NEWS Capacity turnbacks loom as threat to California interstate gas pipelines

!-- Pipeline compressor station at Flagstaff, Ariz., is operated by Transwestern Pipeline Co., an affiliate of Enron Corp. Transwestern is one of several U.S. interstate gas pipelines faced with dedicated capacity being turned back by customers as contracts expire in California, where interstate capacity is overbuilt. Photo courtesy of Enron. --

Capacity turnback is a major problem on the horizon for California's interstate gas pipelines. The result of interstate capacity to the state overbuilt in the 1980s, capacity turnback involves customers phasing down capacity rights once booked under long term contracts with pipelines.

The problem is growing and threatening the financial health of interstate pipelines that serve California.

Industry officials think the problem will spread to other areas of the U.S. during the next decade.

Some say the problem is likely to be manageable. Most industry observers hope for a solution to be negotiated among sectors of the gas industry. They contend significant intervention by government is likely to create new problems.

The problem

Excess interstate pipeline capacity looms as a problem in California under regulatory changes that allow local distribution companies (LDCs) to turn back space they no longer need.

All told, California's pipelines this year are operating with about one third of their capacity unused, Cambridge Energy Research Associates (CERA), Cambridge, Mass., estimates.

That surplus is about to worsen as two major interstate systems serving California, El Paso Natural Gas Co. and Transwestern Pipeline Co., face new rounds of capacity "stepdowns" from LDCs. As part of the Federal Energy Regulatory Commission's Order 636, LDCs can gradually phase down capacity rights once booked under long term contracts with pipelines.

As evidence the problem is spreading, Midcon Corp.'s Natural Gas Pipeline Co. of America (NGPC) also is grappling with capacity turnback problems in the Midwest. Industry analysts say the problem eventually will migrate elsewhere as distributor contracts expire.

"Capacity turnback is a real and potential risk for natural gas pipeline companies, not just in the overpiped California market, but throughout the U.S.," said New York analyst Paine Webber.

California woes

But nowhere is the problem more pressing than in the California market.

California's capacity glut was triggered by the multibillion dollar expansion spree planned during the 1980s. That occurred when concerns ran high that there would not be enough interstate pipeline capacity to meet projected gas demand growth in California this decade. (71370 bytes)

Two new pipelines, Mojave Pipeline Operating Co. and Kern River Transmission Co., plus expansions of three othersEl Paso, Transwestern and Pacific Gas Transmission Co. (PGT)brought more than 2 bcfd of new capacity to California during 1992-94. But demand has not grown as much or as fast as once hoped, hovering today at about 5.65 bcfd compared with pipeline capacity of 6.95 bcfd.

At some time during the next 2 decades, demand is expected to catch up to available pipeline capacity, but just when is a matter of debate.

A forecast by CERA shows the market coming into balance in 2010. The most recent California Gas Report, prepared by the California Public Utilities Commission (CPUC) using data from the state's two largest LDCs, suggests that capacity may begin to fill a few years sooner.

In the meantime, pipelines with extra space to fill are scrambling to stay healthy.

El Paso and Transwestern combined face as much as 2 bcfd in capacity turnbacks the next few years, PaineWebber notes. These could deny the pipelines revenues of about $230 million/year if none of the freed up capacity is resubscribed, the analyst said.

At issue this year is whom pipelines can bill for "stranded investment" in capacity that's not being used.

Transwestern recently had a settlement approved by FERC that splits the costs with customers during a 5 year period. El Paso proposed billing an "exit fee" to LDCsan idea FERC quickly nixedand is now back to the drawing board trying to settle a hotly contested rate case.

Midcon's approach involves adding services to make up for lost transportation revenues and expanding into new markets. The latter is an approach all interstate pipelines are likely to pursue.

El Paso's dilemma

El Paso's situation provides a timely example of the challenges at hand.

This month, the pipeline began an effort to speed resolution of its rate case by negotiating en masse with customers. Typically, such cases go through formal hearings at FERC. El Paso may still have to go that route, if the customer talks don't bring a solution by yearend.

"We're committed to reaching a settlement on contract turnback issues by the end of 1995," said Rick Baisch, El Paso executive vice-president of operations.

Yearend marks a critical juncture for El Paso.

As of Jan. 1, 1996, the pipeline faces a 300 MMcfd reduction in contract demand by its largest customer, Southern California Gas Co. (SoCalGas). It's the second cut of that scope by SoCalGas since 1992. Taken together, Baisch points out, the two cuts will reduce El Paso's firm gas deliveries to SoCalGas by 34%.

But that's not all El Paso faces.

To the north, LDC Pacific Gas & Electric recently disclosed its intent to end its 1.14 bcfd contract with El Paso on Jan. 1, 1998. In the interim, three smaller customers have options to reduce a total of another 136 MMcfd. Combined, that means El Paso could lose nearly half of its firm load between now and 1998.

To offset the effect of the upcoming turnback by SoCalGas, El Paso has proposed a $74 million rate hike. The plan currently includes allocating about $60 million in costs of unsubscribed capacity to remaining firm customers.

Because SoCalGas is still a big part of the firm customer roster, the LDC is unhappy with the plan. SoCalGas is the prime mover behind a coalition of more than 60 customers and other parties, known as the Southwest Customer Coalition, that is pressing El Paso to bear a greater share of the cost burden for unsubscribed capacity.

Opponents of El Paso's approach note that FERC made it easier for pipelines to add capacity with the understanding that they would assume greater risks if markets weren't there. Opponents also claim that El Paso could do more to build new markets elsewhere or bill new customers found for added capacity.

"El Paso has a growing off-system market for gas transported eastward to customers that are not El Paso's historical customers," said CPUC in a separate protest filed with FERC. "El Paso has allocated an insufficient amount of costs to its new off-system market."

Pipelines are still allowed to recover "prudently incurred" expansion costs, contends Skip Horvath, executive vice-president of the Interstate Natural Gas Association of America (Ingaa).

But Warren Mitchell, president of SoCalGas, claims that El Paso's expansion costs weren't altogether prudent.

"El Paso was pursuing $600 million of system expansions at a time stepdowns were foreseeable," Mitchell said. "It's not right for customers to absorb this risk."

El Paso's Baisch counters that something must be done in light of the huge cuts coming from PG&E, which was the main target of the pipeline's now scrapped exit fee concept. Under the exit fee, El Paso would have recovered revenues up front when firm customers cut 10% or more on capacity.

"PG&E is trying to force Southwest gas out of northern California and use its monopoly power to create a market for Canadian gas on its own pipeline," Baisch said. "It's not rocket science (figuring out) what PG&E is trying to do."

Embattled market

PG&E has a vested interest in keeping its PGT subsidiary pipeline full.

PGT's recent 755 MMcfd expansion brings Canadian gas into California through Washington and Oregon.

While PGT has its share of hurdles to cross in the fiercely competitive California market, immediate stepdowns by parent PG&E are not among them.

PG&E has released 405 MMcfd of capacity rights, but these weren't the same as stepdowns "because someone was there to take it" and some of the releases can be recalled, said PGT's David Dodson. The possibility of real stepdowns won't emerge for PGT until 2005.

PGT maintains that the pipeline is fully subscribed, but the load is split between firm and interruptible customers.

The pipeline appears to be doing particularly well as a peak season shipper in hot and cold months.

"We're chock full," Dodson said in early August. "Our average throughput last month was a 95% load factor."

During the first 7 months of this year, PGT averaged throughput of about 1.64 bcfd of its California border capacity of 1.8 bcfd, translating to an average monthly load factor of 92%.

Two other California pipelines, Mojave and Kern River, are also faring relatively better than El Paso and Transwestern, which historically have relied heavily on business with the state's big two LDCs.

Mojave, built to serve the enhanced oil recovery market, has been fully subscribed since the start of operation. Kern River, which serves the same market, also enjoys a relatively high load factor because the pipeline's suppliers are Rocky Mountain customers "who have nowhere else to go and have to take whatever price is necessary," an industry official noted.

That leaves El Paso and Transwestern to bear the brunt of today's market conditions, and the two pipelines have taken very different approaches.

Whereas El Paso has just started negotiating with customers, Transwestern went to the bargaining table early in the game. The settlement recently approved by FERC deals with how the pipeline will handle SoCalGas cuts of about 457 MMcfd slated to occur 11 months after El Paso's, or on Nov. 1, 1996.

The capacity turnbacks will reduce Transwestern's revenues by about $51 million/year.

To help make up the loss, Trans- western's customers have agreed to pay a surcharge that will cover 50% of the costs of unsubscribed capacity the first year, declining to 25% for each of the next 4 years. After that, Transwestern is fully at risk for making use of the capacity.

Beyond the settlement, Transwestern is also looking to expand markets outside California. Ironically, the pipeline is reconsidering an earlier plan to expand its San Juan lateralbut this time, the focus is on moving gas east to off-system markets.

Beyond California

NGPC is the bellwether for indicating how pipelines in other parts of the U.S. may be affected by capacity turnbacks.

NGPC's problems weren't triggered by a building surge. Its problems flow from major distributor contracts that are slated to expire at about the same time. As in California, NGPC shares the market with a number of competitors.

In the future, other multiple-carrier markets will experience the worst fallout from stepdown rights and contract expirations, says Gary Bartlett, executive vice-president of NGPC.

In the past, Bartlett noted, LDCs used their full contract capacity. "The trend is not to do that anymore. Distributors want to pay only for what they use and are turning back firm capacity," he said. "It's not that there's less gas flowing but less under firm contract."

Anticipating the problem years ago, NGPC began expanding into markets on the Gulf Coast, as well as on the East Coast. The pipline then began negotiating with customers and is well along in action on a new rate case.

To make its system more enticing to customers, NGPC's plan offers enhanced services, including an expanded number of receipt and delivery points and new shipping and storage rate options.

LDCs are generally happy with the increased flexibility, but not all are pleased with the proposed costs. A group of six distributors complained that NGPC's cost of service is 15% above what was agreed to in settlement and protested the pipeline's proposed rate-of-return increase.

"There are risks and opportunities going into a less regulated environment," Bartlett said. "Overall, it's good for the industry, but some will have to endure pain. We're trying to make a positive adjustment to the changes."

It's too early to tell if FERC will need to deal with the issue of standed costs for overcapacity on a larger scale, Bartlett said.

Ingaa's Horvath predicts capacity turnbacks will occur at manageable levels. "Contracts have always expired," he pointed out. "Pipelines will have to be creative in making use of unsubscribed capacity."

Horvath believes that while the volumes involved in capacity turnbacks will prove manageable, it is too early to gauge just how large the problem will be in years to come. El Paso, Trans- western, and NGPC are the first pipelines to feel the effects of capacity turnbacks, but they will be occurring nationwide the next 5-10 years, Horvath added.

For the time being, Horvath and others believe it best for policy makers to rule case by case on how to handle the costs of unsubscribed capacity and let private interests negotiate the best solutions they can.

"The more government stays out, the better it will be," said Randy Thompson, senior vice-president of Tenneco. "Just let the markets work it out."