INGAA to FERC: include MLPs in gas pipeline equity return formula

Aug. 25, 2006
An initial US Federal Energy Regulatory Commission decision to authorize a lower return on equity (ROE) from a proposed natural gas pipeline project could jeopardize future investments if it is widely adopted, according to a white paper commissioned by the Interstate Natural Gas Association of America.

Nick Snow
Washington Correspondent

WASHINGTON, DC, Aug. 25 -- An initial US Federal Energy Regulatory Commission decision to authorize a lower return on equity (ROE) from a proposed natural gas pipeline project could jeopardize future investments if it is widely adopted, according to a white paper commissioned by the Interstate Natural Gas Association of America.

The 9.34% ROE initially found to be just and reasonable for the Kern River pipeline project is substantially less than the 12-14% FERC has authorized in most cases during the past 30 years, said Richard G. Smead of Navigant Consulting Inc.

"Even the potential that commission-approved ROEs could fall to a similar level would likely have a chilling effect on new infrastructure investment," he warned in the report issued by INGAA on Aug. 24.

"Investors would question the earning power of new investment, as well as past investment of which there has been over $30 billion in the past 10 years alone. The residual effect of such a shock to investor expectations might take years to correct, while capital would flow away from the pipeline industry in the interim," Smead said.

FERC uses a discounted cash flow (DCF) approach to determine authorized returns by adding the dividend yield rate for a series of proxy companies to a project rate of growth in earnings per share for each company. The commission then typically establishes the ROE at the median for the range of proxy companies, the white paper said.

"The primary reason that the Kern River initial decision arrived at 9.34% as the recommended ROE is that it relied upon a group of proxy companies that is not representative of the pipeline industry," it added.

Proxy group members
The paper noted that the group included three gas utility holding companies—Equitable Resources Inc., National Fuel Gas Co., and Questar Corp.—which may not be representative because of their exploration and production and local distribution businesses.

Another member, El Paso Corp., has an extensive pipeline network but is still showing the effects of the collapse of its merchant energy business, the paper said.

Only two of the proxy companies, Kinder Morgan Inc. and Williams Cos. Inc., are what it called "reasonable examples of healthy stock-traded companies with a significant focus on the pipeline business." The paper questioned even their inclusion because KMI is considering going private and Williams, while farther along, also is recovering from merchant sector problems similar to El Paso Corp.'s.

It suggested that gas pipelines operating as master limited partnerships might be more representative of today's domestic interstate gas transmission business.

FERC originally took the proxy company approach in determining an authorized ROE for a pipeline project because few gas pipeline companies were publicly traded. That has changed as more gas pipeline MLPs filed initial public offerings to a point that they now "comprise a very representative group of true, publicly traded pipeline companies to which the commission can turn for market guidance," the paper said.

It said that financial analysts now place oil and gas pipeline stocks and MLPs in a separate group from integrated oil and gas suppliers and utility holding companies. While the pipelines may transport different fuels and face different regulatory regimes, the markets and issues they face are similar: robust competition, increasingly short-term contracts, diverse and sometimes credit-weak customer bases in important growth sectors, and continuing system and market growth challenges.

'The best place'
"The commercial distinctions among interstate gas pipelines, intrastate gas pipelines, and oil pipelines have become steadily less significant in terms of equity market needs. As a result, the combined pipeline industry is by far the best place for the commission to look when determining the returns required by equity markets for investment in an interstate natural gas pipeline," the paper said.

It said that while FERC uses oil pipeline MLPs as proxy companies to determine ROE, it has excluded gas pipeline MLPs primarily because their distributions to unit-holders include a return of capital, which the commission doesn't consider comparable to stock dividends used in the DCF formula and potentially might skew investor expectation estimates.

That concern is misplaced, the white paper concluded, because an examination of actual returns to investors from gas pipeline MLPs over 5 years showed that a short-term DCF analysis for the same period would have been "a very accurate predictor of actual returns."

It emphasized that the DCF approach itself is not so flawed that FERC should consider abandoning it. "But the commission must recognize the increasingly important role that MLPs play in the interstate pipeline industry by including an appropriate mix of MLPs in the proxy group," it said.

Contact Nick Snow at [email protected].