In much-watched oral arguments before FERC last Monday, California representatives decried El Paso Corp.’s attempts to “mightily” turn the high-profile complaint alleging market manipulation on the part of the company’s affiliates into a case involving pipeline safety.

“El Paso’s cry of safety is a blatant attempt to divert this Commission’s attention from the fact that [it] failed — failed egregiously, failed miserably — to fulfill its contractual service and regulatory obligations in California,” said Kevin J. Lipson, attorney for Southern California Edison.

But El Paso attorneys countered that the state’s accusations rose to the level of an “Oliver Stone-like conspiracy.” They insisted system capacity to the state was reduced in part due to Department of Transportation-ordered pressure restrictions to ensure the safe operation of the El Paso pipeline, and argued that detractors were attempting to second-guess the pipe’s operating judgment.

El Paso attorney Daniel F. Collins argued that FERC Judge Curtis Wagner “had to place considerations of throughput ahead of considerations of safety and reliability” on the El Paso pipeline when he ruled that El Paso withheld capacity from California. El Paso contends it operated throughout the period at an average 97% of capacity and claims Wagner’s ruling flies in the face of DOT safety regulations for the operation of pipelines.

“California parties have not and do not question” the DOT’s restrictions on the operating pressure of El Paso pipeline in the wake of the New Mexico rupture in mid-2000, or the pipeline’s operational judgement to conduct maintenance for safety or reliability reasons, countered Lipson during all-day arguments over the merits of the Wagner’s decision that was unfavorable to El Paso. SoCal Edison is one of several plaintiffs in the complaint case, pitting California against El Paso Natural Gas and El Paso Merchant Energy Co.

But even after subtracting 330 MMcf/d of capacity that was lost due to DOT-ordered pressure restrictions and safety maintenance, the El Paso pipeline still “did not [come] near or close” to operating at its maximum allowable operating pressure (MAOP) during the critical November 2000 through March 2001 period, which made hundreds of millions of cubic feet per day of natural gas unavailable to southern California and sent gas prices soaring, he said. “Let’s be very clear. The magnitude of El Paso’s failure is not minor; it’s enormous. El Paso didn’t simply try hard to fulfill its obligations and just [fell] short. El Paso failed utterly and its failure was intentional,” Lipson noted.

The battle between El Paso and California is shaping up to be a war over capacity numbers. The question is which ones will FERC believe.

While 330 MMcf/d of lost capacity on the pipeline can be justified, there was “no valid excuse” for El Paso not to supply an additional 210 MMcf/d of capacity by operating its pipeline “at or near” its MAOP, make 35 MMcf/d more capacity available to the market by delaying discretionary maintenance, or schedule an additional 23.5 MMcf/d, which it could have done if it had followed standard industry practices, Lipson told FERC Commissioners. He estimated the pipeline intentionally withheld 250-300 MMcf/d during the 150-day period between November 2000 and March 2001.

El Paso “did not even post this 210 MMcf/d related to its failure to operate at or near MAOP,” he said. This capacity was “wholly unrelated” to the DOT Office of Pipeline Safety’s (OPS) order restricting operating pressure on El Paso. “El Paso simply did not deem this capacity available at the outset,” Lipson noted, adding that it was not offered to shippers at “any period of time.”

For the El Paso system or any other competitive gas pipeline, operating “at or near MAOP is not a burden. It is an opportunity.” El Paso and some of its supporters have “tried mightily” to turn this into something that it’s not — a case involving pipeline safety, Lipson said. But these supporters, such as OPS, “don’t know the record of this case.” He disputed El Paso’s claims that an unfavorable FERC decision for the pipeline would have a “seismic impact” on other pipes, forcing them to exceed their MAOPs and expose their systems to safety risks.

Lipson also resisted arguments that the shortage of pipeline takeaway capacity within California kept El Paso capacity from reaching the state. “The record [is] very clear” that takeaway capacity was not an issue here, Lipson said.

But El Paso attorney William Scherman, a former FERC general counsel, noted there were numerous reasons — in addition to the pressure restrictions on El Paso — for the high gas prices and tight capacity situation in California during the 2000-2001 period, many of which have been recognized by the Commission in previous decisions.

In several orders, Scherman said, the Commission has found the market supply and demand conditions that existed in California, including “low hydroelectric power supplies and high temperatures, caused an unprecedented run-up in gas demanded by California gas buyers and utilities in the year 2000.” Further “this Commission has found that November 2000 witnessed the coldest period since 1911 in the Pacific Northwest and in California.” It also said “time and time again that distinctions in the California electric markets distorted the supply and demand signals and led to record high wholesale electric prices,” and that “the most fundamental problem facing California is the relative inadequacy of its energy infrastructure.”

He reminded FERC that in Order 637 it said “high prices during peak periods [were] a legitimate response to supply and demand forces,” and necessary as an allocation mechanism.

The oral arguments addressed Wagner’s controversial decision in September, which found El Paso pipeline withheld “extremely large amounts of capacity” from shippers on its system to drive up prices for natural gas delivered to the southern California border from November 2000 through March 2001. This was a reversal of Wagner’s prior ruling in October 2001 in which he exonerated the pipeline of abusing its market power to manipulate prices.

In the controversial ruling in September, the FERC judge concluded as much as 696 MMcf/d of the 3.29 Bcf/d of capacity that El Paso was obligated to provide to California during 2000-2001 was unavailable, but he noted only 345 MMcf/d could be accounted for. He also ruled both the pipeline and El Paso Merchant abused the agency’s market-affiliate standards. He recommended the full Commission initiate “penalty procedures” against El Paso for the “unlawful exercise of market power” in the capacity market in California, and against both El Paso affiliates for affiliate abuses (see NGI, Sept. 30).

The Commission now has the option to accept or reject in full or part Wagner’s decision. The oral arguments were the last step before the complex, drawn-out complaint case goes to FERC for deliberation [RP00-241]. The complaint case has been pending at FERC since April 2000 (see NGI, April 25, 2000). Since then, the complaint has gone through months and months of hearings, yielded two conflicting decisions by an administrative law judge (ALJ), as well as a full Commission ruling that cleared El Paso pipeline in March 2001 of charges that it rigged the bidding for capacity on its system to favor its affiliates (see NGI, April 2, 2001). The agency re-opened the issues after coming under immediate and intense pressure from all sides, including Capitol Hill.

El Paso: Judge Wagner’s Calculations Flawed

El Paso’s Collins said the delivery capacity assumptions made by the judge were flawed. Wagner had calculated that the pipeline had average physical delivery capacity over the time period addressed of 3.29 Bcf/d and actually delivered 2.594 Bcf/d, leaving 696 MMcf/d unused. “All other pipelines serving California had unused capacity during the time frame” totaling between 300-700 MMcf/d. “No other pipeline in the U.S. runs at 100% load factor every day of the year,” Collins said.

Of the alleged available capacity, 270 MMcf/d was reduced capacity because of safety measures required after the Carlsbad, NM, pipeline explosion; 95 MMcf/d was out for maintenance (of which 60 MMcf/d was required by the OPS); 220 MMcf/d was unavailable to California because of the unprecedented growth in the east of California market; and 110 MMcf/d was capacity that was available, but was not used by customers, the El Paso representatives claimed.

El Paso explained that most of the capacity it held was in Blocks I and II, which had a less desirable (more expensive — Permian) path than Block III capacity or other firm capacity on the system, which accessed the San Juan Basin. El Paso counsel also explained that shipper scheduling at 200 receipt and 145 delivery points with hourly swings of up to 500 MMcf/d was responsible for unused capacity. Open access rules put scheduling control in the hands of the shippers, making it impossible for the pipeline to coordinate deliveries. Also, they said, takeaway capacity was not always available from Southern California Gas at the border.

Contrary to Wagner’s decision in September, SoCal Edison’s Lipson and other California supporters argued that El Paso Merchant, which contracted for one-third of the capacity (1.22 Bcf/d) on El Paso Natural Gas between March 2000 and May 2001, was equally guilty of market manipulation in California starting in the summer of 2000. Every major California shipper on the El Paso system nominated 100% of their capacity at the time, but El Paso Merchant nominated only 76%, according to Lipson. El Paso Merchant flowed only 54% of its transportation capacity during the period, driving up border and basin prices, he noted.

Assuming shippers were operating at an 85% load factor then, Lipson estimated all unaffiliated shippers on El Paso would have had unutilized capacity of 38 MMcf/d during the period starting in June 2000, while El Paso Merchant alone would have had a minimum of 348 MMcf/d of unutilized capacity. The merchant affiliate “made very half-hearted attempts” at releasing capacity, he said. Even “more startling,” California representatives contend the merchant affiliate, assuming a 100% load factor, could have had as much as 500-700 MMcf/d on average of unused capacity between June and November 2000, which they noted was about the size of another Kern River pipeline.

If El Paso Merchant had released just a “relatively small amount” of the capacity that it allegedly kept off the market, the “prices would have remained at competitive levels and [the] California gas crisis would have never occurred,” Lipson said. As evidence of the merchant affiliate’s market power, they noted that gas prices in California dropped significantly when the company’s contract with El Paso expired.

“The sky was the limit [for El Paso Merchant], and it reached for the sky,” said Harvey Morris, attorney for the California Public Utilities Commission (CPUC).

Arguing for El Paso Merchant Douglas Robinson said the merchant company did not have market power, as evidenced by the fact that the merchant affiliate put more supplies into the market when prices were high, which would help drive the prices down. El Paso Merchant was a “price taker — the opposite of a firm that has market power.”

Also the company hedged its transactions, giving up $690 million that otherwise would have been profits to its hedging partners. This shows that far from holding market power, El Paso Merchant was at risk and needed to hedge the use of its capacity.

Questioned by Commissioner William Massey, El Paso’s Scherman said a memo to El Paso Chairman William Wise saying the merchant division could make money by increasing the load factor and widening the basis spread was taken out of context. It was part of an overall report to the board of directors and was not a marketing strategy. It was simply a statement of fact and part of the chairman’s exercise of his fiduciary duty. Moreover, Scherman said, there was no evidence that the head of the pipeline unit was present at the meeting.

Scherman described market conditions at the time of the “perfect storm” that hit California, and said the state had set the stage by ordering its utilities in the mid-90s to turn back firm capacity and quit paying reservation charges. “The CPUC bet on the spot market; it was a fatal flaw in electricity; and a fatal flaw in gas….The rise in prices was the legitimate response to unprecedented supply and demand conditions.”

The Wise memo referred to by Scherman was one of three “protected” El Paso document exhibits that FERC agreed to make public during last Monday’s oral arguments. El Paso attorneys objected to the release of the “confidential, sensitive business information,” and asked FERC to weigh the potential for competitive harm to the energy corporation.

The April 2000 memo to Wise said the company could “make money two ways” — increase the load factor on its pipes and/or “widen the basis spread” between the California border and the producing basins that it serves. The memo, which was written by Greg Jenkins of El Paso Merchant Energy, also talked about the El Paso pipeline’s ability to move gas to “East of the Border” markets, such as Arizona and New Mexico, and away from California, as well as its strategies in Mexico and Texas.

El Paso Document Discusses ‘Idling Large Blocks of Transport’

In one document, which was presented to El Paso’s risk management committee in February 2000, company executives talked about whether there was “sufficient financial liquidity” to “justify idling large blocks of transport.” They also discussed the role of storage to “help manipulate physical spreads, adding to overall transport/storage cost,” and addressed the risk involved “if marketing takes over transport.”

Another document, identified as “Strategic Advantages,” discussed El Paso’s “ability to influence the physical market to the benefit of any financial hedge position,” and its “control of [the] total physical market” at key points along its system (San Juan Basin, Permian Basin and Waha, for example).

FERC Chairman Pat Wood said last week the agency will likely issue a final decision in the case by the end of the first quarter 2003. If the ruling should be unfavorable to the El Paso affiliates, some energy industry experts told NGI they believe the Commission has “very broad authority” to take disciplinary action against the energy corporation and essentially could destroy it, while others believe the agency’s remedial powers are “somewhat limited.”

FERC “has the ability to extract significant punishment which would have a major impact on the company at the receiving end. Essentially, it could eliminate your ability to do business,” said one Washington, DC, energy source. “Don’t just think about monetary penalties. FERC is aware they have many other options” at their disposal, he said.

The agency could strip El Paso pipeline of its pipeline certificate or take away El Paso Merchant Energy’s license to sell electricity at market rates, if either or both are found guilty of withholding pipeline capacity to ratchet up gas prices in the California market, or committing affiliate abuses, the expert said. The agency also could yank El Paso’s license to market gas.

“That’s real world stuff…that has the potential to destroy your business and do damage on Wall Street,” he said. “If they want to extract a pound of flesh, they know how they are going to get it.”

It’s “not only what FERC could do to them [El Paso], but it’s the spillover effect” on Wall Street and in the courts, said a former FERC insider. He believes an unfavorable decision for the Houston-based company could provide the fuel for more lawsuits by California. The effect on Wall Street could be substantial, he said. “The whole industry is kind of in a hair trigger environment, and the slightest piece of bad news triggers concern by the investment community.”

The Commission’s authority to order refunds and penalties, however, is a bit more narrow, experts agree. Under Section 5 of the Natural Gas Act (NGA), which is the applicable law in complaint cases, FERC has no power to order retroactive refunds for gas overcharges. It can call for refunds after conducting Section 206 investigations on the electricity side, but it can’t do this in gas complaint proceedings that are either brought by third parties or instituted by the Commission itself.

FERC’s ability to impose monetary penalties also is restricted. The penalty level “by today’s standards is pretty de minimis,” said the ex-FERC official, adding the fines for violations “were set back when the statute [NGA] was first enacted in 1938,” and they haven’t changed much since then. The Commission’s penalty capability under the NGA is limited to about $500, but it can levy penalties of $3,000 a day per violation under the Natural Gas Policy Act (NGPA), said another energy expert and avid FERC watcher. But since pipelines no longer sell gas, they aren’t subject to the NGPA, she noted.

The Commission’s real remedial authority might be found in El Paso pipeline’s certificate, assuming the pipeline violated it, she said. The ex-FERC official agreed, noting that El Paso’s certificate or tariff might provide a “hook” for FERC to take harsher action.

Experts are split over whether the Commission might refer the case to the Justice Department. “Some provisions under the [Natural] Gas Act call for referral of certain cases to the Justice Department,” said the former FERC member, who thinks the agency may pursue this action. But two other industry experts immediately ruled this out as a possibility.

Some believe that FERC’s final ruling in the California vs. El Paso case could be the most significant ruling it has ever made, but the experts disagreed. “I think it’s an important decision, but it’s not the most important one,” said one.

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