Pipeline Economics
Understand how pipeline transportation rates are set using FERC cost-of-service methodology, rate base principles, and weighted average cost of capital (WACC) calculations.
The Federal Energy Regulatory Commission (FERC) regulates interstate oil and natural gas pipelines under different statutory frameworks, each with distinct ratemaking methodologies.
Oil Pipelines: Regulated under the Interstate Commerce Act (ICA) with three rate-setting options: Index, Cost-of-Service, or Market-Based.
Natural Gas Pipelines: Regulated under the Natural Gas Act (NGA), primarily using cost-of-service rates with negotiated rate alternatives.
The Energy Policy Act of 1992 directed FERC to establish a simplified ratemaking methodology for oil pipelines. The result is the Index methodology, which uses an inflation-adjusted rate ceiling.
Index Rate Ceiling
New Ceiling = Prior Ceiling × (1 + Index)
Index = PPI-FG + Adjustment Factor (currently PPI-FG - 0.21% for 2021-2026)
The Index allows pipelines to raise or lower rates without filing a full cost-of-service justification, as long as rates remain at or below the ceiling.
If a pipeline's costs diverge substantially from what the index allows, it may file for cost-of-service rates. This requires demonstrating that the indexed rate is not "just and reasonable" for that specific pipeline.
| Rate Method | When Used | Regulatory Burden |
|---|---|---|
| Index Rates | Default for oil pipelines; annual ceiling adjustments | Low - simple filing |
| Cost-of-Service | New pipelines, substantial cost divergence | High - full evidentiary case |
| Market-Based | Demonstrated lack of market power | Medium - market power analysis |
| Settlement Rates | Negotiated with shippers | Medium - requires shipper consent |
A pipeline may seek authority to charge market-based rates if it can demonstrate a lack of market power. This requires showing that shippers have good alternatives (other pipelines, trucks, barges) and the pipeline cannot exercise monopoly pricing.
The cost-of-service methodology calculates the total annual revenue a pipeline needs to recover its costs and earn a fair return on investment. This "revenue requirement" is then divided by projected throughput to determine the tariff rate.
Revenue Requirement
RR = Depreciation + Return + O&M + Taxes
Total annual revenue needed to cover all costs and provide allowed return
Tariff Rate
Tariff = RR / (Throughput × 365 × Utilization)
Revenue requirement divided by annual transported volume
The return component allows the pipeline to earn a fair profit on its investment. It is calculated as the rate base multiplied by the weighted average cost of capital (WACC).
Depreciation provides for recovery of the original capital investment over the useful life of the facilities. FERC typically approves straight-line depreciation.
O&M costs include all expenses necessary to operate and maintain the pipeline system.
The tax allowance ensures the pipeline can earn its allowed equity return after paying federal and state income taxes.
The rate base represents the capital investment on which the pipeline is entitled to earn a return. Per FERC Opinion No. 154-B, oil pipelines typically use "original cost" methodology.
Rate Base
Rate Base = Original Cost + Working Capital - Accumulated Depreciation
Net investment on which the pipeline earns its allowed return
| Component | Description | Treatment |
|---|---|---|
| Carrier Property | Pipeline, pumps, meters, tanks, SCADA | Original cost less depreciation |
| Working Capital | Cash needed for day-to-day operations | Typically 1/8 of annual O&M |
| AFUDC | Allowance for funds used during construction | Capitalized interest during build |
| Deferred Taxes | Timing differences in tax depreciation | Reduces rate base (ADIT) |
FERC's Opinion No. 154-B (1985) established the cost-of-service framework for oil pipelines that remains in use today. Key features include:
The Weighted Average Cost of Capital (WACC) determines the overall return the pipeline is entitled to earn on its rate base. It blends the cost of debt and equity based on the capital structure.
WACC Formula
WACC = (E/V × Re) + (D/V × Rd × (1-T))
Where: E = equity, D = debt, V = total capital, Re = cost of equity, Rd = cost of debt, T = tax rate
FERC uses a Discounted Cash Flow (DCF) methodology to determine the allowed return on equity. The two-stage DCF model projects dividend growth at different rates for the short and long term.
DCF Model for ROE
Re = (D1 / P0) + g
Dividend yield plus expected growth rate
Recent FERC decisions have approved equity returns in the following ranges:
The capital structure used in WACC should reflect the actual or hypothetical financing of the pipeline. FERC typically accepts a "hypothetical" capital structure if the actual structure is deemed unreasonable.
| Component | Typical Range | Notes |
|---|---|---|
| Debt Ratio | 40% - 60% | Higher debt lowers WACC but increases risk |
| Equity Ratio | 40% - 60% | Provides cushion for debt service |
| Cost of Debt | 4% - 8% | Based on embedded or current rates |
| Cost of Equity | 10% - 14% | DCF-derived; risk-adjusted |
After-tax cost of debt: 6.0% × (1 - 0.25) = 4.5%
WACC: (0.50 × 12.0%) + (0.50 × 4.5%) = 6.0% + 2.25% = 8.25%
The revenue requirement represents the total annual revenue the pipeline must collect to cover all costs and earn its allowed return. Understanding each component helps identify the drivers of tariff rates.
Consider a $150 million crude oil pipeline with the following parameters:
| Component | Calculation | Amount ($MM/yr) | % of Total |
|---|---|---|---|
| Depreciation | $150MM / 30 years | 5.00 | 22% |
| Return on Rate Base | $150MM × 8.25% WACC | 12.38 | 54% |
| O&M + G&A | Annual operating expenses | 4.00 | 17% |
| Income Taxes | Grossed-up equity return | 1.50 | 7% |
| Total Revenue Requirement | 22.88 | 100% |
With the revenue requirement established, divide by annual throughput to determine the tariff:
Effective Throughput: 100 × 0.85 = 85 Mbbl/d
Annual Volume: 85,000 bbl/d × 365 = 31,025,000 bbl/yr
Tariff Rate: $22,880,000 / 31,025,000 = $0.738/bbl
Pipeline tariffs can be structured in various ways depending on the service type, regulatory framework, and commercial arrangements.
A per-unit charge based on the volume transported. Most common for oil pipelines.
Example: $0.50/bbl from Point A to Point B
Charge per unit per mile, often used for long-haul pipelines with multiple receipt/delivery points.
Example: $0.003/bbl-mile
Combines a fixed reservation charge with a variable throughput charge. Common for natural gas pipelines.
Example: $5,000/month + $0.10/MMBtu
Discounted rate offered to shippers who commit to long-term volume commitments.
Example: 15% discount for 10-year acreage dedication
| Structure | Description | Risk Allocation |
|---|---|---|
| Minimum Volume Commitment (MVC) | Shipper commits to minimum monthly volume; pays deficiency if short | Volume risk to shipper |
| Take-or-Pay | Shipper pays for committed capacity whether used or not | Volume risk to shipper |
| Acreage Dedication | All production from specified acreage must use the pipeline | Shared; depends on production |
| Fee-Based / Cost-Plus | Pipeline reimbursed for actual costs plus margin | Cost risk to shipper |
Pipeline tariffs vary widely based on commodity type, distance, pipeline age, competitive alternatives, and contract structure. The following benchmarks provide general guidance.
| Pipeline Type | Tariff Range | Unit | Notes |
|---|---|---|---|
| Crude Oil - Long Haul | $0.30 - $1.50 | $/bbl | Permian to Gulf Coast typical |
| Crude Oil - Gathering | $0.50 - $2.00 | $/bbl | Wellhead to hub |
| NGLs / Y-Grade | $0.02 - $0.05 | $/gallon | ~$0.84 - $2.10/bbl |
| Refined Products | $0.02 - $0.04 | $/gallon | Regional variation |
| Natural Gas - Interstate | $0.15 - $0.50 | $/MMBtu | Long-haul transmission |
| Natural Gas - Gathering | $0.20 - $0.60 | $/MMBtu | Includes compression |
| Metric | Range | Notes |
|---|---|---|
| Pipeline CAPEX | $50,000 - $200,000/in-mile | Varies by terrain, ROW, regulation |
| Pump Station | $15 - $50 MM each | Depends on HP and redundancy |
| Annual O&M | 2% - 5% of CAPEX | Higher for older systems |
| Asset Life | 25 - 40 years | FERC depreciation period |
Pipeline tariffs are driven primarily by capital intensity (rate base and return) rather than operating costs. For a typical pipeline, return on investment represents 50-60% of the revenue requirement, while O&M is only 15-25%.
Use our Pipeline Tariff Calculator to determine required rates for your project.
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