Issues » Comments on Rules and Regulations

Appendix D2

UNITED STATES OF AMERICA BEFORE THE
DEPARTMENT OF THE INTERIOR MINERALS MANAGEMENT SERVICE

Establishing Oil Value for Royalty Due on ) 30 CFR Part 206
Federal Leases; Proposed Rule ) 64 FR 73820
(December 30, 1999)

A Recommended Rate of Return Methodology for Calculation of Transportation Allowances in Non-Arm’s Length Crude Oil Transportation Arrangements

Prepared for:

the American Petroleum Institute
the Domestic Petroleum Council
the Independent Petroleum Association of America
the United States Oil and Gas Association
January 2000

Prepared by:

Elizabeth H. Crowe
Carl V. Swanson
Swanson Energy Group, Inc.
300 Main Street
Wenham, Massachusetts 01984
(978) 468-4233

Mineral Management Service 30 CFR Part 206 Establishing Oil Value for Royalty Due on Federal Leases 64 DE 73820 (December 30, 1999)

Determining Rate of Return Applicable to Transportation Systems

1. Executive Summary

As part of its proposed 30 CFR Part 206 rulemaking regarding oil royalty valuation, the MMS has requested comments regarding the determination of an appropriate rate of return to be reflected in the transportation allowance under non-arm’s-length arrangements for movement of oil produced from Federal lands to a point of sale off the lease. Based on a review of current publically available data concerning capital structure and cost of capital for companies engaged in upstream oil production activities, as well as the practices of other regulatory agencies which set cost-based rates for public utilities, this report recommends that the MMS adopt a composite industry cost of capital equal to two times the Standard & Poor’s BBB industrial bond rate.

As discussed in more detail in the body of this report, current data suggest that a capital structure of 30% debt and 70% equity would be a conservative measure of a median ratio for the producing industry, particularly given the fact that equity ratios for integrated oil companies are generally higher than 70%. Moreover, this ratio accurately reflects the risks associated with upstream pipelines and other investments in oil and gas assets. The industry composite range for the cost of equity capital of oil and gas companies in 1998 - 1999, as estimated by independent analysts using either a capital asset pricing method (CAPM) or a discounted cash flow (DCF) method, is 7.10% to 17.30%. Using 13% for equity capital and the 1999 S&P BBB yield of 7.4%, combined with a 30/70 debt/equity capital structure, produces an 11.3% after-tax weighted average cost of capital (WACC). Given the fact that oil pipelines are typically financed by parent companies using both debt and equity, and income tax expense will be incurred on the portion of the return associated with the equity investment, it is necessary to calculate the cost of capital reflected in the transportation allowance computed by the MMS on a pretax basis. Given a 35% federal income tax rate, the weighted pretax cost of capital is 16.2%, or 2.2 times the BBB rate.

These results lead us to conclude that a cost of capital of 2 times the BBB bond rate is a reasonable reflection of the actual capital costs incurred by domestic oil transporters, particularly the offshore oil pipelines to which the MMS transportation allowance will largely pertain. The data and reasoning on which this conclusion is based are presented more fully in Section II.

2. Section II
1. Whether to Include an Equity Component in the Rate of Return

The Swanson Energy Group, Inc. has been asked by a group of oil associations and companies, which is filing joint comments in the instant proceeding, to evaluate the MMS policy concerning the rate of return allowance included in non-arm’s length transportation allowance determinations in light of the MMS recent request for comments, and to make recommendations concerning a reasonable cost-based methodology for the MMS to adopt. Our firm’s qualifications and experience are appended to this report as Attachment A.

Under current MMS regulations governing the valuation of oil for royalty purposes, the transportation allowance permitted for non-arms length arrangements includes a return on capital investment which is calculated using Standard and Poor’s BBB bond rate as the rate of return. The basis for this policy, as articulated by the MMS in its December 30, 1999 further supplementary proposed rule (December 1999 proposal), is to attempt to base the transportation allowance on "actual costs incurred to transport the oil." Thus, the MMS is implicitly assuming that the actual cost of money for building a pipeline to move oil from federal leases to the point of sale is essentially the rate at which money can be borrowed by companies in the oil pipeline business, as represented by the industrial BBB corporate bond rate.

The difficulty with this assumption is that pipelines are rarely, if ever, financed entirely by debt. It is highly unlikely that a lender would agree to undertake the entire cost of building a pipeline, given the high risk of default such a situation would create. It is more likely that oil pipelines, especially the offshore pipelines which transport oil from federal leases, will be financed by entities which own, directly or indirectly, economic interests in production from the leases to be served by the pipeline. Less frequently, such pipelines may be financed by entities which do not own such economic interests. In either case, most or all of the capital investment in the transportation facility will be funded by equity rather than debt.

If it is true that transportation facilities are built with at least some equity capital rather than 100% debt capital, the question arises as to whether the cost of that equity capital should be reflected in the MMS transportation allowance at some rate other than the BBB bond rate. The cost of equity capital, while not directly observable in financial markets in the same manner as the cost of debt, is higher than the cost of debt capital. While there are different approaches used by investment firms and regulatory agencies to estimate the cost of equity capital for any given industry or company, the data consistently suggest that investors expect a higher rate of return on their equity investment capital than they do on debt capital. Table 1 presents calculations by several investment firms and financial experts of the recent cost of equity capital computed for various segments of the petroleum industry. As shown on that table, different firms and different methods produce a range for selected oil and gas companies of 7.10% to 17.30% for the cost of equity capital in late 1998 and early 1999. The comparable Moody’s Baa corporate bond rate for March 1999 was 7.53%. To the extent that equity capital is used to build oil pipelines from federal lease locations, then the cost of that capital is an actual cost of the pipeline, and the return allowance computed by the MMS should reflect that cost.

Three questions arise from this conclusion. First, what cost of equity capital should be reflected? Second, should that equity cost be calculated on a before-tax or after-tax basis? Third, how should the relative portions of debt and equity capital be determined? These questions are addressed in turn below.

2. How to Calculate the Cost of Equity Capital

As mentioned above, there are several different accepted methods for calculating investors’ expected return on equity capital for a company or industry. The data in Table 1 reflects both the CAPM and DCF (or dividend growth) methods. It is our judgment that the average of the equity costs calculated by Ibbotson Associates for the oil and gas extraction industry (SIC 13) is a reasonable, and perhaps low, measure of current investor expectations for equity return on a project such as the transportation facilities used to move oil from federal leases. Ibbotson is a recognized authority in the compilation and interpretation of financial data, and their studies include the largest number of companies of any source we reviewed. In addition, the 13% composite SIC 13 industry average of the four methods used to calculate cost of equity capital by Ibbotson is in the middle of the range of equity capital costs produced for comparable industry segments by all sources we reviewed, as shown on Table 1.

As a point of reference, a 13% cost of equity capital for 1999 is lower than the range calculated by the Federal Energy Regulatory Commission (FERC) for an oil pipeline in its most recent determination of cost-based rates for an oil pipeline. In a decision issued in January 1999, the FERC determined that the appropriate range for SFPP’s cost of equity capital was 12.74% to 14.39%, and that SFPP’s risk warranted a 14.27% rate of return on equity capital.

3. Whether to Use a Before-Tax or After-Tax Cost of Equity

Income taxes are a part of any viable economic entity’s cost of doing business. Income taxes are costs incurred by oil and gas pipelines in providing transportation, whether that service is provided for affiliated or non-affiliated shippers. As such, they should be included and reflected in any definition or calculation of the "actual" costs of providing transportation service. To our knowledge, all energy regulatory agencies involved in setting or approving rates for oil and gas transporters allow both an equity return and related income tax component to be included in cost-based rates, in recognition of the fact that these represent normal ongoing costs of providing service which should be included in customers’ rates in a just and reasonable amount. For most regulatory authorities, this amount is determined by calculating the actual federal and state income taxes which would be paid by the utility if the taxable income were equal to the allowed return on equity included in the approved cost of service.

If the MMS does not wish to recognize incomes taxes as a separate line item in the calculation of a transportation allowance, then it follows that the rate of return itself should be adjusted to reflect a before-tax return on equity capital. The simplest way to do this is to "gross up" the allowed rate of return on equity to include the applicable income taxes. Because most of the pipelines to which the transportation allowance will be applied are located in federal offshore waters, we suggest for simplicity purposes that the federal income tax rate be included, but any potential state income taxes be ignored. The 13% rate of return on equity we discuss and recommend above is a nominal, after-tax rate. That is, it is the equity investors’ expected rate of return after corporate income taxes have been paid. A grossed-up after-tax rate of return on equity of 13% would equate to a pre-tax rate of return on equity of 20%.

4. What is the Appropriate Capital Structure to Use

The before-tax cost of equity capital is part of a pipeline’s actual costs. The next issue is to determine capital structure, that is, the relative share of debt and equity financing in any given pipeline’s capitalization. While it would be at least theoretically possible to determine an actual capital structure for each individual facility for which a transportation allowance must be calculated, this approach would be both burdensome and problematic. The difficulties which would arise include the fact that the capital structure of the ultimate parent company of each individual transportation system will often reflect wide-ranging and diverse interests and business activities not necessarily directly related to the oil transportation industry segment for which a cost is being calculated. In addition, such an effort would result in widely diverging debt and equity ratios among transporters, which would produce a wide range in actual costs, even for very similar services.

Given the fact that the data for most integrated oil companies indicate a fairly narrow range of debt to total capital ratios, we recommend that the MMS adopt a standard capital structure to apply in the calculation of all transportation allowances for non-arm’s-length arrangements. As shown on Table 2, the debt ratios for the bulk of the companies included in the reported data range from 25% to 34%. A 30% debt ratio is consistent with both Ibbotson’s report on current debt ratios for SIC 13 and 131, and the average of the EIA’s current and 5-year average debt ratios for the Financial Reporting System (FRS) companies. Thus, we recommend using a 30% debt and 70% equity structure for calculating the rate of return applicable to the transportation allowance.

3. Conclusion

Based on the information and discussion presented above, we calculate a current pretax weighted cost of capital of 16.2%. This reflects a 30% debt and 70% capital structure, a 20% before-tax rate of return on equity, the 1999 BBB bond rate of 7.4% for debt capital, and a 35% federal income tax rate. The weighted after-tax cost of capital would be: (0.074)*(0.3) + (0.13)*(0.7) = 0.1132. Because this rate of return is just over 2 times the BBB bond rate, we recommend that for ease of administration the MMS adopt a rate of return for calculation of the actual cost of transportation under non-arm’s-length arrangements of 2x BBB.

Attachment A Page 1

CARL V. SWANSON

Dr. Swanson is President of the Swanson Energy Group, Inc., an independent consulting firm offering management and economic counsel to the energy industry and energy consumers. Dr. Swanson has been a consultant to industry and government for 35 years. He has advised managers in the energy industries on investment, acquisition, market planning, and business strategy decisions. In providing this advice he has forecasted the supply, demand and price of various forms of energy, analyzed markets in detail, interpreted governmental views, evaluated the impact of changes in the business environment, and defined the competitive position of various suppliers. He has counseled on future supply trends, risks, pricing, and contract terms. He has also helped clients to implement recommendations with training programs, new organizations, and computer-based management tools.

Dr. Swanson has presented expert testimony before legislative, judicial, arbitral, and regulatory bodies on utility rates, energy economics, markets, fuel supply, market power, demand, curtailments, prices and appropriate discount rates. Much of this expert testimony has been before the U.S. Federal Energy Regulatory Commission (FERC) on rates, regulatory restructuring and market power. He has also testified before the Legislature of California and the California Public Utilities Commission on electricity rates and rate policy, as well as the U.S. House of Representatives Subcommittee on Energy and Power.

Dr. Swanson has given numerous speeches about the energy industry. His published articles include: Economics of Regulation Call Attention to Rates, Unbundling, Supply with Elizabeth H. Crowe, Natural Gas, January 2000; Serious Pipeline Issues in 1999, Natural Gas, January 1999; Gas Prices in 1996, Natural Gas, January 1996; Drilling Results: Better but Not Great with Michael Lynch, Natural Gas, November 1993; What Sets the Price of Natural Gas?, Natural Gas, November 1985; and Strategic Changes in Pipeline Rates and Contracts: Response to Market Pricing in the Natural Gas Industry, Oil and Gas Analyst, March 1984.

Prior to founding the Swanson Energy Group, Inc., Dr. Swanson was Executive Vice President and co-founder of Jensen Associates, Inc., an energy economics consulting firm. For five years, Dr. Swanson was on the faculty of M.I.T.'s Sloan School of Management where his teaching and research focused upon the practical use of computer information systems and models to improve management decision-making. While at M.I.T., he consulted with Arthur D. Little, Inc., the RAND Corporation, the MITRE Corporation, the U.S. Army, and the Institute Nationale de la Recherche Agronomique in Paris. He is a member of the Boston Economic Club and the International Association for Energy Economics. He received the degrees of Bachelor of Science in Economics and Electrical Engineering from the Massachusetts Institute of Technology, and Doctor of Philosophy in Management, with emphasis upon Economics and Finance, from M.I.T.'s Sloan School of Management.

Swanson Energy Group, Inc.
300 Main Street
Wenham, MA 01984
(978)468-4233

Attachment A Page 2

ELIZABETH H. CROWE

Ms. Crowe is Vice President of the Swanson Energy Group, Inc., an independent consulting firm offering management and economic counsel to the energy industries. She joined the Swanson Energy Group, Inc. in 1981. Her consulting work has included:

Regulatory Analysis and Expert Testimony

• Testimony at the FERC in pipeline rate cases concerning cost of service, cost classification, cost allocation, rate design and throughput level.

• Preparation of cost of service, rates and financial schedules for pipeline certificate applications.

• Development of an incentivized cost-based ratemaking proposal for gas pipelines.

• Analysis and recommendations in FERC proposed rulemakings to revise Uniform System of Accounts and pipeline filing requirements.

• Analysis of competition on pipeline applying to participate in FERC’s capacity release pilot program.

• Feasibility analysis of FERC’s proposed negotiated services policy for natural gas pipelines.

Supply, Demand and Price Analysis

• Analysis of the competitive positions of specific natural gas pipelines through development of average cost profiles.

• Quantitative analysis of the vulnerability of a producer's sales to specific pipeline companies due to the impact of FERC Order Nos. 380 and 436.

• For a major transmission company, profiles of direct and indirect sales and end-use markets to assist in the determination of market prospects.

• Development of various databases for monitoring supplies, deliveries, prices and other developments and trends in the U.S. natural gas industry.

Prior to working for the Swanson Energy Group, Inc., Ms. Crowe held a staff position with a non-profit organization providing support services for undergraduate student groups. Other work experience includes accounting and financial analysis for a corporation in the biomedical industry. Ms. Crowe received a Bachelor of Arts in Economics, magna cum laude, from Wellesley College.

Swanson Energy Group, Inc.
300 Main Street, Wenham,
MA 01984 (978)468-4233