The Natural Gas Pipeline Capacity Release Market & FERC Enforcement

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The Federal Energy Regulatory Commission (“FERC”) is the agency responsible for monitoring and regulating the interstate transmission of oil, natural gas and electricity in the United States. This responsibility includes regulating the construction and operation of interstate natural gas pipelines under Section 7 of the Natural Gas Act (“NGA”). FERC’s jurisdiction under the NGA covers the natural gas pipeline capacity release market, also referred to as the secondary pipeline transportation market. In this market, parties that own excess pipeline capacity under existing contracts (“releasing shippers”) can sell part or all of their excess capacity to other parties who are in need of such capacity (“replacement shippers”).

In 2005, Congress greatly expanded FERC’s enforcement power with the enactment of the Energy Policy Act (“EP Act”). The EP Act allows FERC to issue civil penalties of up to $1 million per day for noncompliance with relevant federal statutes, as well as FERC orders or other regulations. The EP Act added to FERC’s existing authority allowing for disgorgement of unjust profits from non-complying activities, as well as its ability to enact non-monetary, injunctive remedies.  As a result, most enforcement cases in the pipeline capacity release market now end in a settlement, sometimes involving substantial civil penalties, because companies want to avoid the potentially astronomical fines that can result from litigating an enforcement case.  For example, in 2007, BP Energy Company agreed to pay a civil penalty of $7 million for violating one of the rules under which FERC is wielding it newly acquired enforcement powers. Fines have been even greater in other energy sectors, such as the utility market, where FERC recently assessed a $435 million civil penalty against Barclays Bank for violating a rule against market manipulation.

To date, FERC has placed much of its focus on increasing market transparency and curbing anticompetitive conduct.  This focus is magnified when applying its significantly increased enforcement power against participants in the pipeline capacity release market. The paragraphs below will discuss the three rules that FERC has applied in achieving these goals, and will use recent cases to illustrate the potential fines that companies face when they are involved in an enforcement action.

Shipper-must-have-title. This rule requires a shipper to hold title to the gas at the time the gas is tendered to the pipeline and throughout the course of transportation. The purpose of the rule is to create greater market transparency by preventing shippers from concealing their own activities, or the activities of subsidiaries and affiliates. In its 2014 Enforcement Report, FERC described this rule as “[a] central requirement of the Commission’s open-access transportation program.” This is likely the most aggressively enforced rule in the pipeline capacity release market; about half of all enforcement actions in involve violations of this rule. In 2012, ConocoPhillips Company agreed to pay a civil penalty of $545,000.00 and to disgorge $3,174,900.00 of unjust profits (plus interest) to settle an enforcement action involving this rule. FERC stated that ConocoPhillips violated the shipper-must-have-title-rule in several ways: First, by shipping 32.6 Bcf of gas owned by ConocoPhillips on capacity owned by a customer for delivery to third parties; Second, by shipping 32.1 Bcf of gas owned by ConocoPhillips on a purchased subsidiary’s capacity before the subsidiary assigned its capacity to ConocoPhillips; Third, by shipping its gas on capacity held by a subsidiary that was being eliminated before the subsidiary assigned its capacity to ConocoPhillips; Fourth, by retaining title to gas shipped by an affiliate company; and Fifth, by using uncertain or incorrect designations concerning the delivery point and timing of gas transfer. In the Stipulation and Consent Agreement with ConocoPhillips, FERC stated that “[v]iolations of the shipper-must-have-title requirement interfere with the Commission’s oversight of the natural gas markets and with the Commission’s goal of market transparency.”

Buy/Sell transactions. This rule prohibits transactions where a shipper holding interstate pipeline capacity buys gas at the direction of, on behalf of, or directly from another shipper or party, ships that gas through its interstate pipeline capacity, and resells an equivalent quantity of gas to the original shipper or party at the delivery point.  Again, the purpose of this rule is to increase the transparency and efficiency of the market by preventing shippers with excess pipeline capacity from acting as brokers of transportation capacity or assigning transportation capacity to end-use customers. This rule is heavily enforced and is usually included where there is an alleged violation of the shipper-must-have-title rule. FERC has fined companies under this rule even when the violation did not lead to unjust profits.  Sequent Energy Management, L. P. agreed to pay a $5 million civil penalty in 2009 for violating this rule and two others even though the company only derived unjust profits from violating the rule against flipping (discussed below).  The penalty is especially significant in light of the fact that the company only had to disgorge $53,728.18 (plus interest) in unjust profits.

Non-posted capacity releases. Prior to 2008, releasing shippers were required to post, but not put out for bid on the pipeline’s Electronic Bulletin Board, capacity releases of less than 31 days at less than the maximum tariff rate (the maximum price determined by FERC). Some shippers ignored the posting rule and engaged in gamesmanship to gain a competitive advantage. Two examples of this are flipping (allowing two or more subsidiary or affiliated companies to alternate discounted 30-day releases in perpetuity) and roll-overs (allowing a non-posted, less than 31-day release at a discounted rate to continue past the 30th day, or continually renewing such a contract). Such actions have the potential to greatly impair transparency within the market by continuously hiding the activities of market participants. With Order 712 in 2008, FERC removed the maximum tariff rate as the ceiling price for short-term releases, and expanded the definition of short-term releases to cover any release of one year or less. However, FERC now requires that all such transactions be posted and put out for bidding. Prior to this change in policy, allegations of flipping violations were fairly common in FERC enforcement actions regarding the pipeline capacity release market. FERC viewed Order 712 as a compromise between its goal of increasing market transparency through greater disclosure, and the shippers’ desire for greater price flexibility in the short-term capacity release market. Therefore it is likely that any shipper found to be in violation of Order 712 would face a very substantial civil penalty.

For the last several years, FERC’s annual Enforcement Report listed “anticompetitive conduct” and “conduct that threatens the transparency of regulated markets” as two of its top four enforcement priorities. The 2014 Enforcement Report states that FERC will maintain its focus on the same priorities in 2015 and the Commission will continue to use its expanded enforcement power to meet these goals. The trend toward a greater enforcement of market transparency and increased disclosure by shippers has been made abundantly clear by FERC. While this might be damaging to overall market efficiency, FERC may allow greater flexibility in other areas, such as price flexibility as seen in Order 712, to offset efficiency losses. Considering the potentially massive civil penalties for non-compliance, it is extremely important for participants in this market to remain in compliance, but also to stay aware of any changes to FERC rules and orders that may occur.

Christopher Gemondo can be reached at cgemondo@shalegaslawyers.com.

Outlook: Midstream Infrastructure in Appalachia

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The advent of unconventional drilling techniques has brought about a renaissance of epic proportions in the American oil and gas industry.  These advancements have resulted in a drastic upswing in domestic production.  Based on numbers released by the U.S. Energy Information Administration (EIA) in its recent Annual Energy Outlook 2014, the United States is on pace to surpass Saudi Arabia to be the world’s top oil producing nation.  America has already claimed the top spot in terms of natural gas production, bypassing Russia in late 2013.  In order to maintain this growth trajectory, we must continue to develop our midstream infrastructure.  Without this vital link, the unprecedented production numbers mean little.  The growing demand from foreign markets will be satisfied from other sources, and new consumption applications will never fully develop.

First, let us address the fact that the Appalachian Basin (like many others across the U.S.) is lacking vital takeaway capacity from the unconventional resources being tapped.  While there has been massive investment of capital to remedy this problem, the midstream industry is still playing catch-up.  Nowhere is this more apparent than in Pennsylvania where rig counts have dropped significantly, while Ohio and West Virginia have simultaneously capitalized in their “wet gas” windows.  Despite the exodus of rigs from Pennsylvania, the infrastructure build-out continues in much of the Commonwealth in order to service the backlog of shut-in wells, and in anticipation of the eventual reversal in rig trends.  This anticipatory approach bodes well for the future, but effects will be felt in the near-term as construction resources are spread over a larger area.  The most challenging piece of the whole midstream puzzle is matching takeaway to upstream capacity with the understanding that the upstream capacity often depends on a volatile mix of market forces.

By no means is this issue confined to Appalachia.  Even in the legacy fields of the Permian Basin in west Texas, the infrastructure problem is pervasive.  On an international level, anemic infrastructure has played a large role in suppressing more overseas investment by global E&Ps in areas where promising unconventional reservoirs exist.  Build-out will be critical for all basins to realize their full potential, and while there is progress, the collective voice of industry is clamoring for more…and yesterday.

The net effect for operators in the Marcellus and Utica has been stifled growth.  Growth is a relative term in the current market.  These companies are growing, but they could be expanding significantly faster if infrastructure needs were met.  It is important to note that a network of pipeline did exist before the shale revolution, however, it was completely inadequate to handle the volume of hydrocarbons being produced today.  Expansion of this network, as well as new growth infrastructure, needs to be taking place on every rural road from southeastern Ohio to extreme northeastern Pennsylvania.

The term infrastructure goes beyond transmission lines.  The increase in gas production equates to an increase in NGLs, which are being specifically targeted based on market commodity prices.  This translates into a need for more separation or stripping facilities and fractionation capacity.  Wells Fargo Securities recently forecasted that gas liquids production in just the Marcellus and Utica shale areas could reach nearly 1 billion barrels per day by 2018, which represents approximately five times 2012 output.  The build-out of processing plants must continue at a feverish pace to accommodate this expected increase in supply, or risk further limiting operators.

While we have emphasized what is not yet in place focusing heavily on projections and production curves, there has been significant investment and progress on many fronts.  To be fair, the geographic focus has been a moving target for the midstream community, and it has responded with a certain level of agility considering intrabasin company movement.  The anticipation has been and will continue to be the difficult part of this equation.  Without defined geographical boundaries in these plays, the exploration part of the larger process will inherently mean midstream is catching up.  Now that boundary lines seem to be more certain here in Appalachia than even a few years ago, we just might see midstream gaining some ground in 2014.

 

Christopher Gemondo can be reached at cgemondo@shalegaslawyers.com