This week Hedgeye Energy sector senior analyst Kevin Kaiser hosted an expert call with Richard Kuprewicz, an energy industry expert with over forty years’ experience as an engineer in the oil and gas industry. Mr. Kuprewicz consults to government agencies and NGOs worldwide, as well as to public and industry bodies, on pipeline regulation, operation and design, with particular emphasis on operation in unusually sensitive areas of high population density or environmental sensitivity.
Video of Kaiser discussing Kinder Morgan
Mr. Kuprewicz discussed the current state of long-haul oil and natural gas pipeline maintenance in the US today and its implications for investors in energy MLPs. If you have been following Kaiser’s work on the MLP space, you know he considers the amounts of money spent – or not spent – on maintaining pipeline integrity (“maintenance capex”) is a key to determining whether management is acting responsibly in the interest of the shareholders and society.
Oil and gas pipelines are regulated under the US Department of Transportation’s Pipeline and Hazardous Materials Safety Administration (PHSMA) and its “Integrity Management Program.” The IMP focuses on minimal safety requirements to prevent pipeline rupture. There is no specific spending requirement or set of action steps associated with the IMP. Instead there are what are called “process steps” which assume the operator will pay attention to integrity of its pipelines and specific risks associated with unique conditions. This applies particularly to what PHSMA defines as “high consequence” geographical areas – defined by potential danger to human population, or to the environment. Kuprewicz says that many companies routinely provide “high consequence” level oversight throughout their system. And then, some don’t.
The IMP was instituted about 10 yrs ago. Kuprewicz says PHMSA rulemaking is just a First Step in a process that will take many years to unfold. By itself, Kuprewicz says the IMP standard is not sufficient to impose high safety standards across the industry.
Kuprewicz says PHMSA regulatory enforcement is “mostly reactive,” rather than relying on extensive inspections. He says the agencies involved in pipeline oversight are surprised at the large number of operators who “don’t get the fundamental concept of Integrity Management,’” pointing to a number of serious pipeline ruptures in recent years. Kuprewicz says many of these companies have over-complicated the regulatory process, creating reams of internal documentation about the IMP, but not actually implementing its principles.
Operators are frequently not audited – luckily for them, says Kuprewicz, since many would not pass. Pipeline operators enter their pipeline integrity data into the PHMSA database under a one-way process: the operator can enter the data, but PHMSA can not change it. This means that when operators enter erroneous data – or even fraudulent data – it remains in the record.
Some pipeline operators focus on visible problem areas, leaving most of their pipeline unattended and exposed. “Common sense tells you most of the maintenance cost is in the pumping and compressor stations,” says Kuprewicz, but the highest actual risk is on the miles and miles of main line. A compressor station breakdown will lead to a shut-down. But a main line rupture can have serious consequences, including potential massive loss of life.
Kuprewicz says that age of a pipeline is not the best indicator of risk of rupture. If properly maintained, he says carbon steel pipe essentially has no “useful life.” Well-maintained pipe can last “forever” he says, citing pipelines that have been in continuous operation for a century. Kuprewicz says the accounting practice of taking depreciation on carbon steel pipeline, generally over a 50 or 60 year “useful life,” does not reflect reality.
Of course the key is proper maintenance, including periodic replacement of segments that show signs of stress or other risk factors. Kuprewicz says the key to proper maintenance is the operator’s ability to accurately identify and assess the specific risks to their pipeline, often segment by segment. This makes it logical that the IMP requires “proper maintenance,” rather than specifying spending levels. However, it effectively leaves oversight of the operation to the operators themselves. Conflicts arise in the MLP sector, where the primary business of the entity is often not producing or transporting oil and gas, but rather making increasingly large periodic cash distributions to the unit-holders. One obvious way to increase cash in the till is to not spend it on incidentals such as maintaining one’s pipeline.
An operator’s definition of “acceptable risk” may be very different from yours, especially if you or your loved ones live in a “high impact area.” Operators, like other business executives, calculate “risk” in terms of projected cost. Over time, failure to provide adequate ongoing maintenance makes pipeline ruptures both increasingly likely, and increasingly unpredictable. An operator that doesn’t put up serious maintenance capex is also not likely to do ongoing assessment to identify specific risks throughout their network. Thus, big regulatory changes are almost always brought about by major ruptures that are often both tragic and extremely expensive.
A more recent problem spreading throughout the industry is the lack of reliable records, particularly pipeline maintenance records and risk assessments. Many oil and gas companies have gone through mergers in recent years – indeed, the MLP space continues to be driven at least partly by an ongoing strategy of buying operating properties or companies in order to distribute their cash flow. In the wake of a transaction, the inefficient merger of cultures can lead to chaos. As management focuses on getting control of costs, one place they always look is to the back office. Kuprewicz says a surprisingly large number of merger or acquisition transactions have resulted in managers ordering the destruction of critical records as cost saving measure.
A related risk is the loss of the expertise of older employees. Professionals with 30 or 40 years’ experience are retiring. In an M&A scenario these employees are frequently offered – or forced into – early retirement, with the result that both the industry expertise and critical knowledge of the corporate culture walk out the door and are not adequately replaced. Rather than having older seasoned employees mentoring younger ones, the new hires step right into positions with real operational and decision-making responsibility. Kuprewicz says a number of companies have repeated mistakes they made ten and twenty years ago, sometimes with dire consequences.
Finally, Kuprewicz touched on the phenomenon known as “gold plating,” where some operators spend ostentatiously – often in the aftermath of a major tragedy. “I used to think a billion dollars was a lot of money,” mused Kuprewicz, “until I saw the way some of these operators throw money around” to cover their tracks after a major pipeline rupture. This creates the illusion that the company cares, that management is taking the situation seriously, that it has actually addressed the problem. But these “gold plating” exercises often do not dig down to the fundamental question of why the process broke down, of how the operator lost control of the pipeline.
Cost cutting tends to lie at the root of many pipeline problems and is associated with most breakdowns. Complex organizations tend to focus more on senior management directives to cut costs, and less on engineers in the field who say more resources are needed to address specific risks. Says Kuprewicz, costs decline linearly, but risks rise exponentially. This ends up in literally in a “bet the company,” scenario. Kuprewicz says he does not see a sector-wide tendency on the part of MLPs and other operators to make reckless decisions. Still, when there are massive tragedies, he says there’s nearly always someone in senior management beating the big drum to cut costs.