# Appendix — Association of Oil Pipe Line Lines v. Farmers Union Central Exchange Exchange Exchange, Inc. (Nos. 84-184, 84-185) > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385010_2569%3A2 ## Record - **Collection:** Supreme Court brief - **Document type:** Appendix - **Published:** January 1, 1984 ## Text Sf ‘ + ie ee won US. “tds 4 AUG 2 {984 “1.86 - tt In THE ‘ Supreme Court of the United States OCTOBER TERM, 1984 ASSOCIATION OF OIL PIPE LINES, Petitioner, Vv. FARMERS UNION CENTRAL EXCHANGE, INC., et al., FEDERAL ENERGY REGULATORY COMMISSION, and UNITED STATES OF AMERICA, Respondents. WILLIAMS PIPE LINE COMPANY, . Petitioner, FARMERS UNION CENTRAL EXCHANGE, INC., et al., FEDERAL ENERGY REGULATORY COMMISSION, and UNITED STATES OF AMERICA, Respondents. TEXAS EASTERN TRANSMISSION CORPORATION, i. Petitioner, FARMERS UNION CENTRAL EXCHANGE, INC., et al., FEDERAL ENERGY REGULATORY COMMISSION, and UNITED STATES OF AMERICA, Respondents. APPENDIX TO PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT August 2, 1984 (Counsel Listed on Inside Cover) CL WILSON - Erzs Printine Co.. Inc. - 769-0096 - WASHINGTON. D.C. 20001 CHARLES E. GRAHAM JOHN E. CCMPSON KENNETH P. FOUNTAIN JAMES R. KINZER Harry L. REED SIDLEY & AUSTIN Of Counsel SULLIVAN & WORCESTER HALL, ESTILL, HARDWICK, GABLE, COLLINGSWORTH & NELSON Of Counsel VINSON & ELKINS Of Counsel R. EDEN MARTIN * LAWRENCE A. MILLER VINCENT F. PRADA 1722 Eye Street, N.W. Washington, D.C. 20006 (202) 429-4000 PATRICK H. CORCORAN 1725 K Street, N.W. Washington, D.C. 20006 Attorneys for Petitioner Association of Oil Pipe Lines RoBERT G. BLEAKNEY, JR.* One Post Office Square Boston, Massachusetts 02109 (617) 338-2903 Davip M. SCHWARTZ ROBERT L. CALHOUN 1025 Connecticut Avenue, N.W. Washington, D.C. 20036 (202) 775-8190 WILLIAM J. COLLINGSWORTH JOHN S. ESTILL, JR. Bank of Oklahoma Tower One Williams Center Tulsa, Oklahoma 74172 (918) 588-2655 Attorneys for Petitioner Williams Pipe Line Company JAMES W. MCCARTNEY ALBERT S. TABOR, JR. JOHN E. KENNEDY * DAvip T. ANDRIL First City Tower Houston, Texas 77002 (713) 651-2550 Bo.Livak C. ANDREWS JAMES C. RUTH Texas Eastern Transmission Corporation P.O. Box 2521 Houston, Texas 77252 Attorneys for Petitioner Texas Eastern Transmission Corporation * Counsel of Record — ——-——— + - - Re App. App. App. TABLE OF CONTENTS Court of Appeals opinion, March 9, 1984 _..... Federal Energy Regulatory Commission De- cision, November 30, 1982 .............................. Court of Appeals Judgment, March 9, 1984... Court of Appeals Order Denying Petitions for Rehearing, May 4, 1984 .........00000000000000002.. Court of Appeals Order Denying Suggestions for Rehearing En Banc, May 4, 1984 .......... Statutory Provisions Involved ........................ Federal Energy Regulatory Commission In- vitation to Submit Comments on Rulemaking Principles for Oil Pipeline Rate Cases, April pi ESSERE PRE SESE coe Excerpts from Initial Brief of Williams Pipe Line Company Before Federal Energy Regu- latory Commission, May 1, 1980 .................... Excerpts from Transcript of Proceedings Before Federal Energy Regulatory Com- REST E AC R ae eae f the ICC rate base formula have led experts to call it “nothing less than bizarre; it is a mysterious collec- tion of seemingly unrelated components that, through the wonders of jurists’ algebra, miraculously distill into a single sum.” Jd. at 296. These features have been the subject of criticism throughout the most recent Williams proceeding, and drew the attention of this court in Farmers Union I. FERC, however, failed to provide any reasoned defense to these criticisms, beyond its belief—misguided by its impermissible interpretation of “just and reasonable” rates—that oil pipeline rate regulation can tolerate such “anomalies and inconsist- encies.” 21 FERC at 61,616. Thus FERC in its Williams opinion also “entirely failed to consider an important aspect of the problem” of rate bases. Motor Vehicle Mfrs. Ass’n, 108 S. Ct. at 2867. A-73 Even in the absence of such infirmities in FERC’s method of choice among rate base methods, our review would still include scrutiny of the rate of return meth- odology, to see whether the selected rate of return, applied in combination with the selected rate base, leads to a reasonable result. As FERC observed, the agency must assure that “the combination of rate base and rate of return provides a[n] .. . acceptable end result.” 21 FERC at 61,616. We now proceed to examine whether FERC engaged in reasoned decisionmaking when it chose its rates of return for use in oil pipelines ratemaking. B. Rate of Return FERC divided its rate of return into three components: (1) debt service, (2) the suretyship premium, and (3) the “ ‘real’ entrepreneurial rate of return on the equity component of the valuation rate base.” 21 FERC at 61,644. The debt service element, which represents the cost of interest and repayment of indebtedness, gives rise to no objections from the parties, and need not detain us. The suretyship premium similarly demands little com- ment apart from our previous observations that it re- quires much of the same kind of theorizing involved with the use of hypothetical capital structures. See supra at 55-59. Farmers Union believes that FERC “erred when it assumed that such a premium is an ‘add on’ to the cost of capital without comparing pipeline and parent com- pany risk.” Farmers Union Brief at 59 n.1. Our reading of the Williams opinion, and FERC’s representations to this court, however, convince us that FERC made no such assumption, and, accordingly, pipelines must show that the guarantees reduce perceived investor risk in order to establish their entitlement to and extent of a suretyship premium. See 21 FERC at 61,621, 61,644, 61,711 nn. 492, 493; FERC Brief at 72-73. Only the “real entrepreneurial rate of return on the equity component of the valuation rate base” remains. A-74 FERC began its discussion of this component from the premise that “[i]t seems obvious to us that allowed real rates of return on oil pipeline equity investments should be appreciably higher than those the Commission awards to natural gas pipelines and to wholesalers of electric energy.” 21 FERC at 61,645. Considering that “oil com- panies [and the owners of the independent pipelines] have lots of places to put their money, . . . and that the social need in this field is for returns high enough to induce the construction of new pipelines and to avert the premature abandonment of old ones,” FERC enumerated the following eight measures of the rate of return on equity: (i) Realized nominal rates of return on the book value of shareholders’ equity in the oil in- dustry generally over the past 5 years; (ii) Realized nominal rates of return on the book value of shareholders’ equity in the oil in- dustry generally over the past year; (iii) Realized nominal rates of return on share- holders’ book equity in American industry generally over the past 5 years; (iv) Realized nominal rates of return on share- holders’ book equity in American industry generally during the most recent year; (v) The particular parent or parents’ realized nominal rate of return on total non-pipeline book equity over the past 5 years; (vi) The particular parent or parents’ realized nominal rate of return on total non-pipeline book equity in most most recent fiscal year; (vii) Total returns (dividends plus capital gains) on a diversified common stock portfolio over the past 5 years. ..; and (viii) Total returns (dividends plus capital gains) on a diversified common stock portfolio over the long run—25 years, 50 years, or more.... A-75 See 21 FERC at 61,645. FERC further held that “it would normally be proper to choose the measure most favorable to the particular carrier or carriers involved.” Id. Although most of these rates of return are expressed in terms of return on the book equity of unregulated com- panies, i.e., on the basis of original cost,“ FERC’s methodology would nevertheless »pply them, after an adjustment for “inflation,” to the equity component of the ICC valuation rate base. Moreover, under FERC’s methodology, the “equity component” is equal to the total valuation rate base, less the face value of the outstanding debt. See supra at 21. By this approach, the entire amount of appreciation in the rate base is allocated to the “equity component,” while none of it is allocated to the debt component. We frankly cannot locate the rhyme nor reason of this rate of return methodology; nor is it based upon a con- sideration of all relevant factors in oil pipeline rate- making. To begin with, FERC offered no rational ex- planation that linked its regulatory purposes with its chosen rate of return indices. FERC made no attempt to estimate the risks involved with oil pipeline operations, and therefore could not reasonably estimate the rate of return required to maintain a viable oil pipeline industry. Moreover, in summary form, with a more elaborate dis- cussion below, the “inflation adjustment” to the selected rates of return does not reliably compensate for the appreciation to the valuation rate base, and, therefore, overcompensation for inflation is not reliably prevented. ® Book equity is the original paid-in capital contribution of equity shareholders plus any retained earnings. It therefore represents the net underlying value of the company’s assets in original cost terms. See, e.g., B. Ferst & S. Ferst, Basic Accounting for Lawyers § 2.06, at 73 (3d ed. 1975) ; J. Gentry, Jr. & G. Johnson, Finney & Miller’s Principles of Accounting 372 (8th ed. 1980). A-76 FERC’s willingness to permit the oil pipeline companies to choose among a wide variety of rate of return indices only makes these defects worse. FERC’s method of calcu- lating the “equity component” of the rate base further enlarges the allowable returns without good reason. As a result, the total returns allowable under FERC’s meth- odology have no discernible regulatory significance beyond the fact that they are bound to be very large. FERC does not even offer an explanation of why its ratemaking formula sets “a cap of gross abuse,” let alone a just and reasonable rate. 1. Risk and Allowable Rate of Return As previously discussed, FERC made no effort to study and estimate the risks associated with oil pipeline opera- tions. Accordingly, FERC offered no reason to believe that the risks associated with the unregulated enter- prises from which it derived its rates of return were equivalent to the risks of running an oil pipeline.” Be- 70 For instance, FERC would look to the rate of return of the “particular parent or parents’ ” total non-pipeline operations. Obviously, there are no assurances that the returns to, say, Exxon’s non-pipeline operations—which include its office sys- tems manufacturing, oil exploration, etc.—would reflect the risks of an oil pipeline. Furthermore, because many pipelines are owned jointly by a number of oil companies, it appears that the pipeline could select the “particular parent” with the most lucrative non-pipeline operations over the relevant period. Neither is there any assurance that the profits of the “oil industry generally,” or the “total returns (dividends plus capital gains) on a diversified common stock portfolio” in a sustained bull market would reflect a pipeline’s properly de- served return. Also, although the rates of return on “Ameri- can industry generally” would apparently represent the aver- age risk enterprise, FERC did not establish that the risks of oil pipelines fall above or below or around the average level of risk in American industry generally. Finally, because the FERC method permits pipelines to select for themselves the applicable rate of return index, ll that is required to throw the method entirely out of kilter with a reasonable rate methodology is merely one excessively high index level. A-77 cause the level of risk associated with an enterprise de- termines the returns it requires to attract capital, see supra at 59-63, FERC never established a reasonable con- nection between its stated purpose to preserve the fi- nancial integrity and economic viability of oil pipelines and its selected rate of return indices. FERC attempted to establish such a connection by arguing: If the returns do not exceed those being realized somewhere or other in a roughly comparable segment of the economy’s unregulated sector, it is hard to see how they can be branded extortionate or abusive. Our relative permissiveness makes the risk prob- lem more manageable. Can even the riskiest of pipe- lines argue that it is so hazardous that it is entitled to more than anyone makes any place else? 21 FERC at 61,645-46 (emphasis in original). The first sentence of this passage lacks any semblance of valid reasoning from the record. FERC never even attempted to establish that the relevant segments of the economy’s unregulated sector were in fact “roughly comparable” to the oil pipelines. If the enterprises were “roughly compar- able,” the reference to them might be justified. FERC, however, assumed, without explanation, the existence of that factual predicate in order to justify its selected rate of return indices. Unfortunately, this assumption is not supported by any sound explanation based on the record, and therefore this attempted justification rests on nothing more than a blind, conclusionary assertion of “rough comparability.” The second paragraph in this passage makes use of a non sequitur. In preceding paragraphs, FERC had per- mitted the oil pipelines to choose a rate of return for themselves from a buffet bedecked with those found in a wide variety of lucrative unregulated enterprises. It is therefore pure illogic to assume that the “risk prob- lem” is the spectre that the oil pipelines might claim A-78 entitlement to even greater rewards. As we have dis- cussed above, the real “risk problem” with FERC’s methodology—the problem FERC entirely failed to ad- dress—lies in whether FERC’s selected indices grossly overestimate the risks and needed returns prevailing in the oil pipeline business. 2. The “Inflation Adjustment” and the “Double Count- ing” Problem The problem of “double counting” for the effects of inflation, once in the rate base and again in the rate of return, has plagued oil pipeline ratemaking for some time. See, e.g., Farmers Union I, 584 F.2d at 419, 420-21; Williams Brothers Pipe Line Co., 355 1.C.C. at 487. The ICC rate base formula purports to account for inflation in valuing a pipeline’s assets. See 21 FERC at 61,646; see also Farmers Union I, 584 F.2d at 421. If the chosen rate of return also reflected the effects of in- flation, then the resulting return might compensate for inflation twice, and so would be excessive. FERC attempted to eliminate the double counting problem by subtracting an “inflation allowance” from the nominal rate of return before applying it to the “inflation-sensitive’ ICC valuation rate base. See 21 FERC at 61,646-47. Because the nominal rates of return are derived from original cost accounting, see supra at 74, they include a premium to compensate investors for the expected future rate of inflation. However, because the ICC valuation rate base is, according to FERC, al- ready “inflation-sensitive,’” FERC’s method should de- duct from the nominal rate of return the percentage by which the valuation rate base has been “written up” during “the relevant period.” Id. at 61,647. FERC de- fined “the relevant period” to be “the time period that was looked to in order to derive the appropriate nominal rate of return.” Id. at 61,712 n.511. For example, if the nominal rate of return were set by reference to returns A-79 on shareholder book equity over the most recent year, that nominal rate would be reduced by the percentage amount that the valuation rate base had increased over the most recent year. In this way FERC believed it could “avoid overcompensation for inflation.” Id. at 61,646. Farmers Union, among others, objects to this “infla- tion adjustment” on the ground that it does not com- pensate for actual inflation. It put forward strong evi- dence, including calculations made by Commissioner Hughes in his separate statement, to show that the valua- tion rate base does not track inflation in any predictable manner.” See 21 FERC at 61,725 (Hughes, Comm’r, dissenting in part and concurring in part) (“A... serious defect [in FERC’s decision], and I believe, an uncorrectable one, is the unstated assumption that the trending of the rate base in the valuation formula ap- proximates or should approximate the course of infla- tion.”’) ;7* see also Farmers Union I, 584 F.2d at 519 & 71 Farmers Union and the Justice Department contend that the “inflation adjustment” does not represent the real inflation component of the rate of return for two reasons. First, they show how rate base appreciation in the past has not tracked the inflation rate, as measured by either the consumer price index or the gross national product deflator. See also infra note 72. Second, they remind us that the inflation componert of the rate of return should compensate investors for expected future inflation, not past inflation. 72 Commissioner Hughes continued: “A preliminary review of inflation figures for the period 1970-1981 and of the change in valuation for Williams Company indicates on both a year- to-year and on a total cumulative period significant differences. The [relevant data] shows clearly the unpredictable differences between the rate of inflation, measured by either the Consumer Price Inde (CPI) or the Gross National Product deflator (GNP deflator), and the change in valuation of Williams Com- pany by the ICC methodology. In only one year was inflation (measured by either the CPI or the GNP deflator) within 20% of the change in valuation.” 21 FERC at 61,725. A-80 n.29; J.A. at 2455 (testimony of Thomas C. Spavins) (highlighting “the lack of a clear correspondence be- tween [the ICC] valuation returns and any clear sys- tem of indexing returns for inflation’’). FERC in a footnote anticipated such a criticism, and responded: “Suppose that [the ICC formula] does lead to an overly generous allowance for inflation in the rate base. What of it? The rate of return on equity is re- duced by the precise amount of the overstatement.” 21 FERC at 61,712 n.513. This defense is sound, as far as it goes. Speaking precisely, FERC’s “inflation adjust- ment” does not operate as an adjustment to compensate for the effects of inflation; rather, it operates as an adjustment to compensate for the effects of rate base appreciation, which, if left in the calculus, would lead to “double counting.” The important feature of such a scheme is not that the rate of inflation and tiie rate of rate base “write up” are the same; instead, it is im- portant only to assure that the increase in the rate base —which is affected and indeed justified by the fact that present values reflect inflationary effects—is not counted in calculating rates because expected inflation is already reflected in the level of rates of return. In simple terms, then, the “inflation adjustment” operates to write off the “write-up” in the valuation rate base through a deduc- tion from the nominal rate of return. See 21 FERC at 61,646-47. Unfortunately, however, and without explanation, FERC decided that the needed adjustment should be determined by reference to rate base appreciation dur- ing “the time period that was looked to in order to derive the appropriate nominal rate of return.” See supra at 78. This time period could range from “the most recent year” only, to “the long run—25 years, 50 years, or more.” 21 FERC at 61,645; see supra at 74. The al- lowable returns to the pipeline, by contrast, reflect the entire appreciation in the rate base over the life of the A-81 pipeline’s assets. The “inflation adjustment,” therefore, will not necessarily reflect the full rate of write up re- flected in the rate base. Furthermore, it is likely that the “inflation adjustment” will leave in the final rates significant “double counting,” because under FERC’s method the oil pipelines are empowered to select for themselves the applicable rate of return index, and, as a corollary, they also select the time period relevant to calculating the “inflation adjustment.” Accordingly, the FERC methodology allows the oil pipeline companies to select a time period during which the rate base appre- ciated at a slower rate than average. In this way, the FERC method permits the regulated companies to select the rate of return index that will result in an adjust- ment that wnderstates the actuai overall rate base ap- preciation. In Commissioner Hughes’ words, the FERC method “invites an enormous amount of gamesmanship. Eight rate of return options are suggested, some with multiple choices of time periods. The inflation/valuation variance gives an exciting new twist to a pipeline’s choice among the candidates. Thus a firm might choose to base its return one year on stock market performance after a bull market, and in its next filing switch to a high oil company comparison which might be offset by a small increase in its own valuation.” 21 FERC at 61,726 (Hughes, Comm’r, dissenting in part and concurring in part). 3. FERC’s “Equity Component” Has No Meaning- ful Relation to the Rates of Return on Book Equity Even more capricious was FERC’s application of the rates of return, representing revenues on the book equity of unregulated companies, to what FERC called the “equity component of the valuation rate base.” As noted above, FERC’s notion of the equity component includes the original paid-in equity of the pipeline plus the entire write up in the rate base. See supra at 75. For ex- A-82 ample, consider an oil pipeline, originally financed with $900,000 debt and $100,000 equity. The original cost of the pipeline is one million dollars. Over time, the pipeline’s valuation rate base increases to, say, $1,500,000. Under FERC’s method, the equity component of the rate base amounts to $600,000, six times its book equity, even though the valuation rate base as a whole has appreci- ated only by half. Thus, FERC’s method magnifies the “equity component” of the rate base to spectacular propor- tions, especially in an industry as highly debt-leveraged as the oil pipelines. See supra note 58. At the same time, however, FERC’s selected rates of return reflect the revenues of the unregulated companies as a percent- age of their book equity. To set allowable revenues for 8 Because the extent of debt leveraging directly increases this magnification effect, an oil pipeline with a greater pro- portion of debt financing would receive a higher overall return under FERC’s methodology than a pipeline, identical in all other respects, that uses less debt financing. In a normal cor- porate context, the increased return might have been at least partly explained by the increased risks of default associated with using high levels of debt. In the case of oil pipeline com- panies that benefit from parent guarantees, however, that increased risk is compensated for through FERC’s “suretyship premium.” Indeed, the presence of such guarantees places the risk uf default squarely upon the equity holders in the parent companies, not the equity holders in the pipeline. Finally, we note that this magnification effect would have been reduced, although not eliminated, if FERC had used hypo- thetical capital structures instead of the suretyship premium. In the absence of the parent guarantees, the oil pipelines would not have been able to use debt leveraging to such an extraor- dinary degree; accordingly, the hypothetical capital structure would consist of less debt and more equity, and the leveraging effect would be reduced in the calculation of the “equity com- ponent” of the rate base. In this way, then, FERC indirectly failed to meet its traditional purpose of considering each regu- lated company “as nearly as possible on its own merits and not on those of its affiliates.” Florida Gas Transmission Co., 47 F.P.C. 341, 363 (1972). This purpose, of course, formed the rationale for FERC’s inclusion of a “suretyship premium” in the rate of return. A-83 the oil companies, FERC took these rates of return and applied them to a completely different measure of net worth, the “equity component of the rate base.” Book equity, unlike FERC’s newly devised “equity component,” represents the underlying net assets in original cost terms. Because book value of an equity share has no significance as to the present value of the company’s assets, the returns on book equity likewise have no sig- nificance in relation to the equity component of the valua- tion rate base. See, e.g., J. Gentry, Jr. & G. Johnson, Finney & Miller’s Principles of Accounting 367-68 (8th ed. 1980). Assuming arguendo that the “inflation adjustment” accurately compensates for the rate of rate base ap- preciation, which it does not, see supra at 80-81, such an adjustment would compensate only for the appreciation attributable to the portion of the rate base financed by the paid-in capital of equityholders. It would never com- pensate for the fact that FERC includes the entire ap- preciation on the rate base—attributable to both the equity and debt components of the pipeline—in its “equity component.” Accordingly, FERC’s method ensures that the allowable revenues for oil pipelines will exceed the revenues earned by its selected unregulated companies by the extent to which the pipelines’ “equity component” exceeds the portion of the rate base financed through equity investments. Cf. 21 FERC at 61,712 n.519 (under the “more austere standard of fairness,” FERC “would trend only the equity portion of the rate base for in- flation”). In most cases, this difference will be very large.” Indeed, FERC provides no analysis of why its applica- tion of its selected rates of return to an unrelated meas- 7 FERC offered a typical example in which it would have approved an “opportunity to earn 61% (182/300) on the book value of [an oil pipeline’s] equity” even though its selected adjusted rate of return was 14%. See 21 FERC at 61,647-48. A-84 ure of rate base equity should keep “a cap on gross abuse” in the resulting rates, not to mention the lack of any assurance that the resulting rates will be “just and reasonable.” Commissioner Hughes appears to have rightly characterized FERC’s game as Dialing for Dol- lars instead of The Price is Right. See 21 FERC at 61,730 n.4 (Hughes, Comm’r, dissenting in part and concurring in part). We cannot condone such a rate- making methodology, which assures nothing except that permissible rate levels will be very high. In an attempt to defend the mismatch between its selected rates of return (on book equity) and its “equity component of the valuation rate base,” FERC claimed that its method of calculating the “equity component” gives the equityholders the full benefit of debt leveraging. Just as a seller of a house benefits from the entire ap- preciation of the value of the house regardless of the amount of debt that financed the original purchase, FERC believed that so, too, should the equityholders in oil pipelines receive an “equity kicker” in their rate base. See 21 FERC at 61,648-50. This analysis overlooks the fact that oil pipeline companies are in fact free to sell their assets, and thereby enjoy the full benefit of debt leveraging in the difference between the sale price and _ the original cost of the assets. Such an “equity kicker,” however, has no significant relationship with the deter- mination of the cost of capital. A rate of return should set the proper rewards for investors in the form of cur- rent income, not asset appreciation and sale. FERC’s attempted defense of its use of its “equity component” thus fails to meet minimal standards of reason.” 7 The same can be said of the other defenses FERC offered. First, FERC claimed that its lack of authority over abandon- ments justifies its more generous outlook toward oil pipeline revenues. 21 FERC at 61,650. As we stated supra note 51, this explanation lacks a reasoned basis. Second, FERC declared that its allowance of “seemingly outlandish returns” was justi- fied because “the rate of return on equity is a real rate abso- A-85 While the determination of a fair rate of return cannot and should not be constrained to the mechanical applica- tion of a single formula or combination of formulas, the ratemaking agency has a duty to ensure that the method of selecting appropriate rates of return are reasonably related to the method of calculating the rate base. See, e.g.. FPC v. Hope Natural Gas Co., 320 U.S. 591, 605 (1944); Dayton Power & Light Co. v. Public Utilities Commission, 292 U.S. 290, 311 (1934); NEPCO Munici- pal Rate Committee v. FERC, 668 F.2d 1327, 1842 (D.C. Cir. 1981), cert. denied, 457 U.S. 1117 (1982). Our dis- approval of FERC’s decision to retain the ICC rate base formula, see supra at 71-72, did not turn on the sub- stantive validity of the rate base calculations. FERC may adopt any method of valuation for rate base purposes so leng as the end result of the ratemaking process is reasonable. See, e.g., FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586 (1942); NEPCO Municipal Rate Com- mittee Vv. FERC, 668 F.2d at 1333; Washington Gas Light Co. v. Baker, 188 F.2d 11, 18 (D.C. Cir. 1950), cert. denied, 340 U.S. 952 (1951). Rather, our dis- approval arose out of the FERC’s failure to give a rea- lutely devoid of any inflation premium of any sort.” Jd. As we have discussed, supra at 78-81, however, inflationary effects are counted in the ratemaking formula. If the rate base appreci- ates at the rate of inflation or at a higher rate, the effects of inflation are counted in the rate base; if the rate base appreci- ates at a slower rate than inflation, the “inflation adjustment” reduces the nominal rate of return only by that amount neces- sary to offset rate base appreciation during the so-called “relevant period,” thereby leaving some increment in the rate of return to compensate for inflationary effects not reflected in the rate base. Finally, FERC contended that the “thinness of the equity cushions” in oil pipeline financing, and the associ- ated risks, justifies its methodology. See id. at 61,712 n.522. However, FERC’s method already compensates for such risks through the suretyship premiums. See supra at 73. When the parent company guarantees the pipeline’s debt, the risks associated with the thin equity cushion are shifted away from the pipeline’s equityholders. A-86 soned explanation for its rejection of responsible rate base alternatives. We now find, however, as a result of the foregoing considerations, that the combination of FERC’s rate base and rate of return methodologies does not produce an acceptable “end result.” Accordingly, we disapprove FERC’s ratemaking methodology on this addi- tional basis. VI. MISCELLANEOUS ISSUES A. Purchase Price of Williams’ Assets As discussed supra at 22-23, FERC rejected the Wil- liams Company’s attempts to use the purchase price of its assets in its rate base and depreciation basis calculations. FERC soundly held that the use of purchase price instead of original cost in rate base calculations would engender an undue incentive to trade pipeline assets at a high price, which, under a purchase price regime, would in- crease allowable rates.”* See 21 FERC at 61,635. Fur- thermore, in keeping with this court’s remarks in Farm- ers Union I, FERC eliminated the use of purchase price as the basis upon which to calculate depreciation ex- penses. See id. at 61,635-36.77 As Williams’ procedural and substantive objections to these rulings all lack merit, 76 See also Farmers Union I, 584 F.2d at 420-21 (“It is true that occasional acquisitions of carriers at prices deemed cur- rently reasonable might serve as a mechanism for accurately reflecting inflation’s impact on the value of such enterprises. We have our doubts, however, about either the desirability of encouraging acquisitions solely for this purpose, or of depend- ing on their unpredictable occurrence to serve this function.” ). 77In Farmers Union I, this court observed, ‘The final irra- tionality is that the depreciation basis used, unlike original cost, valuation and other possible approaches, allows deprecia- tion charges, and thus the rates, to change dramatically from one day to the next—so long as a purchase of the assets inter- cedes—even though the cost of the carriers’ public service has not actually changed.” 584 F.2d at 420. A-87 we approve FERC’s decision to eliminate purchase price generally from oil pipeline ratemaking.” B. Systemwide vs. Point-to-Point Rate Regulation As discussed supra at 23, FERC decided in Williams to regulate oil pipeline rates on a systemwide, rather than a point-to-point basis. FERC did so by way of a short discussion, on the assumption that the ICC had in the past given “scant attention to particular rates on 78 First, Williams argues that FERC gave no notice that the issue was to be discussed in Phase I of the Williams proceeding. The record, however, shows that such notice was given and that Williams briefed the issue during Phase I. See, e.g., J.A. at 241 (ALJ’s Invitation to Submit Comments on Ratemaking Principles for Oil Pipeline Rate Cases) ; id. at 4103-08 (Wil- liams’ Opening Brief in Phase 1). Second, Williams claims that if its assets were purchased in good faith and at arms length, then the purchase price should be counted in the rate base. Under FERC’s rationale, however, “a mere change in owner- ship should not result in an increase in the rate”; it therefore should not matter whether the purchase price is bona fide or instead results from an attempt to inflate the rate base arti- ficially. 21 FERC at 61,635 (quoting Shippers’ Initial Post- Hearing Brief at 103). Third, Williams believes that FERC’s ruling resulted from FERC’s mistaken belief that it was bound by a passage from Farmers Union I, when, according to Williams, the passage was dictum. However, even assum- ing that the passage was dictum, FERC should properly con- sider the force of its reasoning. Besides, FERC expressly made its ruling a matter of independent administrative judg- ment. See id. at 61,636 (“[Farmers Union I] binds us. More- over, we agree with it.”). Fourth, Williams contends that FERC’s rejection of purchase price as a ratemaking element constitutes an impermissible extension of FERC’s jurisdic- tion in order “‘to regulate a purchase.” Williams Brief at 29. This contention is plainly frivolous; FERC merely decided not to consider the purchase price as relevant for ratemaking purposes. Finally, Williams says the ruling represents an un- constitutional taking. This contention, too, is frivolous; regu- lated companies have no protected property interest in any given method of calculating a rate base so long as the resulting rates are “just and reasonable.” See supra at 65. A-88 specific routes.” 21 FERC at 61,650. Farmers Union objects to this ruling. It challenges FERC’s interpreta- tion of past ICC precedents, citing ICC cases in which rates were determined by reference to specific point-to- point movements and their related costs and valuations. See Farmers Union Brief at 69. Farmers Union also noted that the Interstate Commerce Act requires “every unjust and unreasonable charge . . . [to be] prohibited and declared to be unlawful.” 49 U.S.C. §1(5) (em- phasis added). Finally, it contends that systemwide rate regulation could shield rate discrimination from proper remedy. Our review of relevant ICC precedents shows that past oil pipeline proceedings have included attempts to set rates “computed on a detailed allocation of costs to the proper section of the pipe-line system.” Petroleum Rail Shippers’ Association v. Alton & Southern Railroad, 243 I.C.C. 589, 663 (1941); see Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41, 54-55 (1944). In both proceedings, the ICC allocated the operational costs of transportation from each originating station, averaged as to distance and weighted as to volume, to every terminal in the relevant system. Because oil pipe- lines rates are charged on a point-by-point basis, such cost allocation ensures that the costs of providing service over a given territory will be recovered only from the companies that use that particular service. See Minnelusa Ou Corp., 258 I.C.C. at 538 (“Operating conditions of defendant pipe lines in Rocky Mountain territory are more difficult than those of pipe line in territory east thereof, as hereinabove explained, but these are reflected for the most part in operating expenses.”). We also find disturbing the apparent tension between FERC’s action and the language of section 1(5). While FERC made assurances in Williams that patently discriminatory tactics will not be immunized from searching regulatory scrutiny, the FERC’s systemwide approach would ap- A-89 parently tolerate substantial variance in allowable re- turns among pipeline segments without any justification, cost-based or otherwise. However, we need not decide this issue at this time, because FERC made its decision prematurely. The ALJ identified the following issue for consideration during Phase I of the Williams proceeding: Which unit should the Commission regulate (i.e., should the Commission determine rate base upon a system-wide or upon a segmented basis (¢.g., petro- leum products pipeline v. fertilizer pipeline) ) ? J.A. at 242 (Invitation to Submit Comments) (emphasis added). The ALJ designated this question as a “rate base issue.” Jd. at 241. FERC’s ruling, however, went well beyond the determination of the rate base issue, and decided further to abandon all cost allocation to particular pipeline segments, calling the allocation inquiry “meta- physical, inconclusive and barren.” 21 FERC at 61,651. Previous ICC cases make clear that the question whether to “determine rate base upon a system-wide or upon 2 segmented basis” is separate from the question whether costs should be allocated to particular pipeline segments. In those prior ICC cases, the rate base valuation was not broken down into line sections, but the ICC nevertheless proceeeded to allocate costs to the proper sections of the pipeline. See Minnelusa Oil Corp., 258 I.C.C. at 54; Petroleum Rail Shippers’ Association, 243 I.C.C. at 663. The rate base issue goes to the determination of the proper valuation units upon which a rate of return will be earned, and accordingly constitutes a proper element of the Phase I inquiry, which centered on how to calcu- late allowable revenue requirements for an oil pipeline. The cost allocation issue, by contrast, determines the fair distribution of the burdens of meeting those revenue re- quirements among the oil pipeline’s customers. See Bon- bright, Principles of Public Utility Rates 291-93 (1961). Thus, the cost allocation issue is more properly charac- A-90 terized as a question of rate design. See, e.g., Second Taxing District v. FERC, 683 F.2d 477, 480 (D.C. Cir. 1982) ; Cities of Batavia v. FERC, 672 F.2d 64, 80 (D.C. Cir. 1982). The ALJ, however, expressly deferred rate design issues until Phase II of the proceedings. See J.A. at 243 (Invitation to Submit Comments) (“A number of addi- tional issues, such as ‘rate design’ . . . were suggested . . . . Those suggestions were not adopted because, in most instances, the issues raised appear to be more ap- propriate for consideration in Phase II of this proceed- ing.’”’) ; id. at 245 (remarks of ALJ at outset of prehear- ing conference) (‘Someone also raised the question of rate design. I consider those Phase II issues. Those issues tend to vary with the particular pipeline.”’). Accordingly, we find that FERC decided an issue not properly before it.” On remand, FERC, if it so desired, could consider the cost allocation issue as a part of Phase I, but if it does so it should give adequate notice to the parties so that the issue can be fully debated before determination. In making a decision on cost allocation principles, FERC should be cognizant of the ICC’s past cost allocation prac- tices, and should accord appropriate consideration to the mandate of section 1(5). C. Tax Normalization As discussed supra at 24, FERC decided in Williams to permit oil pipeline companies to decide for themselves whether or not to use tax normalization accounting, but in any event prohibited companies that choose normaliza- tion from including the resulting tax reserve accounts in their rate bases. AOPL challenges the latter ruling in the belief that the exclusion of deferred tax amounts from the rate base “would completely eliminate any benefits 79 Inosfar as petitioner challenges FERC’s decision to deter- mine rate base on a systemwide basis, we uphold FERC’s con- tinuation of the ICC’s longstanding practice. A-91 that would otherwise result from a carrier’s election of accelerated depreciation.” AOPL Brief at 42 (emphasis in original). We think that this challenge misses the mark. Regard- less of whether an oil pipeline may include tax reserve accounts in its rate base, tax normalization accounting would permit it to benefit from accelerated depreciation without having to flow those benefits through to its customers. Unregulated companies, of course, do not con- cern themselves with rate bases, and yet they choose ac- celerated depreciation solely because it permits them to defer a tax burden. The oil pipeline companies that choose normalization accounting also enjoy the benefit of tax deferral. The amount in the resulting deferred tax account can earn interest even if it is not included in the rate base. Accordingly, we reject AOPL’s notion that FERC’s ruling “completely eliminates” any normalization benefit.” VII. CONCLUSION For the reasons set forth above, we remand this case to FERC. We hope and expect that FERC will accord to this case the high priority that it deserves. In light 80 However, we note other inconsistencies in FERC’s ra- tionale for its normalization policies. The Commission opted to allow normalization for “the essential reason . . . that normalization facilitates the comparable earnings analysis basic to the determination of appropriate rates of return.” 21 FERC at 61,656. Apparently, FERC opted for normalization in order to bring oil pipeline accounting into line with generally ac- cepted financial reporting practices, so that meaningful com- parisons could be made. Yet, as we discussed earlier, FERC effectively abandoned comparable earnings analysis in its opinion. See supra at 59-63. FERC also undermined its stated purpose of meaningful comparison when it announced that pipelines may choose for themselves which accounting method to use. ‘While FERC’s normalization policy may be justified on other grounds, on remand it should articulate its reasons therefor and perhaps reexamine those policies in light of any new ratemaking methods it adopts. A-92 of its excessive long pendency, this case should be disposed of in a reasonably speedy manner. FERC may find it necessary to take additional evidence in light of this court’s opinion, but in any event, FERC already has the benefit of an extensive record and should be able to issue a new order within the next twelve months. We emphasize that FERC should give serious and thoughtful consideration to the admittedly difficult prob- lems presented by this case. Throughout this opinion we intended to provide some important and basic guideposts to assist FERC in that mission. Most fundamentally, FERC’s statutory mandate under the Interstate Com- merce Act requires oil pipeline rates to be set within the “zone of reasonableness”; presumed market forces may not comprise the principal regulatory constraint. De- partures from cost-based rates must be made, if at all, only when the non-cost factors are clearly identified and the substitute or supplemental ratemaking methods en- sure that the resulting rate levels are justified by those factors. In addition, the rate of return methodology should take account of the risks associated with the regu- lated enterprise. It should not be forgotten, too, that the choice of a proper rate of return is only part of what should be an integrated ratemaking method, and accord- ingly FERC must carefully scrutinize the rate base and rate of return methodologies to see that they will operate together to produce a just and reasonable rate. In all these respects, the original cost methodology, a proven alternative, enjoys advantages that should not be underestimated. FERC should reexamine this alternative, and others, in this proceeding which, after all, was insti- tuted in order to take a fresh and searching inquiry into the proper ratemaking method for oil pipelines. In this way, we hope that FERC can meet its statutory responsi- bilities without any further undue delay. So ordered. B-1 APPENDIX B DECISION OF THE FEDERAL ENERGY REGULATORY COMMISSION WILLIAMS PIPE LINE COMPANY Docket No. OR79-1-000, et al. Opinion No. 154; Opinion and Order on Remand from the United States Court of Appeals for the District of Columbia Circuit with Respect to the Contemporary Validity of Traditional Standards for Testing the Legality of Oil Pipeline Rates: (1) Reaffirming Those Standards in the Main but Modifying Them in Certain Respects Insofar as the Computation of the Rate Base is Concerned; (2) Prescribing New Criteria for the Derivation of Maximum Permissible Rates of Return; (3) Dealing with Certain Other Relevant Matters; and (4) Directing Further Proceedings Herein for the Purpose of Applying the Revised Standards to the Facts in the Instant Case (Issued November 30, 1982) Before Commissioners: C. M. Butler III, Chairman; Georgiana Sheldon, J. David Hughes, A. G. Sousa and Oliver G. Richard III. Appearances John M. Cleary, Frederic L. Wood, and Edward J. Twomey for Mid-Continent Petroleum Shippers Donald L. Flexner, Donald A. Kaplan, Robert Fabri- kant, Peter J. Tomao, Nancy H. McMillen, Jade Alice Eaton, Rosalyn J. Rettman, Arlene Pianko Groner, and Margaret Guerin-Calvert for the United States Depart- ment of Justice B-2 Robert Hallman, Lawrence A. Gollomp, Bruce C. Driver, and Michael D. Oldak for the United States De- partment of Energy Robert F. Scott, Michael J. Hogg, Harold E. Spencer, and Stephen C. Herman for C. F. Industries, Inc. Robert G. Bleakney, Jr., David M. Schwartz, Robert L. Calhoun, Paulette S. Kessler, William J. Collingsworth, John S. Estill, and Bradford G. Keithley for Williams Pipe Line Company Howard J. Trienens, Frank L. Heard, Jr., Charles E. Graham, James R. Kinser, Howard D. McCloud, Emil A. Wienecke, Jures M. Perlberg, Shalom L. Kohn, R. Eden Martin, Lawrence A. Miller, and Patrick H. Corcoran for the Association of Oil Pipelines A. Duncan Whitaker and W. Thomas Haynes for Ex- plorer Pipeline Company H. Newell Williams, John T. Updegraff, Robert E. Jor- dan III, Steven H. Brose, and Clifford G. Holderness for Arco Pipe Line Company Kent B. Hampton, John E. Compson, James F. Bell, and Thomas E. Fennell for Marathon Pipe Line Company Cheryl C. Burke and William A. Hutchins for Phillips Pipe Line Company Jack D. Head, Bolivar C. Andrews, James W. McCart- ney, Albert S. Tabor, Jr., and Carol A. White for Texas Eastern Transmission Corporation, Trans-Ohio Pipeline Company, and Allegheny Pipeline Company Thomas M. Davidson, Jack W. Hanks, Allan B. Garten, and Jay A. Zawatsky for MAPCO Ince. Jack Vickery and Cary V. Sorensen for Belle Fourche Pipeline Company and Acorn Pipe Line Company PT B-3 John A. Ladner, Sherman S. Poland, James G. White, Jr., and William A. Mogel for Sun Pipe Line Company Albert R. Beal, Robert H. Young, and C. Stephen Angle for Buckeye Pipe Line Company Frank J. Duffy, Walter E. Gallagher, and Peter C. Lesch for Hydrocarbon Transportation, Inc. Frank L. Heard, Jr., Clifton D. Harris, Jr., Richard J. Flynn, Eugene R. Elrod, and Stephen S. Hill for Exxon Pipeline Company George M. Knapp, James L. Lewis, Gwendolyn D. Prioleau, and Maureen Wilkerson for the Staff of the Federal Energy Regulatory Commission Table of Contents Background Some Questions about the Model What is Going on in this Specific Case? Who is Fight- ing Whom for What? ; Broader Implications What Was the Climate of Opinion that Led to the Regulation of Oil Pipeline Rates? Why Do We Affiict our Readers with all this Ancient History? What did the Congress of 1906 Actually Do about Oil Pipeline Rates? What Does the Statute Say? What Did the Congress of 1906 Mean when it Directed that Oil Pipeline Rates Be “Just and Reasonable’? Is the Original Understanding Really that Important? The Commission’s Oil Pipeline Task B-4 What Does Economic History Tell Us? The Undersizing Hypothesis and its Significance The Implications of the Foregoing for Administrative Policy—Herein of the Public Law Model versus the Pri- vate Law Model The Commission’s Approach to its Oil Pipeline Rate- making Task—Another Word Rate Base What about Rate Base and Depreciation—What Hap- pens when Properties are Sold? Rate of Return System-Wide Regulation or Point to Point Regulation? Holding Company Problems—Transactions with and Payments to Affiliates Another Intrafamilial Problem—Should the Tax Com- ponent of the Cost of Service be Calculated on a Consoli- dated or on a Stand-Alone Basis? A Last Word on Depreciation and Taxes—Normaliza- tion or Flow-Through? What about the Investment Tax Credit? Other Matters—Test Periods, Throughput Variations and Developmental Losses The Commission’s Order Appendix—What was the Nation’s 1981 Oil Bill?—a Conservative Estimate [Commissioner Sheldon’s concurring opinion begins on page 61,716; Commissioner Hughes’ dissenting and con- curring opinion begins on page 61,719; and Commissioner Richard’s concurring opinion begins on page 61,730.] B-5 Background Oil pipelines are expensive. In the argot of economists, they are “capital-intensive.” 1 As a result, there is a sub- stantial barrier to entry into the industry in the sense that substantial resources are a prerequisite to entry. Oil pipelines have often been built by large oil com- panies for fairly fundamental reasons. First, they have the wherewithal. Second, they face the practical necessity of moving their product to market. Thus, they have a significant self interest in moving their own crude from wellhead to refinery and their own finished product from refinery to market.” When it comes to transportation, the large integrated oil companies are their own best customers. At first blush, the rates that they charge themselves for trans- portation services would seem to matter only to them- selves.* They are simply transferring money from one 1 The industry maintains that “oil pipelines have by far the most unfavorable capital turnover of any industry group” (opening brief of the Association of Oil Pipelines [hereinafter cited as “ASSOCIA- TION BRIEF” at 84), that each dollar of investment yields only 29¢ in gross revenue, and that an investment of $3.52 is required to produce a dollar in gross receipts. 2If the traffic is there, the substantial investment required to bring a pipeline into being is well worthwhile. That is so because the noncapital costs of a pipeline operation are extremely low. Pipe- lines use amazingly little labor. That gives them a great advantage over other forms of transportation that use less capital but much more labor, such as shipping or trucking. 8 We recognize that pipelines are frequently built and owned by groups of oil companies.’ In that situation, the co-owners’ interests may not always be harmonious with each other. Assume, for ex- ample, that the A Company and the B Company are equal partners in the A-B Pipeline. But assume further that A generates 75% of the pipeline’s traffic. So A contributes 75% of the revenue. But it takes home only 50% of the profits. Hence A’s interest as a cus- B-6 pocket to another. That looks like mere bookkeeping. But it can be more than that. In the situation referred to in footnote 3 it is more than that. And some think that oil pipeline rates can be of some social significance even when there is only a single shipper-owner and even when that shipper-owner is its own sole customer. Suppose that the shipper-owner gives its pipeline opera- tion a large measure of autonomy. Suppose further that it treats the pipeline as an independent profit center. In that event, the integrated firm will treat the full amount of the pipeline charge that it pays to itself as a real cost, indistinguishable from other real costs incurred in arm’s- length transactions with unaffiliated suppliers. If that be so, the people who set the integrated firm’s pricing policy will seek to pass the full amount of the pipeline charge on to the ultimate consumer of the firm’s products. They will give little or no weight to the fact that a substantial portion of that charge returns to the firm itself in the form of pipeline profit. Should this scenario be accurate, consumers have a stake in these rates, even in those of a pipeline that serves only a single shipper-owner.* tomer is greater than its interest as an owner. That gives A an interest in low rates. Conversely, B has an interest in high rates. Does anyone else have an interest in those rates? Should anyone else care about them? Are there public interest implications? If so, what are they? * The Supreme Court thinks that there is something to this. In the Trans Alaska Pipeline Rate Cases, 436 U.S. 631, 644 (1978), a unanimous Court observed that: “[T]hose who will ship oil over TAPS [an acronym for Trans Alaska Pipeline System] are almost exclusively parents or co-subsidiaries of TAPS owners. Thus, to an indeterminate, but possibly large extent, excess transportation charges to shippers will be offset by excess profits to TAPS owners, creating a wash transaction from the standpoint of parent oil com- panies. Indeed, it is telling that no shipper of oil protested the TAPS rates. Instead ... only the public perceives that it will be injured by the proposed TAPS rates and has objected to them... B-7 The agitation over these issues is almost as old as the oil business itself. The factors that have engendered the controversy are: First, though oil can be moved by train, by ship and by truck as well as by pipe, there are many situations in which pipelines have an insurmountable cost advantage over other modes of carriage. As one perceptive com- mentator who has had many years of practical experience in the business has said: It is the general consensus that pipelines are by far the most economical means of large-scale over- land transportation for crude oil and products, clearly superior to rail and truck transportation over competing routes, given large quantities to be moved on a regular basis. This has been true for many years; figures are readily available for 1964, when the typical long haul pipeline rate was 10 to 20 per- cent of the rail rate. More specifically, pipeline rates average about 1/5 of rail rates and about 1/20 of truck rates and pipelines can usually compete favor- ably with all marine transportation except for ocean going long-haul supertankers.*® Therefore ... unreasonable. . . rates—both generally and in these cases— ... will almost certainly be passed along to ‘a prior pro- ducer or... to the ultimate consumer.’” Quoting with approval from the late Professor I.L. Sharfman’s well-known multi-volume treatise of the 1930’s on the Interstate Commerce Commission. The Interstate Commerce Commission: A Study in Administrative Law and Procedure, 4 volumes in 5 (1931-1937), hereinafter cited as “SHARFMAN.” 5G. S. Wolbert Jr., U. S. Oil Pipe Lines 30-31 (1979). The author was formerly the Shell Oil Company’s General Counsel. So few would accuse him of being biased against the oil industry. Nor are many likely to say that he underestimates the competitive hazards that the pipelines face. In fact, Dr. Wolbert’s footnotes show that his text relies in large measure on the testimony of industry wit- B-8 Second, the industry says that these numbers are enough in themselves to show that its rates are modest. Its critics take a different tack. They say the numbers show that (i) the pipelines’ advantage over their com- petitors is so crushing that there is seldom much of a competitive contest between an oil pipeline and a trans- ) portation medium other than a pipeline; (ii) it follows that the shipper-owners can realize mind-boggling profits on their pipeline operations and nevertheless keep their rates far below those that truckers and railroads absolutely have to charge® in order to cover costs;7 and nesses before this Commission. Moreover, we note that Wolbert’s publisher was the American Petroleum Institute. Dr. Wolbert wrote an earlier book on the subject. G.S. Wolbert, American Pipe Lines (1952). In this Opinion his first book is cited as WOLBERT I, and his second as WOLBERT II. ® Most people in the industry appear to concede that there may once have been some measure of truth to this allegation. But they insist that this is no longer so. As they see it, intramodal competi- tion among pipelines coupled with the pipeline owner’s self-interest in seeing to it that his very expensive facility is used to the fullest extent possible are potent market pressures that keep pipeline rates within an acceptable zone of reasonableness. Th industry’s critics are dubious about that. At this juncture, however, we are not con- cerned with the merits of the debate. We are trying to describe what the debate is about. We shall come to the merits in due course. 7 That does not appear to be true of maritime carriage. The pas- sage from WOLBERT II quoted in the text at p. 4, supra, concluded with a caveat about “ocean-going, long-haul supertankers.” And that caveat is followed by this observation: There are, of course, special situations where other forms of transportation have a competitive advantage over pipelines. For example, heavier petroleum liquids or solids (e.g., residual fuel oil, asphalt, and coke) while transportable by pipelines are more economically handled by other bulk carriers. Often mar- ket volume requirements make barge movement more attractive than by pipeline. In large volume markets having good port facilities, tanker shipments may offer the lowest transportation costs. This is especially true of crudes imported from far away foreign sources. The niche for trucking lies in situations where RT OR NN B-9 (iii) this means that people in the oil business need access to a pipeline and that for most of them such access is a matter of survival.® Third, there is the problem of the small producers and the small refiners that are neither big enough nor rich enough to build their own pipelines. They are constrained to use the pipelines built and owned by their larger and richer competitors. For small firms that have no proprie- tary interest in the pipelines over which they ship, the pipeline charge is a very real and a very substantial cost. None of that cost comes back to them as dividends or in- terest. And the large companies to whom they pay it are competitors of theirs. It is charged that public policy here confronts a perverse economic environment in which the big and the rich have the power to choke the life out of folk of lesser means. Let us look at the small producer. He normally sells to the large, integrated companies. But those companies do not rely entirely on him. They also have their own production. If they can produce oil for themselves at prices that the independent finds uneconomic, they will rely on their own resources rather than on him. The pipeline charge can be important in this instance for several reasons. First, the shipper-owner never pays more than the real cost of the transportation service— including, of course, the cost of the capital invested in the pipeline. However, the freight rate that the shipper- owner exacts from his independent supplier-competitor consists of that real cost of carriage plus what could be a very liberal helping of monopolistic gravy that goes into small volumes over short hauls with many different destina- tions are involved, such as gasoline movements from terminals te jobber piants and to private residences. WOLBERT II at 31. 8 Cf. M.. Ball, This Fascinating Oil Business 73 (1940) “Oil in the field tanks is like: a fat steer on the range; it needs to be taken thence and made into something useful.” B-10 the shipper-owner’s coffers.* If this occurs, it implies that the independent producer who has no ownership interest ® There is an element of fiction here. In the strict, literal sense independent producers very seldom “ship”. Nine times out of ten (perhaps it would be more accurate to say 95 times out of 100) they sell their output in the fields. So they are rarely “shippers”. WOLBERT II at 193-194. But independent producers generally sell at or near the point of production at the prices “posted” by some major oil company that owns pipelines. That “posted price” will normally be the world market price for oil of the grade and quality involved minus the cost of carrying that oil over the pipeline from the well to the refinery. Moreover, some relate the independents’ propensity to sell in the fields to the major companies at the latters’ posted prices ‘» the majors’ ownership of the pipelines and to the majors’ pipeline rate structures. Thus, for example, one student of the industry whose interests have since shifted from petroleum economics to world politics wrote back in 1948 that the pipeline rate structure “is de- signed to persuade the independent producer of oil to sell his prod- uct im the oil fields at prices dominated by the major company, or the few major companies owning the pipe line or lines in that field. The pipeline rates are such as to discourage the seller from paying the costs of carriage on his oil in order to reach a wider market in the refinery area.” E. Rostow, A National Policy for the Oil Indus- try 62 (1948). (Emphasis added.) Some years thereafter Professor Rostow, who later became Dean of the Yale Law School, then moved on to the post of Under Secre- tary of State, and is now Director of the United States Arms Con- trol and Disarmament Agency, amplified this view in a law review article in which he said: In the past at least pipe line ownership gave the major com- panies a powerful voice in the markets for crude. The level of Pipe line rates in relation to field prices provided a distinct in- centive for independent producers of crude oil to sell their oil to a major company pipe line owner in the field. Pipe line rates were so high as to discourage independent producers from transporting crude oil through the pipe lines in their own ac- count, to be sold in markets containing more buyers than are available in any producing area. Similarly, the relation be- tween crude prices and pipe line rates helped keep independent refiners located far from particular fields from purchasing oil advantageously in those fields, and transporting it to their own B-11 in a pipeline can neither bargain about prices with the integrated shipper-owner from a position of strength nor compete on equal terms with the shipper-owner’s own production affiliate.’° account via pipe lines. This effect was enhanced by high tender requirements, and other conditions imposed upon the carriage of oil by pipe line companies. Although the oil and gasoline pipe lines have been common carriers in form for many years, they have until recently transported very little except oil or gasoline produced by other branches of their own companies. Rostow and Sachs, Entry into the Oil Refining Business: Vertical In- tegration Re-examined, 61 Yale L.J. 856, 882 (1952). 10 People who subscribe to this analysis weep copiously for the independent producers. They make much of the fact that 18 leading integrated companies control over 96% of the nation’s crude oil pipeline network and that the lion’s share of the oil that moves over that network belongs to those companies, i.e., they either produce it themselves or they buy it in the fields from independents so that it already belongs to them when it enters their pipelines. Those con- cerned about what they deem excessive concentration in oil proceed to relate this state of affairs to figures that show that the independ- ent producers’ share of aggregate crude oil output role has declined over time. Thus, for example, the June 1978 Staff Report of the Subcommittee on Antitrust and Monopoly of the Senate Judiciary Committee entitled “OIL COMPANY OWNERSHIP OF PIPE- LINES” (commonly referred to and hereinafter cited as the “KEN- NEDY STAFF REPORT”) commented at pages 30 and 31 that: It is often argued that concentration in crude oil production is lower than it is in many other extractive industries in the econ- omy; industry sources frequently claim there are 10,000 pro- ducers. Two considerations weigh against this argument. First, given the number of producers in the industry (in con- trast to, say roughly a dozen each in copper, lead or zinc pro- duction), observed concentration rates in crude oil production are impressive. Secondly, there has been a disturbing increase in concentration rates over the past two decades or so. * * * * The shares held by the thousands of producers outside the 20 largest ... declined sharply from 44.3 percent of the industry’s output in 1955 to no more than 25.0 percent by 1975. This oc- curred in a period when production was rising, from 2.4 billion barrels in 1955 to 3.1 billion barrels in 1975. In other words, B-12 This may not matter very much for the lucky inde- pendent who happens to be well situated in a flush field. It is said, however, to matter quite a lot to the independ- ent who is not quite so lucky, the one who is at the mar- gin in a field past its prime. Excessive pipeline rates are also said to make it impossible for small independents to explore and develop on an equal footing with the major integrated companies. Let us shift from the independent producer to the inde- pendent refiner. He is, it could be argued, in a double bind. He pays pipeline charges coming and going. To begin with, he buys crude from the majors at prices which includes excessive pipeline charges. So he has to pay more for crude than the majors do. That is so because one has to eliminate the shipper-owner’s putative excess pipeline profit in order to arrive at his real cost of crude. For while output directly controlled by the major companies in- creased by 75 percent, from 1.3 to 2.3 billion barrels, that under the control of independent producers fell by 29 percent, from 1.1 billion barrels to 800 million annually. * * * * It is possible . . . that much of the increase in concentration reflected merger or the purchase of reserves located by smaller exploration and production companies. The industry brands this sort of thing poppycock. It points out that: (1) Many years have now elapsed since an audible outcry about the pipelines was last heard from the independent producers. (2) There is no contemporary evidence that a statistically sig- nificant number of independent producers deem themselves victim- ized by the pipeline owners. (3) The Independent Petroleum Producers Association of Amer- ica, which claims to speak for thousands of independent producers, wholeheartedly endorses the pipeline status quo, insists that its members are happy about things as they are, denies that there is any exploitation by the majors, and maintains that proposals for “reform” designed by lawyers and economists who have appointed themselves counsel to the hapless independent producers frighten those gentlemen’s involuntary clients to death. B-13 the independent refiner, on the other hand, the real cost of crude and its nominal cost are one and the same. Then the independent refiner has to send his gasoline or other refined product to market. He normally uses a pipeline for that. But who owns that pipeline? An inte- grated company, or a group of them. Once again the pipeline owner or the coalition of pipeline owners charges more than the competitive cost of carriage. So the ship- per-owners can make a handsome profit on gasoline (or other refined products) at prices that spell disaster for the independent refiner. And its pipelines and pipeline rates are the lever for monopolistic pricing. There are two serious issues to be evaluated. The first is that oil pipelining is a “natural monopoly” or a “nat- ural oligopoly”. The second problem is that the pipeline monopolists are not for the most part primarily interested in pipelines. To them, pipelines are not an end in them- selves. They are a means to an end. That end is domi- nance in oil. The integrated companies are not trying to make money out of pipelines. They are trying to make money out of oil. Hence they are under an irresistible temptation to use their control of the pipelines to embit- ter the lives of the independents, to make their condition burdensome, to reduce them to a state of dependent inde- pendence, and to preclude them from posing an appreci- able competitive threat." So the shipper-owners should be strongly motivated to set oil pipeline rates at levels higher than those that inde- pendent transportation companies interested in competi- tive markets would find optimal.” 11 But see n. 6, supra. 12 Even if he does not actually do so, some argue that he has the power to do so. And that is pernicious. One economist, whose study of the industry has become a classic and is cited with approval by all sides observes: There is nothing really unique about such criticism of the major oil companies. Alcoa, for instance, was accused of using B-14 Thus high pipeline rates’* make for concentration in the oil industry.“ They prevent the independent producer a vertical integration squeeze based on its control of ingot pro- duction. It supposedly sold sheet to fabricators at a price lower than the sum of the price of ingors and the cost of rolling. This left competing sheet producers who paid the market price for ingots at a competitive disadvantage. There is no dearth of respectable economic reasoning to sup- port the validity of such complaints, if not the justice of the remedies sought. Where one company (or small group) in an industry controls one vertical ctage of that industry completely, it is in a position to abuse its less fortunate competitors in the earlier or later stages. Acting as a single or joint monopsonist it can exploit the earlier stages of the industry, and as a mo- nopolist the later stages. Sumh can easily be the economic facts of life in a vertically organized industry; and such, it is said, have been and are the facts of life to the independent producers and refiners in the oil industry, especially to independent re- finers. L. Cooenboo, Jr., Crude Oil Pipe Lines And Competi- tion in the Oil Industry 5-6 (1955). (Emphasis added.) 13 Even persons friendly to the industry concede that the rates used to be high. Thus, for example, Dr. Wolbert says that “formerly pipeline owners charged initial rates as stiff as the traffic would hear, the amount being determined largely by comparable through rail rates. After the lines had paid themselves out, in the absence of regulation or adverse effects of tax laws, rates were maintained at an unreasonably high level, since the charging of rates to ship- per-owners was only a bookkeeping transaction, a figurative shifting of money from one corporate pocket to another, and the higher rates discouraged use of the lines by independents.” WOLBERT I at 20-21. (Emphasis added.) 14 There is, of course, an enormous literature about industrial concentration. Some think concentration an unmitigated evil that will, if unchecked, subvert American democracy and destroy eco- nomic and eventually political freedom. Others consider it bene- ficent, a great engine of economic efficiency and social progress. Be- tween those two extremes, one finds a host of intermediate views. We see no need for exhaustive citations. No one likely to read this document will need references to such treatments of the subject as the future Justice Brandeis’s The Curse of Bigness, available in Osmond K. Fraenkel, ed. The Curse of Bigness (1934), Judge Learned Hand’s opinion in United States v. Aluminum Co. of Amer- B-15 of crude from getting a fair price for his product and stifle the independent refiner."* They also create an indus- ica, 148 F.2d 416, 428-429 (2d Cir. 1945) (expressing the belief that “great industrial consolidations are inherently undesirable, regardless of their economic results” [emphasis added], noting that “among the purposes of Congress in 1890 was a desire to put an end to great aggregations of capital because of the helplessness of the individual before them”, and observing that the antitrust laws were intended “to perpetuate and preserve, for its own sake and in spite of possible cost, [emphasis added] an organization of industry in small units which can effectively compete with each other”), Professor (now Judge) Robert H. Bork’s all-out attack on Hand’s position in The Antitrust Paradoz (1978), the late Pro- fessor Richard Hofstadter’s famous historical essay on What Hap- pened to the Antitrust Movement in his The Paranoid Style in American Politics and Other Essays (1965). Professor John Mc- Gee’s In Defense of Industrial Concentration (1971), and much else that can be found with relative ease by looking at the footnotes in the law reviews, the antitrust treatises and casebooks, and the economic journals and by consulting the card catalogue in a good library. These voluminous disputations are of only fleeting relevance. Our concern at the moment is with questions, not with answers. So the important thing about the concentration controversy is not with its rights and wrongs, but with its existence. People who look at industrial concentration either with delight or with equanimity are unlikely to be disturbed by the oil pipeline problem. They find the parade of horribles in the text so much stuff and nonsense. But those who look at concentration with a jaundiced eye have in the past tended to find the pipeline scene extremely disturbing. His- torically, the oil pipeline debate has in large measure been a debate about the merits and the demerits of industrial concentration and about whether the oil business is or is not more concentrated than it would be in an ideal world. 15 In a well-known treatise on the economics of oil, Professors Alfred E. Kahn and Melvin De Chazeau elaborated on this theme in the following vein: For the refiner not located in the field, crude oil availability is economically inseparable from access to pipelines; and the competitive margin within which he must live will be vitally affected by the tariff he has to pay for transit. Historically, there can be no doubt whatsoever that this crucial fact has B-16 trial milieu in which the motorist, the homeowner, and everyone else who uses an oil-based product are all muleted by monopoly prices.’* been used by the majors to confine their independent rivals to secondary locations in producing fields and to harass those with the temerity to challenge this fate. M. De Chazeau and A. E. Kahn, /ntegration and Competition in the Petroleum Industry at 512 (1959). 16 This is one of the major counts in the many literary indict- ments of the status quo in oil from Henry Demarest Lioyd’s The Story of a Great Monopoly, which appeared in the March, 1881 issue of The Atlantic Monthly and which observed, among other things, that “Standard Oil has done everything with the Pennsyl- vania legislature, except refine it’ and Ida M. Tarbell’s History of the Standard Oil Company (1904) (hereinafter cited as “TAR- BELL”) down to Robert Engler’s The Politics of Oil: A Study of Private Power and Democratic Directions (1961) and The Brother- hood of Oil (1977) as well as the late Professor John M. Blair's The Control of Oil (1976). Blair says that “By its very nature the pipeline is a bottleneck invariably owned and controlled by the majors but of critical im- portance to the independents. Without the services of a gathering line, the independent producer cannot get his product to a refinery. And without the continuous, assured supply provided by a pipeline, a refinery, because of ite high fixed costs, cannot operate efficiently. Even where his supply is provided by independent producers, the independent refiner using a major-owned pipeline is still not free from the influence of his larger competitors. “The opportunities presented by the pipeline for securing mo- nopoly control have long been recognized. When first incorporated in 1870, the Standard Oil Co. controlled only about 10 percent of the nation’s petroleum refining capacity. Three years later, it be gan to gather and transport crude bought from others through pipelines. By 1879, less than a decade after the original incorpora- tion, it had increased its control over refining capacity to 90 per- cent. This astonishing increase was achieved in large part through control over transportation-both pipelines and railroads.” Jd. at 137. This excerpt is followed by a discussion that shows that Dr. Blair thought that the same basic forces are at work in the world of today, that only the form of the thing has changed, and that when B-17 Some Questions About the Model At this point questions arise. Among them are these: (1) Is the model historically accurate? Are the ship- per-owners a kind of a firing squad? And are the ship- pers who are not owners that squad’s helpless victims? (2) Suppose that the model is a faithful portrait of things as they once were. Does it necessarily follow that it is an equally faithful portrait of: (a) The recent past? (b) The present? (c) The industrial environment as it is likely to be in the foreseeable future? (3) Have there been significant contemporary changes in the economic climate? Have countervailing forces that were formerly weak or absent now come into play? If so, have those forces materially lessened the power that used to flow from the ownership of an oil pipeline? Has the it comes to substance, the oil pipeline world is one where the more things change, the more they remain the same. Other versions of that point of view can be found in America’s Energy (R. Engler, ed. 1980), an anthology of articles about en- ergy that have appeared over the years in The Nation. As those familiar with that magazine's orientation might expect, the articles: (1) Are almost invariably critical of big oil companies; (2) Make much of the fact that those companies own most of the pipelines; and (3) Stress the baleful effects that this has on consumers. Finally, note should be made of a forceful and an elaborate presenta- tion of this point of view by the General Accounting Office in its report to the Coagress entitled Petroleum Pipeline Rates and Com- petition—Issues Long Neglected by Federal Regulations and in Need of Attention (July 13, 1979). B-18 non-owner’s actual or alleged plight been significantly mitigated? "7 17 One economist friendly to the industry finds that “The special ‘squeezing’ arguments are implausible because adoption of the hypothesized tactics would annually have cost the large oil com- panies (the alleged ‘squeezers’) billions of dollars to implement.” Professor Richard Mancke in E. J. Mitchell, ed., Vertical Integra- tion in the Oil Industry 67 (1976). Professor Mancke’s views rest on a number of propositions. One is that the “oil companies no longer possess observable monopoly power in any important energy market.” Another is that “the economic structure of the key stages of the oil business is such that the successful exercise of monopoly power is virtually impossible unless the oil companies receive gov- ernmental assistance.” More specifically, Mancke points out that: (1) The idea that the majors “squeeze” the independent refiner rests on the premise that the majors achieve that nefarious end by manipulating the price of the crude that they sell to the independents. (2) The charge is that the majors keep the price of crude up. (3) But the majors are not self-sufficient in crude. They buy lots of crude. In fact, they buy more crude than anybody else does. So why would they engage in all kinds of shenanigans and knock themselves out in order to raise the price of that which they buy? Dealing in detail with the charge that the large integrated majors have had incentives to make their profits in crude and to arrange matters so that refining is unprofitable, Professor Mancke ana- lyzes the Federal Trade Commission’s 1969 estimates of crude oil self-sufficiency for the seventeen largest integrated refiners. He finds that: Except for Getty Oil, only the sixteenth largest, none of these integrated giants produced more than 93 percent of its total domestic needs. Hence, only Getty owned enough crude oil for profit-shifting to be profitable. The after-tax losses if any of the other firms had adopted this strategy would have ranged from a low of three cents on each dollar of profits shifted by relatively oil-rich Marathon to a high of 48.3 cents on each dollar of profits shifted by relatively oil-poor Standard Oil (Ohio). None of these sixteen integrated majors would choose to bear these high costs, which means that, even if it were possible, profit-shifting would never be practiced and thus that B-19 (4) Assume that it is inherent in the structure of the oil industry that firms that own pipelines will often have independent refiners would never be “squeezed. Mitchell, op. cit. supra at 66-67. Of course, much has changed since 1969. Standard of Ohio is no longer “relatively oil-poor.” It now has vast Alaskan reserves. Another and an even more significant change involves the Federal income tax treatment of crude oil extraction. In 1969 large-scale producers of crude had the benefit of the percentage depletion al- lowance. They don’t anymore. In fact, they have been subjected to a windfall profits tax. That is important because the depletion allowance was basic to Professor Mancke’s analysis. His calcula- tions were based on the depletion allowance. Another pertinent change is the substantial post-1969 increase in the market power of the major exporting countries, of whom the United States long ago ceased to be one. Moreover, there is some reason to believe that those countries may now be somewhat more skillful in exploiting that power than they used to be. We are not unmindful of the recent softening of oil prices. Nor have we ignored recent evidence suggesting that all may not be perfectly peaceful and exquisitely harmonious within the house of OPEC. However, these develop- ments are very recent. They may prove of brief duration. It is too early to tell. In any event, we do not believe that they affect the observations made in this paragraph. But it is hard to see how these post-1969 changes invalidate the analysis. Indeed, they seem to strengthen it. We note in this re- gard that Professor Lester C. Thurow of the Massachusetts In- stitute of Technology, a well-known “liberal” economist (see his Generating Inequality (1975) in which he showed a strong egali- tarian bias and took a dim view of the notion that rich people are rich because they are smarter than poor people and his The Zero Sum Society: Distribution and the Possibilities for Economic Change (1980) in which he again expresses great concern over eco- nomic inequality, discrimination, and unemployment and advocates a more progressive tax structure and income protections for the weak) and scarcely a passionate admirer of large oil companies, has recently told the readers of Newsweek that “Oil prices are set in a worldwide market dominated by OPEC where no American corpo- ration, no matter how large, is going to have monopoly power.” Thurow, A New Era of Competition, Newsweek, January 18, 1982, page 63. But we are in an area in which there is a counter-argument to every argument. So those who take a jaundiced view of the majors B-20 significant advantages over those that don’t. Is that suf- ficient to give rise to significant public concern? * What and all their works would have an answer to Professor Mancke as well as a rejoinder to Professor Thurow. That answer-rejoinder would focus on the pipelines. It would probably go something like this: (1) Of course, the integrated oil companies don’t want to raise the prices that they have to pay for crude when they buy it from others. We know that. It was our basic complaint against the old Standard Oil Trust. And we never accused the Trust’s successors cf overpaying the independents for the crude that they bought from them. In fact, we maintain that the majors have historically used their control of the pipelines to depress the prices that the independent producers get. (2) Today, however, “cheap crude” isn’t all that important. In fact, it may no longer be important at all. The majors may not be “self-sufficient” in crude. But they have vast reserves of it. And the higher the price of crude, the more valuable those reserves becomes. (3) For competitive purposes, what really matters is not the absolute price but the relative price. Whether crude is high or low, dear or cheap, you want to be able to buy it for less than your competitors have to pay for it. And the majors’ control of the pipe- lines enables them to do just that. 18 The authors of the KENNEDY STAFF REPORT concluded that it was. They said (at page 151): The integrated owners of pipelines have in fact exploited their advantages. Integrated company ownership of pipelines has had a substantial impact on the ability of nonintegrated re- finers and marketers to compete with the pipeline owners in the market place for petroleum products. Control of crude oil pipelines has enabled these vertically integrated oil companies to gain control of crude oil production greatly exceeding their own refinery needs and has worked to prevent the formation of a domestic crude oil market. Their operation of petroleum pipe- lines allows them to control the distribution and flow—and con- sequently influence the price—of refined petroleum products. The lower real costs of pipeline transportation have not been translated into lower consumer prices but merely into higher oil company profits. Oil company ownership of petroleum pipe- lines has demonstrably failed to make petroleum pipelines a practical transportation alternative for many small refiners and marketers trying to compete with the pipeline owners. B-21 do we have here? Gross inequities that cry out for re- dress? Garden variety byproducts of large-scale enter- prise that benefit the consumer over the long run and are therefore best left undisturbed? Suppose that there is some measure of evil, potential evil, or something in be- tween here. Is that evil small or large? Best endured? * Or better cured? (5) Is therapy appropriate at all? (6) If there is to be therapeutic intervention, what form should it take? Should it be drastic? For example, should integrated oil companies be barred from the pipe- line business and thus compelled to resort to genuinely independent transportation companies? ** Or will gentler measures suffice? (7) Can a regulatory approach solve the problem? ” 19Tf the disease isn’t too serious, the patient may be better off with it than he would be after a painful and an expensive “cure.” Moreover, some cures don’t work. But even those that don’t work have to be paid for. And it is the patient who has to do the paying. In this case the patient is the American people. Spokesman for the oil pipeline industry maintain that there is nothing to cure. They argue that their critics “have a solution in search of a problem.” The industry’s favorite adage is “If it ain’t broke, don’t fix it.” 2 The KENNEDY STAFF REPORT’s last sentence (at page 152) reads in pertinent part: “effective solution to the grave com- petitive problems inherent in oil company ownership of petroleum pipelines: to prohibit oil companies from owning petroleum pipe- lines and to require divorcement of existing pipelines from oil com- pany ownership.” 21 But if the “natural monopoly” thesis be sound, those genuinely independent transportation companies will have enormous market power. That will enable them to exact monopoly profits. So the prohibition of shipper-ownership would not be enough in itself to resolve “the »roblem” in toto. 22 Because of the factor alluded to in the preceding footnote there has long been a school of thought that advocates vigorous rate reg- ulation plus a ban on shipper-ownership. B-22 (8) If so, how should the regulators approach their task? (9) Should they intervene aggressively? (10) Or should they concern themselves only with the grossest abuses and the most shocking injustices? These are not simple matters. The evidence with respect to them is ambiguous. It has to be interpreted. And the interpretation that the particular interpreter comes up with depends in large measure on his or her frame of mind. In petroleum economics, as in art and in love, beauty is in the eye of the beholder. What some find alluring others find repulsive. That is why rivers of ink have been spilled on the questions here presented. History shows that the source of this Niagara of words and num- bers is a conflict between big business and small business. More specifically, what is involved (or what used to be involved) is a collision between Big Oil and Little Oil. What Is Going On In This Specific Case? Who Is Fighting Whom For What? Neat generalizations well supported by history do not always capture every facet of contemporary reality. Thus, for example, in the instant case the position his- torically espoused by the champions of small business and of Little Oil is ably and pertinaciously advocated by the Kerr-McGee Corporation, an integrated oil company. Now Kerr-McGee is not one of the industry’s giants. But it is no pygmy either. Its gross assets come to about $5 billion. Its annual gross receipts are approximately $3.8 billion. Last year its net profits after taxes came to $211 million. It has some 18,000 stockholders. Their equity interest in Kerr-McGee has an aggregate book value of about $1.5 billion. So Kerr-McGee is no Mom- B-23 and-Pop enterprise. It is a large company by any standard.” Kerr-McGee is something of an industry maverick. But that seems to be so only with respect to pipelines and pipeline rates.* In other respects Kerr-McGee is no dis- senter from the industry consensus. It appears to be a member of the petroleum establishment.” Like other large integrated oil companies, Kerr-McGee both owns pipelines and ships much of its oil over pipelines owned by other people.” The Williams Pipe Line Company is one of the carriers that gets business from Kerr-McGee. Kerr-McGee thinks Williams’ rates are much too high. Two of Williams’ other customers take the same view.” Williams agrees with Kerr-McGee and its allies that the rates are far from what they ought to be. But its diagnosis of what is wrong with them diverges from that 23 Kerr-McGee is number 101 on Fortune’s list of the 500 largest industrials. See Fortune, May 3, 1982, at page 265. 24 In that area it is very much a maverick. Its view of the pipe- line problem differs radically from that of its brethren among the major oil companies. When it comes to pipelines, Kerr-McGee stands alone. None of the other integrated companies agrees with its position. 25 Indeed, it seems to be very much part of that establishment. Mr. Dean A. McGee, Kerr-McGee’s co-founder and chief executive officer, recently received the American Petroleum Institute’s Gold Meda! for Distinguished Achievement. Oil and Gas Journal, Novem- ber 16, 1981, page 29. The American Petroleum Institute is not known for its propensity to honor people whom it has reason to regard as enemies of the status quo in oil. Nor is the Institute known for its receptivity to unconventional ideas about oil and its role in the American economy. 26 Kerr-McGee relies heavily on other people’s pipelines. This suggests that Kerr-McGee’s managers have decided that pipelines are not an especially attractive investment and that there are better places in which to put Kerr-McGee’s money. 27 They too are of substantial size. They are agricultural coopera- tives with significant interests in oil. B-24 of Kerr-McGee. Williams says that its rates are too low, that they do not yield adequate recompense for the risks assumed, and that ferocious competition is a market reality for it specifically and for the oil pipeline indus- try generally. Williams maintains that it is operating in a frigid eco- nomic climate that prevents it from earning what it thinks it ought to earn. So Kerr-McGee and the other complaining shippers are buying valuable transportation services at bargain basement prices. But those shippers are very greedy. That their rates are already ludicrously cheap is not enough for them. Motivated by almost un- believable avarice, they have resorted to the legal proc- ess in pursuit of an outlandish effort to knock rates that are already much too low even lower. So far we have an ordinary rate case, a squabble be- tween those who pay and those who get paid about how much is too much and how little too little. But there is more (much more) than that to this massive affair. For one thing, the case has been in progress for more than a decade.** That is an uncommonly long time, even by the relaxed standards of expedition that seem char- acteristic of “big” cases before ratemaking agencies. The affair has dragged on for so long because it has become a great “test case” about oil pipeline rates and their regulation. But it is an anomalous test case on that subject for two reasons: First, the attack on the status quo is being made by a large oil company—all of the other large oil companies are much enamored of the status quo in oil pipelining and maintain that an assault on it is an assault on the American way of life and on the foundations of Western civilization itself. Second, the target of the attack is not an integrated oil company. 28In view of the glacial pace at which the matter has moved, some may think the word “progress” ill-chosen. B-25 Like practically every other oil pipeline company, Wil- liams has a parent. But its parent is not of the Exxon, Mobil, Gulf, Shell, Kerr-McGee breed. The Williams Pipe Line Company is a wholly-owned subsidiary of a Tulsa-based conglomerate known as The Williams Com- panies. The parent is in lots of businesses.” It is in coal,” in fertilizer,*. in metals,** and in real estate * as well as in oil pipelines.“ It is also a producer of crude oil.* So Williams is heavily involved with both the produc- tion of oil and its transportation over a pipeline system. Nevertheless, Williams is not an integrated oil company. For one thing, it is neither a refiner nor a marketer. Second and more important for present purposes, little, if any, of the oil that Williams carries over its pipelines 29 However, the Williams complex is appreciably smaller than Kerr-McGee. As previously noted, Kerr-McGee is number 101 among the nation’s 500 largest industrial firms. Williams is much further down on the list than that. It is number 198. See Fortune, May 8, 1982, at page 266. 30 It holds a 27.5% interest in the Peabody Coal Company. 31 It owns large phosphate deposits and is also an important pro- ducer of anhydrous ammonia. 82 Its subsidiary Edgecomb Metals Co. processes and distributes high-performance metals. 83 Williams’ real estate affiliate, Williams Realty Corp., is develop- ing a major commercial real estate project in downtown Tulsa known as the Williams Center. The company also has other real estate interests. *% Williams’ pipeline system covers a 12-state area extending from Oklahoma to North Dakota and Minnesota. The system has over 8,500 miles of pipeline and approximately 4,900 miles of right of way. 35 Natural gas is also produced. These producing operations are conducted by the Williams Exploration Company and by two other subsidiaries called Louisiana Resources Company and Rainbow Resources, Inc. B-26 is its own.** Hence the link between Williams, qua oil company, and Williams, qua oil transportation company, is financial, not functional. The transportation system and the oil producer are under common ownership. But they do not serve each other. It is as though a diversified industrial holding com- pany that happened to own a steel company also owned an insurance company. If the insurance company wrote casualty insurance and if the steel company bought its casualty insurance from its own captive insurer, we would have a case of “integration.” But suppose that “the insurance company were solely or primarily a life insurer. Now steel companies seldom have much need for life insurance. So a link between a steel company and a life insurer would be an instance of “conglomera- tion,” not of “integration.” That in essence is Williams’ situation. Accordingly, it regards itself (and is generally regarded by others) as an “independent” pipeline company, 1.e., a pipeline company that is entirely or almost entirely eng»ged in selling transportation services to people who are unaf- filiated with it.*” There are several such independent oil pipeliners. In absolute terms some of them are quite large.* Hence they are important factors in some markets. Some of them have been very successful indeed. But the independents are few. They are a minority in the trade. On an industry-wide basis, the shipper-owners’ domi- nance remains overwhelming. Accordingly, the oil pipe- 36 What Williams produces is crude. What it carries on the other hand, consists in the main of gasoline and other refined products. 37 Kerr-McGee has at times suggested that Williams may not be quite so totally “independent” as it claims to be. But those ques- tions are peripheral. They have no bearing on the points that we now have to decide. 38 Williams is said to be the largest. B-27 line controversy has up to now been a controversy about shipper-ownership. That is what the industry’s critics have traditionally regarded as the problem. They have not been up in arms about exploration by the independ- ents. Had they been much concerned about that, the critics would have found themselves in a strange position. Who are the independent pipelines’ principal cus- tomers? The major oil companies.® After all, they are the ones with lots of oil that they want to move from one place to another. Hence concern about the misdeeds of the independent pipeliners would have to rest on the premise that they are taking the major oil companies over the hurdles and ripping them off. Up to now at least, nobody seems to have been terribly worried about that. Those who “exposed” the pipeline problem exposed what they regarded as monopolistic or oligopolistic wrongdoing in oil. What they were really worrying about was not pipe- lines, but oil. Their concern about the pipelines was, as they themselves always stressed, at bottom, a concern about the ownership of the lines. They were upset about the fact that so few of the lines were owned by in- dependent transportation companies. So they could scarcely be expected to go into an uproar about wrongs perpetrated by the relative handful of independent pipe- liners. After all, the principal victin's of those mis- deeds would be the very same major oil companies whose iniquities the critics were so heatedly attacking. So critics of the status quo oil tend to be kind to in- dependent pipeliners. Indeed, one well-known critique singles Williams out for special praise. It says in perti- nent part: Storage facilities or tankage are necessary for the efficient operation of the pipeline. Tankage is re- 39 That is a genc ilization. Most generalizations have their ex- ceptions. And that may be so of this one. B-28 quired at the input point so that the shipper can tender the oil to the pipeline in proper quantities (usually the minimum tender or tenders in excess of that amount). Tankage is required along the pipe- line, known as working tankage, to accommodate line size changes. Finally, tankage is required at delivery points for the delivery of the oil from the pipeline. Thus, the availability of tankage can have a distinct impact upon the ability to use the pipeline. As a general rule, pipelines do not provide tank- age at input and delivery points. Working tankage along the route of the pipeline is provided, but is available only for pipeline operations and not for delivery or storage purposes. As early as 1914, Oklahoma’s Attorney General West, testifying before Congress, stated that com- mon carrier pipeline transportation was of no ad- vantage to independent operators unless there was storage. Others have commented on the lack of storage facilities for use by independent shippers as well as the large capital investment required to furnish suffi- cient tankage at input and delivery points. Shippers on pipelines have emphasized the importance of pro- vision of storage facilities to increased access to pipelines. Williams Brothers, an independent pipeline, is a prime example of a pipeline with common tankage available to all shippers. Williams provides this service at many points along its pipeline for a fee. Many small shippers have been able to take advan- tage of pipeline shipments through Williams Brothers and deliver to many points with minimum capital investments. Competition from independents, as a result, is more intensive in the area served by Wil- liams than in most other ereas of the country. B-29 In stark contrast to the Williams Brothers opera- tion is the experience of an independent marketer desiring to use Explorer pipeline for shipment and delivery to the Dallas area. This independent mar- keter was able to arrange for a contract for gasoline with the refiner-owner connected to the Explorer system. The marketer did not have a terminal con- nected to Explorer for deliveries in the Dallas area, nor did he have a terminal close enough to the pipe- line route to make a connection economically at- tractive. The marketer contacted several companies with terminals connected to Explorer but was unable to secure any space. Even major companies with prior relations with the marketer or friendly atti- tudes toward the marketer refused . . . terminaling space. The refiner-owner attempted to intervene in this situation, since the contract was a good one and provided a new marketing opportunity. The refiner- owner went to the owners of other terminals con- nected to Explorer without any success. The refiner- owner was aware that one of the owners of Explorer had excess terminal capacity in the Dallas area that was available for purchase. The refiner-owner was able to conclude an arrangement for terminal space with this owner; however, the terminal owner placed a veto power in the contract permiting the terminal owner to veto any marketing arrangement not to its satisfaction. When the refiner-owner attempted to use the terminal for deliveries to the independent marketer, the terminal owner vetoed the arrange- ment. The refiner-owner therefore was not czh'e to make deliveries to the independent marketer and the contract eventually fell through. This same refiner- owner found that it was unable to build its own new terminals in areas along Explorer where it did not have existing terminals, since the cost would be too B-30 great and would make any marketing efforts un- economic. Terminals at delivery points are extremely im- portant to independent marketers. Without delivery tankage, they cannot obtain a product from pipe- lines unless the owners of the tankage permit it. New companies without their own existing tankage, even substantial majors, may find it difficult to enter new markets if they must rely on existing terminals (with veto restrictions or other similar arrangements) or on constructing new tankage. Experience indi- cates that independent marketers willing to enter new markets if terminals such as those Williams Brothers operates exist, have been stymied from entering markets served by pipelines through pri- vately owned terminals. The disadvantage is not a theoretical one, but one that is very real and one that effectively limits access to most major integrated oil companies’ pipelines.” At this point, two observations seem relevant. First, oil pipeline owners have done nicely under the status quo. So their affection for it is unsurprising. Some may be reminded of Matthew 6:21: “For where your treasure is, there shall your heart be also.” This is a factor that should be borne in mind. And we do bear it very much in mind. Business enterprises are not eleemosynary in- stitutions. Nor are they supposed to be disinterested servants of the public interest. That is our role, not theirs. As George Bernard Shaw once observed, “Cyni- cism may be a sin. But is rarely mistaken.” When an industry takes a strong position on a public policy question, it normally does so because it has an ax to grind. Nothing in our experience suggests that the oil *# KENNEDY STAFF REPORT at 78-80. (Emphasis added; footnotes omitted.) The shipper-owners maintain that these propositions rest on misconceptions. See WOLBERT II, at 296-298. B-31 industry is an exception to this rule. It gets excited (and it has gotten quite excited here) when dollars and cents are at stake. Litigants who have money at stake take positions calculated to maximize their economic welfare. That is inherent in the nature of things. It is an obvious fact of life. But it would be a mistake to make too much of that fact. Something that is good for integrated oil companies may also be good for society. Or it may not. There is no presumption either way. Second, propositions should be dealt with on their merits. The motives of those who put the propositions forward seldom call for much analysis. When private parties are involved, those motives are rarely mysterious. And they have no necessary bearing on the merits. Thus, for example, defendants in criminal cases are always out to save their own skins. But that is no reason to discount everything that they say. They be telling the truth. And they may be innocent. Even if guilty, prose- cutorial misconduct or concepts basic to ordered liberty may entitle them to an acquittal.“ There are vast differences between economic regulation of the type here involved and criminal proceedings. In some respects the two types of cases are as different from each other as they could possibly be. But similarities of a sort can also be found. Both areas involve limitations on a private person’s freedom to do as he pleases. In both that freedom yields to legislative conceptions of the social interest. In economic regulation, as in criminal justice, those who have to administer the legal order may sometimes think those legislative conceptions dubious or downright strange. Nevertheless, they are not at liberty *1 Cf. United States v. Ro’ Anowitz, 339 U.S. 56, 69 (1950): “It is a fair summary of history to say that the safeguards of liberty have frequently been forged in controversies involving not very nice people. And so, while we are concerned here with a shabby defrauder, we must deal with his case in the context of ... the great themes expressed by the Fourth Amendment.” Dissenting opinion of Frankfurter, J., concurred in by Jackson, J. B-32 to substitute their private policy preferences for those of the legislature.” As administrators of the statute under which this case arises, we have a duty to discharge. That duty is to carry out the intention of the legislature, insofar as that intention can be divined from materials that are some- times cryptic. Here those materials are very cryptic in- deed. This makes our task extraordinarily difficult. That extraordinary difficulty has had much to do with the regrettable delays in disposing of this matter. Broader Implications So this case is somewhat odd. It is also very old. Those features of the litigation are important. Far more im- portant, however, than those case-specific aspects of the matter are its general implications.“® Those have been agitated for the past century. They go to the heart of the oil pipeline rate issue. The debate about that issue is part of a much bigger debate. That bigger debate is not about pipelines. It is about oil. Is the oil business a “monopoly”? A “shared monop- oly’? An “oligopoly”? “Cartelized”? A complex blend of oligopoly and competition where whales “compete” with minnows and elephants dance among chickens? More competitive (perhaps a great deal more competi- tive) that that but nevertheless an industry in which the beneficent flame of competition does not always burn quite so brightly as the late Adam Smith thought it should? 42 See Mid-Louisiana Gas Co. v. Federal Energy Regulatory Com- mission, 664 F.2d 530, 585 (5th Cir. 1981), cert. granted, 51 U.S.L.W. 3219 (U.S. Oct. 4, 1982) (No. 81-1889): “The Commis- sion’s duty is to administer the law Congress passed in light of the purposes for which it was passed. It is not an agency’s prerogative to alter a statutory scheme even if its alteration is as good or better than the congressional one.” 43 This sentence reflects the Commission’s public-interest perspec- tive. To the litigants, to Williams and to the complaining shippers the case-specific features of the matter are obviously all-important. B-33 Or is oil a workably competitive industry mindlessly harassed by moonstruck antibusiness idealogues and ill- formed politicians who equate bigness with badness, who are still fighting quixotic populist wars against John D. Rockefeller’s ghost, who are wilfully blind to technological imperatives and to the major exporting countries’ enor- mous market power, who are oblivious to efficiency con- cerns, who have made an inflexible dogma out of an English economists’s amusing aphorism that “Small is beautiful,” “ and who seek to apply that dogma to an industry in which it has as much place as a fur coat in the baggage of a traveler bound for the Equator? “ People’s answers to those big questions about oil in- fluence their answers to smaller and essentially ancillary questions about oil pipeline rates. What Was The Climate Of Opinion That Led To The Regulation Of Oil Pipeline Rates? Today the questions that we have posed evoke diverse answers. Back in 1906, however, they evoked virtual unanimity. Those virtually unanimous answers were hostile to the industry.“ Most Americans thought the oil business in dire need of radical reform.” Practically 4 See E. F. Schumacher, Small is Beautiful (1973). ** Recent events would seem to strengthen this position. They certainly show that oil prices can move down as well as up. **Of course, John D. Rockefeller and his associates dissented from that consensus. They saw no problem. Some think that they were right. But history’s locomotive was moving in the opposite direction. *? There were no Gallup polls in those days, so the statement in the text cannot be demonstrated mathematically. Most Americans were probably more worried about earning a living and about other private day-to-day problems than they were about the economics of oil. But the historical sources show that the better educated citi- B-34 everybody in the Congress took the same view. So did the President.** Nineteen Hundred and Six was a great Progressive year. And John D. Rockefeller and his Standard Oil combine were Progressivism’s primary targets.*® Rocke- feller himself was widely regarded as Public Enemy Number One. Miss Ida M. Tarbell had much to do with this. Her nineteen articles on The History of the Standard Oil Company appeared in McClure’s Magazine from 1902 to 1904. What they did to Standard had something in common with what Harriet Beecher Stowe’s Uncle Tom’s Cabin did to slavery. zenry were much concerned about oil and that their concern had by 1906 seeped down to a broad segment of the less educated. Jour- nalists, newspaper proprietors, and magazine proprietors thought that oil was “good copy.” Statesmen looking for issues took the same view. That is pretty strong evidence that the public was in- terested. Of course, some would say that a clever propaganda cam- paign had led the populace to consider itself interested. *8 He was Theodore Roosevelt. And he was then busily denounc- ing “the malefactors of greath wealth.” 49 They were uppermost among the “malefactors” referred to in the preceding footnote. One recent historian notes that Roosevelt’s “public relations campaign against Standard Oil was relentless.” B. Bringhurst, Antitrust and the Oil Monopoly; The Standard Oil Cases 1890-1911 (hereinafter cited as “BRINGHURST”), p. 207 (1979). 5% They were then reproduced in two volumes that bore that title. These appeared in 1904. There have been a number of subsequent editions. The book is still very much alive. It is available in a Harper Torchbook paperback edition edited by David M. Chalmers. As Tarbell’s biographer says: “In the sole work for which she is now remembered, The History of the Standard Oil Company, the author, her subject, and the times had met to produce a master- piece which has not declined into a period piece.” M. Tomkins, Ida M. Tarbell 91 (1974) (hereinafter cited as “TOMKINS”). B-35 Stowe was a fervent Abolitionist. And Tarbell was just as fervent a partisan of Little Oil. Tarbell was a champion of the independent producer and the inde- pendent refiner.*' She thought that Rockefeller and his henchmen had driven the independents to the brink of destitution and that they had done so by criminal means.” She excoriated them for that.™ 5i Hence she was allergic to the point of view expounded by John D. Rockefeller, Jr. when he addressed the students at his alma mater, Brown University, on the subject of “Trusts” and told them that “The American Beauty Rose can be produced in its splendor and fragrance only by sacrificing the early buds which grow up around it.” Quoted by Tarbell at the very outset of her History of the Standard Oil Company. 52 Many had, of course, gone over the brink. In Miss Tarbell’s view, pipelines had a lot to do with that. The penultimate para- graph of her great book reads: And what are we going to do about it? For it is our busi- ness. We the people of the United States, and nobody else, must cure whatever is wrong in the industrial situation typi- fied by this narrative of the growth of the Standard Oil Com- pany. That our first task is to secure free and equal transpor- tation privileges by rail, pipe and waterway is evident. It is not an easy matter. It is one which may require operations which will seem severe, but the whole system of discrimination has been nothing but violence, and those who have profited by it cannot complain if the curing of the evils they have wrought bring hardship in turn on them. At all events, until the trans- portation matter is settled, and settled right, the monopolistic trust will be with us, a leech on our pockets, a barrier to our free efforts. 2 TARBELL 292 (Emphasis added). 53 Among Tarbell’s articles was a series entitled Crimes of the Standard Oil Trust. These pieces appeared in The New York Amer- ican in February 1905. % Though proverbially meticulous, her journalism was not dis- passionate. Her father was an independent oil man. So was her brother. Her biographer comments: Tarbell . . . shared with the people of her native regions a deep hatred of Rockefeller, and it activated her study of him B-36 Typical of Tarbell’s viewpoint is this sketch of the idyllic small businessman’s paradise that the Standard Oil Company ruined: Life ran swift and ruddy and joyous in these men [of the Oil Regions]. They were still young, most of them under forty, and they looked forward with all the eagerness of the young men who have just learned of their powers, to years of struggle and development. They would solve all [their] perplex- ing problems of overproduction, of railroad discrimi- nation, of speculation . . . They would meet their own needs. They would bring . . . oil refining to the region where it belonged. They would make their towns the most beautiful in the world. There was nothing too good for them, nothing they did not hope ... Convinced that Rockefeller was of the species most despised on the frontier of her youth, a hyprocrite of a peculiarly of- fensive kind, who taught the Bible version of the Golden Rule to his Sunday school classes and practiced the version of it allegedly taught him by his father, she set out to demolish the whited sepulcher. She left it in ruins. TOMKINS at 90. At an earlier point Tomkins sums Tarbell’s work up this way: ‘Tarbell’s history recounts the development of the oil industry from the early hawking of petroleum as a medicine guaranteed to cure everything prayer couldn’t to its eventual use as a lubricant and fuel for internal combustion engines. The narra- tive follows the rise of the Standard Oil Company from its inception following the Civil War to the height of its un- checked power at the turn of the century. Tarbell’s tone, a mixture of cold disdain and white-hot moral indignation con- trolled by excellent documentation and a facade of objectivity, seemed to hit the right note. An enthusiastic public followed her serial account in McClure’s for two years as she tirelessly communicated to tens of thousands of readers “a clear and succinct notion of the processes by which a particular industry passes from the control of the many to that of the few.” Tar- bell nowhere leaves much room for doubt that she is a partisan of “the many.” TOMKINS at 60 (with a footnote citation to Tarbell’s own statement of her purpose in chronicling Standard Oil’s saga at such length and in such elaborate detail.) B-37 and dare. But suddenly, at the heyday of this con- fidence, a big hand reached out from nobody knew where, to steal their conquest and throttle their future. The suddenness and the blackness of the assault on their business stirred to the bottom their manhood and sense of fair play, and the whole region arose in a revolt which is scarcely paralleled in the commercial history of the United States.™ Another famous Tarbell passage identifies the assailant and describes his tactics. It goes like this: Very soon after Mr. Rockefeller began to “acquire” independent refineries, whose owners were loath to sell or go out of business, unpleasant stories began to be circulated in the oil world of the methods used in getting the offending plants out of the way. When freight discriminations, cutting off crude supply, and price wars in the market failed, other means were tried, and these means included, it was whispered, the actual destruction of the plarits.* A third Tarbellism that bears quotation reads: [T]he work of acquiring all outside refineries be- gan at each of the oil centres. Unquestionably the acquisitions were made through persuasion when this was possible. If the party approached refused to lease or sell, he was told firmly . . . that there was no hope for him; that a combination was in progress which was bound to work; and that those who stayed out would inevitably go to the wall... All over the country the refineries . . . sold or leased. Those who felt the hard times and had any hope of weathering them resisted at first. With 5° 1 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385010_2569%3A2. Public record. Not legal advice.