How Texas firm outfoxed state, PG&E

Kevin Fagan, Bernadette Tansey, Chronicle Staff Writers

Sunday, May 13, 2001, ©2001 San Francisco Chronicle

URL: http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2001/05/13/MN166857.DTL

El Paso Energy was facing ruin.

It was the mid-'90s, and California's energy overseers were sure deregulation was going to drive the cost of natural gas through the floor. So Pacific Gas and Electric Co., with the happy acquiescence of the state, dumped a huge, long-term gas contract with El Paso.

For the state, the decision was a no-brainer: PG&E was buying more space on gas pipelines than it needed. For El Paso, though, it was a disaster. The company started handing out pink slips like they were candy.

But in the long run, it wasn't El Paso that would end up on its knees. It would be PG&E and the state of California. That pipeline space that the utility and regulators saw as unnecessary would soon become precious -- and El Paso, led by a law-sharp chairman with bare-knuckle smarts, would turn itself into the biggest natural gas firm in the world.

So big, in fact, that in the eyes of vengeance-minded lawmakers and regulators, El Paso has become a poster monster for how Californians came to be plagued by rolling blackouts and sky-high energy bills. "They didn't mind seeing all of us at El Paso being dealt a terrible blow back then," said Randy Wu, an El Paso manager then. "And now . . well, let's just say they should have planned better." -- -- --

It's not like El Paso was some new kid on the block. The company was founded in Texas in 1928 and stayed a local concern until 1947, when it laid out 700 miles of pipeline to deliver gas to California.

It grew steadily from there until 1964, when the U.S. Supreme Court decided El Paso was getting too big and ordered it to divest its pipeline holdings in the Northwest. That set off a long tumble that William Wise, who had started at the company as a general counsel in 1970, set out to reverse when he took over as president in 1989.

Wise, a 56-year-old whose lean build reflects both his passion for running and his reputation for driving himself hard, is a rare bird in the world of oil. The University of Colorado law school graduate has mastered both the legal side of his "litigious" industry, as he once called it, and its hardball economic strategies -- skills he honed by surfing the bust-boom cycles of his business at its epicenter, Texas.

Those skills came in handy when El Paso got the hammer blow from PG&E in 1996 and 1997. PG&E had been buying extra space on pipelines crossing into the state at the Arizona ghost town of Topock -- enough to import a whopping 1.1 billion cubic feet of natural gas a day.

The trouble for El Paso was that when PG&E dropped the contract for the pipeline space, $170 million of the company's annual revenue was erased. "It seemed like everyone thought the company was toast," said Wu, the former El Paso manager. "Of course, California didn't care at all."

But Patrick Power, the attorney hired by El Paso to plead the pipeline company's case before the state Public Utilities Commission back in 1996, could see trouble looming for the state. If PG&E and other utilities didn't keep the pipeline capacity to meet future needs, he warned, they would probably regret it later. His words fell on deaf ears.

"The mentality at the PUC, PG&E and Southern California Gas was, 'This will be El Paso's problem,' " Power said. -- -- -- Wise reacted to the loss of the PG&E contract by taking no salary himself for a year and freezing his executives' pay, Wu said. While laying off more than one-third of the company's workers, he and his staff negotiated a hefty settlement from PG&E and other companies in exchange for their having dropped the pipeline space.

Then Wise set off on a plan to absorb other pipeline companies so he could expand his system of delivering natural gas throughout the United States. "Bill Wise knew California had turned its back on the company, so he had to get creative," Wu said of Wise, who has declined interview requests from The Chronicle.

"Attorneys generally don't have a lot of common sense in my mind, but Bill - - he's got extra," said former El Paso Mayor Larry Francis. "He cuts his losses in a hurry, and he recognizes when he has to move on. And so he moved."

Within a few years, Wise stretched the now Houston-based company to full "wellhead to wire" operations, running everything from natural gas drilling to electric generation plants. Before El Paso embarked on this expansion, California constituted fully two-thirds of El Paso's natural gas sales -- much of that to PG&E.

The strategy was that if the state was going to ditch El Paso, El Paso would make sure its reach became so extended in other directions that it would never be dependent on one market again.

Wise's company scooped up interests in 40 electric power plants in 11 states by April 2000. Along the way, it spent billions acquiring enough pipeline companies to spread the El Paso reach along 58,000 miles of pipe nationwide, from Bakersfield to Boston.

"The company was a very traditional gas company until then," said Fred Pickel, a Los Angeles energy consultant who has observed El Paso since the 1970s. "Wise, though, understands the street-level complexities of the business, and what he had the company do was partly smart and partly logic. "He was just able to see the possibilities that nobody here in California was able to see."

But some believe that what El Paso did to take advantage of those possibilities took unfair advantage of California. In his cluttered downtown San Francisco office at the PUC, staff attorney Harvey Morris thought he "smelled a rat" as long as three years ago.

Morris, a natty 47-year-old graduate of Boalt Hall School of Law, takes on the look of a determined terrier when he outlines his suspicions about El Paso -- and he's been carrying that look a long time now.

After losing PG&E, El Paso leased the utility's entire block of pipeline capacity to another Texas gas and electricity giant, Dynegy. Gas experts were stunned that one firm would bid for all that space -- but they, and Morris, were even more surprised by what followed.

Dynegy didn't behave the way PG&E and California officials had expected energy companies to behave in the era of deregulation. Like PG&E, Dynegy didn't need all that pipeline space to serve its own customers. But unlike what PG&E did when confronted with all that extra space, Dynegy didn't resell it at a huge discount. In fact, Dynegy didn't sell any of the space. Instead, it raised the price so high that seemingly nobody wanted to buy it.

Competing gas marketers were alarmed. They suspected that Dynegy was collaborating with El Paso to constrict the supply of gas flowing into California so prices would rise. Great for anyone with space reserved on the pipeline -- but disastrous for those left out in the cold.

In 1998, having convinced his bosses at the PUC that what El Paso was doing on the Dynegy contract was anticompetitive, Morris filed the first of many complaints with the Federal Energy Regulatory Commission. He's still pursuing them. As it turned out, spot prices didn't rise while Dynegy held the contract; gas shippers could still find space on other pipelines for less money. Dynegy let the contract lapse in late 1999.

Not long afterward, the pipeline contract wound up with El Paso's market affiliate, El Paso Merchant Energy. And that's when things started to get really serious, Morris says. El Paso's own marketing arm now controlled more pipeline space heading into Southern California than any other trader by far -- just as the demand for gas was about to soar.

In his many filings, in which the PUC has been joined by Southern California Edison and others, Morris contends that El Paso Merchant Energy prevented pipeline space from being used. "They basically kept so much of the capacity to themselves, the prices went through the roof," he said. "It was the same as closing off part of the pipeline."

El Paso officials, for their part, say market rates started soaring in 2000 simply because the demand for gas overwhelmed supply. They say they never charged more than what industry rules allowed, and that attempts to prove otherwise are preposterous.

And thus far, except for a mild rebuke here and there on technicalities, the free-market-minded Federal Energy Regulatory Commission has not concluded the company did anything wrong -- though a commission hearing is set for tomorrow on the latest allegations filed by PG&E, Edison and the PUC.

Edison estimates that El Paso's "manipulation" at Topock jacked up rates all over the industry so badly that state gas buyers had to pay $3.8 billion more than they should have just in the past year. Whatever the reason, the bottom line is that gas prices in California have been anywhere from two to 10 times as expensive as on the other side of the border in Arizona, and in almost every other state.

Once prices started to rise at Topock, gas marketers throughout California followed suit -- and the ripple spread quickly. Gas prices for consumers started going up. The rise also propelled electricity costs skyward, because three out of every five electricity plants in California run on natural gas.

The firms that own those plants then jacked up electricity prices to the utilities, like PG&E, which had shed many of their own plants as part of deregulation.

The problem for PG&E and other utilities is that they couldn't pass those higher electricity costs on to their customers, because electricity rates were still regulated. So the red ink started to gush, in the hundreds of millions of dollars. And, with gas prices still higher here than anywhere else, it is still gushing.

But not for El Paso. -- -- --

El Paso Energy rose from its financial emergency in 1996 to become not just a survivor, but a $50 billion behemoth involved in virtually every aspect of the energy industry in California and much of the rest of the United States.

The company, renamed El Paso Corp. this February, is now practically printing money. The company's revenue shot from $1 billion in 1995 to $22 billion last year; its profit last year alone was $652 million, its highest ever. Wise's compensation package reportedly totaled $20 million.

And it's not just with gas that El Paso is making its money. Among its holdings are 19 small power plants serving PG&E and Southern California Edison. Under El Paso's contracts, the price of that electricity automatically rises when the price of gas rises. That's true even at the power plants that don't use any natural gas.

All told, in just a bit more than one year alone, consultants for Edison say El Paso earned an extra $85 million thanks to electricity produced by those plants. And all this is blossoming for El Paso while PG&E wallows in bankruptcy court, billions of dollars in debt with no relief in sight.

The one cloud on El Paso's horizon: A host of California legislators, industry experts and state regulators suspect that El Paso's sunny profit picture owes a lot to what happened with that huge block of space on El Paso's natural gas pipeline that PG&E had been so happy to surrender.

The hearing before federal regulators is looming tomorrow, and just last month the state Assembly Subcommittee on Energy Oversight dragged three top El Paso executives -- but not Wise -- to Sacramento to testify on the matter. It was the first time the company has ever felt such heat in this state. And though the executives grimly waved off reporters' questions as they strode from the room, company spokeswoman Norma Dunn stayed behind to insist that the accusations will blow over, "because there's nothing to them.

"The thing to remember is that we have been in this state for more than 50 years, and we want to continue being here," Dunn said. "We take this matter very seriously. . . . We want to be cooperative." Accusations that El Paso caused price spikes by maneuvering to hold pipeline space hostage amount to "nothing but conspiracy theories," she said.

The Assembly panel, however, concluded that both El Paso and Dynegy had manipulated the market at an enormous cost to California consumers. "The numbers tell the truth," the subcommittee said in a report obtained by The Chronicle. "The exorbitant prices cannot be defined away by regulators and bureaucrats, or explained away by corporate lawyers' wordplay." The report was produced by three Assembly Democrats and two Republicans.

Wise, when he addresses the accusations, says he is mystified why state lawmakers are mad. He points to company plans to expand pipelines heading here and to even build a power plant at San Francisco International Airport.

When it comes to California, "El Paso has always tried to be a part of the solution, not the problem," he told a gas industry newsletter in December.

State lawmakers' attempts to pry extensive hard numbers from El Paso have been met with resistance from the company, which calls them proprietary information. And judging by Morris' experience, chasing El Paso to the ground may take the Legislature quite a while, if that's what it decides it wants to do.

Morris found that as he filed complaint after complaint against the company, the Federal Energy Regulatory Commission would either rule against the PUC or put the filings off so long that they were moot when they came up.

The Assembly subcommittee's report was scathing in regard to the commission, saying its approval of El Paso pipeline contracts "raises serious questions about whether it met its statutory duty under the federal Natural Gas Act to protect consumers from unjust and unreasonable rates." The commission did not send anyone to the Assembly hearings and has refused to comment on its rulings.

By the time the El Paso Merchant Energy contract expires May 31, opening the crucial block of pipeline capacity to what critics say is true competition for the first time in more than three years, it will be far too late, Morris said. "The damage was done long ago," Morris said. The state and its utilities are on the hook for billions in debt, money for last winter's bills has already left consumers' pockets -- and regulators fear prices are unlikely to come down soon.

"The market got set, and now we're in trouble," Morris said. -- -- -- PG&E, for its part, sees the whole mess through the eyes of a victim. The utility had paid $560 million to hold its excess El Paso capacity from 1993 to 1997, and the PUC had forbidden the company to recover $167 million of that through customer rates. And in 1996, the PUC and ratepayers were clamoring for lower power bills, and there was a huge amount of pipeline space in the state that wasn't being used.

So when you're trying to cut costs, what better to cut than something you don't need? said Dan Thomas, PG&E's director of gas transmission. "I still think it was the right decision to relinquish the capacity," he said. Still, there's no denying the numbers. At latest count, PG&E owed El Paso more than $150 million for gas and electricity.

As Morris sees it, El Paso is "this big, 800-pound gorilla at the border and can limit supplies as they wish. It's outrageous, and there wasn't a thing anybody could do to stop them."

El Paso officials, of course, put it differently. "All we did was good business, smart business, and people keep dishing dirt about us, but we just don't see ourselves in it," company spokesman Mel Scott said. "It's pretty obvious to the analysts and to us that California set up this faulty deregulation system, and if (PG&E and Southern California utilities) had been in their right minds and signed up for long-term natural gas contracts back in 1996 and 1997, they wouldn't be in this trouble."

Nobody official at El Paso is publicly gloating, but pleasure over the turn of events is never far from the surface. Those who can speak more freely don't mind putting the boot in a bit. "Everything bad that's happening right now (in the pipeline fight) could have been prevented if PG&E just hadn't gotten rid of that contract back then, " Wu said. "But I have yet to hear anyone in this state say that.

"In fact, I have yet to hear anyone even at PG&E say that, and that's sad." What it all comes down to is this: El Paso figured out how to play California's energy game better than California. "Those laws your boys passed there in California -- well, they just left you wide open to anyone who wanted to make an enormous profit," said Tom "Smitty" Smith, director of the Austin headquarters of Public Citizen, a consumer rights group.

"You can't fault the horse for eating hay when you lead it to the barn and put the bale right in front of its face, now can you?"

California's 'energy island'

There are just four points at the border where natural gas comes into energy-starved California. The main one, owned by El Paso, is at the Colorado River. The pipelines originate in the Southwest. They wind 1,000 miles through several states to pop up right where Route 66 used to cut over the Colorado River on its famous arched steel bridge. Today two of El Paso's pipelines are all that use the old bridge.

E-mail Kevin Fagan at kfagan@sfchronicle.com and Bernadette Tansey at btansey@sfchronicle.com.

©2001 San Francisco Chronicle Page A - 1

-- Swissrose (cellier3@mindspring.com), May 13, 2001

Answers

Great piece! Very illuminating, revealing. as to the behind-the-scenes chess game being played.

-- Wayward (wayward@webtv.net), May 13, 2001.