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The Natural Gas Industry Grows Up – a History Lesson and Some Observations

The Natural Gas Industry Grows Up – a History Lesson and Some Observations



For more information, please visit http://www.navigant.com/insights/hot-topics/natural-gas/.

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The Natural Gas Industry Grows Up – a History Lesson and Some Observations The Natural Gas Industry Grows Up – a History Lesson and Some Observations Document Transcript

  • Lessons from the Natural Gas MarketThe Natural Gas Industry Grows Up – a History Lessonand Some ObservationsThe year 2013 will mark two important anniversaries for the U.S. wholesale naturalgas industry – first, the seventy- fifth anniversary of the Natural Gas Act (NGA) andsecond the twentieth anniversary of Order 636 implementation.First, the NGA, the basic statute underlying the regulation of interstate transportationand services, turns seventy-five years old. Now it can get on a plane without takingoff its shoes. One way this makes me feel old is that I remember writing a columnwishing the NGA a happy fiftieth birthday. The fundamentals of the NGA havechanged very little since Franklin Delano Roosevelt included it in his New Dealpackage of transformational laws, so the question of its relevance and effectiveness isappropriate after so many years.Second, and just as important to the history of the natural gas industry, is Order636, which really established the fundamental structure of the interstate pipelineindustry. Order 636, took effect in the winter of 1993 and transformed the industryinto the thriving, competitive market seen today. It was twenty years ago that wewere working out the final details as to how each pipeline could actually operate onan unbundled basis, despite the widespread skepticism as to whether the industrywould ever be reliable or efficient as it had become with bundled merchant service.So this is not a bad time to examine how the industry does work, what role theregulators play in a world that has become primarily market-driven but where manyparties still either have to pay attention to, or seek the protection of, regulators.As noted, the fundamental structure of NGA regulation hasn’t really changed a lotin its 75 years of life. The sale for resale and the transportation of natural gas ininterstate commerce are both subject to the jurisdiction of an agency that startedout as the Federal Power Commission, and then in 1977 became the Federal EnergyRegulatory Commission (FERC). The biggest shifts in jurisdiction and in the way theCommission regulates have involved the sale for resale, “merchant” service. First,back in 1954, the Supreme Court decided that even though the NGA stated that theproduction of gas was exempt from jurisdiction, the NGA still applied to the pricingof that production – thus beginning a 36-year odyssey of market mess.A publication by Navigant’s Energy Practice » May 2013Contents1 Lessons from theNatural Gas Market– The Natural Gas IndustryGrows Up – a History Lesson andSome Observations5 Natural Gas Market Charts8 Legislative and Regulatory Highlights10 About Navigant
  • 2May 2013First, the regulated prices caused severe shortages(i.e., curtailment), and then congressional attempts tofix the shortage problems ended up causing several otherunintended consequences (i.e., the very complex pricingunder the Natural Gas Policy Act of 1978, take-or-pay,and the “gas bubble”). It wasn’t until 1990 that ultimatesolution was reached — statutory decontrol ofwellhead prices.At the same time, throughout that journey pipelinesmost of the natural gas supply in interstate commerce.Pipeline rates for both transportation and sales wereregulated based on accounting costs through the long-established FERC ratemaking procedures, which are stillapplied today to everything except merchant service.What happened to merchant service? That’s whereOrder 636 came in, issued in 1992 and taking effect in1993. Today the FERC still has jurisdiction over anyonebuying natural gas and then reselling it in interstatecommerce, but in Order 636 the Commission decided thatthose sales could be competitive enough not to be price-regulated, if the pipelines that controlled the deliveryfacilities were not involved as commodity sellers. Thus,with the establishment of Order 636, pipeline serviceswere “unbundled,” splitting the merchant service outof the rest of the services, and making the pipelineact as a shipper on itself if it wanted to buy and sellgas. It became pretty apparent, fairly early on, that thebest answer was for pipelines simply to get out of themerchant business—especially since FERC provided abunch of incentives to help pay off all the dysfunctionalcontracts pipelines were stuck in, as a result of thecontracting frenzy after the passage of the Natural GasPolicy Act.Pipelines also got a couple of other things out of Order636 rates were redesigned to recover all the fixedtransportation and storage costs in fixed reservationcharges, rather than being at risk for throughput. Inaddition, pipelines were relieved of a then-existing FERCrequirement that they re-file their rates every three years.However, in return for this newfound rate stability, firmshippers would now be able to resell their capacity,as capacity release, rather than the pipeline holding amonopoly on firm and interruptible transportation overits route—the pipeline’s shippers became its competitorsas well.So pipelines became pure transporters and storageproviders, the structure that we have today. The fact thatthis structure has stayed in place and thrived, and that avery healthy market has thrived for two full decades, is areal tribute to the FERC’s and Congress’s finally getting itright, and to the industry’s ability to adapt and innovate.Why is it worth going through this history lesson abouthow the industry has gotten to this point? Primarilyit’s because there are now very many people workingin the industry who have never known a differentstructure—it’s been in place for their whole careers. Asvarious parties try to address issues such as gas-electriccoordination, expansion to accommodate shale gasabundance, etc., it is important to be very familiar withwhich approaches didn’t work so well in the past. Also,an understanding of the evolution to an unbundledpipeline network and its interaction with liquidcommodity markets is critical in making supply decisionsaround large new consuming facilities. This applieswhether it’s for LNG exports, for gas-to-liquids, or forindustrial use, the importance of the pipeline deliverystructure is the same.The durability of the NGA regulatory structure is reallyborne out by the experience before, during, and afterthe implementation of Order 636. A pipeline rate casetoday looks very much like a pipeline rate case in 1990,except that the number and complexity of transactionsare orders of magnitude higher. A pipeline that typicallymight have had a few hundred monthly contracttransactions with well-known sales customers willnow have thousands of daily transactions with a hugepopulation of competitive shippers. There are someother complexities that have been added to the issuesthat need to be addressed. First, many new services havebeen added by pipelines (this is because one outgrowthof Order 636 was a very expedited ability to implementnew services). Second, many pipelines now have a largenumber of contracts that use “negotiated rates” (i.e.,rates that upon mutual agreement between the pipeline
  • 3May 2013and the shipper may vary from the cost-based tariffrates). However, the rate-case process still involves atraditional accounting-based cost of service, allocatedamong services, and turned into cost-based rates foreach service. Even when non-traditional rates such asthose based on market are evaluated, the starting pointalways seems to be traditional cost-based rates—that is,if a rate exceeds the cost-based rate, everyone assumesthat competitive forces were inadequate. Thus, NGAratemaking is now sometimes the starting point of aninquiry, rather than the end—but it’s still important, stillthe backbone of FERC pipeline pricing.One important evolution is that lately the bulk ofNGA regulatory work centers around other aspectsof regulation, tariff terms and conditions, facilityauthorization, and enforcement areas. It is in theenforcement areas where NGA authority has seen themost profound change, with the additions under theEnergy Policy Act of 2005 to massively increase FERC’spenalty authority, and to task the Commission withpolicing market manipulation. As a result, enforcementactions have become a major part of FERC practice. Butit’s all within the construct of NGA regulation, under thestructure set up 20 years ago in Order 636.The market that has evolved is often unfamiliar andconfusing to businesses from other countries. Themore common choices worldwide are either soup-to-nuts turnkey arrangements under a sovereign energycompany (e.g., the Middle Eastern model) or extremelyopaque offerings, with commodity gas and transportationindistinguishable in their terms, market power, or pricing(e.g., Europe and Russia). The U.S. model, with its brightline between the gas commodity and its transportation,with heavy regulation of the transportation but virtuallyno regulation of the commodity, is difficult to get usedto at first. However, once one is used to it, the successfulmodel for an entity seeking long-term gas supply isclear: Get the right pipeline contract configuration inplace and the market can be relied upon to supply plentyof competitively priced natural gas. Of course, this ishelped along by the rapidly expanding abundance inthe U.S., combined with plenty of competitive sellers.Before shale-driven abundance was realized in the U.S.,it was also in the customer’s interest to tie up long-term gas supplies as protection from overall marketfluctuations. However, with the reality and expectationsof shale abundance, wellhead prices are tending to staywithin a modest range. Meanwhile, for customersworried about the ability of a few sellers to run upprices, restructuring under Order 636 has provided ahigh degree of protection, if the customer has the rightpipeline access. International companies participatingin LNG exports, developers of gas-to-liquids proposals,and international industrial concerns taking advantageof low-cost, abundant natural gas are all navigating thisunfamiliar structure. Then, just when they have it down,they encounter the Texas intrastate market, where thebest deals are often fully bundled gas-and-transportationfrom an intrastate pipeline. It is not a simple world, butit works very well these days.The one piece of the post-Order 636 model that isbecoming very problematic is the intrinsic valuation ofpipeline transportation according to market price basisdifferentials. A robust, competitive commodity marketwith a transparent, regulated transportation networkconnecting its points, naturally moved to differences inlocational value driven by capacity constraints or the lackthereof, and these differences in locational value begandetermining whether pipelines were worth building.Similarly, the industry’s extensive natural gas storagecapacity evolved to valuation based on the differencein commodity value between two points in time. Thesemodels worked well from 1993 until now, other thanthe period around 2000-2001 when some entities wereapparently able to make up the locational prices, andthus create distorted views of pipeline value (hence theFERC’s new authority over market manipulation).However, today the shale boom has caused somecollateral damage to the pipeline and storage industries’basic economic model. Since the shale gas suppliesdriving the newfound abundance are located much closerto market, basis differentials have flattened to well below
  • 4May 2013pipeline tariff rates in many cases,as shown in Figure 1. Similarly, asubstantial drop in price volatility—aterrific development for the growth oflarge, economically sensitive load—has caused storage investment to bea very hard to support, as shown inFigure 2. It has become increasinglyclear in the debate around gettingnew pipe built to bring shale gas tomarket or to serve rapidly increasinggas-fired power generation, or inthe evaluation of new storage tohandle the swings in load causedby fluctuations in power generationdemand, that the locational andchronological price-difference modelis having some trouble supportingnew investment. This is especiallytrue when the potential investors (i.e.,the pipeline companies) are watchingtheir existing investment be seriouslyundermined by market evolutioncaused by the reconfiguration ofsupply. But we need the networkand we need for it to expand. Sothere is an evolving body of thoughtaround the idea that different pricingmodels are needed, to support overallnetwork integrity, to make pipelinetransportation and storage less of acommodity business.Many pipeline firm customers,especially long-term gas distributioncustomers, recognize this withouteven articulating it. They buy pipelinecapacity to support reliability and anoverall portfolio of annual deliveryand diversity of supply. But thedecisions they make in favor of holdingpipeline capacity are undermined by atransparent market that indicates thecapacity is worth more than they arepaying for it. It would be nice if overallindustry pricing models vindicatedsuch pro-network decisions, althoughfiguring out what such models mightbe is a challenge.Nonetheless, the natural gas industryin the U.S. today, is a remarkablemodel of a healthy, vibrant andgrowing business. It is generallyregulated in the right places andunregulated in the right places,with the regulated and unregulatedsegments interacting very efficiently.A lot of the credit for this has togo to a pretty smart (and short)statute, the NGA, and a pretty smartCommission whose earlier colleaguescreated a restructured industry thatworks. So it is appropriate to wish ahappy birthday to both the NGA andOrder 636.— Rick SmeadThe opinions expressed in this article are those of theauthors and do not necessarily represent the views ofNavigant Consulting, Inc.FIGURE 1: DOMINION, SOUTH POINT AVERAGE ANNUAL BASIS TO HENRY HUBFIGURE 2: AVERAGE ANNUAL VOLATILITYAbout theAuthor » Rick Smead is a Director inNavigant’s Energy Practice.-$0.10$0.00$0.10$0.20$0.30$0.40$0.50$/MMBtu2008 2009 2010 2011 2012 2013* 2013 annual average is YTD0%20%40%60%80%100%120%140%Henry Hub Dominion, South Point SoCal Gas Chicago city-gates2000-2003 2004-2008 2009-2013 YTD
  • 5May 2013Natural Gas Market ChartsMONTHLY GAS INDEX PRICE$0$2$4$6$8$10Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13$/MMBtuChicago Opal New YorkAECO-C SoCal Gas Henry HubSources: Navigant/Gas DailyMonthly index gas prices rose last month, with Henry Hub increas-ing 16% to $3.98/MMBtu for April from $3.43 for March.NYMEX FUTURES SETTLEMENT PRICES AT CLOSE$3$4$5Mar-13 Jun-13 Sep-13 Dec-13 Mar-14$/MMBtuSources: Navigant/NYMEXMarAprMayThe average 12-month strip price increased to $4.39/Mmbtufrom $4.06..DAILY GAS PRICE$0$2$4$6$8$10$12$14$16$18$20$22Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13$/MMBtuChicago Opal New YorkAECO-C SoCal Gas Henry HubSources: Navigant/Gas DailyThe daily spot prices ended the month up about 6% versus the endof March, with Henry Hub at $4.28/MMBtu versus $4.03 for March.MONTHLY PRICES: OIL AND NATURAL GAS GULF COAST$0$5$10$15$20Mar-09 Mar-10 Mar-11 Mar-12 Mar-13$/MMBtuWTI (Cushing, OK), Crude OilHenry Hub - Natural Gas Sources: Navigant / PlattsMost recent comparison shows a large but slightly decreasingmonthly price spread, with Henry Hub natural gas price at $3.98versus WTI crude oil price at $14.77, an equivalent energy ratio of3.7 times.
  • 6May 2013Natural Gas Market ChartsU.S. DRY GAS PRODUCTION525456586062646668Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecBcf/day2009 2010 2011 2012 2013Sources: Navigant / EIAU.S. dry gas production continues around 66 Bcfd.MONTHLY U.S. STORAGE ACTIVITY-1,000-750-500-2500250500750Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep OctBcf2012/2013 2008/2009 2009/2010 2010/2011 2011/2012Sources: Navigant / EIAValues above zero represent months with net injections.Values below zero represent months with net withdrawals.U.S. storage activity indicates the injection season has arrived,somewhat behind recent years.U.S. WELLHEAD SHALE GAS PRODUCTION051015202530Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13Bcf/dayMarcellus Eagleford WoodfordFayetteville Haynesville Barnett ShaleOtherSources: Navigant/ LCITotal U.S. shale gas production continues strong at 30 Bcfd.U.S. GAS STORAGE5001,0001,5002,0002,5003,0003,5004,0004,500BcfRange (2003-2012) 2009 2010 2011 2012 2013Jan OctSepAugJulJunMayAprMar DecNovFebSources: Navigant / EIAU.S. storage levels appear to have bottomed out, beginning theinjection season.
  • 7May 2013Natural Gas Market ChartsCANADA GAS STORAGE50150250350450550650750BcfRange (2007-2012) 2009 2010 2011 2012 2013Sources: Navigant / EnerdataJan OctSepAugJulJunMayAprMar DecNovFebCanadian storage inventories are still dropping past the time whenincreases typically start.NAVIGANT PRICE PREVIEWPrices for 2013 are expected to average just under $4.00.U.S. MONTHLY NATURAL GAS DEMAND405060708090100Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecBcf/d2009 2010 2011 2012 2013Sources: Navigant / EIADemand is showing a normal seasonal decreasing trend.U.S. TEMPERATURE OUTLOOKThe temperature outlook is for above normal temperatures for alarge portion of the U.S. from the Southwest through the Centraland Southern Rockies and Plains and most areas east of the Mis-sissippi River.Source2013 Price Forecast(Nominal $/MMBtu)EIA $3.52Barclay’s $3.90Goldman $4.40Stephen Smith $3.90Raymond James $3.85Morgan Stanley $3.93Tudor Pickering $4.00Survey Average $3.93Navigant $3.66Sources: Navigant Survey/Navigant
  • 8May 2013Legislative and Regulatory HighlightsNationalPotential Gas Committee Issues Upward Revision toU.S. Gas Resource EstimateOn April 9, the Potential Gas Committee issued its latestbiennial assessment of U.S. potential future natural gassupply, at almost 2,700 Tcf (based on 2,384 Tcf of poten-tial resources plus 305 Tcf of proved reserves). The PGC’slatest increase is driven by a more than 50% increase inits shale gas resource estimate, from 687 Tcf (2010) to1073 Tcf. As noted by Dr. John B. Curtis, Professor of Ge-ology and Geological Engineering at the Colorado Schoolof Mines and Director of the Potential Gas Agency there,which provides guidance and technical assistance to thePotential Gas Committee, “the PGC’s year-end 2012 as-sessment reaffirms the Committee’s conviction that abun-dant, recoverable natural gas resources exist within ourborders, both onshore and offshore, and in all types ofreservoirs – from conventional, ‘tight’ and shales,to coals.”Gulf RegionTokyo Gas Purchases Barnett Shale AssetsOn March 29, Quicksilver Resources announced the saleof a 25% interest in its Barnett Shale oil and gas assetsto a U.S. subsidiary of Tokyo Gas Co. for $485 million.Quicksilver will remain the operator of the assets. Devel-opment spending will be shared in the proportion of theparties’ working interests.Rockies/SouthwestUtah Passes Law Allowing Rate Recovery for NaturalGas Vehicle Fueling StationsOn March 28, Utah’s S.B. 275 was signed into law, pro-viding for 1) the creation of an interlocal entity to facili-tate the conversion to alternative fuel vehicles and theconstruction, operation and maintenance of associatedfacilities, 2) Public Service Commission proceedings topromote enhanced use of alternative fuel vehicles, and 3)rate recovery to gas corporations for certain expenditureson natural gas fueling facilities and related facilities.Kinder Morgan Announces Open Season for OilPipeline to be Converted from El Paso Natural GasPipelineOn April 2, Kinder Morgan Energy Partners announced abinding open season to determine interest in the devel-opment of an oil pipeline to transport crude oil from thePermian Basin to refineries in California. The pipelinewould consist of the conversion to crude oil service of 740miles of existing natural gas pipeline currently owned byKinder Morgan subsidiary El Paso Natural Gas, as wellas construction of new pipeline and pumping stationsand the return to service of inactive lines. The in-servicedate of the proposed Freedom Pipeline is planned for thefourth quarter 2016.
  • 9May 2013National Energy BoardN.E.B. Issues Hearing Order on Cost Set-AsideProcesses for Pipeline AbandonmentHearing Order MH-001-2013The National Energy Board issued a Hearing Order onApril 19 announcing an oral hearing to consider mecha-nisms proposed by federally regulated pipeline com-panies to set aside and collect funds to cover the cost offuture pipeline abandonment. Group 1 companies (i.e.those with more extensive systems) made a joint filingon February 28; Group 2 companies will make filings byMay 31. The hearing to consider the set-aside and collec-tion mechanism filings will take place in Calgary, Albertain the fourth quarter of 2013. The deadline to apply toparticipate is July 26.N.E.B. Issues New Pipeline RegulationsOn April 10, the National Energy Board published revi-sions to its Onshore Pipeline Regulations, 1999. The newregulations, aimed at improving safety and environmen-tal outcomes, require “management systems” to be inplace for key company programs (i.e. safety, pipeline in-tegrity, security, environmental protection, and emergen-cy management), across all lifecycle phases (i.e. design,materials, construction, operation, and abandonment).Senior company leadership must be accountable for theperformance of the management systems.NationalTransCanada Launches Binding Open Season forPortion of Mainline to be Converted from Natural Gasto OilOn April 2, TransCanada announced a binding open sea-son for its Energy East Pipeline, which will have capacityto transport up to 850,000 barrels per day of crude oil toEastern Canada and be partially comprised of 3,000 kilo-meters of converted Mainline natural gas pipeline. Theopen season will run from April 15 to June 17. If the openseason is successful, TransCanada expects a potential in-service date of late 2017.British ColumbiaB.C. Oil and Gas Commission to Oversee WaterLicenses for Oil and Gas PurposesOn April 5, the B.C. Oil and Gas Commission announcedthat the Ministry of Forests, Lands and Natural ResourceOperations had designated the Commission as the Re-gional Water Managers empowered to issue water licens-es for oil and gas purposes. The designation adds longerterm licenses to the Commission’s existing authority forwater permits valid for less than one year.
  • 10May 2013Featured Brochures: Fuels Services©2013 Navigant Consulting, Inc. All rights reserved.Navigant Consulting is not a certified public accounting firm and does not provide audit, attest, or public accounting services.See navigant.com/licensing for a complete listing of private investigator licenses.About NavigantNavigant Consulting, Inc. (NYSE: NCI) is a specialized, global expert servicesfirm dedicated to assisting clients in creating and protecting value in the faceof critical business risks and opportunities. Through senior level engagementwith clients, Navigant professionals combine technical expertise in Disputesand Investigations, Economics, Financial Advisory, and Management Consult-ing, with business pragmatism in the highly regulated Construction, Energy,Financial Services, and Healthcare industries to support clients in addressingtheir most critical business needs.Out of its Sacramento and Houston offices, Navigant’s Fuels experts focus onthe North American market offering fuels services to utilities and public enti-ties, financial services companies, independent power producers, natural gasproducers, pipelines, LNG developers, and large industrial end-users. Amongother tasks performed for clients, the Fuels Practice has performed due dili-gence analyses and market analyses/price forecast studies, provided contractsupport (transportation, supply, and storage), developed fuel plans, and pro-vided litigation and regulatory support.navigant.comFuels PracticeGordon Pickering, Director916.631.3249gpickering@navigant.com3100 Zinfandel DriveSuite 600Sacramento, CA 95670Rick Smead, Director713.646.5029rsmead@navigant.com2 Houston Center, 909 FanninSuite 1900Houston, TX 77010Bob Gibb, Associate Director512.493.5407bob.gibb@navigant.com98 San Jacinto BoulevardSuite 900Austin, TX 78701Rebecca Honeyfield, Associate Director619.546.6492rhoneyfield@navigant.com3100 Zinfandel DriveSuite 600Sacramento, CA 95670Click on each brochureto read more aboutNavigant’s Fuels Serviceswww.navigant.comE N E R G YNATURAL GAS & LIQUEFIED NATURAL GAS (LNG) SERVICESINSIGHT DELIVEREDNavigant’s natural gas and liquefied natural gas (LNG) experts provide clientswith insight into energy business strategies, project transactions, financing, op-erations, trading and marketing. Our global perspective uniquely positions us toprovide both domestic and international expertise in:» Strategy and planning» Market analysis and planning» Regulatory advisory» Commercial negotiation» Independent due diligenceCHALLENGECHALLENGECHALLENGENORTH AMERICAN NATURALGAS SUPPLY ASSESSMENTCHENIERE: LNG EXPORTIMPACT ASSESSMENTDOMINION: LNG EXPORTIMPACT ASSESSMENTSOLUTIONSOLUTIONSOLUTIONIn 2008, Navigant released the firstmajor study of North American natu-ral gas supply recognizing the poten-tial for shale gas development. At atime when the conventional wisdomwas that U.S. natural gas was a de-clining resource, Navigant defiedthe status quo and supported a fiftypercent increase over the then-pre-vailing resource estimates. Today,the prevailing estimates resembleNavigant’s initial, ground breakingevaluation from 2008, with naturalgas abundance being widely ac-knowledged. Gas shale productionhas been robust enough for LNG im-ports to be replaced by LNG exports.Navigant experts played a substan-tial role in beginning North America’snatural gas transformation.Navigant provided a detailed as-sessment and analysis of the U.S.gas market impact of LNG exports,for Cheniere Energy’s Departmentof Energy (DOE) export applicationfor its Sabine Pass, Louisiana exportproject. Navigant conducted theanalysis with its proprietary industry-leading market model built uponthe Gas Pipeline Competition Model(GPCM) and its expert analysis was akey component of Navigant’s reportin support of the project. The appli-cation for export by Cheniere is atthis time the first and only LNG exportproject to have received DOE ap-proval to non-Free Trade countries.In support of Dominion’s applicationto DOE for LNG long term export au-thority to non-Free Trade countries,Navigant provided a report assess-ing the U.S. gas market impact ofexports from Dominion’s Cove Point,Maryland facility. Navigant’s assess-ment of the U.S. natural gas market,including the Marcellus gas shalebasin, was captured in the marketand infrastructure reports providedto the client. Both reports and theanalysis were based upon Navi-gant’s leading North Americanmarket model built upon GPCM,and were filed in support of Domin-ion’s LNG export application inSeptember 2011.E n E r g yNatural Gas Market Modelingand Scenario Analysis