Freeport Oil Co. v. Federal Energy Regulatory Commission (638 F.2d 702, 1980)

TJOFLAT, Circuit Judge:

The Federal Energy Regulatory Commission (FERC or Commission) regulates interstate sales of natural gas. FERC granted Freeport Oil Company (Freeport), a producer of natural gas, short-term authority to make interstate sales of its gas at a price in excess of the prevailing regulated rate. Subsequently, FERC increased the regulated rate above Freeport’s short-term rate, and Freeport adjusted its own rate to bring it into conformity with the new regulated rate. FERC ruled that Freeport’s rate increase was unlawful and ordered Freeport to refund all sales proceeds attributable to the rate increase.

Freeport now petitions for review of the Commission’s order. Because we find that FERC based its order on a misinterpretation of its own regulations and of the terms of the certificate granting Freeport short-term authority to sell gas interstate, we vacate the Commission’s order.

I

A. Background

To understand the facts of this case and the issues presented, it is necessary to be aware of the statutory and regulatory schemes that formed the background of FERC’s order.

The Commission regulates the sale and transportation of gas in interstate commerce in accordance with the provisions of the Natural Gas Act, 15 U.S.C. §§ 717-717w (1976), and FERC rules and regulations. The Natural Gas Act provides a three-phase regulatory scheme. First, the Act governs the entry of gas into the interstate market. Before gas can be sold in the interstate market, whether from the wellhead or intrastate markets, the seller must obtain from FERC a certificate of public convenience and necessity. Once the certificate is issued and accepted by the seller, the gas is dedicated to the interstate market, and it cannot be withdrawn from that market without FERC approval. Second, the Act controls the price at which interstate gas can be sold. All rates charged for gas must be “just and reasonable.” Third, the Act provides that any change in a contract price for gas must be approved by FERC. No change in price, or in any of the terms of the certificated contract, may be effected unless the seller gives 30 days notice to FERC and to the public. During that 30-day period, FERC may suspend the proposed rate increase for up to five months in order to determine whether the new rate is just and reasonable. If, after the expiration of five months, the Commission has not made a determination, the proposed rate increase becomes effective automatically, but the Commission still retains the power to disallow the increase in the event it finds the new rate not to be just and reasonable. If that is the eventual determination, the seller is required to refund to its buyers revenues it has collected as a result of the new rates.

When the Commission began its regulatory function in 1938, it restricted its jurisdiction to the relatively few natural gas pipeline companies. The Commission was thus able to regulate the sale of gas on a company-by-company basis and to set the just and reasonable rate for each sale. The rate was, uniformly, based on the selling company’s costs of service. In 1954, however, the Supreme Court extended the Commission’s jurisdiction to include the power to regulate the sale of gas, by producers, at the wellhead. Phillips Petroleum Co. v. Wisconsin, 347 U.S. 672, 74 S.Ct. 794, 98 L.Ed. 1035 (1954). Because of the vast number of independent producers, the company-by-company, rate-setting procedure quickly became unworkable. The massive volume of applications for certificates of public convenience and necessity and filings for rate increases made it virtually impossible for the Commission to determine the just and reasonable rate on a case basis, and, consequently, it tended to approve almost any rate the producer, or pipeline company, requested. The Supreme Court curtailed this practice in section 7 certification proceedings in Atlantic Refining Co. v. Public Service Commission of New York, 360 U.S. 378, 79 S.Ct. 1246, 3 L.Ed.2d 1312 (1959). There, it directed the Commission not to issue a certificate of public convenience and necessity if it found the contract price to be not in the public interest — that is, excessive — and suggested that FERC certify only those sales where the price is “in line” with the prevailing certified prices.

The Commission responded to the Supreme Court’s mandate by issuing Statement of General Policy No. 61-1, 24 F.P.C. 818 (Sept. 28, 1960). In that statement, the Commission announced an “in-line” pricing structure to govern the issuance of certificates of public convenience and necessity. “In-line” rates were listed for designated geographic areas, and no rate higher than the prevailing, or “in-line,” rate for sales from a designated area would be approved. As the Supreme Court observed in United Gas Improvement Co. v. Callery Properties, Inc., 382 U.S. 223, 227, 86 S.Ct. 360, 363, 15 L.Ed.2d 284 (1965),

The fixing of an initial “in-line” price establishes a firm price at which a producer may operate, pending determination of a just and reasonable rate, without any contingent obligation to make refunds should a just and reasonable rate turn out to be lower than the “in-line” price. Consumer protection is afforded by keeping the “in-line” price at the level where substantial amounts of gas have been certificated to enter the market

The Commission’s statement also announced a “guideline” policy under which presumptively just and reasonable rates, set out in the statement for each of the designated geographic areas, would govern section 4 filings for rate increases under previously certificated contracts. These guideline rates were generally lower than the “in-line” rates applicable in new certification proceedings because they applied to “old” gas. If a producer sought a section 4 price increase in excess of the “guideline” rate, the Commission would immediately suspend the rate increase and would not approve the proposed increase unless it found the increase to be just and reasonable. The “in-line” and “guideline” rate schedules published in the statement were not considered by the Commission to have been established, as just and reasonable, under section 5 of the Act, but only to provide interim standards pending the completion of the Commission’s area rate proceedings that had been launched under that section. The Commission concluded its statement by announcing that the section 5 area rate proceedings would provide the long term solution to just and reasonable rate determinations.

The first area rate proceeding, covering the Permian Basin, was completed in 1965. Permian Basin Area Rate Proceeding, 34 FPC 159 (1965). For gas produced or transported in the Permian Basin, the new area rates replaced the in-line rates and the guideline rates that theretofore governed section 7 certifications and section 4 filings. The Permian Basin rates were computed by multiplying an average production-cost factor by an average rate of return for the area. The Commission also established a two-tier pricing structure: new gas, under contract after January 1, 1961, was certificated at a price higher than the price that applied to applications for rate increases under pre-January 1, 1961, contracts. The higher price for new gas was designed to stimulate exploration and production. The Supreme Court approved the area rate proceeding device for establishing just and reasonable gas prices in In re Permian Basin Area Rate Cases, 390 U.S. 747, 88 S.Ct. 1344, 20 L.Ed.2d 312 (1968), and the Permian Basin proceeding became the model for price regulation under the Natural Gas Act.

By the late 1960s, it became evident that the area rate proceeding device was an inadequate method of implementing the national gas policy. Area rate proceedings were, characteristically, protracted, and, as a result, the Commission often failed to consider the most current rate-base costs. Consequently, the rates it established proved to be too low to attract gas to the interstate market; instead, the gas was sold in intrastate markets where the price, unregulated, was much higher.

In those parts of the country where area rates had not been established and the interim “in-line” rates still controlled the price of gas under section 7 certifications, producers were reluctant to dedicate gas to interstate commerce because of the possibility that the Commission might subsequently promulgate a lower area rate. The result was a severe gas shortage. See Southern Louisiana Area Rate Cases (Austral Oil Co.) v. FPC, 428 F.2d 407, 434-40 (5th Cir.), cert. denied sub nom., Municipal Distributor Group v. FPC, 400 U.S. 956, 91 S.Ct. 241, 243-44, 27 L.Ed.2d 257 (1970).

In Southern Louisiana Area Rate Cases (Austral Oil Co.) v. FPC, in which we reviewed the Southern Louisiana Area Rate Proceedings, the suppliers of gas took sharp issue with the criteria the Commission took into account in establishing the area rates. Though we found that the Commission had not acted unlawfully in choosing the factors that made up the rate base and, therefore, affirmed, we suggested that, in view of the rapidly deteriorating supply of gas, the Commission could, and should, consider non-cost factors, such as the effect of its rates on the supply of gas in the interstate market. The Commission responded by reopening its Southern Louisiana Area Rate Proceedings to consider evidence bearing on the supply and demand of gas and, then, resetting the area rates at higher levels to encourage further exploration and production and the dedication of more gas to the interstate market. Opinion No. 598, 46 F.P.C. 86 (July 16, 1971), modified on rehearing, Opinion No. 598-A, 46 F.P.C. 633 (Sept. 9, 1971), affirmed sub nom., Placid Oil Co. v. FPC, 483 F.2d 880 (5th Cir. 1973), affirmed sub nom., Mobile Oil Corp. v. FPC, 417 U.S. 283, 94 S.Ct. 2328, 41 L.Ed.2d 72 (1974).

Once area rates were set, they provided the benchmarks for the Commission’s acceptance or rejection of section 7 applications for certificates of public convenience and necessity. The Commission so steadfastly adhered to these rates that it refused to consider undisputed evidence of increased production costs that occurred subsequent to the previous area rate proceedings, or market analyses that may have indicated a need to move the rates upward. See Phillips Petroleum Co. v. FPC, 405 F.2d 6 (10th Cir. 1969).

By early 1970, the Commission finally concluded that its rigid policy of issuing section 7 certificates only in eases where the seller agreed to use the area rate could not secure adequate supplies of new gas for the interstate market. The interstate gas market was so short of supply, with extensive curtailments in natural gas deliveries, that the Commission considered the situation to be an emergency. Several new measures were therefore undertaken to obtain the immediate delivery of gas.

On July 17,1970, the Commission issued a Statement on New Applications for Certificates for Sales from All Areas, Docket No. R-389A, 35 Fed.Reg. 11638 (1970). In paragraph 12 of that statement, the Commission gave notice that it would “accept for consideration applications by independent producers requesting issuance of a certificate of public convenience and necessity for sales of natural gas notwithstanding that the stated rate may be in excess of the [area] or [in-line] rates.” Id. at 11639. Any rate granted by the Commission under that policy statement was subject to prospective upward or downward modification should a rate proceeding that covered the producer’s area subsequently establish a different rate. Id. at 11638. The possibility that a future area rate would not reach the certificated rate, thus causing the producer to suffer a rate decrease, discouraged most producers from utilizing paragraph 12 of the statement to make permanent section 7 dedications of gas. Order No. 455, 48 F.P.C. 218 (Aug. 3, 1972), 37 Fed.Reg. 16189, 16192 (Aug. 11, 1972).

On April 15, 1971, the Commission adopted Rule 2.70 to meet the emergency it anticipated would occur during the 1971-72 winter heating season, when the demand for natural gas would far exceed supply. Measures for the Protection of Reliable and Adequate Natural Gas Service, Order 431, 45 F.P.C. 570 (1971) (as modified, 18 C.F.R. § 2.70 (1979)). The Commission, in rule 2.70, instructed producers that it would approve prices in excess of the area or “inline” rates in accordance with paragraph 12 of the July 17, 1970, statement, and that it would “consider limited term certificates with pregranted abandonment.” Rule 2.70(b)(3). In implementing rule 2.70, the Commission approved a rate if it (1) was in-line with recent intrastate pricing in the producer’s immediate geographic area and (2) was no higher than necessary to draw the gas from the intrastate to the interstate market. See, e. g., Nueces Industrial Gas Co., 45 F.P.C. 1224, 1227 (June 30, 1971). The rule did not alter the Commission’s policy, under paragraph 12, of modifying the producer’s rate in the event the Commission subsequently promulgated a different area rate. Because the term of a rule 2.70 certificate would likely expire before, or shortly after, a new area rate could be promulgated, however, a producer’s risk of prospective revenue loss if he opted to proceed under rule 2.70 was slight.

Despite the implementation of rule 2.70, the shortage of natural gas in the interstate market persisted. The Commission therefore took another step to alleviate the problem, adopting rule 2.75, Optional Procedure for Certificating New Producer Sales of Natural Gas, Order 455, 48 F.P.C. 218 (Aug. 3, 1972), 37 Fed.Reg. 16189 (Aug. 11, 1972). Unlike rule 2.70, which was designed to attract short term supplies of gas, rule 2.75 was intended “to stimulate the immediate introduction of new, long term (permanently dedicated) gas supplies into the interstate market . . . .” Id. at 16192. Like rule 2.70, rule 2.75 authorized the Commission to issue certificates of public convenience and necessity at prices in excess of area or “inline” rates.

The features of the rule 2.75 optional procedure were described by the Supreme Court in FPC v. Moss, 424 U.S. 494, 497-98, 96 S.Ct. 1003, 1006, 47 L.Ed.2d 186 (1976).

First, it permits producers to tender for FPC approval contracts for the sale of new natural gas at rates that may exceed the maximum authorized by the applicable rate order. Second, the FPC will determine in a single proceeding whether the “public convenience and necessity” under § 7(c) of the Act, 15 U.S.C. § 717f(c), warrants the issuance of a certificate authorizing the sale and whether the rates called for by the contract are “just and reasonable” under § 4(a), 15 U.S.C. § 717c(a). Third, a permanent certificate issued by the Commission and accepted by the producer is not subject to change in later proceedings under § 4 of the Act, 15 U.S.C. § 717c, and the rates may be collected without risk of refund obligations. 48 F.P.C., at 226. See 18 CFR § 2.75(d) (1975). Fourth, Order No. 455 authorizes inclusion in the permanent certificate of . abandonment assuranee — or “pregranted abandonment” ... 18 CFR § 2.75(e) (1975).

(Footnotes omitted.) The court cautioned that, although a rate established under rule 2.75 was not subject to increase in a section 4 proceeding, it could be decreased by a future Commission under section 5.

The [rule 2.75] procedure does not . limit the applicability of § 5, 15 U.S.C. § 717d. See 18 CFR § 2.75(d) (1975). The Commission noted in Order No. 455 that it was unable to “bind a future Commission not to invoke the prospective operation of Section 5”; the Commissioners further stated that “[t]o the extent that this Commission can grant certainty of rates, we do so.” 48 F.P.C. 218, 223 (1972).

Id. at 498, n.4, 96 S.Ct. 1006, n.4.

In summary, then, the granting of a certificate of public convenience and necessity under rule 2.75 amounted to a qualified guarantee to the producer that his price would not go down. Order No. 455-A, clarifying Order 455, 48 F.P.C. 477 (Sept. 8, 1972). In the same breath, the Commission gave the consumer an unqualified guarantee that his price would not go up. Section (m) of rule 2.75 provided,

By acceptance of a certificate issued [under the optional procedure], the seller-applicant unconditionally agrees to (1) waive all rights to seek future rate increases under section 4 of the Natural Gas Act with respect to the contract submitted, other than price escalations, if any, as certificated by the Commission.

On June 21, 1974, almost two years after the promulgation of rule 2.75, the Commission established a uniform national rate for “new” gas. The national rate replaced the area rates and those “in-line” rates still in existence. In the order, the Commission rescinded rule 2.70’s authorization of limited-term certificates and paragraph 12, which, as we have pointed out, had authorized the certification of gas at rates above the area or “in-line” rates. Opinion No. 699, 51 F.P.C. 222 (June 21, 1974). On rehearing, however, the Commission reconsidered its decision to rescind the limited-term certificate procedure of rule 2.70 and, on September 9,1974, reinstated the rule in a continuing effort to assist the pipelines, still facing extreme shortages of gas, in negotiating for additional supplies. Opinion No. 699-B, 52 F.P.C. 700, 39 Fed.Reg. 33205 (Sept. 19, 1974). Because the rescission of paragraph 12 was not before FERC on rehearing, it was necessary for FERC, in reinstating the rule 2.70 certificating procedure, to augment the rule to provide for the granting in limited-term certificates of rates above the new national rate. The Commission also stated the standards for determining whether the price requested in a rule 2.70 certificate application is consistent with the public convenience and necessity-

The applicants will have the burden of demonstrating by substantial evidence that the price for which certification is sought is the lowest price at which that particular supply of gas may be obtained for the interstate market and that the supply of gas is available only for the limited period for which certification is sought. We realize that these are general guidelines and state that rates allowed in any given case will not constitute a determination that equivalent rates would be approved in another ease.

39 Fed.Reg. at 33206.

B. Facts

The facts in this case present an excellent example of why the rule 2.70 procedure described above was necessary to stimulate the dedication of gas to the interstate market. Mississippi River Transmission Corporation (MRT), a pipeline company, supplied gas to Laclede Gas Company (Laclede), a public utility engaged in the distribution of natural gas at retail to domestic, commercial and industrial customers in St. Louis, Missouri, and neighboring counties. Laclede purchased all its gas from MRT and was MRT’s largest single customer, accounting for about 60% of MRT’s total sales. MRT, therefore, while not directly selling gas to retail customers, was a crucial part of the flow of natural gas from the wellhead to the individual homes and businesses in the St. Louis area.

MRT purchased 70% of its gas supplies from United Gas Pipeline Co. and 15% from Truckline Gas Co. During 1973, United lawfully decreased its deliveries to MRT by 22%. Truckline likewise decreased its deliveries to MRT in the same year, by 29%. Another of MRT’s suppliers could not deliver gas to MRT during the heating season. Between 1970 and 1973, the total volume of gas purchased by MRT declined almost 18%. As a result, MRT’s customers, and, eventually, the ultimate consumers, were unable to satisfy their natural gas needs during the critical winter months. As the Commission later concluded in granting the rule 2.70 certificate to Freeport Oil Company in this case, “[TJhere is no question that MRT [was] faced with a critical problem which in turn [caused] its customers severe curtailments of natural gas.” Limited-Term Certificate of Freeport Oil Co., Docket No. CI74-78, 52 F.P.C. 1141, 1143 (Oct. 31, 1974).

To help alleviate the shortfall of natural gas deliveries, both MRT and Laclede engaged in a drilling venture with Freeport, an oil and gas producer. Freeport, in a joint venture with a group of producers, had earlier undertaken an exploratory effort to find natural gas in Texas. Some wells were drilled but were unproductive, and the producers, except Freeport, were unwilling to invest in further exploration. Freeport eventually moved MRT and Laclede to help finance an additional test well. MRT and Laclede purchased a part interest in the venture from the other members of the original group and together with Free-port, who served as the operator, paid the drilling costs. Before the drilling commenced, MRT obtained an option, akin to a right of first refusal, to buy Freeport’s share of any natural gas that might be discovered, at the highest price Freeport could obtain from any interstate purchaser. It was understood, however, that Freeport would not have to honor the option if a certificate of public convenience and necessity could not be obtained by November, 1974.

When the additional test well was successful, MRT exercised its option to purchase Freeport’s share of the gas produced. On July 24, 1973, pursuant to the option, Freeport entered into a three-year contract to sell natural gas to MRT at a price of 56 cents per one thousand cubic feet (Mcf) with an annual escalation of one cent per Mcf. The area rate at the time the contract was signed was 42 cents per Mcf with one cent per Mcf annual escalation. Opinion No. 699, supra. The contract contained an area rate clause that called for an increase in the gas price in the event the Commission established a higher area or national rate.

On August 6, 1973, Freeport filed an application pursuant to section 7 of the Natural Gas Act, and rule 2.70, for a limited-term certificate of public convenience and necessity with pregranted abandonment authority. The terms of the certificate for which Freeport applied were the same as the terms of the three-year contract between Freeport and MRT. Record at 212, 215. Thus, Freeport sought a base price of 56 cents per Mcf and “Fixed periodic and area rate (increases).” Record at 228 (emphasis added).

A formal hearing on the application was held before an administrative law judge on January 18,1974, and, on March 14,1974, he issued an initial decision. The judge first determined that MRT had a genuine gas supply emergency. The judge then found that the proposed price was necessary to attract the gas to the interstate market. The essential requirements of rule 2.70 having been satisfied, the judge concluded that the application should be granted and issued an initial decision doing so.

The application next went to the Commission on exceptions to the administrative law judge’s initial decision. Before the Commission could consider the matter, however, the Commission, as we have pointed out, see p. 8521 supra, issued Opinion No. 699, rescinded the rule 2.70 procedure for issuing limited-term certificates and declared that no additional rule 2.70 limited-term certificates would be granted. Free-port’s application, therefore, was perfunctorily denied. Three months later the Commission reinstated the rule 2.70 limited-term certificate procedure. Freeport immediately moved the Commission to reinstate its application, and the motion was granted. The Commission decided to limit its review of Freeport’s application to the record previously established before the administrative law judge. In determining the appropriateness of the 56 cents per Mcf rate approved by the administrative law judge, the Commission used the standard applicable to rule 2.70 applications at the time the judge handed down his decision; that is, whether the applicant’s requested price was (1) in line with prevailing intrastate prices and (2) no higher than necessary to attract the gas to the interstate market. The Commission found that this standard had been met and, further, that the contract rate proposed by Freeport was “just and reasonable.” Record at 79. These findings are not in question in this appeal. The rate was set forth in the Commission’s Order Granting Motion for Reinstatement of Proceeding and Issuing Certificate for Limited-Term Sale of Natural Gas (issued Oct. 31, 1974):

A certificate of public convenience and necessity is issued authorizing Freeport to sell natural gas in interstate commerce to MRT for a period of three years from the date of issuance of this order at the rate of 56