Oil Pipeline Ratemaking 

Methodologies

Michele Joy

Association of Oil Pipe Lines

May 18, 2004
Pipeline’s Goal

To meet competition and to 

capitalize on business 

opportunities.
Regulator’s Goal

To promote competition and to 

protect shippers from the 

exercise of undue market 

power.
Our Goal Today

To understand the content and 

intent of the law so as to 

achieve the regulator’s 

objectives while meeting the 

pipeline’s goal.
FERC Mandate

• 1906 Interstate Commerce Act

– Interstate oil pipelines must be common carriers 

(with a few minor exceptions)

– Rates must be just and reasonable

– Undue discrimination & preferences are 

prohibited

– Carriers must file and post tariffs

• Politics work against deregulation
Status of Oil Pipeline Regulation 

Pre-Energy Policy Act of 1992

• Uncertainty regarding Opinion 154-B

• ARCO experience

• Some companies earning above Opinion 

154-B revenue levels

• Uncertainty regarding market-based option

• Buckeye experience

• Exposure in the event of complaints
The Energy Policy Act of 1992 

(EPAct)

• All existing and unchallenged rates are 

deemed just and reasonable 

(“grandfathered rates”).

• Those rates can only be challenged upon a 

demonstration of “substantially changed 

circumstances.”

• The Commission is told to introduce new 

procedures.
The Energy Policy Act of 1992 

(EPAct) (cont.)

• Congress orders the Commission 

to establish a “simplified and 

generally applicable ratemaking 

methodology”
The Result: Four alternatives

for existing rates

• Indexation

• Settlement Rates

• Cost-based Rates

• Market-based Rates

• Plus Security Cost 

Recovery Surcharge
The Result: 

At least two ratemaking options 

for new service

• Negotiated Rates

• Cost-of-Service

• Market-Based Rates
Indexation

The good news:

–It’s simple

–It’s usually optional

–Challenges are limited

The bad news:

–It’s been negative

–Negative is mandatory
Indexation

• Index applies to pipeline’s ceiling rates

• Actual rates may be less than ceiling rate

• Ceiling rate may be re-set if alternatively set 

rate accepted

• If existing rate above new ceiling rate, it 

must go down or alternative rate 

justification must apply 
Index Adjustment

• To be reviewed every five years

• First review left index unchanged

• Court of Appeals found analysis flawed

• FERC revised index from 2001 to PPI

• FERC plans to review index again in 2006

• Court of Appeals affirms revised index
Settlement Rates

• All current shippers using that service must 

agree to the new rates. 

• If settlement rate is challenged, the pipeline 

may defend the rate on either a cost-of-service 

or competitive basis. 
Cost-of-Service

• This option is not automatically available 

– First, the carrier’s costs must 

“substantially diverge” from revenues the 

carrier is capable of earning under 

indexed rates. 

– The costs must then be justified using the 

Opinion No. 154-B model. 
The Opinion No. 154-B Model

• Cost-of-Service showing for oil pipelines 

differs from other FERC regulated 

industries in two principal respects

– Starting Rate Base

– Trended Original Cost (TOC)
Starting Rate Base

The formula looks like this: SRB = O(d) + R(e)

where:

SRB = Starting Rate Base

O = book net depreciated original cost as of 12/31/83

R = net depreciated cost of reproduction new from 

1983 valuation

d = debt ratio as of 6/28/85

e = equity ratio as of 6/28/85
Trended Original Cost

DOC TOC

A Nominal Rate of Return (ROR) 16.00% 16.00%

B Inflation Rate n/a 7.00%

C Real ROR A-B n/a 9.00%

D Rate Base $1,000 $1,000

E Return on Rate Base

Nominal for DOC A 16.00%

Real for TOC C 9.00%

F Current earnings DxE $160 $90

G Inflation Rate n/a 7.00%

H Deferred earnings GxD n/a $70
Compare - Security Cost 

Surcharge

• No substantial divergence test

• Costs must be linked to enhanced security 

post 9/11/01

• Both capital and operating costs may be 

recovered

• Confidentiality will be maintained if 

warranted
Market-Based Rates

• Requires a mini-antitrust showing. 

• The carrier must demonstrate that there is 

adequate competition in both the origin and 

the destination markets.

• Finding made that individual pipeline lacks 

market power in each market examined. 
Carrier’s case must at least do the 

following: 

• Define the relevant geographic (origin 

and destination) and product market.

• Identify competitive alternatives.

• Compute the market concentration.


Questions about market-based 

rates

• Market-based rates are only permitted 

in markets where a pipeline is found to 

lack market power.

• Uncertainty on how to set rates in less 

competitive markets.

• Only guidance has been to avoid cross 

subsidization.
Initial Rates

• Requires agreement of at least one unaffiliated 

shipper, or

• Rate must be justified using cost-of-service 

methodology.

• Even if the unaffiliated shipper agrees, the rate 

may be challenged by anyone with an economic 

interest.

• Pipeline must then defend using cost-of-service 

method, unless Commission approved alternative.
Alternatives for Initial Rates

• Special contractual agreements 

(Express) 

• Market power showing 

(Longhorn)
Conclusions

• The regulations allow rates to be set using 

four different methodologies

• This flexibility in rate setting reflects the 

history and competitiveness of the industry

• Industry players must understand the 

regulations to structure business deals 

appropriately

• The Commission must understand the 

business drivers in order to foster pipeline 

growth while protecting shippers