Two Important Pipeline Variables

Debt/Equity Ratio and Return on Equity

When analyzing a specific proposal, and especially when comparing two alternative proposals, the proposed debt/equity ratio and the return on equity are two of the most important factors in comparing the projects.

Some might say that the cost of the pipeline is an important factor, but what one company estimates for the cost of the project versus what another company may estimate for the cost of the project is not really material unless it can be determined why one estimate is more than the other. For example, a forty-eight inch pipeline made out of the same grade of steel from the North Slope to Alberta should cost roughly the same whether it is constructed by Denali or TransCanada. Any substantial differences in costs should be able to be identified by some unique benefit one company brings to the table over the other.

But debt/equity ratios and returns on equity create substantial financial impacts to the tariff and to the amount of revenue received by the State of Alaska from a proposed pipeline.

The 2007 State of Alaska presentation to the Senate Finance Committee shows the impact the debt/equity ratio has on reducing the tariff and on the present value in $billions to the State of Alaska. As the graph on page 4 shows, a debt/equity ratio of 80/20 provides a much greater value to the shippers and to the State of Alaska than a 75/25, 70/30, or especially a 60/40 debt/equity ratio. The reason for this is that debt carries a much lower interest rate than the normal return on equity.

The State’s 2007 presentation can be found at http://www.dog.dnr.state.ak.us/agia/pdf/agia_docs/derate_assumptions_sf.pdf

The greater the equity position the pipeline company proposes, generally the higher the tariff. This can be exacerbated when the pipeline company also proposes a higher than normal rate of return on its equity. For example, TransCanada, in its AGIA application proposed a higher than normal rate for its return on equity. In fact, Exxon, in its initial comments to TransCanada’s AGIA Application stated, “… after shifting risk to its customers through “negotiated rate” terms, TransCanada proposes a return on equity (ROE) at the high end of ROEs previously approved by the FERC, and well above ROEs typically approved by the NEB.” Since Exxon is now a partner to TransCanada, perhaps TransCanada’s proposed ROE will be more reasonable.

Exxon’s comments are on DNR’s website at http://www.dog.dnr.state.ak.us/agiacomments/Uploads/030608153830.pdf

All other comments regarding TransCanada’s application can be found at
http://www.dog.dnr.state.ak.us/agiacomments/Comments.aspx

If the State decides to bid its royalty gas at one of the open seasons, it should examine the proposed debt/equity ratio and return on equity proposed by each of the projects prior to making its decision.