Committee of Consumer Services v. Public Service Commission , 1979 Utah LEXIS 844 ( 1979 )

MAUGHAN, Justice:

Petitioners seek review of an order of the Public Service Commission approving an amended purchase and sale agreement, and an amended joint exploration agreement. Both of these were modified by the Commission. They related to Mountain Fuel Supply and its wholly owned subsidiary, Wexpro. The order is reversed and the matter is remanded for a hearing in accordance with the principles set forth in this opinion. All statutory references are to U.C.A.1953.

The order was predicated on the validity of the classification by Mountain Fuel of its utility and non-utility assets, and the conclusion the Commission had no jurisdiction over the non-utility assets and the transfer of those assets to a non-utility corporate entity. These conclusions were premised on the erroneous assumption there was no correlation or connection between the contributions by the ratepayers, through an annual exploration and development expense included in the rate base, and the ensuing benefits from this program.

The key to the nature of misunderstanding of the majority of the Commission is well expressed in the dissent of Commissioner Rigtrup, who stated:

The Commission’s Report and Order represents a fundamental abdication by the Commission of its statutory responsibility to protect the public interest. The result of this abdication, which allows the transfer to an unregulated company of well over $150 million worth of assets discovered and developed with funds provided by the ratepayers of this state, under prior order of this Commission, can only be characterized a regulatory outrage.

In the conclusion to his dissent, Commissioner Rigtrup stated:

I would conclude that the exploration acreage held by Mountain Fuel over the years was used or useful in its natural gas utility business, and should have always been classified as utility assets. The fact that revenues from ‘oil’ or other liquid hydrocarbons have become very significant during the last few years does not change the basic character of those assets. However, it appears that the shareholders of Mountain Fuel have come to expect an unregulated return from oil properties, for which the risk capital was largely derived in rates charged its customers as ordered by the Commission. .

In evaluating the order of the Commission, it is important to review the two avowed purposes of Mountain Fuel in creating Wexpro: first, to provide and maintain a vigorous exploration program in order that Mountain Fuel might secure natural gas reserves for the future; second, “to remove regulatory uncertainty from the non-utility properties of the company which has hung like Damocles [sic] sword over the properties and assets of Mountain Fuel since 1972.”

The latter purpose was the consequence of a finding by the Commission, in a report and order of January 14, 1974, that the oil operations were so incidental to and inseparable from the production and sale of natural gas as to be part of Mountain Fuel’s utility operations; and any other treatment would be purely arbitrary, conjectural, and speculative. The Commission had ordered the investments, revenues, and expenses of the oil operations be included in the appropriate utility accounts, for rate-making purposes. Subsequently, the Commission had rescinded the order for the “roll in” of the oil properties, but the findings were not rejected. These findings, in regard to the inseparable nature of the oil and gas operations, were the sword of Damocles Mountain Fuel sought to have beaten into a non-regulated oil derrick.

In the current order, in finding No. 42, the majority of the Commission concluded that the language of the January 14, 1974, Report and Order “with respect to the ratepayer risk, ratepayer rip-off and exploitation of Mountain Fuel customers is erroneous and should not stand as fact or law.” The dissent responded it was unnecessary for the majority to overrule the prior order. The dissent stated:

The attempt of Mountain Fuel to obtain a ruling in this case which it could not get in Case No. 6668 is not only an affront to the members of the former Commission, but should offend reasonable sensitivities of this Commission.

There are certain basic principles which should be reviewed prior to the evaluation of the positions of the contesting parties.

First, it is the duty of a public utility corporation to operate in such a manner as to give to the consumers the most favorable rate reasonably possible. This duty stems from the fact the State has conferred on the utility of the exclusive right to sell and distribute gas. As a consequence, the utility bears a trust relationship to its customers and must conduct its operations on that basis and not as though it were engaged in a private enterprise with no restrictions as to its income.¹

Second, under the general concepts of public utility law, risk capital is provided by the investor; it is this group which bears the risk of loss as developer of a public utility. It is only to the extent the facilities developed are used and useful to the consumer that they are included in the rate base.²

Third, under the “no-profits-to-affiliates” rule, any amount paid as a profit by a company to any other with which it is directly or indirectly in a control relationship cannot properly be included in the rate base. The basis of the rule is that a profit made by an enterprise dealing with itself does not represent a cost. The rationale underlying this concept proceeds from a simple premise:

If the relationship between two contracting parties is so close that they lose their individual identity and are, in fact, one, there can be no ‘actual legitimate cost’ involved in the payment of profits, since it would be tantamount to a company’s paying itself a profit for interdepartmental services. [Citations]³

Intracompany transactions cannot be used to create an artificial or inflated price to be charged consumers. ⁴

This Court would be remiss in its duty if it did not cite the findings of the Commission, wherein it is said Mountain Fuel has been permitted to pay itself a profit for interdepartmental services. Heretofore, under Mountain Fuel’s classification system, when an oil well has been developed and has been placed in the non-utility account, the non-utility account has been credited with the field price of the associated gas rather than the cost of service price. Under the amended purchase and sale agreement, there is a provision for Mountain Fuel to purchase, at market price rather than cost of service, the gas discovered on properties acquired by Wexpro, other than transferred acreage and that which comes to it under the joint exploration agreement. This provision violates the “no-profits-to-affiliates” rule.

There are certain factual aspects which must be reviewed in order to understand previous rulings of the Commission and the patent inconsistencies in the current order. We now address them.

Mountain Fuel has maintained a utility account # 105 in which has been held the unexplored or wildcat acreage. These assets have been deemed used and useful in the utility business by the Commission and have been included as capital assets in the rate base. As previously noted a utility is usually precluded from including in the rate base any capital asset, until it is developed, and then only to the extent the asset is used and useful in rendering the consumer service.

The determination of the Commission that this undeveloped acreage was used and useful in the utility business was consistent with statutory provisions. Under 54-2-1(30), the definition of a public utility includes a gas corporation, where the gas is sold or furnished to any consumer within this state for domestic, industrial or commercial use. Under 54-2-1(18), the definition of a gas corporation includes every corporation and person owning, controlling, operating or managing any gas plant for public service, within this state, or for the selling or furnishing of natural gas to any consumer or consumers within this state for domestic, commercial or industrial use. The key definition is the statutory one of gas plant.

54-2-1(17) provides:

The term ‘gas plant’ includes all real estate and fixtures and personal property owned, controlled, operated or managed in connection with or to facilitate the production, generation, transmission, delivery or furnishing of gas (natural or manufactured) for light, heat, or power.

Under this broad definition, the undeveloped acreage may properly be deemed an asset of the gas plant, because it is owned to facilitate the production of gas.

As early as 1957, the Commission found funds for exploration and development were a just and reasonable expense as part of the utility function of Mountain Fuel. As a result the company maintained accounts # 795, # 796, # 797, # 798 as utility expense accounts. Covered under these direct exploration expenses were costs for lease maintenance (delayed rentals), non-productive well drilling (dry hole exploration), abandoned leases, and other authorized exploration expenses. Since 1960, $44,981,000 has been authorized by the Commission as a utility exploration expense, which has been reflected in the rates and charges for the sale of natural gas. Between 1966 and 1976, the utility expense account paid for 73.3 percent of dry hole exploration and the non-utility account paid 26.7 percent of this expense." The utility expense account paid 95 percent of the can-celled and delayed rentals on leases and the non-utility account paid 5 percent of this expense. Of the total exploration expenses for the ten year period, $37,250,000 was paid from the utility account, and $8,222,-000 was paid by the non-utility account. It was not until 1972 that the Commission ordered the non-utility account to pay a portion of the exploration and development expenses; that year this account was ordered to bear $300,000 of the expense. In 1974, the non-utility account was ordered to pay 32.88 percent of this expense, and in 1975 the amount was increased to 50 percent.

Thus, as early as 1957, the traditional principles of utility law were modified by the Commission, e. g., generally the investor supplies the risk capital and sustains the losses in a speculative venture; the ratepayer only pays a return on that portion of the investment which is found used and useful in rendering the utility service. Although the exploration and development costs which were reflected in the rates and charges were characterized as a just and reasonable expense of the utility by the Commission, these charges were, in effect, a capital contribution to a speculative venture for the purpose of developing oil and gas sources. However, these charges can be justified under the broad statutory definition of a gas plant insofar as they are used to develop property owned, controlled, operated or managed by the gas corporation, to facilitate the production of gas.

What are the consequences to Mountain Fuel of the ratepayers being the primary source of the risk capital throughout the years? Mountain Fuel responds that the consumer benefits by being assured of a continuing supply of gas, at cost of service prices.

This response is insufficient, since under the statute the charges for exploration and development can be sustained only if they were utilized on property held as a utility asset, and the property remains classified as a utility asset after it is developed. This is so regardless of the nature of the hydrocarbons recovered. Mountain Fuel sustains a trust relationship to its customers, and it has a duty to conduct its operations in such a manner as to give to the consumers the most favorable rate reasonably possible. When the expenses to develop the utility properties were included in the rate base, the ratepayers were entitled to share in the benefit by having the net profits on the oil, and other hydrocarbon substances, sold by Mountain Fuel to others, applied to reduce the cost of gas.⁵

Mountain Fuel, according to the findings, developed a system of classification based on custom or usage. This classification was never reduced to writing by either the utility or the Commission. If the exploration and development produced a successful well, it was classified as oil or gas based on the “value of production.” This system- involved measuring the product at the well head, or field separator facility, and then comparing the field price of gas and oil. Whichever substance had greater value determined whether the site was a gas or an oil well. Thus, any disparity between gas and oil prices at the time of classification could play a decisive role in determining whether it was a gas or an oil well. If it were a gas well, the drilling costs were capitalized and the well was held in a utility account, and any incidental gas and oil sales were credited to a utility account. If it were an oil well, the drilling costs were capitalized and held in the non-utility account; any associated gas was credited at field price to the non-utility account. In addition, any acreage logically related to the discovery was transferred and capitalized in the corresponding account.

There is another aspect of the classification system which requires explanation. The substances in the reservoir or at the surface may be in either a gaseous or liquid state. These substances are passed through a surface separator which separates the primary gases from the primary liquids. The primary liquids are referred to as “separator liquids” or “stock tank liquids.” The primary gases are referred to as “separator gas.” The separator gas is then treated to remove what is commonly known as natural gas liquids; these are sold by the barrel at a price not regulated by the Commission. Gas is a hydrocarbon product, which under normal industrial standards is capable (after removal of contaminants) of being introduced into a natural gas transmission system and sold as distributor natural gas. Oil is all other hydrocarbon products, which are, under industry standards, normally introduced into a barrel or tank and sold in the market in such form. The Commission found these definitions had been employed by Mountain Fuel to separate utility products from non-utility, unregulated products. Mountain Fuel’s definition was predicated upon the end use of the product and was not dependent upon the changeable or transitory nature of the effluent from its original state in the reservoir through the field separator.

The properties in the non-utility account, under this classification system, were the subject matter of the purchase and sale agreement. In its initial determination, the Commission limited the issue as to whether the properties in the non-utility account, which Mountain Fuel proposed to transfer to Wexpro, were properly held in this account under Mountain Fuel’s system of classification. The Commission reasoned if they were non-utility properties under Mountain Fuel’s classification, the Commission had no jurisdiction. The petitioners urged until there was an evidentiary hearing to determine whether, in fact, these properties were non-utility assets, there was an insufficient factual basis to determine the issue of the Commission’s jurisdiction. We agree.

The classification of this property is of utmost importance, since this property is being transferred to Wexpro at a depreciated book value of $33.1 million. The claimed gross revenue from this property for 1976 was approximately $39 million. An expert from Mountain Fuel estimated the fair market value of the property at $150 million. If, in fact, after a hearing the property should be classified as a utility asset, the ratepayers by this transfer, would be deprived of benefits to which they are entitled.

The net effect of the Commission’s initial determination was that their jurisdiction was based on Mountain Fuel's classification. This classification, in turn, was based on the value of production; and whether the substance was deemed gas or oil was based upon the end use of the product. There is no statutory or legal basis to sustain such a classification.

The patent inconsistency in the position of the Commission is clearly revealed in their rulings and order concerning the amended purchase and sale agreement. The rationale to support the transfer was these assets were in the non-utility account, because they were not used and useful to Mountain Fuel in performing its utility function.

The order⁶ permits the transfer to Wex-pro of the non-utility oil properties and interests of Mountain Fuel as they existed on December 31, 1976. The Commission then ordered the gas in Brady-Weber formation, at blowdown, be reserved to Mountain Fuel. Mountain Fuel would reimburse Wexpro to the extent of the depreciated book value of wells utilized thereafter by Mountain Fuel to produce gas. Further, the gas reserves currently developed as utility wells at the Brady, Spearhead Ranch, Dry Piney and Birch Creek Fields were reserved to Mountain Fuel. The order further provided Mountain Fuel should receive all of the natural gas from production which was currently available to its system, from the transferred properties, at cost of service. There was also a provision that Mountain Fuel would own all gas produced and sold from the transferred properties after January 1, 1977.

These provisions are tantamount to an evidentiary finding that these transferred “non-utility properties” were used and useful to Mountain Fuel in performing its utility function; therefore, they should be classified as utility properties.

Another interesting aspect of the order concerning the purchase and sale agreement is a provision that the income, costs and expenses, associated with the extraction of natural gas liquids from the gas stream by natural condensation, or further processing, after field separation, should be shared equally by Mountain Fuel and Wex-pro. The effect of this order is to modify the definitions of gas and oil; yet the transfer to Wexpro of non-utility properties is sustained. The inconsistency arises because the product classification under which Mountain Fuel determined whether it should be included in the utility or non-utility account is modified. Yet the transfer of properties classified by Mountain Fuel’s system is sustained.

The order further provided as to properties acquired by Wexpro, other than the transferred acreage, and those properties which would come to it under the joint exploration agreement, Mountain Fuel would have a right of first refusal to purchase gas at market price. Under the order concerning the joint exploration agreement, it is provided if an oil well is discovered, the well will be capitalized in Wexpro’s accounts, and Mountain Fuel shall pay Wexpro the cost of service price for the production of any associated gas.

A review of the provisions of the two agreements as modified by the Commission clearly indicates that, by the activities performed by Wexpro, it becomes a public utility subject to the jurisdiction and regulation of the Commission under Sec. 54-2-1(30).⁷ Wexpro, by its joint activities with Mountain Fuel, particularly upon the transferred properties is both performing a service, viz., facilitating the production of natural gas, and delivering natural gas to its parent, both of which constitute Wexpro a public utility.

The Commission, in effect, recognized the utility functions performed by Wexpro by the provision in its order requiring Wexpro to cooperate in preparing the annual report and accounting of exploration and development activities, including expenses, capital costs, and revenues associated therewith on properties under, or affected by, the purchase and sale and joint exploration agreements.⁸

The order approving the amended purchase and sale agreement must be reversed, and there must be an evidentiary hearing. The Commission must reassess the transfer and determine whether the properties were utility assets. The following is the criteria by which the properties should be classified:

(1) Was the property, while undeveloped, held in the utility capital account (Account # 105), upon which a rate of return was paid by the ratepayers?

(2) Were any funds from the utility exploration and development expense accounts (Accounts # 795, # 796, # 797, and # 798) applied to the development of the acreage?

(3) Has any natural gas or natural gas liquids been produced from the acreage?

If the answer to any of these is in the affirmative, the assets are utility property. Any transfer of a utility asset should be for fair market value so an appropriate benefit therefrom will redound to the credit of the ratepayers. Furthermore, before approving the transfer of a utility asset, the Commission should determine whether the transaction is detrimental to the ratepayer, and whether it is in the public interest.

The language of the Michigan Public Service Commission in Re Michigan Consolidated Gas Company⁹ is particularly appropriate to explain the operative principles of this case. The Commission stated:

Michigan Consolidated has for many years been engaged in an exploration program to discover gas producing fields. This commission has during this period allowed Michigan Consolidated to include gas exploration costs in its ‘cost of service’ as a legitimate part of its expenses properly chargeable to its utility customers.

In its exploration program, Michigan Consolidated did not deliberately set out to discover only oil or only gas fields. It secured leases and drilled wells where geological or geophysical service indicated some promise of either event. Thus, discovery of oil fields was not by design, but rather by accident and incidental to its gas exploration program.

Michigan Consolidated developed oil production in the Big Hand field in 1963 and discovered the Hardy Dam oil field in 1966. As is the case with most so-called oil fields, these reservoirs contain both oil and gas, and both flow or are pumped through the same wellbores to the surface where the oil and gas are separated. In these fields, the resultant oil is sold to refineries. Some of the gas is used for field purposes and the remainder is vented. Michigan Consolidated’s management decided to treat these production facilities as non jurisdictional and take the profits therefrom ‘below the line’ to inure to the benefit of its stockholders.

The record shows that the gas utility customers have already paid the exploration expenses leading to the development of these oil production properties through the cost of maintaining an active geological and reservoir engineering staff, obtaining leases, and drilling exploratory wells. Until these exploratory wells are drilled, it is not possible to determine whether the ultimate production from a particular lease will be oil or gas, or both. Moreover, Michigan Consolidated has charged some dry holes related to oil production to its gas operations, while venting gas produced with the oil. We also consider it significant that gas which has been vented from the wells producing oil in the Big Hand field will soon be gathered and ultimately utilized by Michigan Consolidated in serving its gas utility customers.

Consequently, we find that these oil production facilities cannot be considered as a separate non-utility operation, but are incidental to the natural gas exploration program and a part of Michigan Consolidated’s gas utility operation. For these reasons, Michigan Consolidated’s investment in these oil production facilities, as well as the revenues and expenses associated therewith, should and shall be treated and recorded as utility plant and utility operations for rate-making and accounting purposes.

In light of the potential loss of the properties transferred to Wexpro under the purchase and sale agreement, it is equitable that Wexpro be relieved of the obligations, if it so desires, it has undertaken in the joint exploration agreement. This latter agreement contains certain infirmities since its format follows Mountain Fuel’s former system of classification of utility and non-utility properties, with the minor modification imposed by the Commission concerning natural gas liquids.

Under this agreement all acreage is held by Mountain Fuel, excepting oil producing acreage held by Wexpro. All exploration and development expenses up to $6,240,258 annually are shared equally by Mountain Fuel and Wexpro. If a gas well is discovered, Mountain Fuel pays for the costs and capitalizes it in the utility account in which it holds developed property. All oil from such a well is owned by Wexpro and obtained at cost of service of production. Acreage logically related to the well is capitalized in Mountain Fuel’s utility account. The same terms apply to Wexpro, if an oil well is discovered. The classification of a well is based upon the value of production of each commodity for a thirty day test period. Mountain Fuel pays no drilling expenses on any acreage held by Wexpro. Wexpro pays fifty percent of the drilling expenses on acreage held by Mountain Fuel in its utility plant in service account; if such a well is successfully completed it is classified as a gas or oil well in accordance with the agreement.

The joint exploration agreement, of course, does not identify the source of the exploration and development funds contributed by Mountain Fuel, viz., whether they are included in the rate base as an expense. Furthermore, the agreement does not reveal whether the account in which Mountain Fuel holds the undeveloped acreage is included in the rate base upon which a rate of return is permitted. Nevertheless, since exploration and development is a utility function to facilitate the production of gas, Mountain Fuel should receive all hydrocarbons produced to the extent of its proportional share of its contributions. Mountain Fuel’s investments, revenues, and expenses arising out of the joint exploration agreement should be included in the appropriate utility accounts for rate-making purposes.

Finally, Mountain Fuel claims the adoption of any other system of classification of their assets (than the one they advance), would constitute a confiscation of property without due process of law. This claim is without merit. Mountain Fuel’s classification was arbitrarily selected, without reference to the relevant statutory provisions previously cited in this opinion.

Mountain Fuel, in fact, would not be deprived of any property by a more realistic classification system; it would yet receive the receipts from the sale of oil. The classification of assets as utility or non-utility is strictly an accounting procedure, to reflect the reality of the situation, and no confiscatory aspect is involved. There are elements of fantasy involved in the claim that a utility asset, which has been held and developed as a utility expense, undergoes a transfiguration into a non-utility asset by virtue of the value of the type of hydrocarbons recovered. To claim the “oil” operations constitute a separate business is a straw man to distract the unwary. If the assets involved, under the tests set forth in this opinion, be utility assets, they are subject to regulation.

Where an activity or business is affected with the public interest, the courts have universally held that to subject such activity or business to regulation does not violate either the Fifth Amendment or the Fourteenth Amendment of the Federal Constitution. [Citations] . . .¹⁰

ELLETT, C. J.,^* and CROCKETT and HALL, JJ., concur. STEWART, J., does not participate herein.

1 . City of El Dorado v. Arkansas Public Service Commission, 235 Ark. 812, 362 S.W.2d 680, 683-684 (1963).

2 . Terra Utilities, Inc. v. Public Service Commission, Utah, 575 P.2d 1029 (1978).

3 .Florida Gas Transmission Company v. Federal Power Commission, C.A. 5th 1966, 362 F.2d 331, 335-336; Utah Power & Light Co. v. Public Service Commission, 107 Utah 155, 192, 152 P.2d 542 (1944).

4 . Cities Service Gas Company v. Federal Power Commission, C.A.10th 1969, 424 F.2d 411, 416.

5 . Re Pacific Gas and Electric Company, 97 P.U.R.3d 321, 335 (1973).

6 . Where reference is made to the order of the Commission, the language used in its description is largely drawn from the order itself. Such accounts for its somewhat obtuse and convoluted nature.

7 . The applicable provisions therein state:

when any person or corporation performs any service for or delivers any such commodity to any public utility herein defined, such person or corporation, and each thereof, is hereby declared to be a public utility and to be subject to the jurisdiction and regulation of the commission and to the provisions of this title. .

8 . There is further posed the serious issue of whether it is in the public interest for Mountain Fuel to divide its utility function between itself and a subsidiary. Relevant factors to be considered in this inquiry include any potential administrative inconvenience caused by the necessity of regulating two corporate entities performing, in essence, a singular utility function; and additional costs and expenses affecting the rate base.

9 . 78 P.U.R.3d 321, 323-324 (1968).

10 . Natural Gas Service Co. v. Serve-Yu Cooperative, Inc., 70 Ariz. 235, 219 P.2d 324, 329 (1950).