Oil Pipelines’ Effects on Refined Products Prices

Mary Coleman, George Schink and James Langenfeld

LECG, LLC

August 2, 2001

1. Overview

Pipeline transportation capacity constraints and pipeline tariff rates can both have an impact on refined products prices. The linkage between refined products pipelines and refined products prices is more direct and predictable than is the linkage between crude oil pipelines and refined products prices. Therefore, our primary focus is on refined products pipelines. Limitations on pipeline shipments can have large affects on refined products prices. Such constraints can arise due to limited capacity available on the pipeline generally or due to seasonal fluctuations in demand or unexpected outages. In addition, in geographic areas with a small number of available shippers on the pipeline and limited alternative sources of supply, shippers may have incentives to limit shipments to the area to increase refined products prices.

Pipeline tariff rates can affect refined products prices, but pipeline tariff rates are a very small part of delivered refined products prices. Further, both refined products and crude oil pipeline tariff rates for common carrier pipelines are regulated subject to a rate cap mechanism based on the producers price index for finished goods which limits the ability of pipelines to increase their tariff rates.

2. The Relative Importance of Refined Products Pipeline Supply Varies Geographically

The importance of refined products pipeline supply varies substantial across different geographic areas. Some areas rely almost exclusively on pipelines for the supply of refined products (e.g., the inland Southeast area including Atlanta). Such areas cannot be supplied off-the-water by barge or tanker and have no, or very little, local refinery capacity. Other areas have significant local refinery capacity and/or can obtain significant volumes off-the-water but still rely on receiving substantial refined products volumes via pipeline (e.g., the upper Midwest area including Chicago). Areas located on major inland waterways or on the ocean usually have port facilities that are or could be used to supply their refined products needs (e.g., Memphis on the Mississippi River or most of Florida). Some areas on the ocean also receive substantial volumes of imported refined products (e.g., the New York City area). Finally, there are areas that are major petroleum product refining centers and/or are areas that could be supplied entirely off-the-water (e.g., Houston). These areas typically are refined products distribution centers that use refined products pipelines primarily to transport refined products to other areas.

3. The Likely Effects of Pipeline Capacity Availability on Wholesale Refined Products Prices

A key consideration in assessing the impact a refined products pipeline might have on refined products pricing in a given geographic area is the extent of excess refined products supply capability (capacity) available to that area and who controls that excess capacity. A given area is potentially supplied refined products by inbound product pipelines, barges or tankers, and local refineries. If the total supply capacity substantially exceeds local consumption of refined products and that capacity is controlled by a sufficient number of different parties, there is limited risk that a limitation of supply from a given pipeline could result in increased products prices. However, if the pipeline accounts for a large fraction of excess capacity, limitations on its supply of refined products might impact refined products pricing.

For a refined products pipeline to profit directly from a limitation in refined product supply to a given area, it must be able to increase its tariff rates. To the extent that regulation of these tariff rates precludes the pipeline from increasing these rates, the pipeline will have no direct incentive to limit supply. However, if the pipeline were owned by a supplier (or a group of suppliers) of refined products, the pipeline owner (or owners) might be able to benefit from a limitation in pipeline supply to an area by being able to charge higher prices for the refined products delivered to that area.

4. Consideration of the Different Types of Refined Products Pipeline Supply Limitations

There are some geographic areas where there are seasonal pipeline capacity constraints, generally because refined products demand (specifically gasoline demand) is higher during the summer months than during other times of the year. In these areas, pricing in the summer can be different than pricing in the other seasons because the marginal source of supply differs. For example, the pipelines from the Gulf Coast to the Upper Midwest (e.g., Chicago) tend to be fully utilized during the summer months. During the non-summer months, the wholesale price of refined products in the Upper Midwest is limited by the spot price on the Gulf Coast plus the cost of pipeline transportation to the Upper Midwest. In the summer months, when these pipelines are fully utilized, wholesale refined products prices in the Upper Midwest rise above the Gulf Coast spot price plus pipeline transportation costs to a level set by the (higher cost) summer period marginal source of supply. Presumably, if there were a pipeline supply disruption between the Gulf Coast and the Upper Midwest during the summer months, this would result in still higher refined products prices in the Upper Midwest.

There have been instances of major unexpected refined products pipeline outages which have caused wholesale refined products price spikes. For example, this occurred on Wolverine pipeline which carries refined products from the Chicago area to the Detroit area in June of 2000. Wolverine was completely shut down due to an unexpected outage for nine days from June 7 until June 16, 2000. Refined products prices in Detroit spiked relative to those in Chicago in June and July of 2000 due to the nine-day outage and due to the fact that Wolverine could only operate at 80% of capacity following the outage because Wolverine was only able to make interim repairs. By August 2000, the price spike had disappeared and the normal summer season relationship between Detroit and Chicago refined products prices was restored. Wolverine scheduled a nine-day outage from August 11 until August 20, 2000 to do the final repairs, and it continued to operate at 80% of capacity until the end-of-September, 2000 pending final inspection and testing of the repaired pipeline. The planned nine-day outage had no discernable effect on refined products prices in Detroit relative to those in Chicago and the normal Chicago-Detroit refined products price relationship prevailed in August and September of 2000.

The fact that an unexpected outage in a major refined products pipeline causes a price spike in the areas where supply is disrupted is not surprising and does not necessarily indicate that the pipeline has market power. The suppliers to the areas where supply was disrupted would not have anticipated the outage and, therefore, would not have been able to implement alternative supply plans. Moreover, the outage would remove a large increment of supply. The issue is whether the price spike dissipates within a reasonable time period (even if the supply disruption continues). According to the Merger Guidelines, if this occurs within one year, then there are viable competitive alternatives. In the case of Wolverine pipeline, it occurred within two months. Further, given advance notice of Wolverine’s planned nine-day outage in August 2000 to complete repairs, there was no price spike effect due to the outage which was of equal duration to the original unplanned outage. Unfortunately, the publicity surrounding unexpected pipeline outages and the large, albeit short-term, price effects of these outages have focused significant attention on the pipelines as a potential cause of longer-term higher prices in a given area.

There are geographic areas that might experience longer-term higher refined products prices if pipeline supplies were significantly curtailed. These include the areas that are dependent on pipeline supply and have limited or no local refining capacity or waterborne delivery capabilities (e.g., the Atlanta area). It also could occur in other areas where the pipeline is the marginal source of supply to the area. Current pricing in those areas is determined by the transportation costs on the pipeline, the refining costs for

potential shippers on the pipelines and the refined product prices at alternative outlets for these shippers. If pipeline supply were reduced in such an area, the curtailed supplies would have to come from alternative higher-priced suppliers. The extent of the price effect depends on the difference in the cost of supply from the alternative sources relative to the cost of supply via the pipeline. The price effects could be small or quite large and would depend on the specific supply situation in each area.

If the pipeline was not the marginal source of supply in an area (i.e., does not set the price in an area), a reduction in that pipeline’s supply might have no effect on prices in the area. If a pipeline supplies a small percentage of the refined products to a given area and is not fully utilized, it most likely is not the marginal supply source. Restricting or increasing supply on such a pipeline might not have any effect on prices in the area.

5. The Effects of Pipeline Tariffs on Wholesale Refined Products Prices

Changes in pipeline tariffs can affect wholesale refined products prices in an area. This would be expected to occur if the pipeline increasing its tariffs were the marginal supply source. If the pipeline were not the marginal supply source, the higher pipeline tariffs would reduce the margins obtained by the refined products suppliers and would not directly affect wholesale refined products pricing. These reduced margins could, however, cause supply reductions and thus might ultimately lead to higher wholesale refined products prices.

A significant increase in a pipeline’s tariff rate, even if passed through in the form of higher wholesale refined products prices, would have a small effect on these prices because the tariff rates are only a very small part of the delivered cost of the refined petroleum products. For example, the cost of transporting refined products from the Gulf Coast to Chicago on Explorer pipeline is 2.5 cents per gallon and the wholesale rack price of unleaded regular gasoline in Chicago is at least 100 cents per gallon. Therefore, a 10% increase in the tariff rate is less than a 0.25% increase in the delivered Chicago price of refined products. Similarly, the Colonial pipeline tariff rate from the Gulf Coast to New York City is only 2.5 cents per gallon. For all refined products pipelines, the average length of haul is 333 miles and the average tariff rate is 1.4 cents per gallon. Significant increases in the pipeline tariff rates would have, at most, a very small effect on wholesale refined products prices.

Oil pipeline tariff rates on common carrier pipelines are regulated by the Federal Energy Regulatory Commission (FERC). These pipelines are subject to price cap type regulation. Oil pipeline tariff rate ceilings are set for each pipeline based on the annual percentage change in the producer price index for finished goods (PPIFG) as published by the Bureau of Labor Statistics of the U.S. Department of Labor (BLS). In a given year, the oil pipeline pricing index equals the percentage change in PPIFG for the previous year less 1%. This index is used to calculate a ceiling for each pipeline tariff rate based on the cumulative change in the oil pipeline pricing index since 1995 (i.e., the ceiling for each tariff rate equals the value of that tariff rate at the end-of-1994 times the cumulative percentage change in the index for 1995 through the present). Oil pipelines can only increase a tariff rate up to its ceiling calculated using the oil pipeline pricing index.

An oil pipeline may obtain tariff rates above the ceiling from the FERC if the pipeline can justify such rates based on its own cost experience. The pipeline’s costs are subject to challenge by the FERC and the shippers on the pipeline. If a pipeline obtains a cost-based exception to the price ceiling from the FERC, the price ceiling is adjusted upward to equal the higher cost-justified tariff rate and the oil pipeline pricing index is applied on a going-forward basis. The total costs of a given pipeline tend to be related negatively to its age. A very large percentage of a pipeline’s costs are fixed costs associated with constructing the pipeline. An oil pipeline is depreciated over a 30-year period for regulatory purposes but a pipeline can operate for 50 or more years. As a pipeline grows older, the reduction in fixed costs due to depreciation generally more than offsets the increases in variable operating costs leading to a reduction in total costs. Also, technological changes are relatively slow in the pipeline industry so recently-built pipelines tend to have higher total costs than comparably-sized older pipelines. There are very significant-scale economies in oil pipelines, so the newer pipelines tend to be built with greater capacity than some of the older pipelines. These scale economies can result in a lower total cost per gallon transported on the new pipelines than for the smaller old pipelines.

Finally, pipelines can request that the FERC exempt some or all of its rates from the oil pipeline pricing index based on a demonstration that the pipeline faces sufficient competition to allow it to charge market-based rates. Some pipelines have obtained market-based rate setting authority for some or all of their deliveries. However, this authority has been granted only in cases where there are at least four and usually at least five significant suppliers to an area and where these suppliers have excess supply capacity into the area. This market-based pricing authority can be revoked by the FERC if market circumstances change or if the pipeline is able to raise its tariff rates to supra-competitive levels.

Some refined product pipelines are proprietary, although the majority of refined products are shipped on common carrier pipelines. Owners of these pipelines can set their own rates. However, if they begin shipping substantial quantities of product for the use of third parties, the FERC can require that they become common carriers.

The ownership of a refined products pipeline and its relationship to the ownership of the refineries that use the pipeline to make deliveries can affect the pipeline’s tariff rate-setting incentives. If the pipeline is independently owned (e.g., by a stand-alone pipeline company such as TEPPCO or Buckeye), then its objective in setting rates is to maximize pipeline profits. If the pipeline owners also own refineries that use the pipeline to make deliveries, then the objective in setting a pipeline’s tariff rates may be to maximize joint pipeline and refinery profits. If the pipeline is supplied mostly or exclusively by the pipeline owner’s refinery, then the pipeline tariff rate need not have any affect on refined products prices in the delivery area. The only issue is whether the pipeline/refinery owner has power in the refined products market in the areas where the pipeline makes deliveries. If a pipeline is owned by a consortium of refinery owners who ship on the pipeline, then the differing strategies and objectives of its owners regarding their refining and marketing operations are apt to preclude the setting of the refined products pipeline tariffs based on anything other than the pipeline’s own profitability.

6. The Refined Products Industry Dynamics Have Had Significant Impacts on Refined Products Supply Capability into Various Areas

U.S. petroleum product refining is becoming geographically more centralized. Historically, relatively small refineries were constructed in the vicinity of U.S. oil fields and in the vicinity of consumption centers. The former tended to be sized to utilize the local crude production owned or controlled by the owner of the refinery. These refineries were linked to major consumer centers by relatively small refined products pipelines. Similarly, small refineries were constructed in inland consumption centers. These refineries were sized to meet local consumption needs and were supplied by crude oil pipelines from U.S. oil fields.

As U.S. oil production has declined, and as the relative efficiency of the very large refineries located in the major refining centers has increased, the smaller refineries in the U.S. oil fields (e.g., Group III) and in the inland U.S. consumption centers (e.g., the Upper Midwest) have closed. The closure of these smaller refineries has increased the need for refined products pipeline capacity into the inland consumption centers from the major refining centers and the coastal port areas where imported refined products are received. There have been expansions of refined products pipeline capacity in response to the changes in the location of U.S. refinery operations and the increase in refined product imports.

This cost of new pipeline construction tends to be higher than was the case for the older pipelines they displace. However, these new pipelines tend to be larger-scale pipelines which tends to offset their higher construction costs, and these new pipelines also link the inland consumption centers to lower-cost large-scale refineries and imported refined products. Delays in obtaining approval for pipeline expansion projects or new pipeline entry can cause supply shortages until these pipeline projects are completed.

There are several pipeline expansion projects designed to increase the supply of refined products from the Gulf Coast into the U.S. Midwest. There are two new pipelines that move Gulf Coast produced refined products into Group III (Seaway and Equilon). Further, there are two pipeline expansions underway that will significantly increase the pipeline capacity into the Upper Midwest from the Gulf Coast (Explorer and Centennial which is a Marathon/TEPPCO joint venture). The completion of the Explorer and Centennial projects should eliminate the refined products market summer period tightness in the Upper Midwest that has occurred recently.

There also are pipeline projects designed to move Gulf Coast refined products into the West Texas, New Mexico, Western Colorado, Utah (including Salt Lake City), and potentially, into Arizona (Phoenix and Tucson). Equilon is operating a large-scale pipeline between Houston and West Texas and is planning to extend this pipeline into New Mexico through Albuquerque and into Four Corners. Williams has plans to construct a pipeline from Four Corners to Salt Lake City. Longhorn pipeline will transport refined products from Houston into El Paso which will allow Gulf Coast refined products to be transported into Tucson and Phoenix as well as into Albuquerque via existing pipelines.

It is generally expected that this new entry will reduce refined product prices in the delivery areas. This would be true during the summer months in Group III and the Upper Midwest and throughout the year in the western states served by the new Equilon, Williams, and Longhorn pipeline projects. These pipeline projects are all relatively large-scale which should create substantial excess capacity which will tend to hold down pipeline rates. Further, these pipelines transport low-priced refined products from the Gulf Coast to areas with higher refined products prices. This should tend to reduce refined products prices in the delivery areas.

7. Crude Oil Pipeline Capacity and Tariff Rates Also Can Impact Refined Products Pricing

Crude oil pipeline capacity availability is a potential concern primarily for inland refineries that cannot obtain their crude oil inputs off the water. The major crude oil pipeline movements are from the Gulf Coast to the Midwest, from Western Canada to the Upper Midwest, and from Western Canada, Montana, and Wyoming to Denver and Salt Lake City. The refining centers on the West Coast, Gulf Coast, and East Coast can be supplied off-the-water. These coastal refineries use U.S. produced crudes, but the marginal crude supply source is imported crude.

If there is a crude oil pipeline capacity constraint for a given crude oil delivery area, this may increase the cost of crude oil supplies into that area. If the capacity-constrained supply was not the marginal crude oil supply source, then the cost of crude oil to the refining area might not increase. If the cost of crude oil were to increase to a given refining center, the price of refined products might increase. The refined products price would increase if the local refineries were the marginal supply source for the area, but refined product prices might not increase otherwise. If refined products prices did increase due to higher crude costs, the extent of this increase would depend on the opportunity cost of diverting more refined products into the area from elsewhere. The linkage between crude oil pipeline tariff rates and refined products prices is much more indirect and uncertain than is the linkage between refined products pipeline tariff rates and refined products prices.

The total inland refinery capacity has decreased over time. Therefore, there generally is excess crude oil pipeline supply capacity into the inland areas. This tends to hold down crude oil prices and crude oil pipeline tariff rates into the inland refining centers.

The inland refinery owners tend to own or have ownership interests in the crude oil pipelines that supply their refineries. Those refinery owners tend to purchase the crude oil in the oil fields and transport the crude oil into their refineries. Therefore, the inland refinery owners have limited concerns with the crude oil pipeline tariffs rates and crude oil pipeline supply available on the pipelines supplying their refineries.

There also has been new entry of crude oil pipelines into the Upper Midwest. Pipeline capacity from Western Canada to the Upper Midwest was constrained until Express pipeline began operation in late 1997. Express pipeline brought Western Canadian crude oil into Montana and Wyoming where it was then transported into the Midwest area via the Platte crude oil pipeline from Wyoming. The Platte crude oil pipeline had excess capacity due to the decline of U.S. crude oil production in Montana and Wyoming.

• The rate cap mechanism effectively limits the annual change in the oil pipeline tariff rates to the percentage change in the producer price index for finished goods in the previous year less 1% (i.e., if the producer price index increased by 2% in the previous year, oil pipeline tariff rates could increase by, at most, 1%). The actual rate cap mechanism is somewhat more complicated in that it establishes a rate ceiling based on the cumulative percentage changes in the producer price index less 1% since the beginning of 1995.
• Waterborne delivery of refined products generally provides cost-effective competition or a cost-effective alternative to pipelines.
• With refined products pipelines, concerns regarding market power tend to be focused at the pipeline’s delivery points and not its origin points.
• There have been other refined product pipeline outages. The refined product price impacts of these outages typically dissipates within a few months (e.g., Colonial in the Fall of 1994, Olympic in the Summer of 1999, and Explorer in the Spring of 2000).
• This is roughly equivalent to using the annual percentage change in the GDP price index less 2%.