000 2,500 3,000 3,500 AprMayJunJulAugSepOctNovDecJanFebMar Month Volume (Bcf) range Withdrawals of 154Bcfand 176 Bcffor the weeks ending Feb. 21 and Feb. 28, respectively 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 1.Code of conduct and confidentiality 2.Completeness—maximum information and liquidity measures 3.Data verification, error correction, and monitoring 4.Verifiability—process audit 5.Accessibility—for customers and FERC

15 Standards for Reporting Prices 1.Code of conduct—on trading and reporting 2.Source of data—independent from traders 3.Data reported—each bilateral physical trade, with price, volume, buy/sell indicator, delivery/receipt location, date and time, term 4.Error resolution process 5.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 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