Third, we can find some means of severing the integrated company from pipeline ownership. This will not only resolve the basic problems of equitable access and effective rate regulation; it would substantially reduce the amount of necessary regulation.

In the end the choices are among private monopoly, massive government regulation, or free enterprise. To permit the continued exercise of private monopoly power under inadequate and ineffective regulation in this vital energy area would be irresponsible. On the other hand imposing the massive regulation necessary to control this power runs counter to all we have learned about regulation over the past decade. Nothing in that experience suggests that such an effort would be successful.

This leaves us with trying to minimize the need for regulation by removing those incentives and opportunities that make such regulation necessary. In our present dilemma, divestiture is by far the least radical solution. It will permit the maximum responsible reliance on the unfettered activity of private business.

PREPARED STATEMENT OF JOHN H. SHENEFIELD

I welcome the opportunity to present the views of the Department of Justice on the subject of divestiture in the oil pipeline industry. My testimony today is consistent with prior statements by Department officials on the competitive problems of vertically-owned and integrated pipelines. One of those statements, the Attorney General's 1976 Deepwater Port report, established the analytical framework that has been followed by the Department since that time. As the Committee may be aware, in the past 2 years, the Antitrust Division's longheld competitive concerns about the petroleum pipeline industry have turned to action on many fronts. Because of the competitive significance of oil pipelines, we have dedicated substantial resources to this area. These efforts have run the gamut from open dialogue with industry representatives to full participation in administrative hearings. In between has come continuous documentary, economic and legal study of the industry, and the communication to others of what we-in what amounts to almost a task force approach-have learned. Those views have principally taken the form of advice to Federal leasing, permitting or licensing authorities, and statements to congressional committees, such as this one, properly concerned with the potential anticompetitive impact of petroleum pipelines.

Our efforts have provided us with a unique vantage point from which to observe the relationship of this regulated industry to those Federal agencies that regulate or otherwise have attempted to license or control it. By this process we have been able to test the validity of the economic analysis we developed to explain and predict the market behavior of petroleum pipelines owned and operated by vertically integrated oil companies. My purpose today is to explain in detail how and why these conclusions point strongly toward pipeline divestiture. To put this discussion in the proper framework, I would like to begin with a general overview of the industry.

I. INDUSTRY OVERVIEW

The pipeline industry is, in many respects, invisible. Buried underground, the lines are out of public view and pipeline transportation is hardly a consumer item. This invisibility belies how important petroleum pipelines are in two major sectors of our economy: transportation and energy. I put transportation first because of the little known but surprising fact that oil pipelines regularly account for up to onefourth of all ton-miles of freight shipped in all forms of inter-city freight transportation.' But as important as pipelines are as transportation networks, they take on an added significance by virtue of the identity of the sole commodity they carry-petroleum, from un

1 Statement of Ulysse J. Legrange, ICC Proceeding, Ex Parte No. 308, May 23, 1977 (now FERC Dkt. No. RM 78–2).

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processed to refined. In fact, pipelines have a significant role at two stages of the petroleum industry: as crude lines, they provide the key link between crude production and refining, and as product lines they connect refining centers with product markets. More oil-crude or product is moved more miles in the United States by pipeline than by any other transport mode.2

A. Industry growth

Historically, crude lines developed before product lines. By the early 1930's, for example, the railroads' share of interstate crude shipments had dwindled to 3 percent, but they still carried 75 percent of product shipments. Today, crude lines' share of total crude movements is still larger than product lines' share of all product movements, owing largely to the need for extensive use of trucks on surface streets to carry product to local markets.

6

Major advances in the development of modern, large diameter oil pipelines occurred during World War II with the construction of the Federally-sponsored Big Inch and Little Big Inch Pipelines. These pipelines, at 24 and 20-inch diameters and capacities of 300,000 and 235,000 barrels/day of crude and product, respectfully, demonstrated to the private sector the feasibility of large diameter pipelines. Despite the success of these lines, post-war movement in the industry to large diameter pipelines was relatively slow, especially for product pipelines. The 1950's and 1960's, however, market the advent of the large diameter joint venture crude and product lines, such as Capline and Colonial. Now, in the post-Arab embargo era, with perhaps the exception of TAPS and its progeny, growth trends have been largely confined to adding capacity to existing lines rather than building large new pipelines over different routes. However, the rate at which significant geographical shifts in demand for pipeline transportation-crude or product-have occurred has traditionally been very low.

Another significant pipeline industry characteristic is the level of ownership dominance that vertically integrated petroleum companies have obtained. For example, 1975 date 10 reveal that there were 104 common carrier pipelines subject to Interstate Commerce Commission (ICC) jurisdiction. The ICC categorized ten of these lines as independents, 59 lines as affiliated with a major oil company, that is, one of the top 20 in sales, and 35 as affiliated with non-major, oil related companies. This listing included 42 pipelines which were joint venture stock companies, of which 5 were owned by non-major, oil-related companies and the remaining 37 by major oil companies. In addition, the ICC listed separately 27 undivided interest pipeline systems operated as common carriers. In some respects, these figures tend to understate the extent to which petroleum companies (majors and non-majors) dominate the pipeline industry. In 1975, the pipelines affiliated with oil

* Senate Comm, on Energy and Natural Resources, National Energy Transportation Report, Vol. I, Publ. No. 95-15, 95th Cong., 1st Sess. 182-84 (1976) (NET).

a Id. at 169.

Id. at 143, 184.

Id. at 173-74.

Id.; A. Johnson, Petroleum Pipelines and Public Policy, 1906-1959, at 325 (1967).

7 NET at 181.

Id. at 190-93; Johnson at 382-83.

NET at 206.

10 Statement of David L. Jones, Ex Parte No. 308, at 8-9 (April 28, 1977) (hereinafter cited as Jones).

companies accounted for 98.6 percent of all crude barrel miles and 86.9 percent of all product barrel miles." The corresponding figures for independent pipelines were 1.4 percent and 13.1 percent.12

B. Industry economics

Pipeline economics play a key role in the structure of the pipeline industry. There are two important principles involved. First, as to competition with other modes of transport, pipelines are the most efficient (ie., cheapest) overland transport mode for the movement of significant, sustained quantites of petroleum between any two given points.13 Even where there is waterborne competition, the larger diameter lines, which include most interstate lines constructed in recent years, are equally, if not more, efficient. Second, as to competition within the pipeline transport mode itself, pipelines exhibit great economies of scale resulting from the technological fact that pipeline capacity varies with the square of the radius of the pipe. This means, for example, that a 36" diameter pipe will carry nine times as much oil as a single 12" diameter line, or three times as much as three separate 12" lines. Since construction costs, for the most part, reflect a more linear progression, throughput costs steadily decline as pipeline size increases (assuming that utilization increases correspondingly). This phenomenon of declining unit costs has been observed to take place over the entire existing range of technologically feasible pipeline sizes, which are now approaching diameters exceeding 4 feet. As a result, in almost all circumstances, one properly sized pipeline will be more efficient than two or more in satisfying the available transportation demand between any two given points.

These two basic economic facts-premier cost efficiency and tremendous economies of scale-are usually referred to as the "natural monopoly" characteristics of pipelines. It does not necessarily follow, however, that because all pipelines have natural monopoly characteristics that each and every pipeline has monopoly power. I will explore the requisites of monopoly or market power more fully shortly, but I would emphasize here that the natural monopoly characteristics of pipelines are generally so significant that it would not be surprising to find that between any two given overland points with a petroleum transportation demand, a single pipeline is the lowest cost, if not exclusive, means of transport. A second pipeline, or a more expensive transportation mode, such as rail tank cars, could not hope to compete effectively, and the pipeline's monopoly is the natural result of ordinary economic and technological forces, rather than monopolizing or predatory behavior.

These basic principles have been well understood by the pipeline industry since its earliest days, when its cost efficiencies over rail transportation first emerged. Those advantages soon led to substantial abuses of market power by the old Standard Oil trust,15 precipitating the Hepburn Act in 1906,16 a congressional decision that pipelines

11 Id. at 17-18. The numbers quoted in the text are arrived at by adding together separately stated figures for major and non-major petroleum companies. 12 Id.

13 NET at 213-14.

14 See, e.g., Report of the Attorney General Pursuant to Section 7 of the Deepwater Port Act of 1974 on the Applications of LOOP, Inc. and Seadock, Inc. for Deepwater Port Licenses, at 28 (November 5, 1976) (Deepwater Port Rept.).

15 Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).

10 34 Stat. 584 (1906).

should join railroads as subjects of regulation by the ICC. I am sure this committee is quite familiar with that bit of history, and I won't dwell on it except to note that it makes clear that regulation under the Interstate Commerce Act was intended to curb pipeline monopoly power in two ways: (1) directly, by limiting rates to just and reasonable levels; and (2) indirectly, by imposing operational, common carrier obligations of fairness and nondiscrimination on the pipeline owner in its treatment of any and all potential pipeline shippers. I will conclude my overview with a few brief comments on the efficacy of those regulatory curbs during the past 70 years.

C. Industry regulation

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The primary and most direct means for effective control of oil pipeline abuses of their market power is rate regulation. Unfortunately, however, oil pipeline rate regulation to eliminate monopoly power has proved an elusive goal ever since the passage of the Hepburn Act. Shortly after the enactment of that legislation, the industry mounted an unsuccessful constitutional challenge to the concept of rate regulation." By the time that litigation was concluded, however, Congress had, in 1913, passed the Valuation Act, which required the ICC to establish a "valuation" for each railroad and pipeline subject to its jurisdiction. Traditionally, that valuation was based on inflationadjusted cost indices, component-by-component, and periodic adjustments to reflect some approximation of current or "fair" value of the facility. This task, however, was not even begun for pipelines for over 20 years, the priority of valuation funds and ICC efforts going instead to the railroads until 1934.19 During this period, there were simply no standards for just and reasonable rates. Pipeline rates were, by any measure, truly monopolistic. For example, even at the depths of the Depression, the pipeline industry as a whole was earning extraordinary before-tax returns on depreciated investment of up to 34 percent.20

In the 1940's, with initial pipeline valuations largely established, the ICC finally set rate of return standards for the industry-8 percent on valuation for crude lines,21 10 percent for product lines. 22 Despite the fact that these benchmarks applied industrywide and took no account of individual pipeline risks or other pertinent factors, these standards went unchallenged, unreviewed and unchanged for well over a quarter century. It was not until the mid seventies that the ICC responding to complaints about rates paid shippers on an independent line 23-initiated a general, industrywide rulemaking into the rate base and rate of return standards historically applied.24 After a somewhat uncertain beginning, that proceeding is well underway, now before the Federal Energy Regulatory Commission (FERC), with the Department an active participant in defining the issues.

17 The Pipeline Cases, 234 U.S. 548 (1914).

18 49 U.S.C. § 19a.

19 A. Johnson, supra at 240-41.

20 L. Cookenboo, Crude Oil Pipe Lines and Competition in the Oil Industry 98 (1955). Reduced Pipe Line Rates and Gathering Charges, 243 I.C.C. 115 (1940); Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41 (1944).

Petroleum Rall Shippers' Ass'n v. Alton & Southern Railroad, 243 I.C.C. 589 (1941). Petroleum Products, Williams Brothers Pipe Line Company, 355 I.C.C. 479 (1976). Interstate Commerce Commission, Notice of Proposed Rulemaking and Order [49 C.F.R., Chapter X], Valuation of Common Carrier Pipelines. Valuation Dkt. No. 1423 (1971 Report) and (1972 Report) (Service Date: September 3, 1974).