VIII. RECENT DIRECTIONS

In recent years several developments have occurred regarding pipelines that must be touched upon. They involve some new directions by both regulator and antitrust agencies and may address some of the concerns developed in this report.

A. FERC Activities

The ICC, now FERC, has embarked on several new proceedings that may alter their approach to pipeline regulation. With the recent enactment of the enabling act for the Department of Energy,' these efforts have been transferred to the Federal Energy Regulatory Commission (FERC). There is the possibility that a new agency may be willing to take new approaches to old problems.

1. VALUATION OF COMMON CARRIER PIPELINES

The ICC and now the FERC has commenced a rulemaking proceeding to reexamine the underlying elements comprising the valuation of common carrier pipelines. This proceeding, started in August 1974,3 has been delayed on procedural grounds, and hearings have been held starting on November 1, 1977. The proceeding is now pending the outcome of procedural motions. The Department of Justice and other parties are taking an active role in the proceeding because of the importance of the issues involved. A change in the method of valuation will alter substantially the return on investment received by the pipelines both under the consent decree and under the guidelines established by the ICC.

The Department of Justice has concluded that the present method of deriving the valuation base is deficient, since it uses reproduction costs as an element which allows pipeline owners to charge excessive rates, thus impeding the efficient transportation of crude oil and petroleum products. The Department has concluded that—

1 Department of Energy Organization Act, Pub. L. 95-91 (Aug. 4, 1977), 95 Stat. 565; Executive Order 12009, 42 Fed. Reg. 46267 (Sept. 13, 1977).

The rulemaking grew out of protest by the Midcontinent Petroleum Product Shippers of the rates charged by the Williams Pipe Line Company based on the ICC's valuation. The ICC decided that an adjudicatory proceeding was not the appropriate form in which to review its valuation methodology and directed the institution of this rulemaking. Petroleum Products, Williams Brothers Pipe Line Company, ICC dkt. 35533; Initial Decision served June 6, 1974, aff'd, by ICC Division Two, 351 ICC 102 (1975), aff'd. 355 ICC 479 (1975), appeal pending sub nom., American Petroleum Company of Texas v. Williams Brothers Pipe Line Company, et al., dkt. 76-2138 (D.C. Cir. 1976).

Valuation of Common Carrier Pipelines, Ex parte 308, Notice of Proposed Rulemaking and Order, 49 C.F.R., ch. X, Service Date: Sept. 3, 1974.

See petition for administrative review and suspension of procedural dates. filed jointly on Dec. 12, 1977 by the Department of Justice, the State of Alaska and the Midcontinent Petroleum Product Shippers, in the matter of valuation of common carrier pipelines, dkt. RM 78-2 (formerly Ex parte 308).

5 See statement of views and arguments by the U.S. Department of Justice, Valuation of Common Carrier Pipelines, Er parte 308, May 27, 1977, p. 5.

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The use of reproduction cost allows pipeline owners an excessive rate of return on equity and total capital when compared with other regulated and non-regulated industries. This result is due primarily to the tendency of reproduction cost to introduce substantial inflation into the firm's rate base at the same time that the overall rate of return allowed by the Commission sufficiently compensates the owners for inflation."

Thus the valuation method really accounts for inflation twice giving the pipelines a much higher rate of return than is warranted."

The data presented by the Department in a companion statement demonstrates that many oil pipelines have profit levels one would expect of an unregulated natural monopolist; indicating that ICC rate regulation really has failed to curtail monopoly profits. For example, 20 pipelines earned returns to equity of greater than 40 percent, while 11 had returns to equity of 60 percent or better.s

The consequences of this regulatory failure are twofold. First, as excess earnings are the result of a rate structure which yields returns beyond what is reasonably necessary to attract capital, we must assume that the actual tariffs charged do not encourage the maximum efficient use of pipelines. Consequently, the amount of oil reaching final markets is artificially restricted and its price is necessarily too high. Second, some oil moves by means of transportation which are less efficient (particularly in terms of energy usage) than pipelines because many pipeline tariff rates greatly exceed cost. Much of economic value of this efficient mode of transportation is thus wasted, a loss directly traceable to the failure of regulation.

The significance of this issue cannot be understated. If Congress or the Department of Justice concludes that divestiture of oil pipelines from oil company ownership is warranted, then rate reform must precede divestiture if the salutory effects of divestiture are not to be determined by defective rate regulation. With defective rate regulation, some of the excess pipeline profits currently allowed may be capitalized in the sale price of divested pipelines and future tariff rates will reflect these capitalized excess profits, reduring the transportation efficiencies to be obtained from pipeline transportation.10

@ Id. at 6.

The Department in a companion statement by George Hay, May 26, 1977. presents rate of return figures for pipelines in comparison to other regulated industries, electric utilities and gas pipelines. The data demonstrates that the rate of return of many oil pipelines is significantly above what is encountered in many other regulated industries. 8 Statement of views and arguments by the U.S. Department of Justice, n. 26. 9 Id. at 27-28. The Department has noted that the vertical nature of the industry helps explain why few complaints have been lodged against the rate structures of the pipelines. First, most of the usage of the pipelines is by the owners, who naturally would not complain about excessive rates. Further, high pipeline rates may be recouped in the downstream market where prices charged by the pipeline owners are higher then they would be if they truly reflected their lower pipeline transportation costs. Consumers, who bear the higher cost, are not likely to identify the true source of the problem. Thus few complaints will be lodged with the regulatory commissions. See Id. at 27, n. 49. Moreover, nonowners, resigned to use of alternative higher cost transportation remain viable in a market whose price reflects the cost of these alternative modes. The monopoly profits reaped by the pipeline owners provide an umbrella for independent competitors. Agitation by these tndependents may precipitate a voluntary or forced lowering of the downstream price by interrated pipeline owners to more truly reflect the economies their pipelines afford. This result would be of little comfort to the independent who would be caught in a price squeeze and therefore may be priced out of the market.

10 Id. at 23.

The outcome of this proceeding is unknown, but it poses important issues concerning effective rate regulation of pipelines and its proper resolution is important to effective future relief regarding other pipeline problems.

2. Investigation of common carrier pipelines

On February 24, 1976, the ICC initiated an Investigation of Common Carrier Pipelines, in Ex parte 308 (sub. 1) pursuant section 11 the Clayton Act and sections 12 and 13 of the Interstate Commerce Act, in order to examine possible violations of section 7 of the Clayton Act. This proceding also grew out of the Williams Brothers proceeding mentioned above and was intended to be a broad based examination of common carrier pipelines to determine what action, if any, should be taken by the ICC concerning the operation and ownership of these pipelines. Subsequently, with the creation of the Department of Energy, this investigation has been transferred to the Economic Regulatory Administration." More than 2 years after its initiation, the proceeding is still in its early procedural stages and therefore the outcome is uncertain.

B. Department of Justice Activities

Recently, the Department of Justice has issued several statements concerning their approach to pipelines that appear encouraging. The testimony of Department of Justice officials before Congress indicated above appeared to lack focus, using a scattergun approach to pipeline problems with the hope that something would penetrate to the core of the problem. Assistant Attorney General Kauper appeared to take the first step in focusing the issue by indicating that pipeline problems essentially were access problems. This focusing has sharpened with the appearance of the Attorney General's report on deepwater ports.12

1. DEEPWATER PORT REPORT

In the Deepwater Port report, the Department for the first time, indicated a coherent theory on pipelines.13 A prior section 14 developed the rationale behind pipeline regulation. That prior discussion indicated that pipelines are monopolies-they exhibit increasing returns to scale-and if left unregulated, as monopolists they would raise the price to use the facilities in order to earn monopoly profits. By increasing the tariff, the monopolist also would be decreasing the amount of oil going through the pipeline. The Deepwater Port report indicated:

Normally, regulation is the method used to pass on natural monopoly cost savings to consumers. Therefore, a pipeline or a

11 See 12 Fed. Reg. 1639-1610, Jan. 11. 1978.

12 Report of the Attorney General pursuant to section 7 of the Deepwater Port Act of 1974 on the applications of Loop, Inc. and Seadock, Inc. for deepwater port licenses, Nor. 5, 1976.

13 A deepwater port is an offshore crude oil unloading facility capable of servicing very large crude carriers up to 500,000 deadweight tons. Since they are comprised of a series of offshore and onshore pipelines and storage facilities, they retain the same economic principles associated with pipelines. Thus the economic discussion will be applicable equally to both deepwater ports and pipelines.

14 Section II.D.1. Monopoly Characteristics of Pipelines and the Need for Regulation.

deepwater port could be prevented from fully exploiting the potential excess profits in transportation by regulation by the Interstate Commerce Commission (ICC) and an antitrust consent decree which place a ceiling on pipeline rates of return. But when the owners of pipelines and deepwater ports are integrated petroleum companies, they can partially circumvent this regulatory effect on their profits by utilizing their transportation cost advantage to earn monopoly profits in the market for delivered crude oil or even further downstream in the market for delivered petroleum products. The source of the transportation cost advantage is, of course, the same as the source of excess profits from an unregulated pipeline economies of scale and cost advantages relative to alternative modes of transportation. Artificial quantity restrictions and resource misallocation remain substantially uncorrected.

This exchange of excess transportation profits for excess downstream profits by the pipeline port owners can be seen by comparing two apparently different situations: (a) the pipeline or port is unregulated, the owners set a monopolistic transportation tariff, and the flow of product through the pipe is reduced below a competitive level, versus (b) the pipeline's profits are restricted by regulation and the owners limit throughput by denving access to nonowners in various ways. Our analysis has led to the conclusion that these two cases tend to result in the same (maximum profit) product throughput and, therefore, tend to yield identical prices and quantities of product in the downstream markets and identical excess profits for the port owners.15

As a result of this economic analysis, the report focused on the problems of access to the port and on the ability to expand the port to a level that would approximate the competitive situation. The report exhaustively indicated how the integrated oil company owners of the port established operating procedures that, in their total effect, would deny access to small shippers; how they undersized the port both to limit their risk and ostensibly to limit the total amount of crude oil that could flow the port; and how, through various statements found in corporate documents, they intended to thwart ICC and consent decree regulation. As a result, the report concluded:

The major conclusion to be drawn from our antitrust analysis is that the integrated oil company owners of the proposed ports have attempted to maximize their profits through various overt and subtle requirements which will have the effect of restricting port throughput by limiting port capacity and access, thus enhancing the owner's profits in downstream product markets.16

The report indicated that there were two remedies to counter the effects of oil company ownership. The first would be to prohibit oil company ownership of the ports. The alternative solution would be to permit integrated oil company ownership but fashion a set of competitive rules that eventually may approximate the effects of nonintegration. In the deepwater port setting, the Department opted for

the competitive rules approach." In reaching the conclusion of the report, the Department stated:

This conclusion is far from obvious, for there are clear benefits to the nonintegration approach. Many of the antitrust problems arise exclusively from the fact of integrated oil company ownership of the deepwater ports. The excess profits which are generated in downstream (or upstream) markets derive directly from that ownership pattern. Prohibiting ownership of deepwater ports by integrated oil companies would yield immediate procompetitive benefits. If they do not own and have control over the operational policies of the ports, these companies cannot achieve excess profits either at the port level or in downstream markets. Nor can they control traiffs, access, or expansion, and many of the adverse ef fects outlined above will never rise. The excess profits in the port permitted by the regulator will accrue to the independent owner. Moreover, with an independent entity owning and operating a port, there would be greater incentive on the part of the oil companies (as affected shippers) to oppose the imposition of excessively high tariffs. This could lead to a reduction of any excess profits associated with present ICC regulation of the ports.18 Although the Department did not elect this approach, in this instance it clearly indicated that it does not follow the same conclusion will apply to oil company crude and product pipelines.19

The competitive rules recommended in the Deepwater Port report are four in number. They provide that the port (or a pipeline) must: 1.) provide open and nondiscriminatory access to all shippers, owner and nonowner alike; 2.) permit any owner or shipper providing adequate throughput guarantees unilaterally to request and to obtain expansion of capacity; 3.) provide open ownership to all shippers at a price equivalent to replacement cost less economic depreciation; and 4.) revise ownership shares frequently (annually) so that each owner's share equals his share of average throughput.20

The rules are designed to dissipate the excess downstream or upstream profits through the creation of a competitive atmosphere among shippers. The rules achieve this result by prohibiting integrated oil companies from unreasonably or discriminatorily restricting access to and the capacity of the port. Thus rules 1, 2, and 4 assure that: any shipper will have reasonable access to the port; any shipper can become an owner and thereby participate in port profits (including excess profits permitted by current ICC regulation); and any shipper will have the ability to ship at the true economic cost of shipping. In addition to these access rules, rule 2 provides any shipper, owner and nonowner, with the ability to unilateraly request expansion. This rule is necessary so that all owners do not join together and restrict access so that all can share in the excess downstream or upstream

17 The Department reluctantly came to this conclusion for several reasons: the Deepwater Port Act did not prohibit integrated oil company ownership; Congress opted for common carrier regulation and antitrust review in lieu of prohibiting oil company ownership; the national Interest in seeing the ports built; and the belief that a set of competitive rules could minimize the anticompetitive effects associated with integrated oil company ownership. [Deepwater Port report at 104-106.]

18 Id. at 104.

19 Id. at 104 n. 2.

20 Id. at 106.