Whereas in the United States there are thousands of natural gas producers, in Mexico there is only one, Petróleos Mexicanos, also known as PEMEX. And, as is the case for many state-owned companies, the prices charged by PEMEX are government regulated. How? Mexico imposes price controls on natural gas by setting them equal to U.S. prices.
Of course, U.S. prices are currently extremely low — about one-quarter the level that was observed at the peak in 2008. These low prices reflect the dramatic increase in U.S. natural gas production over the last few years made possible by hydraulic fracturing. Problem is, Mexican production has not nearly kept pace.
As U.S. Henry Hub prices have continued to decrease, demand for natural gas in Mexico has skyrocketed, particularly among industrial users. And today in Mexico there is a severe shortage of natural gas. A recent article from Bloomberg (click here) reports that large industrial customers in Mexico are seeing ~50% curtailments. Mexico would like to import more from the United States, but north-south pipelines are extremely limited and already running near 100% capacity.
This is a classic textbook example of a price control. When you impose a price control lower than the market clearing price, demand exceeds supply so there is deadweight loss. Mexican buyers with high willingness-to-pay aren’t able to buy natural gas, and the Mexican producer, PEMEX, doesn’t have much incentive to increase production.
In addition to deadweight loss, price controls leads to misallocation. Prices serve to coordinate actions of buyers and sellers, but they also serve to allocate goods to the buyers who value them the most. Without a market mechanism to clear the market, PEMEX is deciding who gets gas on a “case-by-case” basis. This doesn’t guarantee an efficient allocation, and leads to wasted resources as industry executives fly back and forth from Mexico City trying to increase their allotments.
This all reminds me of the U.S. natural gas shortages during the 1970s. U.S. federal price controls led to widespread curtailments, and to battles in Congress about how to allocate what little gas was available. In a recent paper with Lutz Kilian at the University of Michigan, we find that the allocative cost alone from these price controls exceeded $3 billion annually (click here). And it wasn’t until 1989 that there was enough political will to eliminate these costly controls. Fortunately, shortages in Mexico are unlikely to last that long. Plans are already proceeding for additional pipeline capacity linking Mexican buyers to the U.S. market.
Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.