Oil Pipelines Increase Return on Equity — Will it Attract Shipper and FERC Scrutiny?
In comments filed earlier this year regarding FERC’s notice of inquiry about changing its method for calculating the return on equity (ROE) for pipelines, some shippers on oil pipelines indicated a preference to keep the current method. Those shippers also asserted that the oil pipelines were already using the new methods to increase the return that they are claiming in their annual reports filed in 2018.
Today we look at the claim that, in 2018, the oil pipelines increased the ROE that they use in their annual reports -- a claim that we find to be true. But the claim that the increase in ROE in 2018 was a consequence of the pipelines’ use of FERC’s new methods cannot be confirmed. It does appear that many of the major pipelines increased their ROE rate by almost 400 basis points, or approximately 33%, from 2017 to 2018. That may be because they are all using the same consultant and were creatively using the new methodologies, or they all could have used the same proxy group and the old FERC methodology.
An increase in ROE can be crucial for pipelines because increasing the ROE rate increases the pipeline’s cost of service, which reduces any over-earnings that might otherwise be reflected on Page 700 in the pipeline’s annual report to FERC. By increasing the ROE rate and reducing any over-earnings, a pipeline can increase its revenue without increasing its risk of a rate challenge. However, if these unusually high rates repeat in 2019, we would expect shippers to file complaints and FERC to investigate the rates of those with the highest ROE rates. So while the use of higher ROEs may be a short term benefit, it could also be a longer-term risk.
Data Shows 2018 Was Certainly Different
Each year, beginning in 2013 as part of their annual financial report to FERC, oil pipeline companies have had to indicate the ROE rate used for purposes of calculating their cost of service. We have gathered that information for 24 of the largest pipelines that filed such a report each year since 2013. Together, those 24 pipelines account for over 85% of the industry’s interstate revenue as reported to FERC in 2018.
The chart below shows the average ROE used by those 24 companies to calculate their cost of service in each year since 2013. As can be seen, the average ROE fluctuated around 11% until 2018, when it shot up to 14%.
It would be advantageous for a pipeline to increase its cost of service when its revenue was increasing to raise its cost of service and reduce its over-earnings. Therefore, we looked at whether in each year the average ROE rate used by those pipelines with revenue exceeding their costs was greater than the average ROE for those pipelines that showed their costs exceeding their revenue.
As can be seen above, there seems to be no correlation with the profitable pipelines using, on average, a higher ROE. In fact, in most years, the unprofitable pipelines, on average, use a higher ROE. So it does not appear that the pipelines are strategically increasing their ROE to shield increasing revenue.
Consultants May Be a Critical Factor
The shippers alleged that, in 2018, the pipelines began to use other methods for calculating the allowed ROE and that those methods drove up the rates in 2018. While it is difficult to confirm that allegation, the increase in the average rate for these 24 pipelines appears to be primarily driven by the fact, as shown below, that 10 of the 24 pipelines in this group moved in lockstep with each other from a rate of 12.22% for 2017 to 16.19% for 2018, an almost 400 basis point increase.
There does not appear to be a common owner for the ten pipelines, and the owners include major players such as BP, Kinder Morgan, Enterprise Products and Energy Transfer. So it is possible, as alleged by the shippers, that all ten pipelines are using the same consultant and are creatively using the new methodologies to drive the ROE rate up. But it is also possible that the companies simply used the same proxy group and the old methodology to generate the ROE they reported. If those ten pipelines are excluded from the average calculation for 2018, the average rate for the other 14 pipelines is only 12.33%. This is clearly an uptick from the average over the prior few years, but nothing as drastic as the almost 400 basis point increase for the ten pipelines that moved in lockstep.
If, in next year’s report these ten pipelines continue to use an ROE rate substantially higher than the rest of the industry, they are likely to be the targets of complaints by shippers if they are substantially over-earning after adjusting the ROE rate to one closer to the average for the rest of the industry.
The benefit of using a higher ROE is best demonstrated by looking at the report of Sunoco Pipeline. As reported on its Page 700, its total cost of service for 2018 was $623,416,565 and its total interstate operating earnings was $634,592,811, which means it was over-earning by just 1.8%. If instead of the 16.19% ROE it used to calculate that cost of service, it used the 12.22% it reported in 2017, which is consistent with the average of 12.33% used by the 14 other pipelines for 2018, the total cost of service would have decreased by almost $70 million and its over-earnings would have jumped from the 1.8% reported to 14.5%. This result is near the 15% threshold that FERC has in the past proposed for determining whether it should launch an investigation into a pipeline’s rates. In addition, as we discussed in Back on the Radar -- Colonial and BridgeTex Rate Cases Move Forward , FERC allowed complaints against Colonial Pipeline based on adjustments to its Page 700 even though Colonial was over-earning by only 2.5%. That rate proceeding against Colonial continues to this day, with FERC issuing an order earlier this week consolidating that case with a recent one filed by Pilot Travel Centers. Clearly, avoiding a much higher over-earning percentage helps reduce the risk of a complaint by shippers.
The number of companies moving in lockstep with regard to their ROE has also increased over the last few years. In 2013, there were only four in this group; that increased to six in 2014, seven in 2015 and the full ten by 2016. However until 2018, the ROE used by this group was fairly consistent with the average used by the industry as a whole. Only in 2018 did this group’s ROE rate jump much more than the industry as a whole. Whether the shippers or FERC take note of this change will most likely depend on whether the trend continues in 2019 with respect to both the number of companies moving in lockstep and whether the rate they report is substantially higher than the rest of the industry.
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