El Paso Case Full of Twists and Turns

No one was talking about a California energy crisis in spring 2000. But officials at the state Public Utilities Commission thought they smelled a rat.

El Paso Corp., owner of the biggest natural-gas pipeline serving California, had just sold a giant swath of pipeline capacity to its own gas-marketing company, El Paso Merchant Energy. The utility watchdogs at the PUC saw it as a classic conflict of interest. The pipeline company, they worried, might be inclined to pinch gas deliveries to California if that would raise prices for its marketing arm.

Fearing shenanigans, they filed a stern protest with the Federal Energy Regulatory Commission -- but even then never imagined how bad things would get.

By May, gas prices took off. “All of a sudden, we’re thinking, ‘Oh my God, if we’re getting killed in the summer, we’re dead meat in the winter,’ ” recalled Harvey Morris, a senior attorney at the PUC.

But the complaint to FERC sat, and while it sat, the energy crisis struck with full fury, with rising gas prices contributing to astronomical power costs.

A judge’s ruling last month that El Paso deliberately squeezed pipeline capacity to jack up prices was, in essence, a vindication of fears raised before there was any sign of trouble. The decision also could be a major turning point in the investigation of possible corporate wrongdoing in the California energy crisis of 2000-01.

If upheld by FERC, the ruling by Administrative Law Judge Curtis L. Wagner Jr. could help the state recover a portion of the $9 billion it has demanded in refunds for alleged electricity overcharges. Because many of the state’s generators are powered by natural gas, its price is a key part of the cost of electricity.

In some ways, the decision came down to simple math.

El Paso’s pipeline has the capacity to ship 3.29 billion cubic feet of natural gas a day to Southern California. Yet during the depths of the energy crisis -- a critical period from November 2000 to March 2001 -- Wagner found that the average flow was only 2.59 billion cubic feet a day, or 79% of capacity. The difference -- 696 million cubic feet a day -- would have been enough to heat about 3 million homes, or produce electricity for about 700,000 people.

With gas prices in California running two to three times higher than in the rest of the country, gas marketers would have been expected to eagerly snap up any available capacity that would let them sell in California. Interstate pipelines are legally obliged to move gas shipments between marketers and users, and are ordinarily motivated to ship as much gas as possible, because they charge for each unit they transport. But on the El Paso pipeline, the usual dynamics were skewed, according to documents filed with FERC. The reason: the great chunk of capacity that came under El Paso Merchant’s control.

El Paso, the nation’s largest pipeline operator, has vehemently denied manipulating prices, and has launched a fight to have the ruling overturned by FERC commissioners. Among other things, the company contends that safety concerns forced it to operate the pipeline conservatively, limiting gas deliveries.

Compared with the market-manipulation strategies of fallen energy giant Enron Corp. -- whose former top electricity trader in the West pleaded guilty last week to driving up prices with schemes such as “Death Star” and “Get Shorty” -- El Paso’s role in the power crisis is not so clear-cut.

Rather, the case against El Paso comes down more to circumstantial evidence than smoking-gun proof of wrongdoing. El Paso’s story -- which has been reconstructed by The Times from interviews and testimony and documents filed with FERC -- twists and turns like the thousands of miles of plumbing that carry the company’s natural gas to California.

The FERC case has now dragged on for more than 2 1/2 years. The boom-and-bust story of the El Paso pipeline spans most of a decade.

Skewed Dynamics

El Paso is the most dominant player on the natural-gas grid, with ownership of 58,000, or nearly one third, of the 180,000 pipeline miles in the U.S. Yet at times, its line to California seemed more a white elephant than gold mine.

As recently as 1996, the line had been drowning in excess capacity. Then, as now, there were four pipelines serving California, with El Paso claiming about 40% of the total capacity. Two of its smaller competitors--the Kern River pipeline and the Pacific Gas Transmission Co. pipeline -- usually ran close to full because they carried cheap gas from the Rockies and Canada. Because El Paso tapped older, more expensive wells in the Southwest, its pipeline often went begging.

A pipeline makes its money on two basic types of service. It sells “firm capacity” to marketers willing to make upfront payments to assure priority for their shipments. It also sells “interruptible” service to customers that pay only when they ship and take the risk that there won’t be space when they need it.

In the mid-90s, several of El Paso’s biggest customers, including PG&E; Corp. and Southern California Gas Co., relinquished more than 1.5 billion cubic feet -- nearly half of the pipeline’s capacity -- because of changes in the market spurred by deregulation.

In 1996, a settlement was reached to cushion the effect on El Paso and assure it could cover its costs. The customers that relinquished capacity agreed to pay El Paso $255 million.

Meantime, El Paso began looking for new customers for the 1.5 billion cubic feet, nearly half of the pipeline’s capacity, that had been returned. But along the way, El Paso locked horns with the California PUC.

The company’s practice, to this point, had been to discount transportation charges to interruptible customers -- those paying only when they ship. Such discounts accomplished two things: attracting shippers and income when regular firm customers weren’t moving gas; and preventing firm customers from gaming the market by withholding gas.

But in a deal that took effect in January 1998, El Paso stood custom on its ear. It sold 1.3 billion cubic feet of firm capacity to Dynegy Inc. As part of the deal, Dynegy had the right to reduce payments to El Paso as interruptible sales increased. Suddenly, without an incentive to promote such sales, El Paso eliminated the traditional discounts for its interruptible customers.

The PUC claimed this made it easier for Dynegy to hoard pipeline capacity and put upward pressure on prices.

For Dynegy, the strategy brought some success. During the warm winter of 1998, demand for gas was weak. As a result, a price component called the “basis spread” -- the markup on gas between the source of supply and the delivery point -- dropped almost everywhere. An exception was California, where spreads doubled from an average of 17 cents to 36 cents per 1,000 cubic feet of gas, according to documents filed with FERC.

The PUC, joined by Southern California Edison and a gas marketing firm, protested the Dynegy-El Paso pact to FERC. The commission agreed the clause in the Dynegy contract was anti-competitive, but refused to throw it out. According to FERC, the deal had helped shelter El Paso from the earlier loss of the firm customers, and had not had much effect on price.

In February 2000, Dynegy’s contract expired. But what happened next would again set off alarms for state regulators, this time even louder than before.

Preferential Treatment?

After the Dynegy pact ended, El Paso put 1.2 billion cubic feet of firm pipeline capacity up for sale. Twenty-four firms bid for a cut of that, but only El Paso Merchant made an offer for it all. Moreover, Merchant’s bid of $38.5 million was more than double the combined offers of the other firms.

Merchant won the bidding and suddenly controlled 35% of the capacity of its pipeline affiliate, far more than any other shipper. But there was more to Merchant’s winning bid than simply offering the most money.

A few days before the deadline for bids, Merchant Vice President Robin Cox contacted an official of the Mojave Pipeline Co., another El Paso affiliate. Through a connection in Arizona with the main El Paso pipeline, the Mojave line provided an important alternative route for moving gas into Southern California if bottlenecks developed.

Cox arranged a discount for shipments on that line, according to e-mails and logs filed with FERC, and also persuaded Mojave not to post the discount until the day after the bidding for the 1.2 billion cubic feet of capacity closed. Once announced, the price break would be available to all shippers. But without knowing in advance, as Merchant did, other firms were unable to factor it into their bids.

FERC regulations prohibit pipelines from giving preferential treatment to a sister firm. Under the regulations, when a pipeline gives information to an affiliate, “it must provide that information contemporaneously to all potential shippers.” It would later be determined by Wagner that El Paso had violated FERC rules in the run-up to the auction.

Yet at the time it filed its protest with FERC in spring 2000, the PUC had no inkling of the contacts between Merchant and Mojave. To the PUC, the mere existence of the deal put the state at risk.

According to the PUC, Merchant alone could afford to bid on the entire capacity, though it had no market for that much gas. Other bidders knew that if they won the capacity, El Paso would be motivated to again start promoting interruptible sales, as it had done in the days before the Dynegy deal. But by the PUC’s reasoning, Merchant knew the pipeline would not do this with its affiliate’s profit at stake.

Therefore, the PUC alleged, Merchant’s motive was “to exercise market power and artificially drive up prices by depriving competitors of heavily discounted rates.” Edison and PG&E; soon entered the case on the PUC’s side.

At first, the rhetoric far outstripped any tangible evidence of a problem. But that was about to change, thanks to a confluence of adverse events.

Pipeline Not at Capacity

By spring 2000, the state’s economic growth was boosting electricity demand. But for several years, power plant construction had been almost at a standstill. And as the air conditioning season approached, dry weather throughout the West was limiting the supply of hydroelectric power from California and the Pacific Northwest.

That meant gas-fired units would be running overtime. Predictably, prices began climbing.

For gas shipped from the San Juan Basin in New Mexico to the California border, the basis spread rose from 32 cents per 1,000 cubic feet April 1 to $1.48 by mid-August. For gas from the Permian Basin in Texas, the spread widened from 27 cents April 1 to 59 cents by mid-August. By July, spot prices at the California border were the highest in the nation.

One Edison analysis shows that during the first three months of the El Paso contract, Merchant used far less of its capacity than did other firm shippers. From June to October 2000, as prices rose, Merchant used only 54% of its capacity, well below the activity of other shippers. Even after Dec. 1, with prices soaring, Merchant’s 77% utilization trailed other shippers, documents indicate.

In August, September and then again in October, the PUC filed petitions urging FERC to act on its complaint. The message was simple: “We’re going to be in real trouble this winter ... You’ve got to do something,” Morris, the PUC lawyer, recounted.

But the winter came and went without action. Natural-gas prices increased throughout the country, but nowhere as much as in California. Price spreads, which in ordinary times were less than 50 cents, peaked at nearly $50 in December 2000.

According to the Brattle Group, a consulting firm hired by Edison, the withholding of pipeline capacity had raised gas costs about $3.7 billion from March 2000 to March 2001.

A year after the PUC complaint, FERC set the case for a hearing before Wagner. The action came March 28, 2001, two days after an article in the New York Times quoted sealed documents El Paso had turned over.

One document was a presentation by Merchant officials to El Paso Corp. Chief Executive William A. Wise on Valentine’s Day 2000, as Merchant was preparing to make its bid. According to the document, the deal would give the firm “more control” of gas markets. Another memo, dated April 14, 2000, from Merchant President Greg G. Jenkins to Wise reportedly said: “We will make money two ways: 1) increase the load factor 2) widen the basis spread.”

Decision Favors El Paso

During the hearings before Wagner, El Paso Merchant executive Ralph Eads testified that Merchant had made a profit of $184 million since buying the capacity on its sister company’s pipeline. But by the reckoning of its accusers, Merchant did even better than that.

The company also had invested in 15 California alternative-energy plants, which delivered power to the electrical grid at prices pegged to the cost of natural gas. According to the Brattle Group analysis, withholding of pipeline capacity had allowed those plants to make an extra $86.2 million, adding to Merchant’s bottom line.

Altogether, Brattle contended, Merchant had overcharged customers more than $900 million. The company denied overcharging, and said it also lost large sums on certain “hedge” sales that locked it into below-market prices.

Other evidence showed that during the critical period of November 2000 to March 2001, only small volumes of interruptible shipments had flowed on the pipeline -- despite the potent incentive of generous price spreads. Referring to an El Paso chart in which interruptible sales were shown as a series of tiny red dots, PG&E; lawyer Frank Lindh declared: “Those are droplets of blood on the defendant’s socks, Your Honor.”

During a session in August 2001, Wagner blasted the contacts between Merchant and Mojave. “If that’s not hanky-panky,” the judge said, “there’s no such thing as hanky-panky.”

Even so, the judge’s first decision, on Oct. 9, 2001, largely favored El Paso. He found El Paso and Merchant were guilty of “blatant collusion” for the secret Mojave discount. But on the most critical question -- whether the firms had exercised “market power,” unilaterally influencing supply and price -- he came down on El Paso’s side.

“While ... El Paso Pipeline and El Paso Merchant had the ability to exercise market power, the record in this case is not at all clear that they did,” Wagner said. Of significance, he said, was that the pipeline was running full or nearly full during the time of greatest need. On this, Wagner said, “all parties agree.”

As it turned out, the judge had overlooked a serious disagreement on that very point.

Conduct Challenged

The PUC and its allies mainly had focused on the conduct of Merchant, rather than the pipeline itself. Yet evidence had been presented that gas deliveries were far below the pipeline’s maximum capacity of 3.29 billion cubic feet per day.

According to the PUC and others, it’s possible that the operating data were obscured by the blizzard of reports and statistics. The PUC filed objections. But even before its appeal was filed, FERC staff joined in challenging the ruling.

“The record suggests that [unused] capacity existed on the pipeline,” the staff said in a report, adding that “even small amounts of unused capacity can affect prices during a period of supply-demand imbalance.”

“Prices at the Southern California border were very high,” the report said, “raising the question whether the pipeline made all unused capacity available to interruptible shippers.”

The staff recommended “a more complete investigation,” and on Dec. 27, FERC ordered Wagner to take another look, setting the stage for a second round of hearings in the spring.

This time, El Paso’s opponents focused on evidence that the pipeline had shipped an average of 2.594 billion cubic feet per day to California, just 79% of its capacity. During the same period, El Paso’s critics said, interruptible customers had faced unusual difficulties in getting the firm to accept their shipments.

The capacity shortfall of 696 million cubic feet reflected a “stunningly inadequate performance during a crisis of uniquely, punishingly high natural-gas prices in California,” Edison lawyer Kevin Lipson said during oral arguments on April 10.

The company offered its own explanation for the shortfall. It said 270 million cubic feet a day was due to a federal safety order to operate more cautiously in the wake of a company pipeline explosion in New Mexico that killed 12. Some 95 million was due to maintenance, and 100 million was due to the failure of regular shippers to fully utilize their capacity. El Paso attributed the remainder to stronger-than-expected demand from customers east of the California border, which forced it to curtail capacity for all its firm shippers.

“An honest disagreement amongst [expert witnesses] doesn’t come anywhere near meeting the burden of proof that what the El Paso pipeline did was unreasonable,” Bill Scherman, attorney for Merchant and former FERC general counsel, said in closing arguments.

But FERC had produced evidence that suggested otherwise. It had assigned a veteran engineer to study the pipeline operation. Robert Flanders found an alternative route for shipping gas -- a “workaround” -- that he said should have allowed the company to counteract some of the lingering effects of the New Mexico explosion.

He testified that as much as 100 million cubic feet a day of flow could have been restored by using this route. However, El Paso did not inform its shippers that the option was available.

“We’re there to transport what our shippers tell us they want transported,” testified William Healy, a vice president of the pipeline. “It’s really not my place to tell them where they should go [to] get gas.” El Paso also argued that Flanders’ bypass route was unworkable for technical reasons.

Flanders disagreed. “It’s incumbent ... on the pipeline to advise their shippers,” he testified. “It’s ... that kind of careful coordination of pipeline operations and shipper behavior that enables a pipeline to achieve a maximum design capacity.”

Markup Falls 96%

The judge sided with the enforcement staff. That accounted for 100 million cubic feet a day of the 345 million that Wagner would specifically accuse the pipeline of withholding.

Wagner also agreed that California was shortchanged out of another 210 million cubic feet a day because El Paso operated the pipeline at below-maximum-design pressures, so less gas would be pushed through the system. El Paso has countered that it would have been risky to run the pipeline any harder.

Finally, Wagner found that El Paso scheduled non-emergency maintenance work at times of peak demand, causing a loss of an additional 35 million cubic feet of gas that could have come into California.

The total came to an average of 345 million cubic feet a day -- enough to heat an estimated 1.5 million homes -- though Wagner said the amount of withheld capacity was “perhaps much much more.”

The standard of proof required to find a violation in a regulatory proceeding is not “beyond a reasonable doubt,” as in criminal cases, but “substantial evidence.” The question of intent becomes more important in assessing a penalty, which can include the return of ill-gotten profit.

In advance of a showdown before the full FERC--which can still overturn Wagner’s ruling -- El Paso has mounted a vigorous public-relations campaign, saying it has been made a scapegoat for problems caused by supply-and-demand factors and policy blunders by California’s leaders. California’s poorly designed deregulation plan and its failure to build new power plants are what really caused its energy market to implode, El Paso says.

Whatever the outcome of the dispute, California no longer need worry about the alliance between the pipeline and Merchant. When the deal expired Merchant opted not to renew the contract.

The capacity wound up being divided among some 30 shippers. And in a short time, the markup on natural gas shipped to California from gas fields in Texas fell 96%.

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Levin reported from Los Angeles and Alonso-Zaldivar from Washington.