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The Public Service Commission has approved a nearly $5.6 million annual reduction in gas rates requested by Mountain Fuel Supply Co., but it has denied a request by the Division of Public Utilities to reduce the rates further.

The division's request was based on its contention that a settlement of a disagreement with Texaco Inc. was imprudent. That dispute dated to 1984, when a contract with Texaco expired.Mountain Fuel and Texaco had a joint interest in four natural gas wells in the Bruff gas field in Wyoming. When Texaco failed to market its share of the gas, Mountain Fuel used the entire production stream.

Wexpro Co., an affiliate of Mountain Fuel's and the operator of the wells, wasn't told by Texaco that it no longer had a contract with Mountain Fuel Resources or its successor, Questar Pipeline Co., wrote the PSC commissioners.

"For approximately two and a half years Wexpro continued to pay Texaco as it had done previous to the contract termination. When Wexpro did learn of Texaco's lack of a contract it stopped paying Texaco."

The parties had a dispute about how to resolve the disproportionate use of the gas by Mountain Fuel. In 1987 Texaco filed for bankruptcy in New York, and Wexpro and Mountain Fuel agreed to a settlement with that company.

However, the division challenged the costs of gas arising from the settlement. It said Mountain Fuel had entered into the settlement to make up for or bail out its affiliate, Wexpro.

The division said cheaper gas sources were available that could have been used instead of the gas purchased by Mountain Fuel under the settlement. Division officials argued that the settlement should not be underwritten by the ratepayers.

"The Bruff settlement warrants commission review and should not be allowed in rates if found to be imprudent," wrote the commissioners, Stephen F. Mecham, James M. Byrne and Stephen C. Hewlett.

The rate reduction sought by Mountain Fuel, $5,588,000, was part of the company's periodic adjustments, based on fluctuations in its costs. That decrease was made final, but the division request for a further reduction based on the Bruff settlement was denied.