Just before the holidays, the Federal Regulatory Commission issued its final decision on the oil pipeline index rate for the next five years. The what?? Well, once rates for interstate oil pipelines are set and accepted by FERC, the rates can move around to match the market, but any increases are capped by an annual index announced by the FERC each year. The index is equal to the current year’s inflation rate, plus an “adder” that is calculated by the FERC every five years based on an examination of the industry’s results from the previous five years. In today’s blog, we explain how a few tweaks in the way FERC calculates the cost-of-service-based adder will significantly affect how much liquids pipeline rates can rise through the first half of the 2020s.
As we explained in Now Here You Go Again back in June, this indexing approach was part of FERC’s response to congressional direction in the Energy Policy Act of 1992 to simplify the regulation of oil pipeline rates. Ever since FERC took over the regulation of oil pipeline rates from the Interstate Commerce Commission in 1977, the system of regulation had been burdensome and complicated for an industry that craved simplicity. So, while FERC kept some of the onerous stuff like full cost-of-service reviews for certain situations (new services and company-specific complaints, primarily), the industry norm became indexing. These days, over 80% of all liquids-pipeline rates are capped based on the index, meaning that in markets where competition doesn’t push the rates lower than the cap, the indexed rate is what’s really charged.
In the current five-year review, FERC had proposed reducing the adder part of the index from 1.23% to 0.09%, basically eliminating the adder. (We should note that the adder can also be negative, depending on industry performance, so from the companies’ perspective, even a small positive was better than a negative.) After receiving a lot of comments and performing a lot of new calculations, FERC still reduced the adder, but by a lot less — only to 0.78%. This means that for the next five years, the cap on rates for oil pipelines (and pipes transporting other hydrocarbon liquids) can be increased each year by inflation plus 0.78%. This is good news for a midstream sector already under a lot of economic pressure, with the caveat that a higher ceiling on pipeline rates obviously doesn’t mean much if the market is demanding rates well below the ceiling.
The inflation rate to which the adder is added is the Producer Price Index for Finished Goods, or PPI-FG. That’s been a pretty small number lately. Still, the new, 0.78% adder means continued growth in the rates that can be charged by most liquids pipelines — growth that’s faster than inflation. Figure 1 compares where the index was in 2019 and 2020, where it could have been for 2021 forward, and where it is for 2021 forward as a result of FERC’s December 17 final decision. The blue bar segments show the PPI-FG part of the index and the orange bar segments show the adder part.
Figure 1. Oil Pipeline Index Comparisons. Source: FERC
Sure, the total index has dropped a lot since 2019 — and in fact, the adder portion is the lowest it’s been in 20 years — but the total index is more than twice as high as it would have been under FERC’s original proposal last June. How did this change happen? To understand it, we need to summarize the process FERC uses to gather and measure the underlying data.
FERC’s aim in establishing the adder is to determine the change in the cost of service per barrel-mile of a broad sample of the industry over the last five years. The data it uses comes from Page 700 of FERC Form 6, an annual report filed by each regulated pipeline to show its actual cost of service — that is, the cost of doing business experienced by each pipeline. An initial issue in using this data is that the Page 700s filed across the industry are a real patchwork quilt in terms of detail and even which sections are filled out. For example, many pipelines don’t even report barrel-miles. So FERC goes through all the reports and eliminates from its data the pipelines with an incomplete Page 700. Then it compiles the results for everyone else, measuring the change in cost per barrel-mile from the first historic year to the last (in this case, from 2014 to 2019), and determines the annual rate of compound growth that the change implies.
There’s more. FERC also eliminates from its calculation the high-change and low-change pipelines by concentrating on a center group in terms of cost of service growth — the middle of the bell curve, if you will. Traditionally, and in FERC’s initial proposal last June, the commission used data from the middle 50%. But in the final rule it approved last month, FERC accepted industry recommendations to instead base the adder calculations on the middle 80%. That changed the average rate of growth significantly.
The last step is to average the results of the growth rates and determine the differential over (or under) inflation for the five-year study period. Figure 2 shows that final calculation, from the face of the FERC staff’s 28-sheet Excel workbook.
Figure 2. Determination of the Index Adder. Source: FERC
The results for the middle 80% of the study group are statistically analyzed for their weighted average, their unweighted average, and their median. Then, a “composite” rate is determined by averaging the three measures. That composite rate is compared with inflation over the study period and the difference becomes the adder. (One note: as can be seen from Figure 2, the decision to use the middle 80% of results is so recent that the notes still refer to the “50 percent composite.”)
Other than the change from 50% of the eligible pipelines to 80%, the workbook for 2020 looked pretty much the same as the workbook for 2015, the last time FERC set the oil pipeline index adder. For many, the change (or lack thereof) was unexpected, thanks primarily to the FERC’s 2018 policy statement telling pipelines owned by master limited partnerships (MLPs) to take income-tax expense completely out of their costs of service. At the time, while FERC ultimately forced natural gas pipelines to make immediate changes in their rates to reflect the policy, in the liquids pipeline industry — where the MLP policy actually originated thanks to a court decision, and where the prevalence of the MLP ownership structure is much higher — FERC said (and we’re paraphrasing here), “Just change your reporting for now. We’ll handle it in the next index determination.” That cryptic language created a lot of concern in the pipeline industry. It could have meant, for instance, that an MLP-owned pipeline that reflected income taxes in its cost of service in 2014 (as was allowed then) but did not reflect them in 2019 based on the 2018 policy statement, would show a big decrease in cost of service, even if nothing had really changed. A data set that had a lot of MLP-owned pipelines in this situation, mixed with corporate-owned pipelines that included income taxes in cost of service in both 2014 and 2019, may well have been an incomprehensible mess.
So FERC dealt with the issue pretty simply. It removed the income tax allowance (and related deferred-income-tax effects) from the 2014 first-year data for all the MLP-owned pipelines. Thus, if everything else stayed the same in cost of service, the pipeline would show flat costs, not a decrease, and if everything except income-tax related costs went up, that increase would be reflected in the data used for the index. What this means is that the index calculation did not do anything to reduce pipeline rates to reflect the 2018 policy.
Does this mean that MLP-owned liquids pipelines are off the hook for having to comply with the 2018 policy eliminating income taxes? Not really. The policy actually arose out of a complaint filed against an oil pipeline by airline shippers that ultimately made it up to the U.S. Court of Appeals. In a case like that, the pipeline’s stand-alone cost of service becomes the issue, with no protection afforded by the index. That’s a long way of saying that if shippers believe their index-derived pipeline rates have become unreasonably high as compared with the pipeline’s own cost of service, they have the right to complain to the FERC. In the end, if the pipeline is owned by an MLP, it won’t have income taxes in its cost of service.
Will that mean we’ll see more cost-of-service-based complaints against indexed pipelines as a way to get at the income tax issue? Only time will tell. A particularly noteworthy indication is that there was one commissioner dissent from the December 17 decision — from Commissioner Richard Glick, the only Democrat on the commission at the time. He voted against the decision based on the premise that it was more important to protect consumers from high costs than to protect the shippers on pipelines and that the index system as it has been implemented does not afford enough consumer protection. Now, as a result of the change in administrations, Commissioner Glick is a likely choice to be the new FERC chairman. So it is fair to say that the owners of oil and other liquids pipelines dodged a couple of bullets for the time being, but they will need to keep a close eye on the FERC over the next few years.
“Dodged a Bullet" was written by Greg Laswell and appears as the first song on Laswell's seventh studio album, Everyone Thinks I Dodged a Bullet. The song is featured in the third-season finale of the hit television series, The Blacklist, an American crime thriller that stars James Spader and Megan Boone. Personnel on the record are: Greg Laswell (vocals, all instruments) and Colette Alexander (cello).
Greg Laswell is an American singer, songwriter, musician, record producer, and recording engineer from San Diego, CA. His baritone narrative voice has been compared to the vocal stylings of Leonard Cohen and Mark Lanegan. His songs have been featured in many films, commercials, and television shows, including One Tree Hill, Without a Trace, True Blood, Grey's Anatomy, and NCIS. Laswell has released 10 studio albums, three EPs, and eight singles. He still records.