505 F. 2d 355 - Macdonald v. Federal Power Commission

Homer J. Penn, for intervenor George Mitchell & Associates, Inc.

J. Stanley Stroud, Chicago, Ill., was on the brief for intervenor Northern Illinois Gas Co.

Paul E. Goldstein and Paul W. Mallory, Chicago, Ill., were on the brief for intervenor Natural Gas Pipeline Co. of America.

Charles F. Wheatley, Jr., Washington, D.C., entered an appearance for intervenor American Public Gas Assn.

Before WRIGHT and MacKINNON, Circuit Judges, and JAMESON,* Senior District Judge.

Petitioner congressmen challenge orders of the Federal Power Commission1 permitting a natural gas producer, George Mitchell & Associates, to increase its rates for gas sold pursuant to a 1954 contract in interstate commerce to a level about 65 per cent above that which other producers in Mitchell's production area may charge under the Commission's recently established Other Southwest Area rates.2 Since the Commission justified its grant of 'special relief' to Mitchell from the area rate by Mitchell's commitment to invest a certain level of funds in further gas exploration and production, this case requires us to exercise again our responsibility to review the Commission's efforts to respond to the natural gas shortage which all agree now confronts our nation. We recognize the broad discretion which has been entrusted to the Commission 'to devise methods of (natural gas) regulation capable of equitably reconciling diverse and conflicting interests,' Mobil Oil Corp. v. FPC, 417 U.S. 283, 331, 94 S.Ct. 2328, 2356, 41 L.Ed.2d 72 (1974), and that this discretion must be given particular respect 'in this time of acute energy shortage.' Id. However, the Supreme Court this year reaffirmed that the purposes of the Natural Gas Act, including that of protecting consumers from prices which are forced above a just and reasonable level by the market power of natural gas suppliers, impose limits on this discretion.3 And we cannot say on the basis of the record before us that the orders here challenged do not constitute a transgression of those limits.4

* The facts of this case take on greater meaning in the context of the history of federal regulation of natural gas producers. In the first several years after the Supreme Court held the Federal Power Commission to have a responsibility under the Natural Gas Act to regulate gas producers as well as pipelines,5 the Commission evaluated the justness and reasonableness6 of a producer's rates by attempting to determine the producer's individual costs, including of course its capital costs, and adding thereto a fair profit return on its investments.7 In 1960, however, the Commission announced that it would divide the major gas producing regions in the United States into several discrete areas and would initiate proceedings to establish for each of these areas ceilings up to which it would approve producer charges as just and reasonable and above which it would not.8 In the ensuing area rate proceedings, these price ceilings were fixed by reference to average area-wide costs. This meant that low-cost producers would be able to charge rates appreciably above their individual costs and that high cost producers would be limited to rates which would not permit them to obtain a full fair return on their investments or perhaps even to recoup unsuccessful investment costs.

However, in its first area rate decision, Permian Basin Area Rate Proceeding, 34 FPC 159, 225-226 (1965), the Commission made clear that the area ceilings were not to be ignored whenever a showing was made of inordinate producer costs. The Commission declared it would grant relief from the ceilings only in more limited special circumstances such as 'where a producer who has contracted for an above-ceiling price can show that his out-of-pocket expenses in connection with the operation of a particular well are greater than the revenues under the applicable area price.' 34 FPC at 226. The Commission stated that there might be other circumstances warranting special relief, but it did not elaborate on what they might be. The Supreme Court approved the Commission's area rate policy as applied in the Permian Basin Area, specifically finding the provisions for special relief to be adequate. Permian Basin Area Rate Cases, 390 U.S. 747, 770-773, 88 S.Ct. 1344, 20 L.Ed.2d 312 (1968). In subsequent decisions establishing rates for the other gas producing areas, including that for the Other Southwest Area,9 the Commission provided that special relief from the area rates could be obtained in accordance with its Permian Basin precedent.10

By October 1971 when the order establishing rates in the Other Southwest Area was entered, the seriousness of our natural gas shortage had become evident to the Commission. In 1969 the Commission had instituted proceedings to reconsider in light of supply shortages the rates which it fixed for the Southern Louisiana Area in 1968.11 The result of this reconsideration was a 1971 order increasing the ceiling rates for this area and providing incentives for commitment of additional gas to the interstate market.12 The Commission's 1970 Hugoton-Anadarko13 and its 1971 Texas Gulf Coast14 rate decisions also both provided for increased rate incentives in response to the 'present critical shortage of all forms of energy in the United States and the anticipated rapid growth of demand for natural gas.'15 As would be expected, the Commission set the Other Southwest Area rates as well after full consideration of the gas shortage. The Commission stated:

While we cannot expect that this area will be able to supply the potential demand upon it, it is important that its potential be fully utilized in this time of national need for all available gas.

* * * The prices established herein provide incentives, however, to the producers in this marginal area to find gas and dedicate it to interstate commerce. The prices established will enable the interstate market to compete in price with the present and potential intrastate buyers in the area.

46 FPC 900, 910-911, 911-912 (1971). As noted by the Fifth Circuit in approving the Other Southwest Area rate decision,16 the Commission used average cost levels as its major point of reference but also considered supply and demand imbalance and existing inter-and intrastate price levels in establishing ceiling prices which it judged would provide adequate exploratory incentives.17 It is from these Other Southwest Area ceiling prices, established in response to the natural gas shortage, that George Mitchell & Associates sought to obtain 'special relief.'

Mitchell filed its special relief petition less than a year after the Other Southwest Area decision. Under the established area rates Mitchell could sell gas produced from its Wise County region wells pursuant to a 1954 contract with Natural Gas Pipeline Company at 18.859cents per Mcf.18 It requested permission to sell this gas at 30.25cents per Mcf. In support of its request Mitchell did not argue that the costs of its Wise County area operations are significantly greater than the average costs of gas production in its district of the Other Southwest Area.19 Indeed it did not offer any evidence on its costs, or on the profitableness of its wells at the rates it was then charging.20 Rather Mitchell requested the sharply above ceiling rate in return for its promise to undertake additional exploration in the Wise County area.

After a prehearing conference had been commenced and testimony had been placed on the record, a settlement proposal agreed to by the Commission staff and by Natural was submitted by Mitchell to the Commission for its consideration. Two months later the Commission approved the settlement by a two to one vote, there being at the time two vacancies on the five-member Commission.21

The settlement reflected closely Mitchell's request for special relief. Mitchell was permitted to charge 30.25cents per Mcf both for its old flowing gas and for new gas which it had not yet discovered and committed to interstate commerce. Mitchell agreed to drill at least 125 additional wells in the Wise County region covered in the contract between Mitchell and Natural. It agreed to sell in interstate commerce all the gas obtained from such additional drilling to Natural. Mitchell also agreed to expend $16,496,847 on gas or oil exploration within the continental United States in the five years from 1973 through 1977. This $16.5 million commitment is inclusive of the cost of drilling the new wells in the Wise County region.22 It is estimated that the Wise County drilling will cost close to $9 million. Mitchell agreed to offer to sell to Natural at competitive rates all gas which it discovered in drilling outside the Wise County contract area but within 25 miles of Natural's pipeline in the State of Texas. If Natural fails to accept such an offer, Mitchell must make an effort to sell the gas in the interstate market at a price competitive with the intrastate or local market rate. Mitchell, however, has no obligation to expend any of the $16.5 million not used in drilling the 125 wells in the contract region-- an estimated $7.5 million residual-- in gas exploration close to the Natural pipeline, and gas discovered outside 25 miles from the pipeline need not even be offered to the interstate market.

The two-member Commission majority set forth a bare-boned rationable for approval of the settlement. It stressed that, although much evidence indicated the existence of major amounts of untapped gas in the Wise County area, Mitchell had been drilling in the area at a rapidly declining rate. The Commission cited studies which predicted that if no increase in drilling occurred in this region there would be in the years from 1973 to 1977 significant decreases in the gas which could be delivered to Natural from the region. The Commission reasoned that if Natural were forced to obtain its gas elsewhere its ultimate consumers would suffer because of the high price of alternative sources of gas. The Commission explained the hesitancy of Mitchell to locate and produce in the Wise County region by Mitchell's inability in five years to recoup at the rate it could charge under the area ceiling the money it would have to expend in such location and production efforts. The Commission asserted that the 30.25cents per Mcf rate requested by Mitchell for its sale of both old and new gas would be lower than any price which Natural could obtain from alternative sources23 and would not give Mitchell any 'excessive profit returns.'24

The Commission majority based its statement that Mitchell would not obtain excessive returns from the settlement on a computation which, though disputed by dissenting Chairman Nassikas and by petitioners, indicated that Mitchell in five years would obtain only $3 million in revenues from the rate increase above those funds which it would have to expend in drilling and running the wells.25 The Commission did not consider the $3 million to be 'excessive' because Mitchell was committed to expending in gas or oil exploration $7.5 million beyond that which it would have to expend in the Wise County region on the 125 new wells.26

The Commission, however, had no evidence before it on how Mitchell's past costs and profit margins at the rates it had theretofore been charging compared with those of other producers in the Other Southwest Area. There was thus no way in which the Commission could determine from the record of this case what Mitchell's overall profit margin in the Wise County region would be under the 30.25cents per Mcf rate. The disputed $3 million figure represents only an incremental profit which will derive from the settlement agreement. Furthermore, as stressed by dissenting Chairman Nassikas, in computing even this incremental profit the Commission failed to consider any revenues Mitchell can expect to obtain beyond the five-year period in which it is committed to drilling the 125 wells. Chairman Nassikas, using present value accounting and the best though admittedly inadequate data on Mitchell, computed that if these revenues are acknowledged Mitchell could expect even under the area rates to earn a handsome 20 per cent return on its exploration investment.27 Chairman Nassikas urged remand of the proceeding for a further hearing before an administrative law judge to develop a record on Mitchell's costs and profit margins. He also argued that the Commission should at least have required all extra revenues beyond those obtainable with area rates to be reinvested in exploration for gas which would have to be dedicated to the interstate market.28

We cannot agree with the Commission that the Supreme Court's recent decision in Mobil Oil Corp. v. FPC, supra, constrains us to approve the Commission's grant of special relief to Mitchell on the evidentiary record before it. The Commission's action in the instant case goes a significant step beyond that which was given approval in Mobil Oil. As explained above at pages 358-359, the Commission has attempted to address the gas shortage by developing area rates which include not only an average area cost base, but also noncost incentives for new gas exploration and production. Mobil Oil was an affirmance of the Commission's development of such area rates in the Southern Louisiana Area. Wise County is part of the Other Southwest Area, the rate structure for which was set by the Commission to provide adequate incentives for production in light of the gas shortage. The Other Southwest Area Rate structure was approved in In re Other Southwest Area Rate Case (OSWA I), 5 Cir., 484 F.2d 469 (1973), cert. denied, 417 U.S. 973, 94 S.Ct. 3180, 41 L.Ed.2d 1144 (June 18, 1974). Mitchell obtained a special exemption from the Other Southwest Area incentive rate ceilings without developing any evidentiary record to compare its costs and profit margins with the average costs and profit margins in the Other Southwest Area. We cannot conclude under the standards of appellate review of Commission orders set forth in Permian Basin Area Rate Cases, supra, and reaffirmed in Mobil Oil, that the Commission acted within its discretion in taking this additional step on the record before it.

The Mobil Oil Court focused upon three criteria of judicial review articulated in Permian Basin:

First, (the reviewing court) must determine whether the Commission's order, viewed in light of the relevant facts and of the Commission's broad regulatory duties, abused or exceeded its authority. Second, the court must examine the manner in which the Commission has employed the methods of regulation which it has itself selected, and must decide whether each of the order's essential elements is supported by substantial evidence. Third, the court must determine whether the order may reasonably be expected to maintain financial integrity, attract necessary capital, and fairly compensate investors for the risks they have assumed, and yet provide appropriate protection to the relevant public interests, both existing and foreseeable. The court's responsibility is not to supplant the Commission's balance of these interests with one more nearly to its liking, but instead to assure itself that the Commission has given reasoned consideration to each of the pertinent factors.

Permian Basin Area Rate Cases, supra, 390 U.S. at 791-792, 88 S.Ct. 1344, 1373, 20 L.Ed.2d 312 quoted in Mobil Oil Corp. v. FPC, supra, 417 U.S. at 307-308, 94 S.Ct. at 345. The Supreme Court in Mobil Oil made clear that Courts of Appeals rather than itself have the major responsibility in applying these standards of review, especially that of determining whether substantial evidence supports each of the Commission's findings.29 'Whether on the record as a whole there is substantial evidence to support agency findings is a question which Congress has placed in the keeping of the Courts of Appeals.' Mobil Oil, supra, 417 U.S. at 310, 94 S.Ct. at 2346, quoting from Universal Camera Corp. v. NLRB, 340 U.S. 474, 491, 71 S.Ct. 456, 95 L.Ed. 456 (1951).

We cannot find on the basis of the evidentiary record developed by the Commission that it 'has given reasoned consideration' and 'appropriate protection' to the public interest in not paying prices for gas substantially in excess of those needed to induce production of an adequate gas supply.30 Though the 'substantial evidence' standard has been applied with some flexibility, under any interpretation of its stringency it can be stated that there is not sufficient evidence supporting the Commission's conclusion that Mitchell will not earn an excessive profit charging 30.25% Per Mcf on both its old flowing and newly discovered gas in the Wise County region.

This deficiency in the Commission's order is critical. Protection of the consumer from profiteering in the gas industry was the primary purpose behind passage of the Natural Gas Act. 'It is abundantly clear from the history of the Act and from the events that prompted its adoption that Congress considered that the natural gas industry was heavily concentrated and that monopolistic forces were distorting the market price for natural gas.' FPC v. Texaco, Inc., 417 U.S. 380, 397, 94 S.Ct. 2315, 2326, 41 L.Ed.2d 141 (1974). The 'only justification for giving the Commission the duty to regulate prices was the determination by Congress that the producers have a supply that is so restricted in relation to demand that they have the economic power to bargain for prices that will be injurious to the public.' United Gas Improvement Co. v. FPC, 5 Cir., 290 F.2d 133, 135, cert. denied, 368 U.S. 823, 82 S.Ct. 41, 7 L.Ed.2d 27 (1961).31

The Commission determined early in its regulation of natural gas producers that protection of the consumer from these producers' market power could best be accomplished by setting rates tied to the producers' costs. In this way the producers' return on capital could be computed and held to that rate necessary to call forth needed gas supplies. As traced above, the Commission first set rates on an individual company cost basis before switching to its areawide average cost policy. The Commission's cost-based approach to regulation obtained unanimous judicial approval. As stated by Judge MacKinnon, 'When the inquiry is whether a given rate is just and reasonable to the consumer, the underlying concern is whether it is low enough so that exploitation by the producer is prevented. * * * No factors apart from producers' costs are available to guide efforts to make that determination from the standpoint of the consumer.' City of Chicago v. FPC, 147 U.S.App.D.C. 312, 332, 458 F.2d 731, 751, cert. denied, 405 U.S. 1074, 92 S.Ct. 1495, 31 L.Ed.2d 808 (1971).

The courts have also made it clear that the Commission cannot fulfill its 'responsibility to maintain adequate supplies at the lowest reasonable rate,' Mobil Oil Corp. v. FPC, supra, 417 U.S. at 321, 94 S.Ct. at 2352, by assuming without consideration of producers' costs that the market price of gas in unregulated markets is a 'just and reasonable' one. As recently as this term the Supreme Court spelled out to the Commission that in 'subjecting producers to regulation because of anticompetitive conditions in the industry, Congress could not have assumed that 'just and reasonable' rates could conclusively be determined by reference to market price.' FPC v. Texaco, Inc., supra, 417 U.S. at 399, 94 S.Ct. at 2327.32 In this case the Commission could not base a determination that Mitchell's 30.25cents per Mcf rate for new and old gas was just and reasonable solely on a comparison of this rate with alternative gas prices such as those in the unregulated intrastate gas market. Such a 'what the market will bear' approach is simply inconsistent with the Commission's regulatory trust.

We perceive no reason why the special relief provisions in the Commission's area rate orders cannot be utilized to encourage needed gas exploration.33 But when the Commission permits an individual producer to depart from an area rate structure which has been developed with reference to average area-wide costs to provide producers a necessary but not excessive profit incentive for gas exploration, its regulatory trust requires it to give complete consideration to that producer's individual costs in order to ensure that the producer's profit margin is not thereby raised to an unreasonable level.

The Commission did not give such consideration to the profits Mitchell will obtain from Natural's consumers under a 30.25cents per Mcf rate. The Commission's discussion of the estimate of the excess of 1973 through 1977 revenues from its rate increase over the costs of the new Wise County drilling surely did not constitute such consideration. As stressed by Chairman Nassikas in his dissent, the new wells drilled in the Wise County region are expected to produce gas for many years beyond 1977 and the revenues, as well as any costs, from the late years of production need to be taken into account on a discounted basis in order to calculate the incremental profit which Mitchell will obtain from the settlement agreement.34 In addition, the Commission should have obtained past cost data from Mitchell in order to compute the profits which it had been obtaining at its old rate level on its old flowing gas. Bacause area rates are computed with reference to average costs, it is very possible that these profits were much greater than the average considered reasonable by the Commission for the Other Southwest. Area.35 Mitchell's incremental profits need to be supplemented with this old profit margin to compute its new profit expectations. Only incremental profits would, of course, be directly relevant to Mitchell's decision whether to invest in additional drilling, but the Commission must consider Mitchell's overall profits to determine the general reasonableness of the rate increase. If Mitchell's profit returns on old flowing gas at its old rate were already above the area average, the Commission might decide that the rate on the newly drilled gas, but not that on the old flowing gas, should be increased so that Mitchell, rather than Natural's ratepaying customers, would bear what seemed the minimal risk of the new drilling being unsuccessful.36

A higher overall profit return derived from lower than average costs on the old flowing gas should also be relevant to the Commission's consideration of whether Mitchell's quid pro quo for its rate increase-- its exploration commitment-- is adequate. Higher profit levels would demand a greater gas exploration commitment, and greater support for Chairman Nassikas' position that all gas found by such a commitment be dedicated to the interstate market.37

We remand this case to the Commission for reconsideration of the reasonableness of Mitchell's settlement agreement in light of a full evidentiary record on Mitchell's costs of production in the Wise County contract region and the profits which it can expect to obtain over the life of its new and old wells in this region. Inasmuch as Mitchell is now in its second year of drilling toward its 125-well Wise County region commitment and the success ratio of this drilling can be determined, the Commission can make accurate estimates of the amount of gas Mitchell will be able to sell as a result of its exploratory investments.38

It is for the Commission to determine that rate level which is necessary to induce Mitchell to complete its drilling in the Wise County region, and it is for the Commission to determine whether the overall profits which Mitchell would obtain at that level are reasonable in light of any commitments to provide further gas for the interstate market.39 If made within a 'zone of reasonableness,'40 we are to respect those determinations41 as a balancing of public interests within the Commission's discretion.42 However, these determinations cannot be made without full consideration of Mitchell's costs. Absent such a full consideration, we cannot conclude that the Commission's order granting Mitchell special relief from the area rates is 'supported by substantial evidence.'43

Remanded for further proceedings consistent with this opinion.

I concur in the foregoing opinion except as to part of footnote 2. It is my opinion that since Congressman Macdonald is clearly not aggrieved by the order, this court lacks jurisdiction over his petition under section 19(b) of the Natural Gas Act, 15 U.S.C. 717r(b). It is unnecessary to consider the further question whether his petition would satisfy the case or controversy requirement of Article III of the Constitution.