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What Controls Oil Prices

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					  Oil Price Controls: A Counterproductive Effort
                               HANS H. HELBLING and JAMES E. TURLEY

       HE U. S. oil industry has been subjected to
                                                                            United States Petroleum Supply and Demand
varying degrees of price controls since August 1971             9090, S,o!o                                                                                         9,6, 0,,’,
                                                                ~09O0’9o I,r,.I,
                                                                        If          Pu soy                      A~~’ID’”                    MiOko,   If       Bo,,,O, P,r Soy
when general price controls were levied on the entire           20.01                                                                                                     20.0
                                                                                                      ~--.J                                               ~                  050
U. S. economy. As conU’ols were “phased-out” in other                  I                                       Domooloc Domfod ‘,
industries, more stringent price regulations were im-           00.0   L    ___-~~--~       ~                                                                                ‘0.0
posed on the oil industry in response to the October                                                                                  .   Domestic   Prodoctom —
1973 oil embargo and the subsequent quadnipling of
world oil prices.
   The oil price control program is directed at cush-
ioning the domestic impact of sharply higher external
oil prices. In this respect, the controls effort can be
regarded as successful since the effective domestic
price for petroleum remains, in fact, below world
market prices. Economic analysis, however, indicates
that the controls will (1) become ineffective, over
                                                                   .3                   -_-~—-_-~-                       -_~~-—--i-                             I               3
time, with respect to the above stated intention and                 1947      5950             955        5959            963        0967           970              9975
 (2) will enhance the ability of external suppliers to                                                                        I972. I97 3

manipulate prices.                                                                      1773 ,,!6,,!~d ,,th,

   In support of these conclusions, this article in-       eral factors, including price controls and envfronmen-
cludes a discussion of the mechanics of the controls       tal and safety regulations, were responsible for in-
program as it currently exists. Using economic theory      creased U.       reliance on foreign sources of supply.

as a foundation, the eventual effects of controls on
domestic production, imports, and the domestic price                               OIL PRICE CONTROLS
of oil are derived. In this regard, two of the more
                                                              Through a series of steps, the Federal Energy Ad-
popular questions regarding decontrol are analyzed
                                                           ministration (FEA) has decreed that “old” oil that                                                          —
    will decontrol result in (1) higher domestic petro—
                                                           is, oil produced from domestic wells not exceeding
lenin prices and ( 2) increased domestic production
                                                           the 1972 rate of output from these wells     can sell                                              —
and reduced imports?
                                                           for no more than $5.25 per barrel. As of March 1975,
                                                           imported oil sold for $13.28 and “new” domestic
                  BACKGROUND                               oil that is, oil produced from both new wells and

   As indicated in Table I, U. S. oil refiners currently   from old wells in excess of 1972 output      sold for                                          —

process about 12.9 million barrels per day (MBD). Of       $11.47 per barrel (Table II) ,1
this total approximately 4.7 MBD, or 36 percent, are
                                                              In March 1975 (latest available data) total crude
produced abroad.
                                                           oil used by domestic refiners consisted of approxi-
  The United States did not always rely to such an         mately 41 percent “old” domestic oil, 27 percent “new”
extent on external oil supplies. In the mid—1960s oil      domestic oil, and 32 percent imports. The effective
imports represented only 20 percent of total U. S.         domestic price paid by domestic refiners for a barrel
consumption. In fact, as late as 1971 import quotas        of oil is simply the weighted sum of the three prices:
on petroleum products existed in order to prevent                      (0.41) >< $5.25 + (0.27) x $11.47
“cheap” foreign oil from placing domestic oil pro-                         ± (0.32) x $13.28 = ~9.49
ducers at a “competitive disadvantage”.
                                                           I   As indicated ho Table II, pctroleonn price data are available
   Beginning in 1966, the rate of increase in domes-           through July 1975. but the proportions of “new” and ‘old”
tic petroleum production began to decline, and in              domestic production are only available through March. For
                                                               the sake of data consistency, the analysis in this paper is
1972 domestic petroleum production in the United               based on the prices and relative proportions that prevailed
States actually decreased from its 1971 level, Sev-            iso March 1975.

Page   2
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FEDERAL RESERVE BANK OF ST. LOUIS                                                                                                                          NOVEMBER            1975

    Table II
                                                 AVERAGE CRUDE OIL PRICE TO DOMESTIC REFINERS
                                           Otd    ,                           New                            Import,                                 Weighted
                                                                                                                                   Effective          Averoqe
                                                 Osontity                         Ouont:Iy                         Quont~ty        Domestic            Price of
                                  Price            as o           Price             as a            Price            a, a            Price              New a             Price
                                   per            Percent          per             Percont           per            Percent           pa’ -           Imported
                                                                                                                                                             2              of
                                  Ba’rel         of Total         Ba re:          of Total          Barrel         at Total         Barrel               Oil    ,      Entitlement
    ‘974 November                 5125           45.5’            SI 0.90           22.4           312.53           32.1’            58.83             Si 0.25           $5.00
            Decernbe’              5.25           44.9             1 1.05           23.1             12.82          32.0              902               10.25             5.00
    1975 January                   5.25          39.7              11.28            28.8             12.77          31.4              9.27              11.25             6.00
            I’ebruory              5.25          41.3              11.39            264              13.05          32.4              9.40              12.00             6.75
            March                  5.25          41.0              11.47            27.4             13.28          31.6              9.49              12.56             7.31
            April                  5.25               NA            11.64           NA               13.26             28 5               NA            12.54             7.29
            May                    5.25           NA                11.69           NA               13.27          29.2                  NA            12.64             7.39
            June                   5.25               NA            11.73           NA               14.15          31.9                  NA            13.07             7.82
            July                   5.25               NA            1 2.30P         NA               14.03P         34.3                  NA            13.38             8.13
            Aogsst                 5 25               NA             NA             NA                 NA           36 2                  NA            13.56             8.31

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      TI,e’~u’iorhte9s,,’ l,’ow’ or’rn, ‘‘ ,e’.d.,’o,n~,: ‘i. rc .Irse’r.r’ tie .00591                  LOut 1,,: ‘‘‘‘14’ 0,04w]   the nrIcf’ f,., ,t’ivr,I,tlrrnent.
    1’ ‘ I• ‘il:m.
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basis of this ratio, all refiners are issned entitlements                                         Refiners with access to less than the national aver
to enable them to purchase “old” crude in the same                                             age of old crude can sell entitlements to those
proportion as the national average. For example, if                                            refiners with mote old crude than the national aver-
total crude usage in the nation in any particular                                              ige The sale of entitlements represents a source of
month consists of 41 percent “old” crude, then each                                            revenue to the refiner with less than the national
refiner is “entitled” to purchase at least 41 percent                                          average of “old” crude. The refiner who, for example,
of his input mix at the controlled price of $5.25 per                                          O ehes mamlv on imported oil can use his entitlements

barrel, no matter where the oil actually comes from.                                           revenue to reduce the effective cost of his crude oil
   In principle, the refiner with access to less than the                                      input.” With “old” oil representing about 41 percent
national average of” old” crude oil can present his                                            of the national input mix and the price of an entitle-
entitlements to another refiner, who has more than                                             merit at $7.31, the effective cost per barrel of fin-
the national average of “old” crude, in exchange for                                           ports to the refiner is reduced by $3.00 (.41 >< $7.31).
crude at a price of $5.25 per barrel. In practice, how-                                        That is, imports are subsidized to the tune of $3.00
ever, the physical exchange of oil rarely takes place.                                         per barrel. For every barrel of oil imported, the im-
Rather, the entitlements are bought and sold among                                             porter is entitled to purchase 0,41 barrel at the con-
refiners, with the price determined on the basis of                                            trolled price of $5.25 and is forced to pay the market
the difference between the controlled and uncon-                                               price for only 0.59 barrel.
trolled price of a barrel of oil.5 For example, in                                                On the other hand, a refiner who uses more than
March the average price per barrel of “new” domestic                                           the national average of “old” crude is required to
and imported crude was $12.56. Therefore, the FEA                                              purchase entitlements in order to enable him to proc-
established an entitlement price of $7.31 for that                                             ess “old” oil in excess of the national average. A
month. This is the price at which petroleum refiners                                           refiner who is able to meet his desired production
exchanged entitlements in March.                                                               schedule using only “old” crude is required to pur-
4                                                                                              chase entitlements for 59 percent of his input. In
 For ease of illustration, it is assumed that entitlements are
 physical documents which are issued by the FEA. iso reality,                                  this case the effective cost per barrel to this refiner
 however, they are simply accounting fictions to which refiners
 are expected to adhcrc.                                                                       is increased by $4.31 (59 x $7.31). That is, “old”
   The FE k establishes the price per entitlement but their                                    domestic oil is taxed to the tune of $4.31 per barrel.
 choice is isot arbitrary. The market price of an entitlement
 would rise to the difference between the controlled and un-
 controlled price of a barrel of crude, even if the FEA re-                                    “The analysis with imported oil is also applicable to “new”
 snained out of the transaction.                                                                domestic oil.

Page 4
FEDERAL RESERVE BANK OF ST LOUIS                                                                                                               NOVEMBER 1975

                                                                                                             The continued maintenance of the oil price con-
       Old Crude Oil as a Proportion of Total Crude                                                       trols program will not prevent domestic oil prices
                                                                                                          from rising. This would occur even without price
                                                                                                          increases for any of the three sources of supply
                                                                                                          (“old”, “new”, imports) to domestic refiners. As pro-
                                                                                                          duction of “old” domestic oil declines and imports
                                                                                                          increase as a result of the controls program, the
                                                                                                          proportion of the higher priced oil (domestic “new”
                                                                                                          and imports) increases, thereby raising the effective
                                                                                                          domestic price of petroleum.
                                                                                                             The response to the lifting of domestic price con-
                                                                                                          trols will be an immediate rise in the price of petro-
                                                                                                          leum. As long as the United States imports any oil
                                                                                                          at all, the price of crude to domestic refiners will
                                                      Price                                    Belt ars
  Dettors                               Ettitlemeol                                                       be dictated by the foreign oil cartel. Accompanying
                                                                                                          the price rise, however, will be an increase in the
   S                                                                                                      quantity of oil produced domestically. Although the
                                       —                                                                  increase would probably not be of a magnitude to
                                                                                                          allow achievement of self-sufficiency in time short run,

                                                                                                          it does imply a cutback in imports.

    :t:     :i~~F~1TPFP
    NOV. DEC.
                 JAN    FEe   MAO     Ape   MAY   JUNE


                                                                              r:~J~ :1: 0
                                                                             SEP   DCV   NOV

                                                                              0’~51 Ad,,VieEVE,,
                                                                                                             Such a situation would create difficulties for foreign
                                                                                                          suppliers, particularly the Organization of Petroleum
                                                                                                          Exporting Countries (OPEC), who have already
                                                                                                          been forced to cut back production in order to main-
                                                                                                          tain existing prices. With reduced U.S. purchases of
            ,Jd,,,.w,dJ,,p,Y,Y,J],,     th,be,Jeeft,MIMp~i’’0        th,,flV,,,  ,,ooeoo.Vh,
                                                                                 0                        imported oil as a result of decontrol, additional down-
            FEA,,E,’eMA,,]d ,,ud,,,Ip,,p,,E,,,’the            ,Ld,iJ ,Jpplyt’wp,0 y

                                                                                                          ward pressure on external oil prices would result, In
                                                                                                          order to maintain prices, OPEC would have to volun-
   In essence, the price control and entitlements effort                                                  tarily accept a further cut in production and income
is an income redistribution program within the oil                                                        —   and at a time when their domestic development
industry. Domestic “old” oil is taxed and the pro-                                                        programs are in high gear
ceeds are used to subsidise the purchase of imported
oil. This subsidy/tax program, through its effect on                                                      is the Market Solution Viable?
the relative prices of imported and domestically pro-                                                       The free market, or decontrol, solution is rejected
duced oil, has had a perverse impact on the national                                                      by various groups of society. Proponents of continued
goal of self-reliance. Domestic production is discour-                                                    price controls on “old” oil suggest that although the
aged by the imposition of price controls and there-                                                       market price of petroleum products has’’already
fore has continued to decline. This, in turn, has in-                                                     doubled, the reduction in the quantity of petroleum
creased our reliance on external suppliers.                                                               products consumed has been insignificant. In fact,
                                                                                                          they argue that whatever reductions have been ob-
                                                                                                          served can be attributed to the reduction in business
              .AN EVALUATION OF SOME
                                                                                                          activity, not the increase in prices. In addition, they
              DECONTBOL                            ARGUMENTS                                              snaintain that the current high prices have not elicited
                                                                                                          increased petroleum production. Curiously, these
Will Decontrol Lead to Higher                                                                             arguments lead to the conclusion that in order to
 I’etrolenni Prices?                                                                                      achieve both less reliance on imports -and greater
                                                                                                          domestic production, price increases substantially in
   Regardless of whether petroleum prices are coms-
                                                                                                          excess of those already observed would be necessary.
trolled or decontrolled, the price of crude oil to
domestic refiners is going to increase, However, the                                                        Opponents of continued price controls, on the other
price increases associated with either alternative have                                                   hand, argue that economic agents are not indifferent
completely different implications for domestic produc-                                                    to the prices they pay and do indeed respond to
tion and imports.                                                                                         changes in relative prices. They point out, however,

                                                                                                                                                            Page 5
FEDERAL RESERVE BANK OF ST. LOUtS                                                                        NOVEMBER 1975

that it is necessary to distinguish between a short-run                Former Secretary of the Treasury George P. Schultz
and a long-run response of both quantity supplied                   recognized this dilemma of uncertainty. He suggested
and quantity demanded. With respect to the quantity                 that if self-reliance is indeed a national goal, uncer-
demanded, the opponents of price controls point out                 tainty which faces domestic producers should be
that the short-run response to a hike in prices can                 eliminated. To this end Schultz proposed a variable
indeed be very weak. This has to do with the fact                   tariff on imports designed to maintain today’s high
that the nation’s capital stock is energy intensive and             external price. In the event that the foreign oil cartel
costs of rapid adjustment to less energy intensive                  would disintegrate and world market prices decline,
means of production are substantial. The energy re-                 the proceeds from the tariff could he distributed to
quirement per unit of output that has been built into               consumers via the tax system.
production processes has been based on “cheap” oil,
                                                                       In general, then, tlmose opposed to decontrol are not
and as a result of today’s prices, much of the existing
                                                                    convinced that market forces will produce greater
capital stock has become inefficient.
                                                                    self-sufficiency and lower petroleum product prices.
   Reductions in the quantity of oil demanded depend                Those in favor of the removal of petroleum price
on time substitution of relatively less energy intensive            controls, however, contend that government restric-
means of production. An example would be the re-                    tions only hinder domestic oil production and provide
placement of an automobile that averages 15 miles to                incentives to import, thereby supporting the collusive
a gallon of gasoline with one that gets 30 miles per                actions of OPEC. Both of these effects tend to enhance
gallon. The fuel costs per passenger mile as a measure              the unity of OPEC members, whose continued
of the product produced by an automobile would then                 strength would result in higher petroleum prices for
be reduced. While this substitution process is pro-                 U. S. consumers. An additional objection is that reli-
ceeding quite rapidly in the area of automobiles, the               ance on controls to provide solutions to economic
conversion cost to many industries is very high in the              problems in many cases only aggravates and intensi-
short run and therefore would be expected to take                   fies the initial problem.
place only over time. Although this adjustment does
take time, it must not be forgotten that the economic                                 (::ONCLUSION
incentives to make it are great and there is no reason
                                                                       The analysis presented in this article points out
to believe that the adjustment will not eventually be
                                                                    that the currently existing oil price controls program
made. The quantity demanded is indeed responsive
                                                                    has been successful in achieving its intended purpose
to price if sufficient time is given for the affected
economic agents to respond.                                         —   cushioning domestic prices of petroleum products
                                                                    from the higher world oil prices. But the analysis
   Opponents of continued price controls also point out             also suggests that the controls program is in conffict
that the response of the quantity of oil supplied to a              with its stated purpose over the long run. In particu-
change in price has not been substantial because a                  lar, controls provide both disincentives to produce oil
great deal of uncertainty surrounds the return on new               domestically and incentives to import oil. As imported
investment projects. For example, exploration for new               oil becomes an increasing proportion of total domestic
oil wells, more intensive utilization of existing oil               consumption, the effective domestic price of oil \vill
wells, as well as research into new methods of produc-              increase also, The greater U. S. reliance on foreign
tion (such as the liquification of coal and offshore                sources of supply, in turn, enhances the unity of time
drilling) all require extensive capital investments.                foreign oil cartel such that the United States becomes
Even though today’s high market prices for oil might                increasingly vulnerable to external pricing and pro-
justify such investment expenditures, uncertainty with              ducing decisions. A situation has been fostered which
respect to the future price of oil greatly lessens the              would perpetuate rising world oil prices in the future.
incentive to undertake such investments .~This argu-                   There is an alternative to this rather ominous
ment implies that domestic producers expect world                   scenario. Even though petroleum prices would in-
market prices to decline from their present highs and               crease as a result of decontrol, incentives for both
that “cheap” imports could once again be substituted                increased domestic production and reduced imports
for domestic production.                                            are provided. Increased domestic production and
7                                                                   reduced imports, in turn, would tend to strain the
 1’here is the additional problem of uncertainty about future       unity of the oil cartel, and hence, be conducive to
 tax prograuss which could reduce sharply the rate of rcturn
 on these investments, even if the current price of oil prevails.   lower world market prices for petroleum in the future.

Page   6

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