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October 10, 2001 


El Paso Corp. Absolved of Manipulation Charges (For Now), 
But Affiliate Abuse Allegations Linger 



By Will McNamara
Director, Electric Industry Analysis 


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[News item from Reuters] El Paso Corp. (NYSE: EPG) was cleared on Oct. 9 of manipulating natural-gas prices in California, but the agency judge overseeing the case expressed impatience with company executives who engaged in what he described as "hanky panky" in arranging pipeline shipments. Curtis Wagner, FERC's chief administrative law judge, ruled that El Paso did not unfairly drive up natural-gas prices on its four pipelines into energy-starved California last year, but used blunt language in assessing the behavior of two executives with the Houston-based energy giant. Wagner said telephone records of the conversations showed "blatant collusion" between company affiliates in booking pipeline space at a discounted rate for future shipments. 

Analysis: The best assessment of this ruling in the ongoing case against El Paso Corp. is that it is a mixed bag of judgments, and only one more step in what will continue to be a very long and drawn-out case. On one hand, the FERC administrative law judge appears to be absolving El Paso Corp. of the accusations that it intentionally manipulated conditions in California to gain market power over the state's natural-gas market. That is the good news for El Paso Corp. However, on the other hand, the same judge has also intensified lingering claims that El Paso exclusively shared market-sensitive information between its affiliates, violating a FERC standard of conduct that a pipeline must give information about natural-gas transportation to all potential shippers as well as a company's own marketing affiliates. Further, as noted Judge Curtis Wagner has indicated that existing telephone records from last year indicate "blatant collusion" between El Paso Corp. company affiliates, potentially violating FERC rules that a pipeline's operating staff and the staff of its marketing affiliate function independently of each other. The next step in this case will be to determine any possible fines that might be affixed by the full FERC commission on the basis of the alleged collusion or affiliate abuse issues. 

The case against El Paso Corp. is a very complicated one, but it essentially comes down to one core issue. The case revolves around allegations that during the period of May to November 2000 El Paso improperly shared market-sensitive information with one of its affiliates, which drove up natural-gas prices, pre-empted competition from non-affiliated companies and resulted in extra costs for fuel in the range of $3.7 billion for Californians. El Paso Corp. has consistently maintained that it engaged in no wrongdoing. The case has carried enormous significance for the energy industry as it impacts not only the profits earned by El Paso Corp. but also the degree to which federal regulators may continue to intercede into wholesale markets. In addition, the other key aspect to this case is the extent to which FERC, under the leadership of new Chairman Pat Wood, will exhibit strong regulatory oversight over these claims of market abuse and issue its own harsh financial penalties against El Paso Corp. 

What is critically new about this case is the information now available from transcripts of phone conversations between El Paso affiliates. First, let me establish some background that will help to explain the significance of the transcripts. El Paso Corp. is the parent of subsidiaries El Paso Natural Gas and El Paso Merchant Energy, which are the companies in question regarding the California transactions. El Paso Natural Gas, a regulated company, operates pipelines and El Paso Merchant Energy, which is unregulated, markets natural gas. El Paso Natural Gas owns and manages the Western Division pipeline, which includes 14,604 miles of interstate transmission pipeline, serving markets in California, the southwestern United States, northern Mexico, and throughout the Rocky Mountains. In early 2000, El Paso Natural Gas awarded approximately one-third of the capacity on this interstate pipeline to El Paso Merchant Energy. This contract essentially gave subsidiaries of El Paso Corp. control over transporting about one-sixth of the state's daily demand in California. As such, this gave the El Paso affiliates between 35 and 45 percent of the Southern California gas market, clearly positioning it as the largest natural-gas provider in the state. 

As subsidiaries, all of El Paso's operations fall under FERC's "arms-length" rule, which enforces a separation between affiliated production and pipeline companies that exist within a corporate family. Since early 2001, FERC has been examining allegations that El Paso manipulated natural-gas prices in California by blocking competitors' access to the interstate pipeline. California officials have claimed that El Paso subsidiaries secretly shared information about the pipeline that was not available to other companies. Specifically, the transcripts of phone conversations between executives at El Paso Merchant and Mojave Pipeline Co., an El Paso affiliate, reportedly include comments from El Paso Merchant that inquire about a delay in publishing information about the pipeline's available capacity to all potential competitors. 

The existence of these phone records gave some credence to ongoing claims that El Paso had shared what should have been public information only with its affiliates. According to Reuters, the executive at El Paso Merchant asked the executive at Mojave Pipeline to hold off on posting competitive data about the capacity on the pipeline for a week. This allegation has important ramifications. First, the sharing of this non-public information might mean that El Paso's subsidiaries had provided preferential treatment to affiliated subsidiaries, which gave the company as a whole an unlawful advantage over competitors. Any potential abuse of affiliate standards could include the unlawful exchange of classified information between subsidiaries or the extension of discounted prices between two affiliated companies. Yet, according to Judge Wagner this sharing of information among affiliates did not contribute to a clear case of market power abuse, and in fact should be dismissed outright, which is why the ruling is such a mixed bag for El Paso Corp. 

Nevertheless, the California Public Utilities Commission (CPUC), Pacific Gas & Electric Co. and Southern California Edison may continue to fight the case with an appeal on the ruling that could be launched within 30 days. According to the California parties, this alleged manipulation cost Californians an extra $3.7 billion in unnecessary power purchase costs that the two utilities are still attempting to recover. It is important to note that San Diego Gas & Electric, California's third IOU, purchases all of its natural-gas supply from Southern California Gas and is therefore not a participant in this case against El Paso. 

In response, El Paso has repeatedly denied any wrongdoing, including market manipulation or inappropriate sharing of information between its affiliates, and thus has not violated any standards set out by FERC in its "arms-length" policy applied to affiliates. Instead, El Paso claims that the seemingly high prices that it charged in California resulted solely from nationally high gas prices. However, according to the Energy Information Administration, delivery prices for natural gas in California during the October 2000 to January 2001 timeframe were considerably higher than other national markets. For instance, during this time period, natural-gas prices in California were running near $23/MMBtu, while prices at Henry Hub and in Florida were at around $7/MMBtu. 

El Paso says the sudden drop in natural-gas prices once its contract on the pipeline expired is the result of constraints that are inherent in California's distribution system. In addition, the company claims that mild weather in the region and increased storage levels of natural gas have also driven the dramatic price swing. Further, El Paso says that it hedged most of its gas capacity into California to protect itself from potential losses, cutting potential profits in the process. The significance of this, El Paso contends, is that the company's hedging indicates that it had no foreknowledge that gas prices would be higher than normal. In other words, El Paso hedged on its gas supply because the company thought that prices would be flat or go down. On the other hand, hedging is a common practice among seasoned traders and gas traders have countered that hedged contracts are often resold at higher multiples before the gas is ultimately delivered. 

It will be interesting to see where this case goes from here. As noted, the "new" FERC that has emerged under the leadership of Pat Wood may demonstrate a decidedly lower tolerance for any allegations of affiliate abuse and consequently issue stiff penalties. In addition, it is interesting to note that other pending affiliate abuse cases have recently been launched by FERC, indicating that the commission is increasing its efforts to investigate such abuse. For instance, last week FERC ordered an inquiry into whether Exelon Corp., PECO Energy and their affiliates improperly manipulated Northeast power markets in 1999 by possibly sharing non-public information. Further, Wood has made no bones about the fact that he embraces a market philosophy that includes regulatory intervention when necessary. Consequently, Wood could very well spearhead a re-examination of FERC's methodology regarding market-based rates in markets that become deregulated, along with how merchant plants calculate their rates, and the ruling on potential fines against El Paso Corp. could be the first indication of this policy change. 


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