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Yesterday (10/8) we hosted an expert call with Elisabeth Myers, an energy lawyer with twenty years experience in oil and natural gas pipeline regulation, rates, safety, and compliance.  Ms. Myers litigated on behalf of shippers against SFPP and CALNEV (Kinder Morgan subs) for ~10 years in several ground-breaking cases before the FERC and CPUC.

Listen to the replay, and see below for our key takeaways and notes.

Key Takeaways

  • Regulation is always "playing catch-up."
  • Regulation of oil/product lines is very different from that of natural gas lines.
  • "De facto deregulation" of oil/product lines over last 10-20 years.  Gets little FERC attention.
  • FERC takes regulation of natural gas lines much more seriously, especially over last ~4 years; regulated under a consumer protection statute (NGA).  
  • No expectation of a change in FERC policy re: MLP income tax allowance "any time soon."
  • No regulation of pipeline maintenance spending; DOT / PHMSA may come in "after the fact, if there is an issue."
  • Pipeline only incentivized to "gold-plate" in twelve months leading up to a rate case; otherwise, the incentive is to cut costs.
  • LP investors are getting their own money back; it's only sustainable if MLP can continue to issue new equity and debt.

 Rate Setting Basics (2:55 mark)

  • Both a federal and state component to regulation of pipelines … Rates typically set by pipeline filing tariffs, and settlements.
  • Oil pipeline rates are largely regulated under the principle of settling with the shippers … If the pipeline can’t settle, then they have to cost-justify it … Primarily we are dealing with cost-based regulation for oil pipelines in the event there is a dispute.”
  • Similar for natural gas.  Natural gas pipelines are clearly cost-based regulation.

 “Unjust and Unreasonable” Rates (7:38 mark)

  • Oil Pipelines…  Indexing is the most prevalent way of changing [oil] rates …  Every year an index is established, and what that means is that any [oil] pipeline can file, basically automatically, an increase across the board for all of its rates within that index …  The oil index can be applied annually.
  • In the 2010 – 2011 reporting period, about 26% of oil pipeline companies were reporting over-recoveries on their FERC Form 6 …  Some are substantial … Colonial was ~$250MM (annually) over-recovered.
  • Natural Gas Pipelines…  There is no indexing for natural gas lines.

FERC Resources and Attention (11:18 mark)

  • Staffing…  Can count on 1 or 2 hands how many staff are allocated to oil pipeline issues …  Natural gas, in contrast, is well-staffed.  Perception is that FERC indexing for oil pipelines was supposed to take care of the issue of unjust and unreasonable rates ... Perception is that shippers on oil pipelines tend to be major oil companies, can take care of themselves, don’t need regulators' help ...  Seems forgotten that many pipelines have monopoly power.
  • Statutes…  Oil pipelines regulated under the Interstate Commerce Act (ICA, 1887) – designed to protect shippers and consignees … Natural gas pipelines under the Natural Gas Act (NGA, 1938) – it is a consumer protection statute ...  Natural gas rates as well as sighting are regulated under the NGA.

Trends in Regulation (14:55 mark)

  • "De facto deregulation" of oil lines over last 10-20 years ...    Index increases have been unchallengeable by shippers ... Protests and appeals dismissed ... Trend of light-handed regulation of oil lines is here to stay unless new FERC chairman comes in, or cases get up to the Court of Appeals, and Court mandates change.
  • In contract, on natural gas side, circa 2009, FERC called in natural gas lines for excessive rates; all proceedings were resolved with lower rates via settlement ...  Commission is much more in tune to regulating natural gas lines ...  Consumers can't protect themselves.

Maintenance Spending (19:10 mark)

  • Pipeline safety is regulated, not spending ...  Nothing that says "you must spend X to maintain your pipeline"...  FERC presumption is that pipeline operators are "prudent."
  • On gold-plating...  If pipeline is coming in for a rate case, it may be incentivized to over-spend.  If on the other side, during a rate settlement, the incentive is to cut costs.  "Typically you don't really have 'gold-plating' going on unless you want to put, in a specific 12-month period, which is going to be your test period of 'representative costs,' you might want to bump that up.  But, over time, once you establish a rate, the incentive is to cut costs as much as possible."
  • Reorganizations / restructuring (via acquisition) often results in lower cost structures for pipelines ...  This can lead to future rate cases. 

Income Tax Allowance for MLPs (23:45 mark)

  • C-Corp's given an allowance for income taxes in rates to avoid double-taxation of its investors ...  At the same time, pass-through entities (MLPs, LLCs, and LPs) do not pay income taxes ...  "However, the FERC, in its infinite wisdom, has decided that it will nonetheless allow a pass-through entity to collect an income tax allowance in its rates."
  • 2004 FERC Court ruled that could not give allocation for "phantom tax" ...  FERC then reversed decision and established principle on "policy basis."
  • Raised same issue of "phantom tax" with CPUC ...  CPUC found that there should be no income tax allowance for SFPP ...  Rates were lowered, "major settlement payments."
  • California's decision are not binding at FERC or other states ... "I do not think that the FERC will change its policy on income tax allowance any time soon."

More on MLPs  (31:15 mark)

  • Cash is flowed through to the LP investor, not income, which is why there is no tax liability ... Cash reduces the basis, or capital account ...  LP investors are "getting their own money back" ...  When LP investor sells unit, it pays a capital gains tax.
  • On GP/LP relationship... Surprised that Kinder Morgan's partnership agreement expressly disavows fiduciary duty (of GP to LP) ...  Partnership agreement signed on behalf of GP and all of LP investors by same persons ...  Cash distributed to GP / LP based on IDR splits (currently 50% / 50%) ... The income follows the cash to the GP, and then the LPs are allocated losses to "balance the books." 
  • FERC is currently "quite happy" with the MLP structure ... FERC does not want to hear anti-MLP arguments ... Stark contrast to CPUC's decisions with respect to KMI's 2007 "go-private" transaction.
  • A sustainable model?  MLPs - Kinder Morgan referenced - only sustainable if able to raise debt and equity to pay cash distributions ...  More concerned with what happens to shipper clients if the MLP "folds;" what happens to customers that rely upon the pipeline?

Q&A (42:10 mark)

  • Typical natural gas rate case?  Tariffs vs. complaints.  Typically natural gas shippers are in reaction mode, i.e. protesting tariffs; burden of proof is on the shippers ...  FERC can file proceeding against gas pipeline under Section 5 of NGA ...  Burden of proof is on the FERC, not the pipeline.
  • Are useful lives / depreciation expenses argued often?  Not a "hot topic," but it is an issue that does get litigated from time to time ...  Shippers tend to rely upon the FERC to regulate useful lives, as it has depreciation experts on staff.  
  • Mandated / regulated level of CapEx?  No - nothing regulated by FERC.  DOT / PHMSA will come in "after the fact, if there's a problem" with Corrective Action Orders / compliance plans.  
  • Importance of CPUC income tax allowance decision?  Very significant decision - but not binding in other jurisdictions ...  It is "reasoned decision making" - there is no tax liability, therefore there should be no tax allowance ... Ratepayers are paying personal income taxes of investors in MLP.
  • Victories and defeats in Kinder Morgan cases?  Major victory was overturning SFPP's "grandfathered rates"  ...  Disappointment was losing the income tax allowance case at the FERC (which they won at the CPUC).
  • Respond to FERC Commission Spitzer's comments in December 2007 Order on Complaint (FERC Docket OR07-14-000)?  "Let me first say that as an officer of the court, and in filing these pleadings, basically, it's not under oath, it is my ethical duty not to mislead the tribunal.  That's one of the things that I could be disbarred for.  We put into our pleadings for this case facts and evidence that we had obtained in the public record, in the records in our other proceedings related to SFPP, and in understanding how the MLP structure - with respect to Kinder Morgan - worked.  And I stand by what we said there.  We were since, since this order came out, the CPUC has pretty much vindicated what we said.  CPUC did not throw us out for making these same allegations.  Instead they offered us the opportunity to develop them with evidence, to cross-examine witnesses that Kinder Morgan put on, and to actually prove our point.  In stark contrast to this [FERC] Order, which was an Order on Complaint, basically dismissing it peremptorily without any further procedures.  I stand by what we said; and, frankly, as I said a few minutes ago, if the only way that the MLP structure can continue to pay out cash distributions at the level it's paying out is to issue new units or borrow money, to me, that is a classic example of ponzi.  And in my discussions with some SEC folks early on in these cases, they said, 'Wow, that's amazing to us.'"   

Kevin Kaiser

Senior Analyst