Earl Warren: 99, 100, 101, 102, 105, 117, 181, 261, 262, 266 and 388. Mr. Solomon.
Richard A. Solomon: Mr. Chief Justice, members of the Court, this case on clause appeals from the Tenth Circuit presents for the Court's consideration, the validity of the Federal Power Commission's first area rate determination fixing just and reasonable rates for the sale by producers of natural gas for resale in interstate commerce. The particular decision here involves the so-called Permian Basin of West Texas and New Mexico, which is a major producing area responsible for approximately 12% of the gas flowing in interstate commerce. Off of this gas, roughly three-quarters, a little bit more than three-quarters, goes to the California market and the remainder to on-route are points in Arizona, New Mexico, Texas and by another pipeline to the Midwest. The prices fixed by the Commission in this case will result in refunds. That is refunds with respect to increased prices which had previously been suspended by the Commission and allowed to go into effect subject to the refund obligation of approximately $32 million plus interest. In addition, and certainly no less important, the decision will result in annual rate reductions beginning as of September 1st, 1965, the date of the Commission's decision, of approximately $16 million a year. But obviously, the decision although important for itself, has greater importance in establishing the legal framework for all producer ratemaking. And this includes the four other cases that we now have before the Commission in various stages which together with Permian, when they are completed will fix the rates for gas flowing in interstate commerce approximately 93%. In other words, with these first five cases by process of packaging, we will be able to dispose of 93% of the gas flowing in the interstate commerce.
Speaker: Does those involve other (Inaudible)?
Richard A. Solomon: Yes sir, the one which is nearest to being completed is the Southern Louisiana area. There is a case involving the so-called Hugoton-Anadarko Area of Kansas, Oklahoma, and Texas. There is a case which is concurrent with it which involves three of the Texas Railroad districts along the Gulf of Texas. And there are some newer cases which has packaged all of the areas in between in the southwest which probably will depend on how you split them up where they're closer to one group or another. Yes, it is different areas. We are strongly urging in this case that the Commission's decision be infirmed in its entirety. Now, the genesis of the action under review here today is of course the Commission -- this Court's decision in 1954 in the Phillips case, hearing of 347. It's first held with the rates which natural gas producers should sell their gas in the interstate commerce, are subject to regulation by the Commission. I don't think I really have to go into detail with this Court as to the history during the succeeding six years, or rather a board of history of the Commission's attempts to resolve this price in question by conventional individual company cost of service rate making technique. As you are aware, in the second Phillips case, which in this Court is styled Wisconsin against the Federal Power Commission, decided in 1962 in Volume 373. In the second Phillips case, the Commission reached the conclusion that the individual company prudent investment cost of service technique made no sense for the natural gas industry, economically, administratively does not acquire it legally. Instead, it's cited that would institute these area rate proceedings of which this is the first. In the interim, building on this Court's decision in the CATCO case, the Commission has utilized its conditioning authority under Section 7 of the Natural Gas Act, to as the Court put it, hold the line, this program has worked. It does not only stopped the previous spiral of prices which the Court is aware of, but its resulted in the last seven years, in price reductions below contract levels which for the seven-year period have aggregated about $134 million. And I want to say that there're another $20 million in refunds which will ride on the decision of this Court in another series of cases to be heard later this term. The petition -- the Commission's 1960 Phillips decision decided that we were going to regulate by area rates, but I'm afraid, it's fair to say, a very little else. Accordingly, when the Commission instituted the Permian proceeding which it did roughly two months thereafter, that on December 23rd, 1960, there were virtually no guidelines as to how the parties to -- should proceed, or for that matter, what the Commission's real intent was. I very strongly suspect that this uncertainty together with certain language in the Phillips decision itself which could be read as indicating that the Commission would drop consideration of costs and rely largely on unregulated field prices was responsible for the unhappiness of the consumer interest such as the State of California, who unsuccessfully challenged the Phillips decision in this Court. But as I will show, that if this was what they were afraid of, their fears have not -- their fears were unwarranted. I think it maybe helpful to the Court in evaluating the Commission's end product here. If I briefly outline the procedure the Commission followed in reaching its decision, the order of December 23rd, 1960 named about 330 producing parties who were -- had filed rates on file in the Permian area as respondents. And in addition, about 47 other parties, some big and some small, were allowed to intervene in this proceeding. The first thing that happened was that the Commission held a prehearing conference in Midland, Texas in March 1961, to try and workout with the party some way of proceeding. But again, I'm sorry to say that very little was accomplished here, except what I guess was important, a recognition that there wasn't any real agreement as to how area rates should be established. The one thing that did come out of this proceeding in subsequent discussions among the parties was agreement that there should be a cost questionnaire developed by the Commission staff with the assistance of the industry. And since it was recognized that the preparation and the filling out and compilation of this cost questionnaire was going to take time, it was decided that they would -- we would split up of the hearing and we would start the hearing with general evidence on the economic phases of the industry. Now, this economic phase in the -- of the hearing were important phase of the hearing, started in October of 1961. It started essentially with producer testimony. They stressed as one would expect the alleged existence of a free and competitive market for the sale of gas from producers to pipelines. And the more -- they need to encourage gas exploration and development to meet the ever increasing demands for gas. The producers in effect asserted that the only way the country was going to be able to get enough gas to meet these increasing needs was by substantial price encouragement to the producing industry to go out and explore for and develop new gas fields. And this they suggest that in terms of the Permian Basin would necessitate a ceiling price of about 20 cents which was roughly about 4 cents higher than the going price for gas in Permian at that time. Now, in the course of this presentation, the producers presented some very significant and fairly unique as of that time evidence that the production industry which formulate had been very much tied together between the exploration and development of oil and gas, was that they were locked together whether they like it or not, that the production industry as of about the time of the beginning of this case, you can't fix a definite date, some people got this, what I'm about to say earlier, others who were getting it at the time. But roughly about this 1960 period, the production industry had developed the ability and capacity to explore and drill directly for gas reserves as contrasted with oil reserves. Now, the importance of this is perfectly clear. In the first place, it was important to the basic argument being made by the producers, because as long as gas is merely a byproduct of oil, the argument that you need very high prices to induce gas exploration obviously is not a very good one. But if now for the first time, you could really explore for gas individually, and if you could decide where you're going to put your money, that price arguably became significant. The producers put forward this directional argument as a contention that there should be a general increase in prices or at least a high ceiling applicable to all gas. They did this despite the fact that a lot of the gas, flowing gas, was oil-well gas or what in this standpoint is the same thing, residue gas produced from oil-well gas. Let me -- maybe I be better to find some terms that I'll be throwing around here. By gas-well gas, we're talking about dry gas, gas which more or less is not connected with oil. It's about -- it comes out of reservoirs which are not oil reservoirs. As we'll get into in a few minutes, there's a serious problem here too because gas-well gas or at least most gas-well gas does have some heavy hydrocarbons condensate which are liquefiable and which not only are liquefiable but which are probably more valuable economically if they are liquefied. So we still have the condensate liquid problems to deal with. But --
Byron R. White: Mr. Solomon, may I ask you, what was the proportion of gas that (Inaudible)?
Richard A. Solomon: The proportion of gas-well gas is increasing. In Permian Basin, there was at the time of this decision still roughly two-thirds oil-well gas. The Permian Basin essentially started out as being one of the big oil reservoirs of West Texas. But even in Permian Basin, the gas-well percentage is increasing nationally. It is I think, almost up to 50% or maybe higher are -- well, 66% nationally now. And I think everybody in this room recognizes and believes that the future here lies with gas-well gas.
William J. Brennan, Jr.: You mean two-thirds of it is now are --
Richard A. Solomon: Two-thirds of it nationally –-
William J. Brennan, Jr.: (Inaudible)
Richard A. Solomon: -- is now gas-well gas.
William J. Brennan, Jr.: Over what period does that derive?
Richard A. Solomon: Pardon?
William J. Brennan, Jr.: Of what period of years does that come about?
Richard A. Solomon: Well, you can't talk that way. The original gas discoveries in Kansas or the thing which probably more than anything else started the natural gas industry is the pipeline industry was gas-well gas. Then you've got a lot of this oil-well gas in the big developments in Texas, then in Northern Louisiana, and now the offshore gas. A lot of the offshore gas which certainly bring major gas is coming in as gas-well gas. It's exceedingly rich and condensate. So we're not just talking about the natural gas industry, but it's not oil. Well, the point I was making was that the -- this directional hypothesis were put forward as a general claim for a price increase, even though most of the gas in Permian to be priced was oil-well gas or residue derived from the oil ones. And even though all of the flowing gas or practically all of the flowing gas had been developed prior to the time in which there was any significant directional search. Now, the reason for this of course and maybe I should mention this again because another basic fact is distinguished with this industry from certain others, is that gas is sold on 20-year contracts. Actually, these contracts after they expire they tend to be even further selling, gasses sold now which was developed 15 to 20 years ago. And the flowing gas of 1960 isn't gas that was developed in 1960. Now, based on the facts that I just mentioned and the recognition that gas-well gas is the need for the future, the distributors in their economic presentation put forward to the Commission a basic new approach to the whole subject of gas pricing. They relied largely on policy testimony by Dr. Alfred Kahn, the chairman of the Economics Department of Cornell University, has developed a more concrete terms by his economists statistician, what have you, colleagues of a private organization going under a rather fancy name of the National Economic Research Associates. I would -– I should give any impression that this is a governmental body. And the distributors working through these people developed what has been known as the two-price system, which the Commission eventually adopted. They started from the premise and that there is a finite and discernible cost for the separate search development and production of gas as distinguished from oil. And Dr. Kahn proposed that if this is the case, that the new gas-well gas, the gas of the future, the gas which was going to be responsive to price and was the gas that needed to adduced, should be separately priced from the old stuff and should be priced not on historical cost concepts but price on the basis of its own current cost for this search and discovery of gas, this of course would achieve a number of basic advantages. Afar from the least is that it would eliminate in this basic pricing determination many of the more difficult allocation problems which have driven us all mad in this case of trying to determine what the joint cost of oil and gas should be when they are joint product that people aren't -- are really operating one better than the other. And I said, there are still all these all problems of condensate but at least you got rid of the -- the oil part of it. In addition --
William J. Brennan, Jr.: Are these problems of condensate is the same as just -- as to other aspects of the same problem?
Richard A. Solomon: They are similar but they're not --
William J. Brennan, Jr.: As far as the allocation --
Richard A. Solomon: What, what?
William J. Brennan, Jr.: As far as the allocation as between the products?
Richard A. Solomon: No, we don't think so. And if you look at the decision, you'll see for example that in this new gas-well pricing, instead of making an allocation of embedded cost, what the Commission was able to do using the information supplied in the record by both producers and distributors in picking and choosing the proper ones, was to price the gas and have priced the operation which leads to gas and have a condensate liquid credit based upon the value, and on regulated liquid business and simply determine that the liquid credit which is what these people are getting from liquids is the part of the cost which can be subtracted from gas, and to a large extent, avoid these allocations. Now, we do have some, I don't want to oversell this, like most things, this is a matter of degree. But if you will read the very good discussion on this in the Commission decision and the examiner's decision, you'll see that the very great advantages and improvements were made on this issue. The other point I'm trying to make and certainly equally important is that by this two-price system based on a current cost for gas, we are able to adjust prospectively gas prices as conditions in the cost or otherwise required without automatically raising the price on oil as other flowing gas and giving windfalls to people who produce gas under very different conditions. This is not important in terms of the Permian decision that we have here before us. This math that we could fix and did fix a cost based price for new pipeline gas of $16 and a half cents without affording the 2 cent windfall which would have resulted if we priced flowing gas at this price which on historical basis came out to $14 and a half cents. Now of course, you could have done it another way, you could have combine these prices and come out with something in between. But if you would have done that, maybe you would have avoided the windfall to a certain extent if not completely. But you wouldn't have had as higher price for the new development and search as the Commission found was the appropriate price if you're going to induce enough gas. Let me take sometime here, it's a useful thing to do, to discuss some of the arguments against this two-price system. Nobody was bored originally except the distributors, the staff of the Commission and the staff of the California Commission argued that this was all very well in theory but there really hadn't been much of the demonstration that this directional search had been put into effect as yet. And they said that under these circumstances the historical method was appropriate, particularly since the evidence indicated that there were not any great price up trends in cost since about 1958. The Commission disagreed with this and concluded that the evidence did show that there was a real increasing directional ability here and that it would agree with the producer and distributor evidence on this point. And this of course required the rejection of the two staff's argument. It also --
Abe Fortas: Rejection of what?
Richard A. Solomon: -- I'm sorry to say --
Abe Fortas: Rejection of what, Mr. Solomon?
Richard A. Solomon: Rejection of the argument against the directionality.
Abe Fortas: When you say distributors, you mean the pipeline companies?
Richard A. Solomon: No sir, I do not.
Abe Fortas: Whom do you then?
Richard A. Solomon: One of the interesting things as I will bring out in this argument is the relative silence of the pipelines. The --
Abe Fortas: What do you mean when you've been talking about distributors (Voice Overlap) --
Richard A. Solomon: The distributors are primarily a group of the distributors of gas in California, Pacific Gas & Electric, Pacific Lighting Companies, San Diego Gas & Electric. The people who are selling gas on the firing line, one of the more interesting factors in this case is the pipelines are much less interested in this price for their own gas even though its one of the major components of the costs.
Abe Fortas: And the producer --
Earl Warren: Even though what?
Richard A. Solomon: What?
Earl Warren: I didn't hear that last part, even though what?
Richard A. Solomon: Even though the cost of purchased gas is one the major components in a pipeline's cost, the people who are interested in price here and the people who are arguing that the price should come down and knots go up, the people who were fighting this case from a consumer's standpoint outside of the Commission and outside of the California Commission, were the distributors, not the pipelines. There are very good reasons for this which I will get into. The rejection upon the acceptance of directional capability did unfortunately require of the rejection by the Commission of a major pioneering effort by the staff. Our chief economist, Dr. Harold Warren had developed and put into evidence an econometric study attempting to relate supply and demand in this industry. His study had not taken into account directionality and the Commission felt that as a result of this, that it was necessary to -- they couldn't rely on it. The Commission noted with respect to this study as well as certain other imperfect pricing techniques which had been put forward here, it's hoped that future developers might make their use possible in subsequent proceedings, because I want to make it perfectly clear. We're convinced that this present area rate decision is a good one. Fully meeting the end requirement task of the Hope -- but we don't suggest it's the final word and we know that we're going to develop further insight into this problem with experience in the other cases and with experience in our future review. The producer argument of the gas two-price system, was of course that they should -- as I said, that they should get the higher price for all of their gas. And it's most unsophisticated level that the argument is gas is gas. And the consumer, the pipeline, can't tell whether a molecule was old gas or new gas, but therefore, even if the old gas had been developed as a pure byproduct of the search for oil, it should have the same price. We don't think this is a really a good argument. This is the same type of argument that got this industry into trouble though the indefinite escalation clauses whereby everybody in the industry would always get the highest price that was being charged at a later date. Now you can -- just as well say money is money which of course it is, but that doesn't mean -- because money is money, that where interest rates on a mortgage -- mortgages go up, that the interest rates on old -- the old mortgages go up as well. The fact is that gas maybe gas molecularly but the value of gas and the cost of gas at different times and on different circumstance are not the same thing.
Abe Fortas: Mr. Solomon, when you talked about directionality, you mean prospecting, directed to the discovery of gas-wells as distinguished from oil?
Richard A. Solomon: Yes sir.
Abe Fortas: Well now, in this -- can you tell what the – a producer or prospector is going for? In other words, does the technique used to prospect for gas is so different from the technique used to prospect for oil, if you can tell which names the outcome, that is --
Richard A. Solomon: I don't think it's somebody --
Abe Fortas: -- that's the subject of the facts here.
Richard A. Solomon: I understand your question. I'm not an engineer. I don't think this is an engineering question so much as a geological question, various techniques of seismograph and other things. We are just better equipped to judge on the basis of what we know before. Whether if you drill at this particular spot to a given level, that you're more likely to hit a gas reservoir as contrasted with an oil reservoir. Now, this is not a matter of absolute. Somebody drills right under this building, you probably won't hit anything, but there are obviously be no basis to determine whether this is going to be oil or gas if they hit something. This is a basis of accumulated experience. But it is pretty well established now that this industry does what inland -- know what it's going to search for when it's searching. The other contention against the two-price system is that a one price high price should be allowed for all gas because revenues from gas have been the primary source for reinvestment. But as the Commission pointed out the allowances in the old gas price here, in over beyond out-of-pocket cost, the allowances for exploration and development in DD&A depreciation, depletion and what's that? I forgot. In return, will all provide more than adequate revenues for reinvestment if the price is right. If the price for new gas isn't right, it doesn't matter how much money you give for old gas, they'll simply put their money on other places. Moreover, the producer just aren't restricted to old gas revenues, they have plenty of revenues from other sources which they'll put into gas if the price is right. And they have accessed to equity and debt. In short, gas exploration and development will continue as long as there's a profitable market for natural gas and won't continue if there isn't. The choice of the two-price system resulted in another problem for the Commission and that is the evidentiary problem. As I indicated, we had agreed to prepare and did prepare with the cooperation of the producers and the distributors and the clients, a detailed cost questionnaire. The data from this cost questionnaire is very useful, subsequently used as the basic method of fixing the price for old flowing gas. It was also used to a very great extent for new gas but it was not adequate to this task. It was not adequate to this task because it had been geared at the beginning of this proceeding to a conventional historical cost approach and there was a lot of information which would need it if you're going to get a current cost for gas discovery which was just not in this cost questionnaire. Now this presented a problem but it was not an insoluble problem and the breach was filled and testimony by both producers and distributors, by a careful selection by expert witnesses of information taken from a variety of sources to supplement the cost information. These sources range from the United States Census of Mineral Industries, to a Chase Manhattan Bank gas survey, to information developed on a regular basis by the American Gas Association, the American Petroleum Institute, to trade publications such as the Oil & Gas Journal and the World Oil Magazine. The witnesses were on an agreement generally as to what they were looking for by way of information. They disagreed as to what was the better source when there were one or more source to be picked from and exactly how the matter would be derived from these sources. But their individual expositions on this matter were subject to most extensive and thorough cross-examination and most careful and detailed analysis by, first, the examiner, and second by the Commission.
Abe Fortas: Was the information that was collected confined to the Permian Basin, these questionnaires you're talking about?
Richard A. Solomon: No sir. The information collected in the questionnaire was both national and Permian. And the information that I'm talking about now is the broader information, was in some respect only matched as of --
Abe Fortas: Only matched?
Richard A. Solomon: Only matched, so the --
Abe Fortas: So that the conclusions here are based on national data?
Richard A. Solomon: The Commission decided for the reasons that they explained in some detail that the new gas-well gas price would be based on national data or as part of a new discovery for the future generally. The Commission also decided and utilized for Permian figures which are more directly related to Permian. But even there, they picked and chose and when they got to a matter like exploration and development expenses for dry holes for the non-product of the search, they used -- as everybody agreed, they had to -- national figures. The Commission also faced up to the question as to whether there was a justification or not in new gas-well price for separate deviations for this national law for Permian cited there was not, this has not been shown on this record. These selections were by no means one way. I think it's fair to say that the examiner and the Commission costing is largely based from the evidence of Dr. Roseman (ph) who was a witness for the distributors, but there are situations in which the Commission found he was too low. There are other situations where they found he was too high. There areas where they picked other testimony which they thought better reflected the true fact. This picking and choosing of statistical information of the pipe I'm talking about has been criticized in the briefs here primarily by the Sun Oil Company as being outrageous attempt to get away from anything which is real in the way of cost. It's surprising since Sun or the other producers were violently against the effort by the California Commission to adopt the uniform system of accounts during the course of this proceeding. But actually Sun was right and California was wrong. Because any efforts to adopt the uniform system of accounts which give the – which – we'd had one. The beginning of this proceeding, it would have almost certainly not proved adequate to the past because this whole directional idea and lot of the other developments here were things which grew up in the course of this proceeding. We picked and used on a thoroughly analyzed basis, good statistical sources by no means skew against the industry. We analyzed them to the best of our ability and the argument that we should have waited until there could be agreement as to a uniform system of accounting and statistical information. And then developed area rate making is of course only an argument that we should postpone, area rate making in depth, the Commission was not willing to do this. Sun is also challenged and maybe it's a good point to mention this, the data we used in pricing old gas-well gas, the flowing gas, now here the information from the cost questionnaire which we had agreed with in various parties was available and usable. And it was used as the basic way of pricing the old gas-well gas. It was, however, and I think this is not unimportant, wasn't just on that way. The examiner has suggested that there was a possibility of a technique of trending back the new gas-well prices that he had found on basis of cost trends over a period of years to get the old gas-well gas. And the Commission used this technique as a check against its historical cost and technique and came out with a quite comparable figure of the old gas-well cost on a historical basis with about 14.39 or 37. On the trend back, it was 14.67 or something like that and the Commission felt that this was a reasonable check on its figure which had grounded off to 14 and a half. Now, Sun objects to the Appendix B form which was the basic form, cost form, which were used for this old gas-well gas because it says it's unrepresented. In fact, this Appendix B form includes the cost for the producers who in Permian account for 85% of the gas-well gas. Sun knew that the figure of 15% on some place or other achieves this figure of 15% by simply ignoring the fact that the Commission, to avoid the worst of these allocation problems, Justice Stewart, shows not to price oil-well gas, flowing oil-well gas at all, but instead priced gas-well gas and fixed the price of oil-well gas on a value basis at the same level. It also gets this low figure by of course of the Commission in another similar effort. It didn't use the figures which we had on the record, in which of anything. It gives a slightly lower price relating to so-called combination of oil and gas leases. Again, we avoided using these figure because it involved an allocation between oil and gas which we thought would produce a result less true than if we didn't used these figures at all and used the other mass of material we had. The only real question as far as the use of the questionnaire information is concerned, as I said, is with respect to small producers and whether these costs are representative of the cost of small producers. Now here --
Abe Fortas: Before we get to that, Mr. Solomon, let me see if I understand this. You just said that the Commission arrived a cost of gas-well gas and then trended that back to find the cost for old well gas --
Richard A. Solomon: Old gas-well gas.
Abe Fortas: -- old gas-well gas, and the -- then took that figure and used that as the basis for costing the --
Richard A. Solomon: No.
Abe Fortas: -- gas in association with oil?
Richard A. Solomon: No. What I said was that the old gas-well gas was fixed primarily on the historical cost from the cost questionnaire, checked out against this back trending.
Abe Fortas: Yes.
Richard A. Solomon: We fixed the price for gas-well gas. We did not fix a cost for oil-well gas or residue gas. We decided that the costing of oil-well gas or residue gas because of the additional allocation problems --
Abe Fortas: Yes.
Richard A. Solomon: -- which would lead to horrible fights -- large amounts of money which allocation we'd picked, would not get any meaningful figure and instead we said that this gas has the value in the marketplace as the marketplace in this year showed of the gas-well gas, the old gas-well gas.
Abe Fortas: That's what I --
Richard A. Solomon: And we will give them that price.
Abe Fortas: That's what I understood you to say. In other words, that the -- let me make sure, that the oil-well gas was priced by reference to the old gas-well gas.
Richard A. Solomon: That's --
Abe Fortas: Now, have I got it?
Richard A. Solomon: You have, that's correct.
Abe Fortas: Alright. Thank you.
Richard A. Solomon: Oil-well gas was valued --
Potter Stewart: Well, how about this sweet gas and sour gas oil?
Richard A. Solomon: I'll get to that in a minute.
Potter Stewart: Alright.
Richard A. Solomon: I knew how to speak briefly about the small producer problem. The small producers, has a real problem on information. They just don't maintain the type of books upon which you can get any meaningful information. The Commission tried to handle this by providing for a simplified Appendix C questionnaire which was optional for small producers under 10 million Mcf a year and it didn't work very well. Of about 285 small producers in this area, 25 of them chose to respond on Appendix B. That's the main one. A 130 responded on Appendix C, but of that information, only 60 of them had anything which you could even use for compositing the factors. It's true and an argument is made here that the composite cost of the 60 small producers who did submit usable material on Appendix C, are somewhat higher than the Appendix B clause which we used for old gas-well gas. But it is also true that the 25 small producers who filed on Appendix B who went about as much gas as the 60 will file on Appendix C, it's slightly lower cost than the major producers. Casting real doubt upon whether these higher costs on Appendix C were really meaningful, and moreover, if we had included these Appendix C clause in our old gas-well gas, which we did not, the total effect would have been roughly -- well, it's less than a mill, seven-tenths of a mill on the entire business. I don't want to give the impression that we -- in our decision here, as the result of this ignored small producer problems. There isn't any evidence as far as I know that small producers really have lower cost on the overall basis. There is some evidence that some other costs are lower such as drilling companies. There are also evidence offsetting this that some of their cost -- pardon me, some of their costs are higher really, also evidence that some of their costs are lower. They used the geophysical and geological and lease work of the majors in the like piggyback ride. But what's more important, even if the smaller producers as a class did have demonstrably higher cost which they don't, it wouldn't materially aid them to set a separate higher price for their gas. The reason for this is clear, even assuming that you could establish different prices for the same type of gas, nearly on the basis of the size of the company. The pipelines would not and should not buy gas for more money when there's gas for less money available in the same area. And the small producers recognized this dilemma. They have not sought a higher separate price for themselves and they have not even asked for exemption entirely from area rates as various people including Justice Clark of this Court has suggested from time to time. Instead, what they were asking is that the highest possible price for all gas so that they can ride along. A perfectly reasonable eye concept to what the real marketplace is here, the Commission was understandably, unwillingness -- unwilling to raise overall prices on this unproven claims of the small producers. But they have done two important things for smaller producers. In the first place, we have established a small producer certificate system which allows the producer to get out of the administrative burdens which are much more real for them than for the big company of continually filing with our Commission. Now they can get one certificate which is good for all of their sales and they can file up for increase as their contracts permit up to the ceiling, as we've said here without bothering to come to us with rate claims. The second place, we have, because we found it was not worth the price to do otherwise but also because it would benefit them, relieve them from observing the quality differentials that the Commission established on major permission. Now, let me get to the problem that I -- that you asked before Justice Stewart. This quality question presented another major problem for the Commission acquiring innovation of some sort or another from itself is very simple. Particularly in Permian, considerable percentage of the gas which the pipeline buy, more important, not what they buy, considerable percentage of the gas as it comes to the pipeline is not of pipeline quality and has to be processed by the pipelines at considerable expense for them and their consumers. There are a number of kinds of this deficiency which were set out in the record, high sulfur, too much water, too little pressure, and particular nasty thing in the Permian Basin, other gas comes out with a lot of CO2. And whereas the petroleum industry has shown tremendous ability to make use of all sorts of wastes and byproducts, so far, at least on this record, they haven't figured out what to do with CO2. This may come yet, but it hasn't come out. And there's additional problem and that's the Btu problem. Btu is the heating content of the gas. I think its British thermal units. Gas as it comes out of the round, depending on its molecular structure is of this different heating value. The Btu problem will come back to as a little different than these others because it goes both up and down. Now, the producer said, don't worry about the quality problem, you can depend on the pipelines to bargain this down from any ceiling rates you set for bad quality gas. And it certainly is evidenced that the pipelines in certain areas have paid less for low pressure gas which they had to compress to bring up to the level. But there's also evidence that this is far from the perfect system and the Commission was unwilling to do this while a lot of gas which has a low quality get the ceiling because there hadn't been such provisions and contracts and allow a higher in effect ceilings for bargaining in the future. What the Commission did was to treat the risk, a very real risk in the Permian Basin, of finding and developing gas of less than pipeline quality. As one of the major elements which it relied upon in fixing the 12% rate of return which fixed not for average quality gas but as the return for finding pipeline quality gas. In other words, it said, essentially the risk of finding low quality gas is analogist to the risk of finding no gas or the risk of finding gas in insufficient quantities. And we will consider it as one of the major elements in determining on a 12% rate of return on investment here. The Court of Appeals in one stage of its opinion seems to have thought this was wrong, that the -- rather being treated as risk, we should treat as a producer cost. We don't understand this because obviously this is not a producer cost, bad gas cost of producer, no more and no less than good gas. And the gas we're talking about, the processing cost we're talking about here are the cost which the pipelines have to pay. There is producer of processing gas. Of course, there's producer processing of gas in Permian, but where the producers process the gas in Permian and then sell it, they get the pipeline quality ceiling price but without any discount. Now, we don't suggest that the technique the Commission adopted for handling this difficult quality problem is necessarily the only one. The examiner equally innovating had a different one in which he fixed the price for average gas and then had a -- what you call a gold standard, above that where higher quality gas and a compression technique for lower quality gas. And the -- whereas this is far from -- perfected in the examiner's opinion, this a possible approach to the problem also. We adduce --
Potter Stewart: Is that -- is this -- sour of gas or otherwise that --
Richard A. Solomon: Sour means too much salt.
Potter Stewart: Too much sulfur.
Richard A. Solomon: Right.
Potter Stewart: Or otherwise deficient so far as the pipeline quality gas goes peculiar to oil-well gas or --
Richard A. Solomon: No, it's not --
Potter Stewart: -- more likely to be found on oil-well gas or in gas-well gas or is there any --
Richard A. Solomon: It is not --
Potter Stewart: -- any correlation at all?
Richard A. Solomon: It is not peculiar to oil-well gas. I am sure, but I have not the confidence to tell you what, that some of these deficiencies are more likely in some areas than other, but the answer to your question is no.
Potter Stewart: No correlation then, between the two?
Richard A. Solomon: I'm sure there's a correlation, but there are deficiencies and sometimes major deficiencies with gas-well gas as well as oil-well gas.
Potter Stewart: Although the deficiency is maybe of different (Voice Overlap) --
Richard A. Solomon: Different magnitude, different degree, that's right. And this is one of the reasons why the Commission decided that rather than a general reduction, it would have the quality of each individual sale determined on the basis of relationships between -- agreements between the pipeline sellers as to what the actual cost of bringing this gas is up to pipeline quality.
Potter Stewart: And this -- as a matter of practice, these costs are born by the pipelines, aren't they or are they (Voice Overlap) --
Richard A. Solomon: The costs we're talking about are borne by the pipelines.
Potter Stewart: Of course there are -- or are there, as a matter of practice, some where the producers just to -- takes his gas --
Richard A. Solomon: Oh, sure!
Potter Stewart: -- and brings it up --
Richard A. Solomon: Oh, sure!
Potter Stewart: -- with pipeline (Voice Overlap) --
Richard A. Solomon: A processing plant which is owned by the producers will -- as well as extracting higher Btus, usually raise the quality of the gas, and to the extent of the producer raises the quality of the gas.
Potter Stewart: And that's part of his costs?
Richard A. Solomon: He gets the --
Potter Stewart: But he --
Richard A. Solomon: -- he gets --
Potter Stewart: But he gets the higher price?
Richard A. Solomon: He gets the higher price –-
Potter Stewart: Right.
Richard A. Solomon: No.
Abe Fortas: But if we're going to say -- and then say 12% rate of returns which you have talked about, are you going to elaborate on that?
Richard A. Solomon: Yes, but --
Abe Fortas: The 12% rate of return, or was that a private -- is that applied across the board to all producers?
Richard A. Solomon: Yes. Well, it is the return which was allowed in fixing a ceiling. All producers won't get it, some will get more and some will --
Abe Fortas: I understand --
Richard A. Solomon: -- get it less.
Abe Fortas: I understand that but --
Richard A. Solomon: Yes.
Abe Fortas: -- it was not especially calibrated being a small producer?
Richard A. Solomon: No.
Abe Fortas: Are you telling us that it --
Richard A. Solomon: One of the factors the Commission mentioned was the small producers in fixing a return as high as 12%. But it was not specially calibrated to the small producers.
Abe Fortas: Then what percentage of the -- totaled out for the -- in the Permian Basin to distribute it to small producers as you define small producers. You said there's (Voice Overlap) --
Richard A. Solomon: 85% of the gas-well gas in Permian was produced by the large producers.
Abe Fortas: Are you telling us that a 12 -- that the 12% figure as a rate of return was determined by the Commission because of the problem of the small producers?
Richard A. Solomon: No, far from it. This was one of the minor factors --
Abe Fortas: You were saying --
Richard A. Solomon: -- that was taken --
Abe Fortas: -- that everybody --
Richard A. Solomon: -- into account.
Abe Fortas: -- everybody gets such a nice, good, fat rate of return that small producers aren't -- not to complain despite the possibility that they may have a special argument.
Richard A. Solomon: No, no, no Mr. Justice Fortas, as is normal in rate of return determinations, the Commission considered lots of factors. It considered notably minor factor but did mention the small producer problem. It considered as a major factor the quality problem. It considered the risk of finding anything. It compared the risk of this industry with the pipeline branch of it. It considered, as this Court have said, it must consider in the Hope case and other cases, what comparable industries were secured so that it – you make sure that there'd be enough of an investment inducement here for people to invest in this industry.
Abe Fortas: Well, I understand that. Well, I have a difficulty in reading the material, the – in understanding here in -- that there was any special relationship between the 12% rate of return and the special problem, if one exists with the small producers. And to what you've said now, I gather that this is not the same that the 12% whole rate of return overall are to take care of the smaller producers as well as everybody else.
Richard A. Solomon: Exactly. Well, the only other thing I want to say on this quality problem at this point because I'll get back to it a little later is that the idea the we didn't know the -- we couldn't quantify it, is not right and Commission, for reasons which I'll get into a little later expressly found that the range of quantification of this quality business was going to be between about seven tenths of a cent, one and half cent. This is based on evidence in the record. We've been accused of supporting this by post record filings of these quality statements of the actual amounts. Each individual sale is going to have -- deducted from it. Now, this isn't true. Then, we have referred to these filings which support the Commission's judgment based on the record of what the extent of the quality differential would be because it does show we were right and because we know that if the specific quality statements have shown that we were wrong by 2 or 3 cents and that this was a much more serious problem that the Commission had counted on in fixing the rate of return, that the producers quite properly would be back here saying, “You have to remand it, you've made a serious mistake even if there was a basis for you're making”. Let me say a quick word about the Btu problem. This is heating content, and here you can have very low Btu and very high Btu and this is not only a natural phenomena, but much more important, it is feasible and economic for pipelines unless there's -- for producers unless there's a good reason to the contrary to extract the high Btu's which can be converted into bottled gas and sold as propane and butane. Now, traditionally in this area, there has been a downward Btu adjustment starting at 1000 Btu per cubic foot and the Commission adopted that in its opinion. Traditionally, there has been no upward Btu adjustment in this area, but traditionally, the average value of Btu value of the gas sold was about 1042 Btu at least, this were the best statistics we could get on. And this is not insignificant because particularly in this area, the pipelines sell to the California distributors on a thermal basis, high Btu gas, they don't just extract it for their own operations. The Commission felt that significant and important here to provide an inducement to the producer not to extract the high Btu's before it got to the pipeline. And they provided for the first time, unique in this area for upward Btu. They set the upward Btu in a 1050, an approximation of the average Btu in the area. The very simple reason that the -- if they were going to give a bonus or no bonus was ever before been given, they weren't going to give a bonus for people giving less valuable gas than they have been supplying without a bonus. The Court of Appeals couldn't understand this gap of figure that we had to -- apparently a figure that if we're going to have a Btu adjustment half a start downward or an upward from the same point. For the reasons I just state, I don't think this is true but if we had done that, as long as we would have set it somewhere at around 1042 or 1050 both upwards and downwards and that would not benefit the producers quite a bit.
Potter Stewart: The way you have done it, do I understand it correctly is -- is that a downward from a thousand and upward from 1050?
Richard A. Solomon: That's correct. We used the 1000 figure which is the conventional figure --
Potter Stewart: (Inaudible)
Richard A. Solomon: -- for downward, and we used the figure approximating what was conventional without bonuses for the upward.
Potter Stewart: And in the area from a thousand to 1050, that was just standard gas area?
Richard A. Solomon: No, adjustment.
Potter Stewart: No adjustment either way.
Richard A. Solomon: That's right. Now, maybe belatedly let me turn the basic legal challenges to the Commission's action in this case. The Court in giving a green light to area rate making in the second Phillips case, as we already made clear or rather reiterated, that the Natural Gas Act does not impose any special method for fixing just and reasonable rates, and particularly that the individual company prudent investment costs of service technique which has become conventional in utility rate making since this Court decision in Hope is not the only perhaps to a reasonable end result in dealing with the industry like natural gas. The essential difficulty when utilizing individual company costs and pricing natural gas were set out by the Commission in the second Phillips decision and are summarized in Justice Harlan's decision affirming the Commission. In short, unlike a normal utility fixing a transportation or communications or heating and lighting service, prudent investment and gas exploration will have only a tangential relationship to the end product of what you will get at and maybe more important, the conversiveness equivalent grades of gas from producers with different cost. Now, whether this results from efficiency or luck, whatever, will not and should not have different values in the marketplace, likewise are not going to play high prices to one producer and another. Even if as certainly is not the case in this industry, even if gas were sold on a cost or price competitive basis. And the fact which I think measures -- mentioned in Phillips previously, that two or more producers with quite different cost frequently share the same well or the same lease, only is a further illustration of the absurdity of attempting to price on the individual cost basis. There are other problems. As the Court pointed out, individual company pricing will penalize the person who takes the risk and reward the person who say – say for a fellow who follows after him because the risk taker will have less cost for buying leases on a property where they don't expect gas. Then the fellow comes along later and buys on the periphery of a known gas reserve. And of course, the extremely grave administrative problems in fixing rates separately, even for the 45 major producers say nothing with the smaller producers is significant. The record in this case here fully confirms the validity of the Commission's original determination on this case. In fact it goes beyond this. It suggest that no pricing system based on individual producers cost will provide any real picture of even that producer's long-term cost. As we have set forth in our brief, the cost for even of the largest of producers who might be expected because of the sheer magnitude of their operations to balance out very tremendously from year to year, and not only very tremendously from year to year but there's many pattern within any one producer. Now on the contrary, the evidence on this record also indicates that for the industry as a whole, there are meaningful cross trends, reasonably three of this board swings. Thus, we've got to a situation here where you can really say that for almost any given producer, the average industry cost rather than any historical cross section of his own cost at a particular moment for several years will be a far more likely indication of what his probable cost are for the future. Of course true, that this group average experience will not be reflected by any individual company at any given moment but more in the long run to good years balancing bad years. But this is the true and accurate picture of this industry. And attempting to price individually would distort the structure. If you -- if a particular company's cost for a given year of what you have used, given a series of years which you've used as test years were high, higher than average and you set its prices on this basis. Would be a very good chance that he'd be going into a low cost period that is high cost or because he had made investment which hadn't matured yet and that in fact would be setting a windfall price range. At the same time, if you set -- if an individual company has low cost for a test period and you set his individual rates on this low cost, just as good a chance that he is about going to a high cost cycle and will be in trouble as a result of that. In short, group or area rate making not only makes sense to the industry as a whole in the consumers, but it makes more sense than anything else for the individual producer. Now these tracks in our opinion alone would support the use of the area rate procedure in the absence of a congressional directive that we couldn't use but there's plenty of judicial pressing. I've already referred to the Phillips case and the other decisions of this Court and the lower courts which have consistently indicated that an area rate proceeding might be an appropriate way for handling producer rates. More important than this maybe, under a virtually identical statute, this Court has held involving the Packers & Stockyards Act, this Court has held in the Tagg Brothers case at 280 F.2d – from 280 U.S. in the Acker and Corrick cases in 298 that you can have group price making under this type of statute. And the F.C.C. has group price making in the international telegraph field under a similar type of statute. And of course, the numerous federal and state statutes providing for group rate or price making in milk and coal, warehousing, insurance, and aviation, all indicates that there isn't any statutory or constitutional need to fix rates which are geared to individual company. Specifically, this is maybe the guts of the legal issue here. We don't believe there's any statutory or constitutional right for any claim that because average group cost will necessarily be higher than the cost of some of the members of the group at any given time and lower than the cost of others that high cost producers are entitled to rates to meet their so-called cost. As I've indicated, everything in this record indicates that over the long run, most individual producers cost will fluctuate around the industry average, and that today's high cost producers will be tomorrow's low cost producers and vice versa.
Speaker: But you might run into a problem (Inaudible)?
Richard A. Solomon: We might run into a problem, but let me attempt in the next few minutes to what we think should -- how that problem should be narrowed.
Speaker: (Inaudible) that was -- the Court of Appeals have (Inaudible) the decision.
Richard A. Solomon: No, I don't think so. I think the Court of Appeals -- yes you're right, they did think our escape clause was too broad or something. What I'm saying isn't a new proposition clause. The Stockyard cases which I mentioned, Packers & Stockyard cases which I mentioned a few minutes ago, the Court expressly made clear in those cases that the fact that the approved rates would mean in some marginal dealers with high cost wouldn't make any profit at all did not invalidate the decision and did not involve confiscation. And this really is the universal reading of group rate making cases, going back as far as Munn versus Illinois, let me read if I may what this Court said in 321 U.S., Bowles v. Willingham which was a rent fixing case, I think written by Justice Douglas, which he said it's implicit in cases such as Nebbia v. New York which involved the power of New York to fix minimum and maximum prices of milk. And Sunshine Anthracite Coal Co. v. Adkins which involved the power of the Bituminous Coal Commission to fix minimum and maximum prices of bituminous coal, that high cost operators may be more seriously affected by price control than others. But it has never been thought that price-fixing otherwise valid was improper because it was on a class rather than an individual basis. Now, it's true and in some of these cases as one of the rationales for saying the people could be hit by group rate making, even though it hit them farther than certain other people. The Court has referred to the fact that if they didn't like it, they could get out in the business. And it's equally true that under the Natural Gas Act, nobody can get out of the business without getting abandonment authority from the Federal Power Commission. But the Commission has made clear in this decision that it would continue to do what it is always done and that is freely permit abandonment an out-of-pocket cost of a particular well exceed revenues of that well. And it stated, let me read again if I may from the Commission decision, this actually appears at 659, unlike the case of some public utilities which cannot abandon service without harming a public dependent thereon, we will seldom have a situation on which a particular producer's abandonment of some or all of its sales in the area will significantly affect the purchasing pipeline. Say nothing to deal with consumers.
Abe Fortas: Will significantly affect what?
Richard A. Solomon: Significantly the affect the purchasing pipeline to say nothing of the ultimate consumer. In other words --
Abe Fortas: There were conservation interests involved here?
Richard A. Solomon: There could be, but --
Abe Fortas: And does the Commission takes that into account on abandonment?
Richard A. Solomon: Yes, it does.
Abe Fortas: And then they'll conduct --
Richard A. Solomon: Yes.
Abe Fortas: They will continue to do so?
Richard A. Solomon: There is a possibility that you would have a situation where there would be a conflict between conservation interest and the abandonment. It's a -- we have lots of these cases that we cite in our brief where people have abandoned to go into intrastate commerce. Maybe that's the solution. We're not dealing with a situation in which you have to get out of the business. It isn't like the rent control cases. You can stay in the business from going to intrastate commerce.
Abe Fortas: There's a – as the price fix --
Richard A. Solomon: But -- what you're saying is a possibility. It is a problem here. There are conceivable situations where abandonment is not the alternative where some other relief will be necessary and this is what the Commission said and provided here.
Abe Fortas: As the fact that this is a natural resource of -- that there are conservation values involved here give you any comfort with respect to supporting this price regulation.
Richard A. Solomon: I guess –
Abe Fortas: I don't --
Richard A. Solomon: -- I don't --
Abe Fortas: I don't remember any reference to the special impact, if any, that in fact, that this natural resource may have upon the legal issues to some of the cases, how much you rely.
Richard A. Solomon: Well, I am not -- I'm not -- it gives me comfort in this sense. Conceivably, if you took the lid off completely or set a very high price, obviously, one factor of that would be to some extent it would be to encourage a lot of marginal drilling which maybe shouldn't be encouraged. To that extent, yes, we do get satisfaction. But we recognized the need for continuing exploration and development and within the proper limits, we are encouraging. I don't know what to say in answer to your question Your Honor but the --
Abe Fortas: Yes.
Richard A. Solomon: In addition, anybody claiming confiscation would in our opinion be up against at least two major areas in this cost which we don't think is part of any confiscation claim at all. In first place, the Commission is allowed about 4 cents for E and D allowance, for E and D expenses. These are expenditures which went down the drain which didn't produce anything of value for the customer. Now, we don't agree with Justice Clark's suggestion in the second Phillips case that it was improper to allow disallowance. As part of a general pricing system in order to attract revenue to this industry, these expenses are part of the cost of the general operation in this industry, but producers of this industry have no obligations whatsoever to take their revenues and put them back into production. And under these circumstances, while we think it's appropriate to allow disallowance in the cost, we do not think anybody can claim constitutional right to these 4 cents. Similarly, we don't believe that anybody coming to us claiming, “I'm a high cost producer” has a right to claim that he is a high cost producer entitled to special relief because he isn't making 12%. This rate of return we allowed in large part because of the various risk of this very industry. Now --
William J. Brennan, Jr.: (Inaudible) he wouldn't get any either without a proper (Inaudible).
Richard A. Solomon: Oh, certainly.
William J. Brennan, Jr.: Even --
Richard A. Solomon: And the --
William J. Brennan, Jr.: Even though it's only because he's a high cost producer?
Richard A. Solomon: We think that if he isn't getting his out-of-pocket expenses, that he is constitutionally entitled to relief. We think the relief will normally be abandonment. In certain cases, this may not be possible and then we may have to find other relief, it maybe raising his lower rates on some of the contracts which he got a contractual limitation on and maybe otherwise. In that situation, yes, he is entitled to relief. And this is what he Commission said in establishing this special relief procedure. It didn't --
Byron R. White: (Inaudible) and what do you think of (Voice Overlap) --
Richard A. Solomon: No, not --
Byron R. White: You should just leave for clarification on later cases?
Richard A. Solomon: Well, fuzzy only on the sense the Commission didn't attempt in making its first area rate determination to set out all the individual exceptions thereto. It did say that there is some area where your cost, vis-à-vis your revenues will involve a constitutional issue of confiscation.
Byron R. White: Well, you just – that is a – would you give me a little enlightening up, do you say that the fellow was entitled to any – for any price relief just because he'd been making the 12% if he happens to be a high cost producer. But (Voice Overlap) --
Richard A. Solomon: But I didn't say --
Byron R. White: -- that if he had a high enough cost, if he's bad enough as far as cost wise is concerned, you'd give him price relief.
Richard A. Solomon: I -- no, I didn't say at all.
Byron R. White: Well, you said it was a possibility?
Richard A. Solomon: I said it's a possibility. The reason why --
Byron R. White: So why would you?
Richard A. Solomon: What?
Byron R. White: Why would you give him a price relief if a -- if you wouldn't get -- if a fellow instead of having -- being over -- he is above normal cost by X, you don't give him price relief? If he's over cost -- a normal cost by 2X, you do.
Richard A. Solomon: Well --
Byron R. White: That doesn't make (Voice Overlap) --
Richard A. Solomon: If this was a situation in which somebody could have five times the normal cost as a result of well drilling, if that happened, which it doesn't, then obviously that person was --
Byron R. White: You don't put --
Richard A. Solomon: -- putting in --
Byron R. White: -- anybody that has never drilled anything but a dry hole --
Richard A. Solomon: What?
Byron R. White: (Inaudible)
Richard A. Solomon: He isn't even involved in this case. The people who only drill dry holes don't even get this as far as the Commission. They're not in the business anymore. The person, if he wants to put gold plating on his well, have a gold plated well, and maybe some of the people in this industry are in the high enough tax bracket so they can, we're not going to pay for that. Maybe some of these high cost producers are people who are high cost producers because they are in the higher tax brackets and therefore can take the risk --
Byron R. White: Can you give me an example that allows price relief for the situation where a fellow doesn't cover his out-of-pocket costs when you assumed that there is normal cost in the field.
Richard A. Solomon: No, I cannot give you a situation because I don't know whether it exists.
Byron R. White: Well, it's a very pretty fuzzy line?
Richard A. Solomon: What? I don't know whether it exists. I can tell you that there – your situation where somebody is entitled to relief, at least to getting out of the responsibility of staying in the business with this well.
Byron R. White: So it is a fuzzy line?
Richard A. Solomon: It's a line which has not been pricked out because we're at the start rather than the end of this procedure. If the Commission had done, attempted to do what the court below seems to have suggested we should do, not only established a general price structure but also spell out all of the possible exceptions thereto which are conceivable in this industry we would not only -- never finish this case but it would have been most outrageous thing to do on this record. We established a procedure. We explained that it was available for the people with out-of-pocket expenses with respect to individual wells normally. We also set forth other reasons where it might be used or certain -- unlikely, but possible cost squeezes which people can get into as a result of some of our pricing. We said that if you do get into this, we don't think you will, but if you do come around and ask for a special exception.
Byron R. White: Under the -- under this exception?
Richard A. Solomon: What the --
Byron R. White: (Inaudible)
Richard A. Solomon: Of course, when you're in the problem of whether or not there are special relief situations, it's very difficult when somebody asked you, “What would you do with a particular case which we haven't had before us yet?” And frankly --
Abe Fortas: What's about -- what is the range of variation in the contract price now in the Permian Basin? (Inaudible)
Richard A. Solomon: There were some contract prices as of this decision as high as 20 cents. There were some old contract prices lower than 9 cents.
Abe Fortas: No, let's take a contract negotiation in a short range of time. Well, let's say --
Richard A. Solomon: The range --
Abe Fortas: Let's say --
Richard A. Solomon: -- of prices in -- there are always some deviations for types of gas. But the range of prices for relatively good gas at the time of this decision were about 16 cents.
Abe Fortas: Yes, but I say --
Richard A. Solomon: Some were higher.
Abe Fortas: -- there's so much variation within that --
Richard A. Solomon: Oh yes.
Abe Fortas: -- take contracts that are negotiated within the 10-day or 30-day period of time, is there much of a range in the price term of those contracts?
Richard A. Solomon: There is a tendency on the part of the industry to -- and the pipelines to operate on the kind of a posted price basis. But there are variations within these standards. If people have very little gas, the pipeline won't spend the money to go and build a feeder line to him. If people have --
Abe Fortas: What I'm really trying to get at is whether in the negotiation of contracts at a particular point of time, the individual situation determines price, whether the price is determined by the clustering of the marketplace.
Richard A. Solomon: I understand your question. The record indicates that the general price range is the major factor but there are individual situations which play in particular contracts, there is no indication that these individual situations aren't related in anyway to costs. It's a question of how much gas a particular producer has at a particular moment, nobody has suggested that the low prices were for low cost producers or the high prices were for high cost producers which I think maybe the basic problems we're getting at. We also think there's no justification for the Court's suggestion that this special relief -- and when anybody applies for a special relief, he should be able to stay the entire Commission's decision and not lower his -- higher the just reasonable rates until we pass on this. This would obviously just flood us with this request to keep up with this rate. Cases such as the New England division's case indicate this is totally unnecessary and that the real proof of the putting here is that we have allowed in either the old gas or the new gas were such a higher figure than the out-of-pocket costs of anybody except for our gold plated friend that the ability of anybody to show that he is going to be significantly harmed if he operates under these ceilings while his special exemption is processed is in our opinion nil.
Earl Warren: Continue.
Richard A. Solomon: Before lunch, I was talking about the special exemption procedure and I may have misstated myself in talking with Justice White. We have suggested Justice White that we will allow pre-abandonment when their out-of-pocket expenses on particular sale are more than the revenues on that sale. And we have made clear that we will not do that and we see no immediate necessity for any special relief for other than out-of-pocket expenses and particularly the – and the 12% rate of return.
Byron R. White: How about the rate for the --
Richard A. Solomon: Was what I'm saying -- I don't mean to suggest at all that the Commission has suggested that somebody who is a moderately high cost producer will get no relief, but that somebody who is really bad will get relief. On the contrary, if there are such people who have say, 50 cents instead of -- or a dollar cost, if that means anything --
Byron R. White: There are from circumstances (Inaudible) which are or probably not the (Inaudible)?
Richard A. Solomon: It's not so much that there are – well, there are in the circumstances. It's a standard operating procedure in this industry to have individual wells become unprofitable. This is nothing new. The Commission for years has worked a simple procedure for these wells which become unprofitable to be dropped out.
Byron R. White: (Inaudible)
Richard A. Solomon: I'm not saying there is any justification for giving a higher price and the Commission hasn't said so. It said what clearly isn't the justification and I don't want to give any false impression that if a producer can show that his prices are on the average, 30 cents higher than other people, and that this is something which is not the result of bad management or shooting for the moon by going off on the marginal prospects, hoping it will strike it rich, or something like that. I don't want to give any impression that anybody who really has high prices and can show that this is going to continue to have high prices will be allowed to do anything more than gradually get out of the business. Now, I'd like to turn to the group of producers who suggest that area rates will swell but the cost is not a good basis for area rates. I think there's great balance at this stage of area rate making, whether it would be appropriate at all for the Commission not to use cost as a basic yardstick in determining area rates. There maybe stages once you have the cost base started out whereby, as economic situations change, the factors other than cost may become increasingly more important. Firstly, I doubt very much whether it would have been appropriate from the standpoint of making sure that the consumer is not being -- getting -- paying more than he needs to, whereas to start out absent of cost basis. But even assuming that it will be legally possible, obviously, the Commission's determination to use cost is a judgment of the Commission which a very heavy burden would be on anybody trying to offset. And certainly, this burden hasn't been met here. As usual, I find my time is running and therefore I'm not going to go in my argument here very much into the matter which was discussed at great length in our brief as to why the argument that there's free competition in this industry. And that that alone is good enough to justify, relying on the market price rather than a cost based price is sufficient. The fact of the matter is, although there are a lot of producers in any field and they compete among themselves for new leases that there isn't a type of price competition which will -- can be depended upon to protect the public. On the contrary, the history of pricing in Permian is very much like the history of pricing in Southern Louisiana which lead this Court in CATCO to say something has to be done and the regulatory agency has to move in. The reasons for this aren't obscure, and as this Court pointed out in the El Paso Divestment case, the way this business operates is a pipeline will, in addition to its usual increments of gas, every once in a while, it's making a big new sale and needs a lot of gas quickly. Then it has to go to the producers in the particular area who have the gas, these are usually a few producers, they obviously can -- as the record here indicates, it can get the prices up. The history of this business is this quasi posted price business that I mentioned before. All other prices go up and with the escalations in the old contracts even the prices for flowing gas goes up. When you add to this, the fact that one of the major pipelines in the Permian Basin and the one which broke the pipe -- the price line but good in 1960, the Transwestern Pipeline was at that time very largely owned by producers, and when you add the strange absence of serious participation in this case by the pipeline, you'll see what's going on. I said I tell you why the pipelines didn't participate, a very simple answer. The pipelines much more than one would -- might suspect can pass on a higher price as they get to their customers is particularly true in this case. The residential consumer is always more or less of a captive customer who can't switch back and forth. And particularly in this case where we're dealing with California where the industrial consumer also is dependent largely on gas, price competition does just not hold down the prices and the pipelines as a result relatively disinterested. The other argument with respect to don't use cost or rather if you use it, use it as a very minor factor is a little different. It goes on this basis. There's too little gas being discovered to meet future needs and even under the Commission's pricing system we can't be sure that there's going to be enough gas discovered therefore don't use cost or anything else to really put much of a lid on it. The fact that in every year, not only through this record, but since this time, reserves at it have been more in production and the fact that in Permian, since the Commission in 1960 put a guideline price on which is about the same as the new gas-well pipes, have been tremendous development, is discounted and what this type of argument talks about is the declining reserves to production ratio nationally, the RP ratio. This has been going down, it certainly has, it was about 32 to 1 at a time when gas was a waste product and it has been going down steadily ever since. Slower but still steadily and it's now about 16.5 to 1 and may go down through. The Commission recognized this and so it wasn't disturbed by this, that it was far from clear that the present ratios are not too high in the sense of -- in the economy and the consumer standpoint requiring present consumers to pay for too much gas for the future. The oil industry which is certainly not comparable in all respects, the RP ratio there is leveled off at about 11 to 1. And far from clear that something similar to this wouldn't be equally good in the gas industry. The Commission hasn't ignored this problem. The Commission in fact added one cent to the E and D allowance to provide for exploration and development greater than the current figure in order to provide for further advancement in exploration and development. Let me be clear about this one. We're fully aware of our -- that our obligations to the gas consumers and we think that is to fix prices at the lowest possible level consistent with a healthy industry and reasonable profits to the producers, cannot be met by ignoring the long-term interplay of the factors of supply and demand. We shall and must continue to watch current and future trends on the production side and to the extent that price can play a positive role area, be prepared to adjust prices for future vantages of gas to meet current conditions. But on this point, let me read from the decision of this Court in the Hope case, in response to a similar claim by the State of West Virginia. We have set production cost there. Tends to be cost for the individual pipeline but the point is the same. At too low a level to insure there'd be adequate production. And what Justice Douglas said in that case and we thinks it's completely applicable here is the following. I'm reading from 320 U.S. at 615, if in the light of experience, they, that is the rates, turn out to be inadequate for the development of new sources of supply, the doors of the Commission are open for increased allowances. This is not an order for all time. This is equally applicable here, and the 16 and a half to 1 RP ratio, that means, there is proven reserves, admittedly understated as to the actual reserves, but proven reserves 16 and a half times the present production is more than adequate to provide lead time if this in this year shows that something should be done. Now, let me turn to our third group of producer arguments who accept as at least within our discretion reluctantly, tying cost -- tying rates to cost yardsticks. That they argue and here they're joined by the Court of Appeals that the Commission, either by fixing minimum as well as maximum rates or by raising the maximum rates, has to ensure that producers as a group will recover revenues equal to their average costs. And the edge -- alleged failure of the Commission to make this assurance was certainly one of the main grounds of the Court of Appeals' decision remanding it to us because the Court said that this is contrary to the end result test in Hope. It will also form this Court's basis on rehearing for saying that the refunds cannot be made even on increased rates which are above the just and reasonable ceiling we have set here. Unless we first find out they're not offset by lower rates which some of the producers are voluntarily agreed to in their context. The Court of Appeals construed this end result test of Hope to requiring a balancing of cost with expected revenues. It reversed the Commission because it did not specify the total revenues which the producers would secure on the established rate. If you remember Justice Stewart, the same argument was made last year in the Chicago Northwestern Division case. And also because the revenues would necessarily not equal cost average cost to the extent that contractual limitations precluded producers from filing from appropriate ceilings. The Commission in response to this letter claimed expressly denied its intent to match jurisdictional revenues with jurisdiction cost. And what it said was, and I'm reading from our record 1114D, it would be contrary to all regulatory principles to permit prices in excess of a just and reasonable rate for certain purchases merely because other sales have been voluntarily made below costs. But the Commission went on to make clear that there was no basis for believing that overall producer revenues would be inadequate for the maintenance of the healthy industry. Now the Court of Appeals was dissatisfied with this latter conclusion because it felt that the failure, I'm quoting from the Court, the failure of the record to disclose the revenue impact of the adjustments in the area rates to reflect quality differentials. As I've already indicated but I'll expand upon a little bit here, that this is just plain wrong, it overlooks the finding of the Commission on this point. Now, let me explain this problem and I think the Court was confused. There isn't any evidence in the record and we don't pretend there is as to the pipeline cost at their processing plants of bringing the gas up to pipeline quality. And therefore, since the Commission was establishing the system of matching the individual sale to its quality, it was necessary to provide for a special procedure of quality statements filed by the producers at the consultation with the pipelines with respect to the particular discount for the particular sale as a result of the particular processing operations. But there was evidence. There was considerable evidence in the record of the approximate overall impact of the quality reduction. What was this evidence? First of all, there was evidence based upon producer cost in their processing claim of performing the same functions of bringing gas up to the pipeline quality. Secondly, there was an evidence of certain contractual provisions and some of the contracts where pipelines expressly provided for their -- they should be reimbursed where they had to bring gas up to pipeline quality. And third, there was expert testimony based on these facts as to what the impact would be. This wasn't something the Commission invented. The examiner -- it's -- in his decision had quantified this that about 1 to 1 and a half cents. The concurring Commissioner said 1 to 1.7 cents. And the Commission in the light of certain adjustments to quality which it made that the producers' behest on rehearing found that the range of this quantity discount would be .7% to 1.5%. And what they found on the basis of the record actually squares with these quality statements. There is thus no, if I may use the term the Court used, there is no revenue deficiency.The question at all is with respect to quality adjustments. The producers aren't going to receive the ceiling price which we have set for pipeline quality gas for the large percentage of Permian gas which is far from pipeline quality. But this was exactly what the Commission anticipated whether it adopted a rate of return, deliberately set to take into account the quantified risk that Permian gas would not qualify for ceiling prices. Now let me get back to the other aspect of this problem. This relates to contract pricings made by various producers over various periods of time by which they agreed in selling gas to the various pipeline at the maximum price they could charge at a given moment was X and X may, and is in certain areas, less than we have found the maximum they could have charged. The Court of Appeals originally seems to have believed that we were under an obligation to take care of these contracts by setting minimum rates which would aviate the overall impact of these limitations on filing up to the area of ceiling. Now rehearing, it seems to have also suggested that maybe instead of setting minimum rates, we could simply set the base rate higher, similarly to negate the effect of these contractual limitations. But while it isn't entirely clear what the Court of Appeals said we should do, as far as we're concerned, the Court of Appeals is one of either respect. Now, what is the basis, the legal basis for this position? Essentially, we go back to this Court's decision in the Mobil and the Sierra Pacific cases at 350 U.S. -- at 332 and 348. Now, the point of these cases which of course billed on earlier cases in the railroad and natural gas fields, state natural gas law field, the point of these cases is that regulation under the Natural Gas Act does not automatically supersede freely made contracts between buyer and seller. Contractual limitations, not only cannot be circumvented by the sellers filing a rate increase, under Section 4 of the Act, that's the Mobil case. But as Justice Harlan made clear in the Sierra Pacific, the Commission itself cannot and shouldn't raise a rate which by contrary, the seller in this industry has set at a lower figure than he could have charged merely in order to enable that seller to return -- earn the full return that would have been permissible. What Justice Harlan said there, the test he said we had to apply and the test we're – or if you're willing to apply here too is that before somebody volunt -- before somebody who has voluntarily agreed to a lower rate to perform this service, that he might have been entitled in this range of what's in the public interest. It must be demonstrated and here I am quoting, “That the rate is so low as to adversely affect the public interest”, as where it might impair the financial ability of the public utility to continue its service, passed on other consumers in excessive burden or be unduly discriminatory. And nothing is in the Sierra case as we read suggest that the decision rest on the assumption that the company involved could -- without a similar public interest showing, charged rates on other sense higher than otherwise would be appropriate on these sales simply to make up for the loss in maximum profits who doesn't voluntarily agree to bear. On the contrary, the Natural Gas Act which we were construing here today, expressly states and I'm quoting from Section 4 of the Natural Gas Act that all rates and charges of a natural gas company must be just and reasonable. And that any such rate or charge that is not just and reasonable is hereby declared to be unlawful. And this Court in the Tennessee case, at 371 U.S. similarly made clear that losses in the first instance do not justify illegal gains in the other.
Abe Fortas: But you do take -- do you take the position on where the contract price is higher than the -- merely price -- the contract price suggested value?
Richard A. Solomon: We certainly do.
Abe Fortas: But now, how do you distinguish the two as a legal matter?
Richard A. Solomon: People who charge a series of rates don't charge as to one rate. Have rights under special circumstances whether to charge the less than the full rate that the -- as a matter of regulatory cost, so you wouldn't get -- you would allow them to have. The fact that they charged less than what they might have got, in our opinion, and as we read Sierra and other cases, does not justify them to charge more than is the appropriate rate whatever that may be. On other side, they cannot, in other words -- because they have voluntarily entered into an agreement to charge one customer, less than they might have charged, they raise the rates to the second customer. The customer is entitled to have his rate no higher than what's just and reasonable taking -- and not to have a higher than the normal rate because the company has entered into lower sales with other people.
Abe Fortas: Well perhaps, I don't understand this. But I'm going to ask you this question. A producer in the Permian Basin has a contract 10 years ago for the sale of gas at a price that is lower than your area rate. The producer with the consent of the company purchasing from that producer comes to the Commission and says that, “I want to raise my -- this contract price”, do you or do you not permit that or do you prohibit it?
Richard A. Solomon: If the contract, typically, relies for not only initial rate but certain escalations in that --
Abe Fortas: I'm not talking about the escalation.
Richard A. Solomon: Yes, he may file for these escalations in this rate.
Abe Fortas: No, I'm going to come back to escalations. They want to bring it up to the rate that – as described in your schedule?
Richard A. Solomon: If he has a contractual right to bring it up to the rate, yes he has a contractual right to bring up --
Abe Fortas: No, they come in and say it doesn't – it's not written into this contract where originally entered into but we agree now that the rate be raised, the producer and the purchaser, and with your schedule from the pricing system here prohibit that?
Richard A. Solomon: If there are renegotiations between the pipelines and the producers of contracts which now prohibit the filing for the area rate, under our system this would not have to be -- this renegotiation could take place and they could file them because there would be no contractual innovation. I don't want to give the impression that necessarily unless there were some consideration for this that we would look at the pipeline when it comes up for a rate increase we might very well ask the pipeline, what was the consideration for you -- allowing higher rates where you previously bargained to? As far as the producer is concerned, renegotiation is appropriate and it was renegotiated, that were fine. We're talking about the situation where the pipelines were unwilling to renegotiate. They want to stick with their bargain. Let me explain what the problem is, it's very, very clear in Permian. A lot of the very low rates here are the result of the bargains made by Northern Natural Gas Company with some producers. Now, Northern has got the benefit of these bargains, and this is going to benefit its customers in the Midwest. A lot of the higher rates which were subject to refunds here, subject to reduction of the result of El Paso agreeing to high charges in part to get rid of some of these escalations that we mentioned in its raise. Now, maybe Northern is going to allow that the goodness of its heart because it's so important to it, agree to allow these rates to be raised, but the problem really is El Paso. El Paso's customers have been paying these rates which we found to be too high, and the question is whether they should get any relief for it, both from the area of reductions for the future and in refunds for the past. Don't get me wrong, we believe that the Sierra test is applicable and if somebody can show that these low contract rates are in fact inhibiting the industry from performing its functions, not only to itself but to its customers then obviously there is justification under – that's it the appropriate tests for raising these low contract rates. But, there hasn't been any such showing. With respect to the new gas-well gas, the gas -- the prices we've set for new gas-well gas for the future perfectly clear that there can't be – there's some showing. They're under no contractual innovations. We haven't set any. They can contract for the area rate. It's conceivable as some of the producers point out that despite these innovations, various sales will in the future go for less than the area rate. But certainly this is not the basis for our fixing the new gas-well rate at some arbitrary higher figure to take care of this situation. With respect to the old gas-well gas rate and the oil-well gas which is tied to this, the continuing operations here are -- as I've indicated before, basically a relationship of the continuing production cost. And we don't see how anybody is going to make any showing, certainly not on the group basis. Certainly not of the group basis that if these rates are not raised and they continue to have to get what they contracted for here that this industry is going to be adversely affected from the public interest in any respect. Now, let me make a very strong caveat, I don't think the industry can come close to making a Sierra type point and they certainly haven't made it on this record. I can conceive money. Individual producers with high embedded cost or other special problems who could make the Sierra form. I can conceive of an individual producer who is in the problem that Justice Fortas mentioned before who's got an unprofitable sale which is not in the public interest to allow to be abandoned, I believe they're on that sale or another sale has a contractual limitation coming in and saying, “This is good justification for allowing me to raise the contractual limitation here”. And we do think it's possible that there will be on an individual basis pursuant for the special exception procedure, individual showings as to why some are all -- low contract rate should be raised. But we don't think this is a general matter and we don't think it's anything that requires as the Court did a remand to the Commission. And what I have said here is at least in our opinion equally applicable to the refund situation.
Abe Fortas: Well, then your position is that your escape clause is broad enough so that somebody thinks that confiscatory result has been occasioned by a preexisting application. Can come in and seek relief or he can file or (Inaudible) and start and take off a proceeding that way which presumably would be subject to judicial review?
Richard A. Solomon: Sure.
Abe Fortas: Is that so, or is it not?
Richard A. Solomon: That is so, and what I'm saying specifically is that, there may very well be situations, individual situations. For a part of the relief that somebody makes under this special exception thing will be to relieve him from a particular low contract which are squeezing him and making it difficult for him to perform as a producer performing useful content in this industry.
Abe Fortas: And the Commission's order does not commit the Commission on granting relief in those circumstances but you would say that it has power to do it, is that right?
Richard A. Solomon: That is correct. Obviously --
Abe Fortas: The Court of Appeals, I suppose on the criticisms the Court of Appeals had in mind was that you -- the Commission did not commit itself to give relief in these hypothetical con -- in situations of individually confiscatory rights?
Richard A. Solomon: I think that's a fair statement of the Court's opinion and I think it's a fair statement of the Commission's opinion that we could not and certainly don't have to commit ourselves in advance as to how we will treat individual situations which necessarily vary from case to case. Now, to go --
Speaker: (Inaudible) not just standards but the wordings upon this to the -- wanted to apply, found themselves in this position of what the Commission would entertain, not – they continue to grant them. Am I wrong about that?
Richard A. Solomon: No, I think you're right also. I think this certainly was one of the things that the Court said. One of their problems with our special exemption procedures is just -- they said you haven't spelled it out sufficiently. You haven't stated in greater -- of detail as to what type of things will entitle people to special relief. As I've indicated before on that, I think we spelled it out as adequately as is possible at this stage of area rate making in the absence of any claims of this nature at this day. I don't think -- I'm sure there wouldn't -- I sympathize with the Court of Appeals, obviously the more that an agency can spell out how it will react to individual request for special relief, the more it can do so, the better. But we're dealing with a problem where you only don't have the record to do it. We don't have the claims before us. And to ask for the specificity that the Court wanted, in our opinion, is certainly not legally necessary and under the circumstances here, it's just impossible.
Speaker: Well, what did you do about it supposing the (Inaudible)?
Richard A. Solomon: I really haven't the vaguest idea. I tried to figure out how we could comply with that part of the Court of Appeals decision. And I frankly haven't the slightest idea how we could comply. Unfortunately, my time is going pretty fast, I do want to say on the refund business. If I indicated, the refunds are largely to El Paso whose under an obligation to flow them onto their customers, a large percentage of the low price contracts are normal. That shows you the type of problem it is. The Court of Appeals originally believed as we think rightly that refunds of rates which these people have been allowed under the Act, to put into effect and charge only upon the agreement that they would pay back to their customers if they were found to be high -- have to be on an individual basis. The Court was persuaded on rehearing that this Court's decision in the second Phillips case, the Wisconsin case, precluded that termination and that there had to be a more general balance. Now this is a misreading of Phillips. Briefly what happens in Phillips was this. If you remember, we started out to fix Phillips rates for all its sales throughout the United States. Some of these sales were much higher and some of them are much lower than the average -- and the average cost. This isn't surprising. There sales involved there were not only in Permian, there is Hugoton-Anadarko which is the oldest and shallowest field in the Unites States. There were in Southern Louisiana, they're all over the continent. The Commission didn't finish that up. It never got the rate design part of the Phillips case in which it went through the exercise of determining whether some of these high sales were or were not in the light of the particular circumstances too high. And therefore, there was no presumption that they were above a just and reasonable standard in their area merely because they were higher than the Phillips cost statute. What the Commission did was, they said, “We're not going to go through this exercise and with respect to the 10(4) (e) increased rate filings we have. It isn't worth our time or anybody's time to make these allocations at this stage of the game. And the Court in affirming us, made very clear that it was limiting us to the particular facts of this case. Justice Harlan's decision noted that we had in the subsequent case said that a high rate isn't necessarily justified merely because the comparison of overall costs and overall revenues were balanced out. But Justice Harlan pointed out that in that case, the rate wasn't locked in as it was in Phillips and as they are not here. And he also pointed out that in that case, in the Hunt case, this rate was higher than that area's average, analogous to the situation here. And he distinguished the Phillips situation on that basis. And we think that this is all what Phillips really stands for that in the particular circumstances of that particular case, it was justifiable for the Commission as was said, it wasn't going to go ahead generally with this allocation to refuse to make it for these 10 sales on the off chance that a few of the high sales might turn out to be more than just and reasonable. Certainly, that's not the present situation. In the brief time, before I have to sit down I would like to say one more word. The Commission has done another innovative thing in this proceeding. At least it's innovative as far as the Federal Power Commission is concerned, and that is the establishment of a moratorium on any increased sales for a discrete period of time. The Commission in excess of precaution because this was the first case, because of the nature of area rate making at this stage, limited this moratorium to a two-year period that would expire on January 1st, 1968. But this is an important question for future cases and this is by no means moot because there are a number of sales increased during this moratorium period.
Speaker: (Inaudible)
Richard A. Solomon: It works out to a little more than two years in this case. I don't want to give the impression that the two-year moratorium is the minimum or maximum that we could have done, and what we chose under the facts of this case of the status of area rate making in this case.
Speaker: The effect of that is to whether or not (Inaudible)?
Richard A. Solomon: The effect of that is for the Commission -- by a Commission Act to eliminate escalation clauses of -- for that period. This isn't a unique matter as you remember under our certificate authority. We have similarly wiped out escalation clauses for a discrete period. And this Court has upheld this authority both in the Hunt case with respect to temporary certificates and the Callery case with respect to permanent certificates. And more important --
Speaker: (Inaudible)
Richard A. Solomon: In most cases by the way, Justice Harlan, as in this case, we haven't precluded all rate findings. We've allowed them up to the ceiling so that anybody who has a limitation that is eliminated during this period and at least $3 million of it -- it have here -- they can try. We're only talking about increases over the ceiling. And the point I -- the only point I want to make is that not only that this has been allowed for our Commission by the certificate authority of Section 7, but we think that it is equally permissible under the provision of Section 5 of the Act and that's what we're dealing with which provides that the Commission shall determine the just and reasonable rate to be thereafter observed and enforced and to fix the same by order. This is exactly the same language which this Court found over 20 years ago in the U.S. v. Corrick case at 298 justified the Secretary of Agriculture in refusing to consider rate increase filings filed under an identical statute in Section 4 of our Act. And the Court pointed out that when the Commission, in a rate case of this nature, not merely responds to allowing company made rates to go into effect. But where the Commission has done the legislative job that under this type of language, the Commission's action in effect, Justice Harlan, takes the place of contractual limitations on Section 4 that we were talking about in the Mobil case. And we think that the same situation here certainly justified on the record on this proceeding. If you don't mind, I would like to reserve the limited time I have for rebuttal.
Earl Warren: Mr. Simpson.
J. Calvin Simpson: Mr. Chief Justice, may it please the Court. The people of the State of California, the California Public Utilities Commission, Los Angeles, San Francisco and San Diego appear before this Court to urge that it affirm the Commission's decision in this case in its entirety, whether by design or accident when the Commission shows the Permian Basin area of West Texas and Southeastern New Mexico to initiate this pilot pioneering case. It involved California very deeply because as you have been informed on the basis of the test year volumes, approximately 85% of the gas produced in the Basin is consumed in the California market. The volumes sold from the Permian Basin have increased subsequently and my best information now is that the volumes are larger, but that we consume some 77% of the gas. In appearing before this Court, we rep -- we feel we represent the consumer interest and we hope that we can give some perspective to your evaluation of the decision through looking at it from the point of view of the consumer. That the consumer interest is important especially in California, I think it is shown by the fact that we lack economical alternative sources of energy, not only for residential space heating and the like but also for the generation of electric power. Also, we have a very severe air pollution problem in California which I'm sure the Court is familiar with. Therefore, it's very important to the economic wellbeing of California that we obtain natural gas at the lowest reasonable rates.
Potter Stewart: You have a -- the (Inaudible) of oil in California.
J. Calvin Simpson: I beg your pardon sir.
Potter Stewart: You have (Inaudible) oil in California the last time I heard.
J. Calvin Simpson: Yes sir, we do and the -- I think that the statistic show that for residential purposes and they are truly the captive customers, most of the appliances especially for space heating are gas burning appliances meaning that once the consumer has made an election to use that kind of fuel, the price would have to go very high indeed in order to justify as discontinuing the use of his durable good type appliance and switching to something else. However, industrially speaking, under the interruptible rate schedules Mr. Justice Stewart, there are alternative uses or rather facilities for the use of oil in steam generation plants. But there is a drawback to that because the oil, unless it's a very special low salt or bearing type, does create air pollution problems. Therefore the City of Los Angeles, through it's Air Pollution Control District has a rule that the distributing -- or rather that the steam generation plants in the -- in Los Angeles County burn natural gas to the extent that it is available.
Potter Stewart: I didn't question it, but I certainly know that California is a great and wonderful state. I just wondered about whether or not your people out there's so unique. But you have to say this case would be applicable if it was done very generally I suppose in the United States.
J. Calvin Simpson: I think that is right except for the fact that we do not at the present time have coal --
Potter Stewart: You don't have coal?
J. Calvin Simpson: -- as one of the basic sources of our energy. And I certainly agree with you sir that in participating in this case, we have realized that our job is not completely parochial and that our responses to the problem suppose in this case do have a certain national importance insofar as the decision in this case may stand for precedent for the future development of area rate making. As this Court well knows, consumer protection is the primary aim of the Natural Gas Act. In fact, in the Atlantic Refining Company against Public Service Commission of New York, the Court referred to the Natural Gas Act by indicating that it was framed to provide consumers a complete, permanent and effective of bond of protection from excessive rates and charges. Certainly, this has been the kind of bond that has taken a very long time indeed to mature. We have waited some 11 years for a decision from the Federal Power Commission fixing just and reasonable rates for independent producers in measuring that period of time between this Court's decision in Phillips Petroleum Company against Wisconsin until the issuance of Opinion 468 which is now before the Court. And of course, the rest of the time has elapsed going to the necessity for judicial review and I would point out that the rate reduction portions of the Commission's order, they have been stayed by the court below. And the Commission itself stayed the operation of the refund portion of its order in this case, so that as we appear before the Court right now, there's still no relief in terms of the impact of just and reasonable rates insofar as consumers are concerned. Despite all that, or ready enough in -- not in spite of it but we feel as though certainly the time has come that the solution ought to be before us. And we asked that the Court affirm the Commission's decision in its entirety because for the first time, an effective and administratively feasible system of regulation of independent producers has been created. For the first time, just and reasonable rates both in terms of Section 4 and Section 5 of the Act had been established by the Commission. And we think this is important too for the first time, all the thickets and tangles involved with the suspect price doctrine and inline pricing with which I'm sure that the Court is familiar, that too will be a disappearing thing, because the Commission has indicated that it expects to apply the just and reasonable rates determined in the area to newly certificated sales of gas. Now, there's one thing I would like to correct. In developing the case below that a -- within the Commission, we did support the two-price system. In fact, we went along the little different route from some of the other economist who made presentations, California was the only party to present, for the examiner's consideration a -- an estimated cost of new non-associated gas-well gas which was based on area cost as opposed to national cost. Our thought being that the purpose behind area rate making was to the extent possible to focus on the cost experience within that area so that the cost of the gas could be determined for the area. The presiding examiner rejected our showing in that regard because he felt that it would -- that it relied too much on allocations which he felt were not reliable basis for decision when one is attempting to find an economic cost of gas for the future which the cost of the new gas-well gas is.
Abe Fortas: But it's in the record, isn't it?
J. Calvin Simpson: Yes, it is.
Abe Fortas: Does the --
J. Calvin Simpson: It's Exhibit Number 222 --
Abe Fortas: And does it –
J. Calvin Simpson: And it --
Abe Fortas: Can you tell me generally whether it's shows a higher or a lower cost?
J. Calvin Simpson: It shows a lower cost although to be fair about it, I must indicate that the rate of return of which California relied on was that which was advanced by the staff, by its witness Dr. Shaffner of 9 and a half percent whereas the Commission and the presiding examiner chose 12%. It was mentioned by general counsel for the Commission at the beginning of the -- of his argument as to the plight in which we found ourselves when this Court handed down its decision in the second Phillips. It is true, I think as Mr. Justice Harlan's opinion for the Court shows that within -- the closest to advocating that the individual company cost to service method was the only method which the Commission ought to pursue. Just to amplify that a little bit, first of all, we're not here to reargue second Phillips. Our disappointment in the result there was that we were very much afraid that the development of area rate making might cast itself lose entirely from any kind of attention to costs. Our concern was not so much that the rates would be predicated on individual company experience as that the rates would not be predicated on costs. That the thinking of the language in City of Detroit that we would free ourselves completely of the anchor and discard all of the experience under the Act as we ventured into this rather uncharted at that time problem of devising area rates. And when that case was argued before this Court, there had been some reason to believe this that when we went to Midland in 1961, one of the producers, in fact was a large group of major producers, offered the Commission a motion which indicated that no individual company cost of service data would be allowed in the case as admissible evidence. Not only that, but no group of cost to service would be allowed in, only cost data. Now, that's a peculiar distinction, what's the difference between cost data and cost of the service data. Well, I suggest although I'm not sure yet, I suggest that the difference is that you take the raw cost trending data but you don't match it up with respect to the gas that is sold. And we thought that it was the means whereby no evaluation of the profitability of the rates could be established. It was not until 1962, in fact, May 14 of 1962 that pursuant to our motion, the Commission reversed its order of April 5, 1961 barring all costs of service presentations of any type or nature from the case and said that upon further consideration of the matter, they might be of some usefulness and we'll let them into the record for whatever use they may provide. And I think that that might give the Court some perspective as to the long journey which California consumers travel through this case to reach any kind of cost based area rates. After that, the staff of the Federal Power Commission put in complete cost of service presentations with respect to the categories of the gas and we rely very heavily upon them. Now just why is it that we are so concerned about costs? Is this just some sort of fixation? I think not. From the consumer point of view, we think that the alternative are notions of market value that mark that value and we are convinced speaking for consumers that we are not dealing with a situation wherein competition has proved effective. The Commission has so found in this decision and the Court of Appeals has approved that finding. However, I don't think we should lose sight of it from the consumer point of view in looking at the Commission's decision. And that of course comes back again to what I said that in large measure, gas consumers do not have a choice insofar, as their costs have passed on to the interstate pipeline companies, they are in turn passed on to the locally regulated California distributors in this case PG&E, Pacific Lighting Companies and San Diego Gas & Electric. They finally end up in a little brown envelop which is delivered to the customer and are paid in full. They can't be argued about consumers rely in the first instance upon the Federal Power Commission and in the second instance in our situation in the California Public Utilities Commission for protection. They cannot delegate this function to huge interstate pipeline companies to bargain effectively for them, for we are convinced that if the pipeline company is in the position to pass on these costs, their incentive to bargain is -- at least it is fair to say diminished to some extent. They don't have a buyer who can say, “I don't want it”. Now the Commission to our great -- the Commission has used cost in this case and this is of course we think very important and permits us to come before this Court today and asked that this be affirmed. The Commission has said that cost provides an objective price standard based on cost. They said the cost is the bedrock of the decision. And in another instance it said that it is the nature ingredient of the decision. Now, let us be clear about this. It is a cost based decision. It is not entirely based on costs. Its cost based to the extent that new gas-well gas which is gas produced not in association with oil. And old gas-well gas, those prices are based on cost. However, it's -- it has been pointed out to you, 66% of the gas sold in the Permian Basin area is oil-well gas, it's not the gas-well gas. And the Commission has said because of its disinclination toward making allocations, (Inaudible) myself by saying that we've never really agreed with that point of view. We think that allocations can be made by rational men and that it isn't necessary just because joint costs are involved simply to refuse to do it. But we're not here to quarrel about that. But apparently is the view of the Commission that it is to be avoided wherever possible and that is what they've done, but they priced most of the gas which is going to be sold on the basis of value. Well, some interesting questions arise there. One wonders whether or not that would not have been an abuse of discretion if the Commission had had no idea whatever as to what casinghead and residue gas costs. Would it have been an appropriate exercise of their administrative responsibilities under the Act to have simply priced most of the gas at the gas-well gas price but the Commission was not fully unaware as to what the cost of oil-well gas was. The staff had made a full presentation on that. All of the parties, California and the California distributors took the point of view that the gas should be historically caused it. So that -- we're not too concerned within the framework of this particular decision that the value has been misused, we think that, as the Commission itself recognizes, the oil-well gas does in fact costs less even using the same rate of return and not changing any of the comparisons than gas-well gas. And we would recommend or invite the attention of the Court to that section of the Commission's opinion on rehearing, 468-a beginning I believe at 1112D called revenues versus costs. There, the Commission was addressing itself to be problem which apparently concerned most greatly the Court of Appeals and that is the argument that costs do not -- rather that revenues do not balance cost. And the Commission was fully aware of this argument and gave consideration there to it. And I would like if I may to go through some of the observations that the Commission made and as a prelude to that to point to the Court, that with each one of these observations, I think it should be realized that consumers had been made to pay a price that these are matters which go against us. The Commission first of all pointed out that exploration and development costs were allowed at 4.08 cents even though in its judgment, the oil-well gas was found as a byproduct of the search for -- for the search for oil. Now, that there'd be no misunderstanding of this, that 4.08 cents does have within it, when you look at the cost -- at the yardstick, the old gas-well gas cost, it is an allocated cost. The condensate which is separated at the least does bear a part of this E and D cost that is being reflected over to the old flowing oil-well gas. And furthermore, the Commission reversed the examiner or refused to accept his recommendation with respect to the Spraberry contracts. These are contracts for the sale of residue gas flowing oil-well residue gas. The plants are owned by El Paso Natural Gas Company. And the contractual arrangement between it and the producers is such that the producer is paid for the gas at the well-gas -- however the price that is paid to him is figured at the tailgate of the plant after the natural gasoline has been extracted which we think is one of the primary purposes of directing those plants. Moreover, there is a division or percentage of the liquid revenues which are a part -- part as retained by El Paso and part is given back to the producer. Now, the Commission decided that this contract was a useful mechanism in the industry and permitted it to remain as such and rationalized the result in the ground that there was no showing in the record that El Paso did not retain sufficient of the liquid revenues to offset it's costs of running the plant. I suggest by the converse that there was no evidence in the record that the contrary is not true and if it is not true, then consumers are going to pay a higher price for that residue gas in the Spraberry contracts than otherwise. The truth to the -- the reason that we say that is that El Paso is under the ordinary approach that the Commission takes in pipeline cases are -- El Paso is required to credit its revenue from those liquid sales to its cost to service in determining our pipeline rates. So that we don't end up paying all of the costs of the plant and not get any credit whatever for some of the revenues which had been enjoyed by El Paso as the result of those costs inputs in the plant. Our problem has always been that we've been unable to get a cost for the plant operations in order to determine whether El Paso does make out all right on the amount of the liquid revenues which it attains or whether it goes in the whole. If it goes in the whole, we're going to pay the bill. But rather, the Commission turned its attention to what would happen to the -- it turned its attention to the Commission, or rather to the pipeline and said that, “Well, if this isn't going to be satisfactory, well, we would expect you to renegotiate with the producer”. I have already indicated at least our -- less than our faith in the motivation that the pipeline company refused to undertake those negotiations especially in view that they can pass on costs to the consumer. There's one other item too which is right in the same thing and that is that the Commission in this discussion points out that in constructing its yardstick for old gas-well gas, they did not include a plant liquid credit. Now, such a credit was included in making the new gas-well gas cost study. It was not included in the old gas-well gas and it is the yardstick that is applied to this huge resort of gas which is sold in the Permian Basin. The distinction there is that although the -- there's an allocation of the cost to take care of the revenues and liquids which are separated at the least. There was an old allocation of the plant costs because the plant cost were not even figured in the basic cost. However, the -- if you're going to strip the gas beyond the least and extract even more liquids from it, then it would appear and this is all that we think that the Commission was saying that that those revenues should also be taken into account. I should like now to move on to what I would call the basic finding of this case and you'll find it in paragraph 4 of the further findings of the Commission. That's at 687(d) when it says that -- when the Commission says that the just and reasonable rates for past, present and for post sales of natural gas to which this order applies are the applicable area rates set forth in ordering paragraphs (a) and (b). That means that these applicable area rates should perform three functions. Prospectively, under 5(a) they are the just and reasonable rates to be here after observed. Under 4 (e) they are the just and reasonable rates which have to be applied to the rate schedules to calculate refunds. And as I mentioned earlier, they would replace the concept of in lineness which is presently necessary because there is no just and reasonable rate at least on such -- until such time as this decision is affirmed and we hope it will be. Turning to the refunds, our concept of refunds is that is -- that is merely a derived calculation under the Act. Section 4 (e) states that all the rates of the natural gas company must be just and reasonable and if they're not just and reasonable, they're unlawful. That's a very, very simple straightforward statement we think. And what we think that means is that once you've determined what the just and reasonable rate is, you look at the total amount of money that was collected subject to refund by the Natural Gas Company and that excess must be refunded. The converse of corollary of this is, that if you do not do so, then you must really be finding by implication at least that the -- that to the extent that you do not require the full refund of -- the whole refund, the distance between the amount collected subject to refund and the just and reasonable rate, if you don't do that, then what -- what we argue is that you must have raised the just and reasonable rate by implication.
Potter Stewart: But since that the matter is intact, if the Commission is upheld, how would these refund going to work?
J. Calvin Simpson: What the -- we think that the Commission was very explicit right in its opinion in specifying what the refund reports should show. And I can't remember just what it says but they want the producers to pay to all of their rate schedules and indicate what rates were collected subject to refund, the refund obligation, and then apply to them the applicable area rate. And of course, that difference is the amount which is to be refunded.
Potter Stewart: That's refundable and that's --
J. Calvin Simpson: That is refundable.
Potter Stewart: It goes to the pipeline side.
J. Calvin Simpson: Not really. We've had some trouble with the pipelines Mr. Justice Stewart.
Potter Stewart: Pipelines were the first to do so.
J. Calvin Simpson: Yes sir, however, the Commission just heard an argument in a case that is not before the Court now but I rather think it will be. We're in -- there is -- the Commission had shown a concern and certainly from the producer or rather from the consumer point of view, we've shown a concern that these refunds be passed through the pipelines and they have another step to go after that. They have to go through the locally regulated distributors too.
Potter Stewart: To the consumer?
J. Calvin Simpson: To the consumer, that is certainly our --
Potter Stewart: I --
J. Calvin Simpson: -- position, otherwise we feel that the protection given us by Section 4 (e) of the Act – well, it just won't be there. It well be swallowed by somebody else --
Potter Stewart: Now, that was – and the question and perhaps I think you understood it was, as a matter of mechanics under the -- in this case, not some other case that might come to us someday. But in this case, if the Commission is upheld, as a matter of mechanics, how will this refund be refunded?
J. Calvin Simpson: Very well, Mr. Stewart -- Mr. Justice Stewart, I can answer that. With respect to El Paso and Transwestern who served California, we presently have entered into agreements with them that arose out of the settlement of other issues, but as part of the bargaining in those settlement conferences, we were able to obtain a commitment from El Paso and from Transwestern to flow these refunds through.
Potter Stewart: Now, by we, you mean the Public Utility Commission of California.
J. Calvin Simpson: Well, I think -- I mean all of the -- yes, because I only used the word “we” is because we were the party along with the staff of the Federal Power Commission, I should certainly add. The rule insisted that these provisions be concluded. Of course they didn't have to include them. But the Commission presently has a policy to which it refers in opinion 468 that they will not release refunds from producers to pipeline companies until the pipeline company indicates to the Commission just what kind of disposition it's -- is going to be made of it. We could go all further into this by equitable entitlement in your interstate case and so forth. I wonder if it might not do to indicate that there are some unsolved problems here that certainly the consumer interest are doing the best that they can to try to solve them because -- although it may just be brought to say so, we're very anxious that this Natural Gas Act work for the benefit of the people who are those who are protected by its primary aim.
Potter Stewart: How much in terms of dollars exactly would this refund amount to, to the average domestic user in your case?
J. Calvin Simpson: I don't have a figure for that Mr. Justice Stewart. I can -- I -- my guess would be, but I wouldn't want to mislead you in any way. It might at the range of -- we think it's probably when this is all over. It will be up somewhere around $40 million would be in the case.
Potter Stewart: Well, not for domestic users?
J. Calvin Simpson: No. No, no, no, no. Hardly -- I didn't mean that but that would be -- give you some sort of a gauge of the amount of money which would --
Potter Stewart: Well, I don't --
J. Calvin Simpson: -- be divided
Potter Stewart: I don't have an idea how many domestic users there are. How much of the --
J. Calvin Simpson: Well, there are about five --
Potter Stewart: -- if you refund those – in the industrial and commercial users.
J. Calvin Simpson: Yes, well, I don't have a calculation of that. But and so there really would be no point in my trying to make a guess. I'm not quite sure. I will say that when we did receive about a $136 million in refunds which were actually available for distribution to California customers that figure comes to my mind. The refunds among residential customers ranged all the way from -- as I recall from 06 even up to $10. So that would give you some kind of a – although, you can get it all figured out, I just don't -- I have not meet the calculation. Before leaving the refund part of the argument, this Court has observed that re -- that the refund protection Section 4 (e) is a very disadvantageous kind of relief. We don't use this kind of relief under the Public Utilities Code in California. We used a different system which does not involve refunding and we think that in your deliberations on the refund question that if anything, it must provide a sanction against filing unwarranted increased rates because to the extent that that can happen, they just borrow the consumers' money. And that if we read the refund section out of the Act to this area refund concept adopted on rehearing by the Court of Appeals, then as we observed in our brief, the sanction of individuals making up their own minds will sound as in the judgment as to whether or not an increased rate can be justified is certainly reduced, because once again, the consumers are at the end of the line when it comes to the refunds. We don't think there should be any trouble at all in the Commission's observation that the just and reasonable price should become the inline price in future cases. And I'd like to turn now to the notion that we're dealing here with just a limited remand. If we go down to the Power Commission again, if you take into account the fact that the Power Commission in it's decision has indicated that there's a certain degree of generosity in the determinations that they had made on the value basis and if we are going to reexamine as the Court of Appeals would have as do, the 12% rate of return which was expressly made that high in order to protect the producers from quality deduction that the Court keep in mind if it would that this entire Opinion 468 in our judgment at least is an interdependent package. There are many considerations which have to be looked at from the point of view of the entire decision. It is not the kind of thing that ought to be changed just on a piecemeal basis. There is a severe danger I think that consumer interest who have decided that it is in the interest of consumers to support this decision that they go back only for corrections the other way. I would point out to the Court that we file a petition for rehearing before the Power Commission. We objected to this 12% rate of return. We objected to a minimum rate of 9 cents. And we objected to a dividing date between new and old gas of the -- of January 1, 1961 because the very basis for having the two-price system is the price performed, the function of eliciting supply and that the price carrier -- be out there for everyone to see in order to make his decisions by back dating it to the 1st of January 1961 that didn't -- was not in accord really with economic theory in our judgment of the two-price system. There is no question that in our mind that what we really end up here within the area rate making is a just and reasonable uniform price. As Mr. Solomon in the answer to a question from Mr. Justice Fortas indicated that the price could, by renegotiation go up to this just and reasonable price and the Commission by its regulations, if the contract permits it, producers can file up to it. That's the theory of this. There is -- when you say that the price is just and reasonable, then there's an implication that that people want to be able to get it. But I would certainly join in the counsel's concern that there – be some indication on the part of the pipelines that it's -- that there is a quid pro quo for changing your contracts, because fundamentally, you can talk about group rate making but we are in fact fixing rates on individual producer with individual sales.
Abe Fortas: (Inaudible)
J. Calvin Simpson: I visualize that it would take a very long time indeed. It would take a long time on the balancing in my judgment. In order to hear all the arguments about whether the minimum rate should come up to the ceiling rate, indeed the -- as it were, the floor, whether or not a whole system of non-uniform rates rather than uniform rates be as -- be established and further grant -- the Court has also indicated that we have to go back into the quality section of the case and that might take a very long time indeed to unravel all of that. I would bluntly say that what the Court of Appeals has done in the sense of its balancing notion is to try to import completely the notion of individual company cost of service rate making over to the area rate making as though the Permian Basin is some sort of super corporation and of course it's not. It is many, many consumer or rather many producers operating in the area. But we would have reason to believe that the Commission might have to start all over again and in fact, we would have to make certain demands that it do start all over again because we have trouble with the idea of value based prices being balanced. If the – if they were cost based then causes less trouble. But they're valued based and we know that there is something extra in there as the Commission itself concedes. So we do think it would take a considerable length of time. Now I know that I've made many critical remarks of the opinion. But let me close by saying that we think that the Commission has done a responsible job that it has addressed itself to all of the questions that this very complex area poses. We think that we might have been able to do better by the consumer but nevertheless, we think that all of the prices which had been adjudged in this case are in – are within the zone of reasonableness albeit as we see at page 32, Footnote 25 of our brief, at the very top of that zone of reasonableness. The problem of the contracts apparently is going to be a transitional thing. We would expect in the future that there are going to be contracts at the applicable just and reasonable area rate. We ask this Court from the consumer point of view to affirm the Opinion 468 in its entirety.
Earl Warren: Mr. Furbush.
Malcolm H. Furbush: Please the Court. I represent the Pacific Gas & Electric Company, one of the California distributors that had been referred to here today. We participated in this case before the Commission because we were convinced that a price had to come out of this decision which would be adequate, but no higher than adequate to bring forth the supplies of gas that are required by the consumers in our area. Now, that statement which I just made, the price which is adequate and no higher than adequate or no higher than necessary is really a statement of the function which price plays in our basic economic system. And we approach this case from that point of view and retained economist as Commission counsel has described to you this morning, to help us make our presentation. And they, on their review of basic economic law concluded that that is just what should be done here. We should seek that price. Now, the question is how do you determine the price that is as high and no higher than necessary to bring forth the required supplies. Parenthetically, I might say that the major producers interestingly enough adopt the same standard before the Commission. But the dispute was, what evidence do you use? What you utilize to determine that price? Our economist told us and told the Commission to a testimony that such a price cannot be determined without some reference to cost. Some reference to cost. And also that price can only perform that function of eliciting supply in respect to such supplies as will be responsive to price. And the history of the industry was such that gas had not historically been responsible to the -- did not respond to the price of gas because gas was historically a byproduct found in the search for oil and produced in conjunction with the production of oil and thereby controlled by the demand for oil. And that therefore price will not perform that function, but with the advent of the directionality ability of the Commission -- of the producers, price could then perform that function. However, recognizing as the Commission recognized and as the Court, and as the evidence clearly demonstrates that the bulk of the flowing gas supplies were found as a result of the search for oil and as a byproduct of that search, it was therefore in economic terms fairly clear that paying an incentive price, a high price necessary to bring forth new gas-well discoveries would not be necessary in respect to that flowing gas. And as a consequence, our economist suggested that that price need only be one that was fair and reasonable and the price will not perform the function which we had assigned to it. Now you have heard a great deal of discussion today and you will certainly hear more tomorrow on costs. And I would like to talk today about cost as I take it from the proper context of this case. Now, and I'll have to -- could I address for a moment to talk about what we're regulating hereto. What is being regulated is price. The producers aren't being regulated. The producer is free to go out and search throughout the nation for gas or for oil and do whatever he wants with the funds that he gets from the sale of the gas. He may engage in as much production as he wants to when he -- and as much exploration. And when he finds gas, he can sell it anywhere he wants. He can sell it in the intrastate market and if he sells it in intrastate market, the Commission has no jurisdiction over it. And it is only if he sells it into the interstate market for resale, that his sale becomes subject to the jurisdiction of the Commission and hence to regulation. Now, the record clearly demonstrates in this case that insofar as Permian gas is concerned, 50% of it is consumed intrastate, 50%. And so we're talking about only 50% of the gas in the Permian Basin which goes into the interstate market which is subject to sale. Now, with that thought in mind, let's go back to cost as it is used in this proceeding and talk about cost of service for a moment. Now, cost of service applied to a producer does not mean the cost of gas which is subject to that price order. It means the cost of engaging in the exploration development, production and sale of gas as the producing industry engaged in that business. As it engaged in the business, now --
Abe Fortas: What -- excuse me sir, what percentage if you can give us an idea, what percentage of the cost figure here is represented by exploration cost?
Malcolm H. Furbush: Well, at 4.08 cents of the cost of flowing gas is represented by exploration. Now it -- so if we take -- well it's at least, say around 30%.
Abe Fortas: 30%?
Malcolm H. Furbush: At least 30% of the cost. The highest of course -- highest element is in the -- is in return.
Hugo L. Black: Is in what?
Malcolm H. Furbush: Return allowance. Now, this 4.08 cents representing exploration in the flowing gas here, remembering now all along that this flowing gas cost is of gas-well gas which the Commission said and the highest cost of any of the types of gas which were being subject to the regulation. But that cost study included 4.08 cents for exploration. Now you know what that means, that means it includes for dry holes, geological and geophysical expenses, delayed rentals, abandoned leases, all of the expenses of a non-productive nature. Now, that is not the exploration cost which resulted in the gas that was flowing during 1960. That was the exploration cost which was incurred during the year 1960 under the exploration programs conducted during that year which, however, to get the 4.08 was assigned to production during that year. And what does this mean? This means that the costs of exploration which the record demonstrates resulted in the finding on an average of 138% of production, 138% of production. The cost of that are included in the flowing gas cost. Now, immediately, we harkened back these overall traditional uses of public utility regulation in the Hope case itself, don't we? And what do we find there? The great question was whether or not original cost should be used, the Commission used, employed for fair value which is just replacement cost. So what do we have here? We're having that 4.08 cents per Mcf not only the replacement cost of the gas produced during that year, and we don't dispute that at all, but the amount of money necessary for the producers to find 38% more to increase their inventory by 38% more than they produced during that year. Now, we can also harken back the Hope and the quotation in Hope about -- well, from Natural Gas Pipeline Company, to the effect that a producer embarking upon a wasting asset business or a regulated entity embarking for the wasting asset business has no constitutional right to have more at the end of that business than he had at the beginning of that business. Now, here, we have at the end of the business, the producer is going to have a 138% more than he had when he started. Now, we don't object to the inclusion of that extra amount which if you want to compute it, 138% and you go through all the mathematical maneuvers applying that to 4.08 cents, you come up with 1.11 cents per Mcf which I classify as a cushion against confiscation.
Abe Fortas: No, I beg your pardon? What is that 1.1 cents?
Malcolm H. Furbush: That is the amount of the exploration expenditure --
Abe Fortas: I see.
Malcolm H. Furbush: -- in the flowing gas which could be attributed to the 38% over simply replacing the gas produced.
Abe Fortas: That's against the 4 point something cents.
Malcolm H. Furbush: Right, right. Its 1.11 of the 4.08. Now in the price for new a non-associated gas, it's clearly stated 1.11 cents per Mcf was provided for increased exploration activity. Now we subscribed to the proposition that this should be included but we do so recognizing that we are doing it for economic reasons in the hope that the industry would utilize these funds being supplied in this manner to acquire reserves which it is hoped by us, will find their way into the interstate market.
Hugo L. Black: Isn't that compelled within the (Inaudible)?
Malcolm H. Furbush: Absolutely not Your Honor. They're not compelled at all.
Abe Fortas: Now, as I understand your position that – should at least say it this way that you're saying that 1 -- only 1.1 cents out of this 4 point something is relevant to the constitutional standards and beyond that, there is an allowance made as a matter of public policy, (Inaudible)? Is that what you are saying?
Malcolm H. Furbush: Your Honor, Mr. Justice Fortas, I would just switch it the other way around. I wish I could say that for the purpose of the argument but that -- I did not mean that. The 1.11 cents or 1.12 in the case of the flowing and 1.1 in the case of the new is that which is being supplied for public policy. The remainder --
Abe Fortas: Oh, I see, that is --
Malcolm H. Furbush: Yes.
Abe Fortas: -- that is that part --
Malcolm H. Furbush: Right. Now, let's --
Abe Fortas: And the remainder is the replacement of the price, (Voice Overlap) --
Malcolm H. Furbush: Yes, yes Your Honor.
Abe Fortas: -- of spending stock as preserved presented so to speak.
Malcolm H. Furbush: That's right. It's replacing -- it's not the original cost. It's the replacement of the gas and as we recognized that insofar as the casinghead gas is concerned, oil-well gas, well, you're replacing it with a new and much higher cost -- form of gas than what was originally discovered. Now, if you would indulge for a moment, I would like to get a little legalist here if I might. I don't think there's any concept at all such as group confiscation. I can't read that in our constitution. There is obviously confiscation of the individual. And so you really don't get to the question of confiscation until you see what happens to the individual when he comes up and claims that he -- his property is being confiscated but for the purpose of my discussion here to point out that there is this great question against confiscation, I like to look on this situation as being (Inaudible) that the just considerate producer having the cost experience that was employed in the yardsticks – the yardstick cost. And then we see whether or not his property would be confiscated on the basis of the yardstick cost that were employed. And in that context, is where I talk about the confiscation and I say that there we have right off the top of this, over a cent cushion against confiscation. And as I say, we supported the inclusion of this but we supported for these other reasons.
Abe Fortas: You're talking about the average, are you?
Malcolm H. Furbush: Yes, yes. We're talking -- the yardstick cost is what we referred to as the average. We can call it the average. You can call it an adequate sample. You can call it whatever you want.
Abe Fortas: Is there any indication in the record about the extreme or to say that very high cost producer.
Malcolm H. Furbush: No. No, there isn't. But then should that bother us really at all. You know the constitution --
Abe Fortas: That's another question, I was --
Malcolm H. Furbush: Yes, yes. Well, no it doesn't -- but you know, the constitution does provide for bankruptcy legislation as I understand it. And so even in those early days, it was recognized that in our economic system, there are going to be some fatalities.
Abe Fortas: To most figures, you don't like the idea.
Malcolm H. Furbush: Well that -- that's right. I don't think any of us would like it Your Honor. Now, the Commission as has been pointed out several times today employed in this -- as its yardstick, this cost of gas to which I had referenced which had this cushion end of one -- of over one cent. But in addition to that, it was recognized as being the highest cost gas which was being costed by the participants in the proceedings. And the Commission referring to cost of casinghead gas said that it could not be accurately determined. And one of the criticisms which it leveled against it was that any method of costing casinghead gas, gas that comes along with oil which allocates to that gas a significant or substantial amount for exploration, one was found as a byproduct of oil, it just doesn't make sense. Now, that's the finding of the Commission and that is the context in which the Commission was criticizing the cost studies in the record relative to casinghead gas. But the Commission also said in recognizing that will be sold, that even though there were cost studies of casinghead gas in the record which under this finding would still be overstated. That even those cost studies were less than the cost yardstick employed by the Commission. Now this being so, we submit that during -- when you hear during the course of this argument references to cost that you keep in mind that the cost which was referred to by the Commission, the yardstick costs which were used and employed in the development of the Commission prices were costs which not only had this cushion against confiscation, but were also the highest cost which the Commission felt that it could employ. Thank you.
Earl Warren: Mr. Ormasa.
John Ormasa: Mr. Chief Justice, members of the Court. My name is John Ormasa. I'm general counsel for the Pacific Lighting System of Companies that includes Southern California Gas Company, Southern Counties Gas Company of California, and Pacific Lighting Services Supply Company. We are distributors, serving gas to some 10 million people in Southern and Central California. Our interest in this proceeding is different from that, of any other party to this proceeding. I'd like to spell that out a bit if I may.
Hugo L. Black: What is your position?
John Ormasa: Our interest Justice Black is this, that we are a straight gas company. We have no electric service that we provide at all, that's provided by other utilities, that all bears on this question.
Hugo L. Black: What is your position on the order?
John Ormasa: We -- I'm sorry.
Hugo L. Black: What I asked you, what is your position on the order?
John Ormasa: We support 100% affirmance of the Commission's order.Not to say that we would have prepared the order that way, Mr. Chief -- Mr. Justice Black, but we are reasonably satisfied that it does the job. Now, what do I mean by that, “what is our interest”. We are not interested in the lowest possible conceivable rate. We are not interested in a rate that probably will bring forth the gas supplies. What we are interested in is a rate that will produce with reasonable certainty those gas supplies that our customers must have, that's number one here. On the other hand, we must have a rate that is not too high. We must have a rate that permits us to sell our product in competition with alternatives that are available to our customers. Let me say this, we are the largest single purchaser of interstate gas going out to the Permian Basin. Its contract -- in our companies in El Paso is not a gas flowing intrastate out of the Permian Basin. We're talking about 1945. In 1946, we got a certificate as El Paso did. 1947, just 20 years ago, the gas started to flow to us in Southern California. Before that time, we produced all of our own gas in California. Today, our companies import possibly 75% to 80% of our gas supplies subject to the jurisdiction of the Federal Power Commission. In 1954, this Court said in Phillips, “You, the Commission, whether you want to or not must regulate the fuel price of the producer”. And you know what we went through? We went through unregulated field price period. 1950's the gas-well price in the Permian Basin kept jumping and jumping. The price skyrocketed. El Paso is buying. The Northern Natural came in to the Basin. The Transwestern came in to the Basin. Under the Natural Gas Act, when the cost increase of the pipeline company, it files for rate increase and the Commission has no jurisdiction -- cannot prevent an increase after a six-month period then the increase goes into effect. So in fact, we in California were paying very high prices for gas flowing out of the Permian Basin, at the same time that this gas prices supposed to be regulated and in fact was not. (Inaudible), our largest customer, a large part, out to seek its own independent gas supply because it didn't want to have what in fact was an unregulated price that can jumping. They wanted to get an unregulated price at a fixed rate not subject to the jurisdiction of the Federal Power Commission. It's only because of the activities of this Commission, the Federal Power Commission in this area rate proceeding has been some stability went to the industry.
Abe Fortas: Well how did your largest customer range for that gas? Is it somewhat -- it's a pipeline more than El Paso?
John Ormasa: Pardon? Yes, it did.
Abe Fortas: The matter what – made that way --
John Ormasa: It entered to contracts with producers in the field and that a new company is to be set up by one of the existing pipeline companies to transport the gas from -- actually it was in South Texas to California. Now, with -- we have felt sufficiently encouraged by what the Commission has done in this area rate area that this is what we have agreed to do with our two largest customers, these electric utilities. We have a contract with them. The largest one is for 175 billion cubic feet of gas per year and the contract amount for the Department of Oil and Power is somewhat smaller. At a fixed price, guaranteed price by our companies, 29 and three quarter cents per million Btu. We've gone that far in order to try and meet their desires and their needs. What's going to happen if this case goes back to the Commission, Justice Harlan, you are raising question about that. As I said, we're going to have chaos. You've got a brand new Commission. You've got -- I'm not relating those two obviously. You have new Commissioners, what I'm saying is, we don't know what they feel or think, what their views maybe. Commissioner Swidler, Commissioner Black are gone, Commissioner Baggy (ph) who was on the Commission and is but did not participate in the Permian Basin proceeding. Commissioner O'Connor went along --
Speaker: (Inaudible)
John Ormasa: No, no, no Mr. Justice Harlan, don't misunderstand me. The point I'm trying to get at is this. Is that these gentlemen are not committed to the prior opinion rendered by the Commission. And what's going to happen when it goes back as we don't know it's going to happen. There are people who will say I'm sure, you have a stale record and they're saying that already in this case, that you have a stale record. What happens if we go back on remand? Everybody will say, we'll we've got a stale record. We've got to present new evidence. We'll be back here before this Court in the 70's without area rate concept. You'd finally determine in the Permian Basin, this is the risk that we're running. These are the things we've got to think about.
Byron R. White: (Inaudible)
John Ormasa: And with another stale record, yes Mr. Justice White.
Speaker: (Inaudible)
John Ormasa: Let me turn to one last point and that has to do with the use of the area rate itself as the inline price in certificating new gas sale. As we see it, this is essential and proper. Why do we have inline prices? If I remember what the CATCO case said, it says as to hold the line until the Commission has had a chance to determine the just and reasonable rate. That's the purpose of the inline price. Well then how do you ignore what the Commission has just found to be a just and reasonable rate? You say, “No, we'll set as the inline price with some other rate”, I'll leave that problem with you. Thank you very much Mr. Chief Justice, my time has expired.
Earl Warren: Mr. Ames.
C. Hayden Ames: Mr. Chief Justice, may it please the Court. My name is C. Hayden Ames. I represent San Diego Gas & Electric Company. In the few minutes that I have this evening, I want to discuss or point that I believe would -- will be concerning all of you individually and collectively after having listened all of this time to the description of the massive evidence both economic and cost that is going into the development of the regulations appear under review. And this question is naturally this, is this going to work?
Hugo L. Black: Are you for or against the order?
C. Hayden Ames: I'm very much for the Commission's order. The question, is this going to work? Is the area rate mechanism going to produce a fair result? Is the price in the words of Justice Jackson in the Hope Case going to bring -- to be an effective tool in bringing the gas to the market? We as distributors are greatly concerned over this as Mr. Ormasa has indicated. We are -- have large amounts of plant as well as our consumers plants invested which would hardly be used for other purposes. For this reason, we find that the producers' argument which we've heard time and time again, somewhat annoying but at the same time intriguing in this argument. You've heard it today, that they should be allowed to have their unregulated contract prices. And unless they have their unregulated contract prices, they won't bring the gas to the market. Now, this is annoying because this Court has said on numerous occasions as it ordered the Federal Power Commissions to get on with the job of regulation, in the CATCO decision, and other decision so that there's no help to suggest in effect to non-regulation. It is intriguing to me in this respect that the actual effect in the Permian Basin has in a way mocked the claim of the producers. I'm sure, they may be unhappy about this. But practically, in a lot of steps with the proceedings we're considering here and after the guideline where prices were adopted in 1960 and at 16 cents, a prodigious and very prolific effort commenced in the Permian Basin, in the deep Delaware and the (Inaudible) portion of that Basin where these producers we're going down to depths of 20,000 feet below the surface of the Earth, the deepest gas wells in the world. This commenced in about 1961 at the same time that Dr. Hills, their witness, testified before the Commission as the second witness that this would be the area where the gas would have to come from and there would have to be incentives to bring the gas forth. And Mr. Justice Fortas, one of the reasons why they can look for gas as distinguished from oil was that as -- that's it's a physical fact that the further you go in depth, the less you get an oil, the more you're getting gas. Anyway, they've been going to these great depths to get this gas and this is since -- let's say in 1960, the Commission adopted the guideline prices of 16 cents. In 1964, Examiner Ware (ph) came up with the 16 and three-quarter cents for new gas in this area. And finally, in 1965, the Commission came out with it and the price you were considering here, 16 and a half cents is the ceiling price. All of this period, these men who are I'm sure very hardheaded not in the sense that they are dumb but in the sense that they are economically astute, were drilling for gas in the Permian Basin and it became one of the large producing areas in recent time. Now this is documented in the -- not only in the record but subsequent to the record, the Commission who has the same concern that you have, is this going to work, the Commission had before it a number of cases including the Pipeline case that Mr. Ormasa referred to which was all in Opinion 500 where they said -- they preferred a large pipeline expansion of El Paso and Transwestern coming partially at least as a reserve or partially out of the Permian Basin over this competing project which would have dedicated 6 trillion feet of east -- Eastern, Southeastern Texas gas to the West Coast. So the Commission knew at that time and they continues to have cases, Opinion 519 to new pipeline projects into the Permian basis -- Basin just adopted in March of this year that the gas is forthcoming. We don't say that this is the end of the line. We say that the price is acting as a tool and hopefully we believe that it will continue and that the Commission will -- through its continuing jurisdiction develop and refine this method so that they can keep in touch with what's going on in the field and bring the gas so that we can use it in California. Thank you.