Getting Inside The Trans-Alaska Pipeline

On Aug. 27, 2019, Hilcorp, a privately-held Houston-based petroleum producer, agreed to buy out BP's Alaska assets. This includes its drilling operations in the Prudhoe Bay oil fields and its unused leases in the Arctic National Wildlife Refuge (ANWR). The deal, costing Hilcorp $5.6 billion, represents a significant addition to its current off-shore operations in Alaska's Cook Inlet.

On the transportation side of things, Hilcorp also bought out BP's ownership stake in the Alyeska Pipeline Service Company which runs the famous Trans-Alaska Pipeline System (TAPS). This is quite the splash given that the Hilcorp – an S-corporation known mostly for its Gulf of Mexico operations – started business in Alaska in 2012. Indeed, it purchased part of BP's North Slope holdings in 2014. BP had been in Alaska since the 1968 oil discovery in Prudhoe Bay. Since those early days, Alaska's petroleum operations have become a complicated web of strategic alliances and public policy and Hilcorp will have to work diligently to maintain a suitable return on its investment. As an example of these strategic alliances, let's further consider Alaska's premier petroleum transportation infrastructure, TAPS.   

TAPS is a strategic piece of infrastructure with a storied mixture of politics and engineering. Hilcorp will join ExxonMobil, ConocoPhillips, and Unocal in the joint role of being an owner and a customer of the Alyeska Pipeline Service Company. It is certainly an intriguing combination not often considered in the theory of supply chain management. Along a supply chain the owners sell downstream and customers buy upstream. But with TAPS, the owners are customers of their own asset. While this sounds convoluted it does make sense given: (1) the benefits of spreading risk in large capital projects; and (2) the realities of U.S. anti-trust law. Consider these two points further. 

Oilfield production is by no means consistent in a given area. At the same time, if a company wishes to move its product to market via a pipeline, it needs to incur massive fixed costs up front. So, with fixed costs being certain and revenues not, it makes sense to spread the risk especially when nearby competitors are looking to solve the same transportation and routing problem. In this case, one pipeline is better than having three or four running along the same 800-mile route from Prudhoe Bay south to the awaiting supertankers at the Port of Valdez (the nation's northernmost ice-free port). Each user benefits from the economies of scale in having one pipeline with a higher utilization rate. This is especially important today because TAPS's utilization rate has been falling since its peak of 2.1 million barrels/day in 1988.

Current throughput is just around 500,000 barrels/day and TAPS, though an engineering marvel when completed in 1977, was not designed for such a low utilization rate. This presents a challenge in the form of higher maintenance costs because less throughput of warm crude oil raises the risk of pipeline cracks and ice particle build-up during Alaska's long and bitterly cold winters. This is, of course, on top of a certain degree of daily risk resulting from the threat of earthquakes. This is why the pipeline runs in a curious zig-zag pattern mostly above ground and supported by beams which allow for lateral movement. This design allows for extra flexibility during tremors. However, to better understand the temperature swings during the 800-mile trek, the crude oil enters the pipeline at about 100 degrees F and exits at 58 degrees F. To deal with these challenges, TAPS's owners have financed Alyeska Pipeline's usage of high-quality scrapers and sensors (known as pigs) and even artificial intelligence (AI) programs to better anticipate maintenance operations and costs. 

Anti-trust law enters the picture because the owners (which are independent competitors) cannot be seen to be controlling, in an oligopolistic fashion, how capacity on TAPS is priced. In other words, Alyeska Pipeline can only discuss certain issues independently with each company. Yet, perhaps surprisingly, this is not a process whereby Alyeska Pipeline, like any standard for-hire carrier, sets a tariff or even negotiates one with its users. It only discusses its costs with the owners and not its revenue. So, how is oligopolistic behavior avoided? Actually, the owners are required by the U.S. Department of Justice to compete with themselves when booking capacity on TAPS. After gathering cost information from Alyeska Pipeline each owner would, in effect, set its own tariff to charge itself in order to provide revenue to Alyeska Pipeline.

This regulatory system, under the control of the Federal Energy Regulatory Commission (FERC), requires these independent tariffs to cover TAPS's operating cost for the capacity plus a rate of return on invested capital in the pipeline. This after-tax rate of return is currently regulated to be no more than 9% and that, in effect, sets a price ceiling. So, the owners could compete with each other by charging themselves less than this and, thereby, making their own transportation costs lower. Also, by charging less, the owners could attract other North Slope oil companies to pay to use their capacity on the pipeline. In fact, Hilcorp was one of these "other" oil companies once it started business there in 2014.

So, Hilcorp will be entering a new league in its Alaska business while BP exits one of its oldest. The TAPS owners are certainly a unique club. The petroleum business in Alaska has made yet another zig-zag along its fascinating journey.

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