Anticipating Rate Increases for Oil Pipelines in 2021 through 2025

Effective July 1 of this year, over 1000 oil tariffs were increased by 4.3108%, under FERC’s simplified method for setting oil pipeline tariff rates. In a 2015 proceeding, FERC set the index at 1.23% plus the Producer Price Index for Finished Goods (PPI-FG) for the period July 1, 2016 through June 30, 2021. In 2020, FERC will review this index once again and set the index for the period July 1, 2021 through June 30, 2026. Presuming FERC follows the methodology it used in 2015, the index will be based on the average cost of service increase across the industry between 2014 and 2019.

Today we use the five-year period for 2013 through 2018 to assess what the rate may be under different assumptions with respect to how FERC addresses the impact of the corporate tax cut and FERC’s decision to no longer allow pipelines owned by Master Limited Partnerships (MLP) to include an income tax allowance in their cost of service. Our analysis shows that the index could vary from as low as 0.16% to as high as 3.03%, depending on how FERC rules on these issues. While FERC has yet to establish a proceeding for this decision, we will be following it next year once one is established.

Why Does the Index FERC Uses Matter?

Our analysis assumes FERC will use the same basic methodology in 2020 that it used in 2015, but at least two key factors may dramatically impact the results of the process: (1) the tax cut that took effect in 2018, and (2) FERC’s decision to no longer allow a tax allowance for pipelines owned by MLPs. FERC has not clearly articulated how it intends to address these issues and, as seen in the chart below, the choices it makes can have a substantial impact -- with the five year cumulative additional revenue varying from a low of approximately $15 million to a high of almost $60 million.

In the chart below, we look at the expected additional revenue for a pipeline that earns $100 million in the year ending on June 30, 2020 and then increase that revenue over the 2021 to 2026 indexing period under the different scenarios outlined below. We then calculate the additional revenue the pipeline could expect to earn in addition to the assumed $100 million baseline, assuming the PPI+FG increased at a rate of 0.74% annually, as it did annually between 2013 and 2018. As can be seen in the chart above, the decisions FERC makes in applying the existing methodology could have a substantial impact on the projected revenue for our notional $100 million revenue pipeline, with the five-year cumulative revenue ranging from approximately $15 million to almost $60 million. Each of these cases is discussed below.

FERC’s Methodology

Since 1993, FERC has fixed the index through use of the so-called “Kahn Methodology” which uses pipeline data from the prior five-year period to determine an index to be added or subtracted from the PPI-FG during each of the following five years. The Kahn Methodology involves the following steps:

1. Calculate every pipeline’s cost change on a per barrel-mile basis over the prior five-year period.
2. Remove statistical outliers by trimming the data to those pipelines in the middle 50 percent of cost changes.
3. Calculate three measures for those pipelines in the middle 50 percent: the median, the mean, and a weighted mean.
4. Calculate a composite by averaging these three measures and calculate the difference between the composite and the PPI-FG index data over the same five-year period.
5. Set the index level as the PPI-FG plus, or minus, this differential.

In its 2015 order, FERC adopted one key change to how it derived the data for use in the Kahn Methodology. In the past, FERC had used accounting data from each pipeline’s Form 6, but in 2015 it decided to use data solely from the Page 700 included in each pipeline’s Form 6.

We have taken that same Page 700 data for 130 oil pipelines for the period between 2013 and 2018 and have applied the Kahn Methodology to project the index. In addition, we look at two issues that FERC will need to address in next year’s proceeding that did not exist in 2015, and we also consider the impact of FERC’s method for calculating the weighted mean used in the Kahn Methodology.

Impact of the Tax Cut and FERC’s Change in Treatment for MLPs

Two key issues that were not present in 2015 are the tax cut that Congress passed in 2017 that reduced the corporate rate from 35 percent to 21 percent, and FERC’s decision in March 2018 to prohibit pipelines owned by MLPs from including a tax allowance in their cost of service. When FERC issued its proposal for addressing these issues for other types of companies in March 2018, Commissioner LaFleur asked the staff how these issues would impact oil pipelines. In response, the staff indicated that the reduction in costs would flow through to customers when the index was adjusted in 2020 because costs in the final year of the test period would be lower than they otherwise would have been, and the index would therefore be smaller.

However, FERC has never formally addressed these questions and we believe that they will be a key debating point in next year’s proceeding. But assuming that the staff answer is applied as described to Commissioner LaFleur, there would be no change in the Kahn Methodology or the data. We consider this to be the base case for next year’s proceeding and if we use this unadjusted data, the following index results:

Base Case

Separate Adjustment for MLPs and Corporate Pipelines

FERC’s decision to eliminate a tax allowance for pipelines owned by MLPs only impacted the cost of service for those pipelines. Corporate-owned pipelines will almost certainly argue that including the MLP pipelines in the same group as the corporate-owned pipelines suppresses the actual costs for those corporate-owned pipelines and would overcompensate MLPs. Therefore, we expect that a key request in next year’s proceeding is that FERC apply the Kahn Methodology separately to MLPs and non-MLP pipelines. Applying the Kahn Methodology to non-MLP pipelines separately results in the following index:

Case 1a

Applying the Kahn Methodology to MLP pipelines separately results in the following index:

Case 1b

Is the Index Forward or Backward Looking?

As we discussed in Oil Pipelines Take Annual Increase at TRRC and FERC, But DC Circuit Questions Methodology , the DC Circuit reversed a recent FERC decision because it found that FERC had not adequately explained whether its indexing is designed to be forward-looking or backward-looking. This issue could also be a key topic in next year’s proceeding and may result in a decision that contradicts the FERC staff’s response to Commissioner LaFleur.

If the index is backward-looking, then the FERC staff’s answer would be correct and one of the analyses we set forth above would be appropriate. However, if the index is intended to be forward-looking, the pipelines will almost certainly argue that comparing the unadjusted results from the final year would not be appropriate, as that would factor in a tax cut and the elimination of a tax allowance that would be unlikely to occur again in the forward-looking period of 2021 to 2026. If this view were to prevail, FERC would need to adjust the final year’s results to include a tax allowance comparable to the one that was included in the first year of the test period. Adjusting both the MLP and non-MLP pipelines in this way results in the following index as compared to the base case above:

Case 2

One Final Issue with Surprising Impact

As seen in the above calculations, one of the key measures is a weighted average cost increase. This weighted average can be greatly influenced by the inclusion of the largest pipelines in the data set. In 2015, FERC rejected what it termed “manual trimming” of the data to eliminate Enbridge’s Lakehead and Colonial Pipeline. As FERC explained, this manual trimming creates a risk of arbitrariness and the Kahn Methodology’s long-standing use of a weighted average had gone unchallenged. Interestingly, no one challenged which year of the data should be used for the weighting and FERC apparently weights the average based on the barrel-miles of the pipelines in the first year of the test period.

This is the weighting we have used throughout all of the above analyses. However, there is a non-manual method that produces a different result, which is to base the weighting on the barrel-miles of the pipelines in the last year of the test period. This would have a logical appeal, since it is the more current time period and is more likely to reflect the industry in the indexing period. Changing this one variable is not immaterial. Adjusting Case 1 by this single factor results in the following index:

Case 3

While a 21 basis point reduction in the index may not seem huge, over a five-year period, the compounding of such a difference would probably not be viewed as immaterial by either the pipelines for revenue purposes or the shippers fighting to keep their costs down. LawIQ will continue to monitor and report on these issues and if FERC follows the process it used in 2015, we expect it to establish a docket on or about June 30, 2020 to solicit comments about the method to be used for the period beginning on July 1, 2021.

Let us know how we can support you!

Insights Coming Soon

• Timeline for Restoring Service after a Force Majeure
• Mont Belvieu Expansion of Crude Storage

Recent Insights

• Tale of Two Basins - Permian and Marcellus Pipeline Buildout
• Gas Pipelines With Seasonal and Year-Over-Year Contract Growth