This is the story of Paragraph 211.67 (e) in regulations of the Federal Energy Administration. Five hundred words long, the paragraph is adding $55 million a month to the cash flow of the nation's "small" oil refiners.

The "small" refiners benefited by the paragraph include such up and coming concerns as Penzoil Corp., Dow Chemical Co., the Union Pacific Corp. and a refining company partly held by the heirs of the late H. L. Hunt. (Dow and Pennzoil are on the "Fortune 500" list of top U.S. corporations.)

The tale of Paragraph 211.67(e) known in the oil business as the "small refiner bias," illustrates how private interests, astute legal advice and the political process can work in Washington to benefit those who know how to milk the system.

The paragraph was originally put into the regulations in 1974, in response to a general directive from Congress that FEA protect the ability of small refiners to compete with the major oil companies.

In 1975 this "bias" in favor of "small" refiners was significantly enlarged, largely through the assiduous efforts of an influential Washington lawyer and lobbyist, now Secretary of Health, Education and Welfare, Joseph A. Califno Jr.

It has since been expanded even further by FEA, in part to offset what the agency regarded as some unfair effects of the changes Califano won.

Califano declined to comment directly on either the fee he was pad or his exact role in amending legislation to benefit a group of small refiners. Well-informed industry sources reported the fee to have been in excess of $1 million. The aggregate value to the refiners of the amendment during its six-month longevity was $237 million.

In the personal financial statement he filed before joining the Carter Cabinet, Califano reported an income of $505,490 from his former law firm of Williams, Connolly & Califano in 1976.

The small refiners bias is part of the complicated entitlements program FEA administers under the Emergency Petroleum Allocation Act.

When the Arab and other oil-exporting nations quadrupled the price of curde oil in the winter of 1973-74, the federal government did not let U.S. domestic oil price quadruple.

Instead, it put U.S. oil under price controls.

Those controls created two kinds of oil - "old" and new. Old oil - essentially oil from wells that had been drilled before 1973 - was limited to a "low" price which is now about $5.25 a barrel. New oil was allowed to rise toward the world price; it now sells for a little over $11 a barrel.

The reason for this system was partly to keep producers of old, or flowing, oil from reaping windfall profits as world oil prices rose.

The difficulty with the system was that it gave some refiners a huge competitive advantage over others. Those whose sources of supply were mainly "old" oil had an advantage over those that had to pay new oil or world prices for their crude.

The entitlements program was designed to offset this advantage. It is a giant price equalization scheme. The government maintains a kind of kitty; refiners who have more than the average amount of old oil coming into their refineries pay money into the kitty, and this money is used to compensate those who have above-average amounts of higher-cost new or imported oil.

In theory, everyone's costs per barrel of crude thus end up the same.

The original small refiner bias that FEA created in this system was simple.A small refiner that owed money to the kitty because it had more than the average percentage of old oil did not have to pay as large an equalizing fee per barrel as a large refiner in the same circumstances. Similarly, small refiners owed money from the entitlements kitty got more per barrel than large refiners in the same position.

But some small refiners wanted even more of an advantage than this. One of them, the Pasco Oil Co., then based in Englewood, Colo., went to Califano in 1975.

Pasco was a company with an above-average amount of low-cost old oil, but it did not want to make the payments to the entitlements kitty that this requried. Its objective was an amendment to the entitlements program, under which small refiners that owed money to the pot would be forgiven those obligations entirely. Those were owed money would continue to receive it as before.

In effect this amounted to an increase in the bias, but only for some small refiners, not all.

Califano initially sought a ruling from FEA exempting Pasco from making entitlements payments. Later he spearheaded a successful lobbying effort on behalf of as many as 30 small refiners to get the exemption enacted into the 1975 Energy Policy and Conservation Act.

His amendment was introduced in the Senate by Frank Church (D-Idaho) and in the House by Rep. Bob Eckhardt (D-Tex.), both legislators with liberal credentials.

Their amendments, as finally put in the law, exempted small refiners from paying entitlements fees on the first 50,000 barrels of oil a day they processed, and allowed them a reduction in payments on the next 50,000 barrels.

There were then 112 refiners in the country that met the congressional definition of "small" - refiners with a capacity of less than 175,000 barrels of crude oil per day. (That is the equivalent of more than 7 million gallons of gasoline with a retail value of about $5 million.)

Half those small refiners were in the same position as Pasco, in that they owed money to the entitlements kitty.

The Califano amendment saved these 56 refiners up to $39 million a month during the six months it remained in effect.

Tproblem was that it disadvantaged those other small refiners that were owed money under the equalization program; the Pasco-type refiners ended up with lower costs than their other "small" competitors.

FEA wanted to correct the uneven-ness in the program. At the same time it was under intense political pressure from the Pasco-type refiners not to increase their costs too much, if at all.

In May of last year the agency found a way to satisfy both conflicting pressures, at least in part. It went back to its original type of small refiner bias, giving the same advantage per barrel to small refiners which owed and were owed payments under the program. But it sweetened this advantage per barrel for small refiners versus large ones.

It is this sweetened bias provision that is now adding $55 million a month to small refiners' net income - most of which goes to profits.

That $55 million a month is not coming directly from the public, but from the larger refiners. The entitlements program is a zero-sum game, in which the amount paid not equals the amount paid in. The more the small refiners take out - or the less they pay in - the greater the cost to their larger rivals.

But FEA experts say some of these higher costs are passed on by the larger companies to the public in higher prices for refined products.

John Hill, former FEA deputy administrator, said "joe was the guy who put it together . . . it was an incredible lobby coming from every side."

Califano was assisted in his lobbying for the 1975 exemption by another attorney, Jerry L. Shulman. They put together a letter-writing campaign, asking senators and House members to write letters in the small refiners' behalf to Ford administration energy policy-makers.

Pasco also received a helping hand from the Justice Department. Donald I. Baker, who headed the department's Antitrust Division, wrote a memorandum to FEA asserting that, without changes, the entitlements program "would force Pasco to buy entitlements which . . . could significantly affect its marketing area and the industry generally."

Pasco was the only refiner mentioned in the letter.

"We spoke to Baker," Shulman acknowledged in an interview. "We brought the problem to their attention." But he said "we nothing to do with drafting their statement; that was entirely theirs."

Hill says "Califano successfully painted it as the big refiners against the little refiners." Another onlooker, who was a Senate aide during the 1975 drafting sessions, said Califano's success was based on "Congress" Robin Hood mentality that the big oil companies are inherently evil, and the small firms deserve anything they want."

Yet the small firms, this former aide observes, "have a long history of rolling over the federal government, going back to the 1950s."

The problem with the program now is that FEA experts think it overcompensates the small refiners. They also say the bias is so great that it has led to abuses - and they are seeking ways, at the staff level at least, to tighten the system.

These abuses include a proliferation of small so-called "tea-pot refineries" which J. Lisle Reed, director of FEA's office of oil and gas, says are "coming out of the woodwork . . . just to get some of this entitlements action" under which a small refiner can sell at a greater profit than a larger rival company.

There is also a suspicion within FEA that small refiners are spinning off individual plants under "dummied" ownership, so they can increase their cash flow throught the entitlements system, under which the smaller the refiner, the larger the bias.FEA is now investigating at least one such company, and other investigations may follow.

FEA has also come upon:

A series of "processing agreements" under which small refiners sometimes claim entitlements benefits for oil processed in other refineries. For example, C & H Refinery Co., the nation's smallest refiner, has a 200-barrel-a-day plant in Lusk, Wyo. Last December the company claimed over $500,000 in entitlement benefits for 9,700 barrels a day processed in a Hawaiian refinery over 3,000 miles away. FEA has now promulgated a ruling to stop such processing agreements, which takes effect at the end of this month.

Growing evidence that small refiners' profits have been so high that some refiners have been able to "pay out" the cost of a new refinery in lesss than a year, using just the increased cash flow from the small refiner bias. Generally, according to James Cunningham, vice president and energy financing expert of First National Bank of Chicago, it takes about seven years for a refinery to pay out.

Most damaging of all is a recent FEA report indicating that the small refienr bias - on a weighted basis - gives a 10,000 barrel a day operation a 44 cent a barrel amrgin on gasoline over refiners larger than 175,000 barrels a day. For naphtha, a refined product used in petrochemical processes, the margin goes up 87 cents on the barrel.

An internal FEA document says that "the impact of the present bias levels goes far beyond (the original) intent . . . The small refiner bias in the entitlements program provides incentives that lead to the creation of a group of refiners who exist only by reason of the bias. This result is undesirable for the interests of the consumers, the industry or the government."

Califano spoke of his part through Eileen Shanahan, HEW's assistant secretary for public affairs. "As far as he is concerned," she said, "he didn't do anything wrong, he got a lot of money for his clients."

And the next year, she quoted Califano as saying, "'the big oil companies beat us.'"