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The economics and politics of oil pricing
Washington report Richard Corrigan reports on
The economics and politics of oil pricing The US Congress never has been known as a sanctuary for economic theories, since the dictates of politics tend to batter most theories out of shape and since politicians as a rule are not well drilled in economics to begin with. In their efforts to promote the general welfare and their own careers, members of Congress tend to use economic principles, if at all, only to support positions they already have settled into through their own instinctive ways of reasoning. The point here is not that economists are wiser than politicians, or the other way around, but simply that politicians usually do not accept what economists tell them unless it is what they are inclined to hear. There is a doctrine in the American oil industry concerning the Most Expensive Barrel. It might make sense to industry economists and executives, but to most politicians it holds no attraction whatsoever. And so long as the industry clings to this line of thought, there will be no peace between the industry and Congress. According to this doctrine, the price of oil is determined by the cost of the Most Expensive Barrel and not by the cost of the average barrel. An explanation for this economic phenomenon has not been put forward in the public debates over energy policy; it just seems to be something the industry accepted long ago, and which it regards as one of the natural laws of energy. Even the existence of this doctrine is rarely acknowledged in public forums, not through any conspiracy on the industry's part but because it is regarded as an elementary concept that need not be discussed.
Richard Corrigan, a Washingtonbased writer specialising in energy, is Washington Correspondent of ENERGY POLICY. 156
While most Members of Congress might not have encountered this doctrine in its pure form, they certainly have become familiar with its manifestations. They see prices going up, they hear voters complaining, they read about the industry's profits, and they come to the conclusion that by attacking the oil companies they will be doing the country and themselves a great service. The oil companies then profess surprise and outrage at being set upon by Congress, and complain that no one understands the free-enterprise system any more. (The current Congress is handily controlled by members of the Democratic Party, which traditionally is not as attuned to the interests of business as is the Republican Party, of which President Ford is a member. The antagonism in Congress toward the industry extends well beyond party lines, however.) The Most Expensive Barrel doctrine did not cause much trouble here until 1974, when the member nations of OPEC decreed a staggering increase in the government take and sent the price of their oil up to the $11-a-barrel level. The Administration denounced this new price as wholly arbitrary, unjustified and unconscionable, and then encouraged US producers to charge the same price for new domestic oil. US producers did just that, while saying they also should be permitted to charge the same price for old domestic oil.
N e w oil and old oil Under the price control system, the classes of oil allowed to be sold as new oil without any government ceiling amounted to 40% of domestic production; the wellhead price on the remaining 60% which was rated as old oil, was held to $5.25 a barrel. In his energy message in January, President Ford told Congress that under
his executive authority he intended to lift price controls on old oil within a few months. Mr Ford also asked Congress once again to enact legislation that would allow the removal of wellhead price ceilings on new supplies of natural gas, which would mean that new gas could sell at the same price as new oil on an energy-equivalent basis, at about $2 per thousand cubic feet rather than the maximum of $0.51 now permitted in interstate sales. Mr Ford furthermore said he would impose through existing authority new fees on imported oil totalling $2 or $3 a barrel, and asked Congress to place a $2-a-barrel tax on domestic oil. All of these steps and more were necessary, Mr Ford said, to discourage the consumption of energy, to reduce the flow of imported oil and to encourage more production of domestic energy. During 1974 the United States consumed about 17.5 million barrels of oil a day, of which about 6.5 million barrels were imported. Less than 1 million barrels daily came directly from the Arab members of OPEC. Considerably more Arab oil was brought in after being refined elsewhere, although the origins of all oil were not disclosed to the public; the total flow of Arabbased oil has been estimated at 3.5 million barrels a day. As the Most Expensive Barrel doctrine took effect, the new price range instituted by the Arabs was duplicated around the world - by, among others, the Iranians, the Nigerians, the Venezuelans, the Canadians and, most importantly, the Americans. As a result, more domestic oil was being sold here at the OPEC price than Arab oil. For all the publicity given to the new-found wealth of the Arabs, the OPEC price also served to enrich a great many American oilmen. Before 1973, domestic producers were restrained by the low prices then prevailing for foreign crude, and they had to struggle to keep price levels at the higher domestic range. There were persistent entreaties from oil consumers to the government to allow more imports, so as to dampen the price of oil. As domestic production proved unable to meet demand, the import quota programme was dropped, and as the volume of imports increased, so did the per-barrel price. And as the price of imported oil rose, the price of new
E N E R G Y P O L I C Y June 1975
WashhTgtonReport domestic oil matched the pace set by the foreign income of US-based multinational oil companies. Mobil Oil CorOPEC. The committees of Congress have poration looked at the Senate's been told that the actual cost of produc- language and said it might have to move ing oil in the Persian Gulf is of the its international headquarters out of the order of $0.10 to $0.20 a barrel. country. Congress has tended to agree with the These changes in the tax treatment of Ford Administration that the US must the oil industry (which at this writing accelerate the production of all sources were yet to be made final) were adopted of domestic energy, to avoid paying a without the endorsement of the Adprice for foreign oil that is beyond any ministration or of the chairmen of the relationship to its cost and to reduce the tax-writing committees, demonstrating the readiness of the Members of threat of an interruption in supplies. Congress has not, however, accepted Congress to challenge the industry. the proposition that American oil and Throughout the debates, members said gas should sell at the OPEC price - that oil companies both large and small even though the cost of production in were making too much money and payUS fields may be substantially higher ing little or no taxes to the US Treasury. than in the Persian Gulf. Early in 1974, Here again, the workings of the Most Congress passed legislation that would Expensive Barrel doctrine brought have rolled back the price of new about a retaliation by the legislators; if domestic oil, thus voiding the decision the companies' revenues and profits had by then-President Nixon to decontrol not been inflated by the OPEC price new oil supplies. Mr Nixon vetoed that levels, the depletion allowance might legislation, and the Senate was unable to well have remained intact. gather the two-thirds margin needed to The Ford Administration also asked override the veto. As a first order of Congress for greater authority to business this year, Congress by decisive regulate the price of foreign oil in order votes ordered Mr Ford to delay his un- to protect new investments in domestic ilateral decision to impose fees on im- energy ventures. This proposal ported oil. Mr Ford vetoed that direc- amounted to another concession by the tive, but a further confrontation was Administration to the Most Expensive avoided, at least temporarily, when Barrel doctrine. The Administration's Congress and the President agreed to argument was that US companies seek a compromise arrangement. would not develop such high-cost forms Congress also took preliminary steps of energy as shale oil, gasified coal or toward halting the decontrol of old oil. liquefied coal under the threat of possiAnd Congress resisted all attempts to ble price cuts by OPEC. Therefore, the decontrol the price of natural gas, agree- Administration sought a mechanism to ing that the regulated price may be un- ensure that the Most Expensive Barrel necessarily low but saying that was no would not be priced out of the by attempting to reason why the price should be un- marketplace, guarantee that all oil would sell at the necessarily high. same minimum price - that is, the highest price. Congress expressed no enthusiasm The depletion allowance In a direct attack on the oil industry, for this concept, as several members both the Senate and the House agreed to wondered aloud how the Administration eliminate the oil and gas depletion could continue to say that it wanted allowance, except perhaps for some in- OPEC to drop its prices while at the dependent domestic producers. The same time the Administration was trydepletion allowance, a once-sacred pro- ing to put a floor under prices. Congress vision of the tax code that permitted did show keen interest, meanwhile, in a producers to deduct 22% of the gross proposal advanced by M.A. Adelman, of economics at income on their wells from their taxable professor income, was justified by its defenders as Massachusetts Institute of Technology, providing an incentive for exploratory for a system whereby foreign producers drilling. Critics said that at today's would compete for the right to sell oil in prices, such incentives hardly were the US market through sealed bids for needed. The Senate, in its version of the import licences, the idea being to entax bill, also voted to capture more of courage members of the cartel to cut
ENERGY POLICY June 1975
their prices and shatter the cartel's unity. Yet another manifestation of the Most Expensive Barrel doctrine arose in connection with investigations into the operations of oil and gas companies. The Federal Energy Administration uncovered cases in which companies sold old oil under the guise of new oil, in order to obtain the better price. And the Federal Power Commission and the Interior Department opened separate investigations into the operations of leaseholders on the Outer Continental Shelf, in an attempt to determine whether natural gas was being held off the market, in the midst of a nationwide shortage, on the expectation of government actions that would allow price increases. The launching of these investigations, and the publication of preliminary findings, did not enhance the stature of the companies in the eyes of Congress, the public and the press. The oil and gas companies, in concert with the Ford Administration, kept asking for a relaxation of controls on the energy business so that prices could be set by the free market system. When Members of Congress protested that there was no free market system, since a cartel of foreign governments was fixing the world oil price, the rejoinder was that the market system eventually would bring about a reduction in the OPEC price level - at least until it became necessary to establish a minimum price. The arguments went in circles, and Congress, displaying a new awareness of its power, continually rebuffed the Administration while considering what national policies should be adopted. A spokesman for natural gas producers said his industry was being singled out for attack. The cost of production was one thing, he said, but the prevailing market price was another, and 'no one ever asked Mr Wrigley what it cost to produce a package of chewing gum.' Political fortunes do not, of course, rise or fall with the price of chewing gum; nor do the economies of the world. Congress cared very much about the costs of producing and buying oil, and having learned that it did not cost anything close to $11 a barrel to produce it, Congress was looking for a way to separate the US from OPEC's o i l and from OPEC's prices.
157
The economics and politics of oil pricing The US Congress never has been known as a sanctuary for economic theories, since the dictates of politics tend to batter most theories out of shape and since politicians as a rule are not well drilled in economics to begin with. In their efforts to promote the general welfare and their own careers, members of Congress tend to use economic principles, if at all, only to support positions they already have settled into through their own instinctive ways of reasoning. The point here is not that economists are wiser than politicians, or the other way around, but simply that politicians usually do not accept what economists tell them unless it is what they are inclined to hear. There is a doctrine in the American oil industry concerning the Most Expensive Barrel. It might make sense to industry economists and executives, but to most politicians it holds no attraction whatsoever. And so long as the industry clings to this line of thought, there will be no peace between the industry and Congress. According to this doctrine, the price of oil is determined by the cost of the Most Expensive Barrel and not by the cost of the average barrel. An explanation for this economic phenomenon has not been put forward in the public debates over energy policy; it just seems to be something the industry accepted long ago, and which it regards as one of the natural laws of energy. Even the existence of this doctrine is rarely acknowledged in public forums, not through any conspiracy on the industry's part but because it is regarded as an elementary concept that need not be discussed.
Richard Corrigan, a Washingtonbased writer specialising in energy, is Washington Correspondent of ENERGY POLICY. 156
While most Members of Congress might not have encountered this doctrine in its pure form, they certainly have become familiar with its manifestations. They see prices going up, they hear voters complaining, they read about the industry's profits, and they come to the conclusion that by attacking the oil companies they will be doing the country and themselves a great service. The oil companies then profess surprise and outrage at being set upon by Congress, and complain that no one understands the free-enterprise system any more. (The current Congress is handily controlled by members of the Democratic Party, which traditionally is not as attuned to the interests of business as is the Republican Party, of which President Ford is a member. The antagonism in Congress toward the industry extends well beyond party lines, however.) The Most Expensive Barrel doctrine did not cause much trouble here until 1974, when the member nations of OPEC decreed a staggering increase in the government take and sent the price of their oil up to the $11-a-barrel level. The Administration denounced this new price as wholly arbitrary, unjustified and unconscionable, and then encouraged US producers to charge the same price for new domestic oil. US producers did just that, while saying they also should be permitted to charge the same price for old domestic oil.
N e w oil and old oil Under the price control system, the classes of oil allowed to be sold as new oil without any government ceiling amounted to 40% of domestic production; the wellhead price on the remaining 60% which was rated as old oil, was held to $5.25 a barrel. In his energy message in January, President Ford told Congress that under
his executive authority he intended to lift price controls on old oil within a few months. Mr Ford also asked Congress once again to enact legislation that would allow the removal of wellhead price ceilings on new supplies of natural gas, which would mean that new gas could sell at the same price as new oil on an energy-equivalent basis, at about $2 per thousand cubic feet rather than the maximum of $0.51 now permitted in interstate sales. Mr Ford furthermore said he would impose through existing authority new fees on imported oil totalling $2 or $3 a barrel, and asked Congress to place a $2-a-barrel tax on domestic oil. All of these steps and more were necessary, Mr Ford said, to discourage the consumption of energy, to reduce the flow of imported oil and to encourage more production of domestic energy. During 1974 the United States consumed about 17.5 million barrels of oil a day, of which about 6.5 million barrels were imported. Less than 1 million barrels daily came directly from the Arab members of OPEC. Considerably more Arab oil was brought in after being refined elsewhere, although the origins of all oil were not disclosed to the public; the total flow of Arabbased oil has been estimated at 3.5 million barrels a day. As the Most Expensive Barrel doctrine took effect, the new price range instituted by the Arabs was duplicated around the world - by, among others, the Iranians, the Nigerians, the Venezuelans, the Canadians and, most importantly, the Americans. As a result, more domestic oil was being sold here at the OPEC price than Arab oil. For all the publicity given to the new-found wealth of the Arabs, the OPEC price also served to enrich a great many American oilmen. Before 1973, domestic producers were restrained by the low prices then prevailing for foreign crude, and they had to struggle to keep price levels at the higher domestic range. There were persistent entreaties from oil consumers to the government to allow more imports, so as to dampen the price of oil. As domestic production proved unable to meet demand, the import quota programme was dropped, and as the volume of imports increased, so did the per-barrel price. And as the price of imported oil rose, the price of new
E N E R G Y P O L I C Y June 1975
WashhTgtonReport domestic oil matched the pace set by the foreign income of US-based multinational oil companies. Mobil Oil CorOPEC. The committees of Congress have poration looked at the Senate's been told that the actual cost of produc- language and said it might have to move ing oil in the Persian Gulf is of the its international headquarters out of the order of $0.10 to $0.20 a barrel. country. Congress has tended to agree with the These changes in the tax treatment of Ford Administration that the US must the oil industry (which at this writing accelerate the production of all sources were yet to be made final) were adopted of domestic energy, to avoid paying a without the endorsement of the Adprice for foreign oil that is beyond any ministration or of the chairmen of the relationship to its cost and to reduce the tax-writing committees, demonstrating the readiness of the Members of threat of an interruption in supplies. Congress has not, however, accepted Congress to challenge the industry. the proposition that American oil and Throughout the debates, members said gas should sell at the OPEC price - that oil companies both large and small even though the cost of production in were making too much money and payUS fields may be substantially higher ing little or no taxes to the US Treasury. than in the Persian Gulf. Early in 1974, Here again, the workings of the Most Congress passed legislation that would Expensive Barrel doctrine brought have rolled back the price of new about a retaliation by the legislators; if domestic oil, thus voiding the decision the companies' revenues and profits had by then-President Nixon to decontrol not been inflated by the OPEC price new oil supplies. Mr Nixon vetoed that levels, the depletion allowance might legislation, and the Senate was unable to well have remained intact. gather the two-thirds margin needed to The Ford Administration also asked override the veto. As a first order of Congress for greater authority to business this year, Congress by decisive regulate the price of foreign oil in order votes ordered Mr Ford to delay his un- to protect new investments in domestic ilateral decision to impose fees on im- energy ventures. This proposal ported oil. Mr Ford vetoed that direc- amounted to another concession by the tive, but a further confrontation was Administration to the Most Expensive avoided, at least temporarily, when Barrel doctrine. The Administration's Congress and the President agreed to argument was that US companies seek a compromise arrangement. would not develop such high-cost forms Congress also took preliminary steps of energy as shale oil, gasified coal or toward halting the decontrol of old oil. liquefied coal under the threat of possiAnd Congress resisted all attempts to ble price cuts by OPEC. Therefore, the decontrol the price of natural gas, agree- Administration sought a mechanism to ing that the regulated price may be un- ensure that the Most Expensive Barrel necessarily low but saying that was no would not be priced out of the by attempting to reason why the price should be un- marketplace, guarantee that all oil would sell at the necessarily high. same minimum price - that is, the highest price. Congress expressed no enthusiasm The depletion allowance In a direct attack on the oil industry, for this concept, as several members both the Senate and the House agreed to wondered aloud how the Administration eliminate the oil and gas depletion could continue to say that it wanted allowance, except perhaps for some in- OPEC to drop its prices while at the dependent domestic producers. The same time the Administration was trydepletion allowance, a once-sacred pro- ing to put a floor under prices. Congress vision of the tax code that permitted did show keen interest, meanwhile, in a producers to deduct 22% of the gross proposal advanced by M.A. Adelman, of economics at income on their wells from their taxable professor income, was justified by its defenders as Massachusetts Institute of Technology, providing an incentive for exploratory for a system whereby foreign producers drilling. Critics said that at today's would compete for the right to sell oil in prices, such incentives hardly were the US market through sealed bids for needed. The Senate, in its version of the import licences, the idea being to entax bill, also voted to capture more of courage members of the cartel to cut
ENERGY POLICY June 1975
their prices and shatter the cartel's unity. Yet another manifestation of the Most Expensive Barrel doctrine arose in connection with investigations into the operations of oil and gas companies. The Federal Energy Administration uncovered cases in which companies sold old oil under the guise of new oil, in order to obtain the better price. And the Federal Power Commission and the Interior Department opened separate investigations into the operations of leaseholders on the Outer Continental Shelf, in an attempt to determine whether natural gas was being held off the market, in the midst of a nationwide shortage, on the expectation of government actions that would allow price increases. The launching of these investigations, and the publication of preliminary findings, did not enhance the stature of the companies in the eyes of Congress, the public and the press. The oil and gas companies, in concert with the Ford Administration, kept asking for a relaxation of controls on the energy business so that prices could be set by the free market system. When Members of Congress protested that there was no free market system, since a cartel of foreign governments was fixing the world oil price, the rejoinder was that the market system eventually would bring about a reduction in the OPEC price level - at least until it became necessary to establish a minimum price. The arguments went in circles, and Congress, displaying a new awareness of its power, continually rebuffed the Administration while considering what national policies should be adopted. A spokesman for natural gas producers said his industry was being singled out for attack. The cost of production was one thing, he said, but the prevailing market price was another, and 'no one ever asked Mr Wrigley what it cost to produce a package of chewing gum.' Political fortunes do not, of course, rise or fall with the price of chewing gum; nor do the economies of the world. Congress cared very much about the costs of producing and buying oil, and having learned that it did not cost anything close to $11 a barrel to produce it, Congress was looking for a way to separate the US from OPEC's o i l and from OPEC's prices.
157