Petroleum, Politics, and Prices

In recent weeks the oil industry has continually been in the public eye, whether through advertising attempting to explain the gasoline shortage or as the target of Congressional demagoguery. Many libertarians, as advocates of capitalism, automatically rush to the defense of companies, like those in the oil business, that are threatened with increased government regulation. But defenders need to know what they are defending. The oil industry, as Dr. Armentano demonstrates, is hardly the innocent victim of prior government regulation, but rather an active partner with the State, of long standing. Any solution to our current energy problems must include the unraveling of this unhealthy status quo.

The businessman's role in the U.S. economic system, and particularly his participation in the formation of the political economy of that system, has always been a keen source of controversy among libertarians. Some libertarians, many libertarian conservatives, and most libertarian Objectivists are fond of arguing that American business—and particularly American Big Business—is, to borrow a hotly disputed phrase, "America's Persecuted Minority" when it comes to governmental economic policy. What these people mean, apparently, is that the hard working American businessman has been harrassed constantly by repressive and thoroughly nonobjective legislation that violates his rights and sometimes makes legal defense—as in the case of antitrust litigation—almost impossible. And with this fundamental primary implication, certainly, we can find no quarrel at all.

However, it is with the additional implications and ramifications of this thesis that the matter becomes controversial. For some libertarians go on to imply that (1) the nonobjective legislation was fundamentally the product of altruistic, do-gooding liberals; (2) that businesspeople are essentially competitive individualists who are committed to free enterprise and despise government interventions; and (3) that anyone who dares attack business for "ripping off" consumers must either be "out of focus", a simple-minded left-wing radical, or against all achievement and material progress.

This particular "right-wing" libertarian point of view has prompted a fundamentally opposite position from some "left-wing" libertarians. They would hold that big businessmen are devils, that large corporations (especially multinational corporations) are responsible for much of the modern world's evil, and that all important domestic and foreign policy was engineered by a well-defined corporate aristocracy.

The facts indicate to this author that neither generalization will suffice in the extreme. Some businesspeople are independent, courageous, and committed to free enterprise; most, unfortunately are not. Some are devils in a libertarian sense and have spent much of their energy destroying the system of "natural liberty"; most businessmen, of course, are not engaged in any such conspiracy. And certainly some economic markets are "monopolistic" and consumers are exploited when they purchase in those markets, though the monopoly and exploitation are far different from what is usually assumed.

In sum, businessmen are both victims and victimizers, exploiters and certainly part of the exploited, legitimate recipients of praise—for where would we be economically without such people—and yet, also, legitimate recipients of scorn—for where would we be if some had not willingly participated in the block-by-block construction of corporate socialism in America?

The discussion which follows deals with monopolization in the petroleum industry and business' alleged role in that monopolization. The method of approach reflects the author's belief that the only way to discover the truth about a particular matter is to investigate it. Bombastic a priori pronouncements concerning guilt are just not good enough. Understanding in political economy can only be attained through correct application of economic theory and careful analysis of the actual relationships between government and business or, more accurately, between politicians and businessmen. We shall have more to say on this subject below.

MONOPOLY AND ANTITRUST

Within the last year, the Federal Trade Commission (FTC), the State of Florida, and the State of Connecticut have all brought important antitrust suits against the major domestic petroleum companies. These legal actions charge the companies with conspiring to restrain and monopolize trade in interstate commerce with respect to various petroleum products, in violation of the Sherman Antitrust Act, the Federal Trade Commission Act, and the respective state antitrust laws. A quote from a section of the Connecticut indictment will indicate the breadth of the allegations in these cases.

For at least the last twenty years, the Defendants have contracted, combined or conspired among themselves and with others to restrain and monopolize trade in interstate commerce by agreeing among themselves to fix, control, maintain, limit or discontinue the production of crude oil, in violation of Sections 1 and 2 of the Sherman Act. They have agreed among themselves to prevent the independent sector of the petroleum industry from gaining access to crude oil supplies, the effect of which has been to substantially restrain trade between the Defendants and independent refiners in the purchase of crude oil for refining.

The Connecticut indictment then goes on to charge illegal restraints of trade in various other areas including pipelines and gasoline products, and a concerted illegal effort to run the "independent" oil dealers out of business. And, finally, in its "prayer for relief," it asks that the court declare the total integration of the defendants' oil companies to be, in and of itself, a violation of the Sherman Act (!) and order, accordingly, an extensive divestiture of crude oil holdings, exploration activities, and pipelines. The FTC and Florida suits, respectively, are almost identical in allegations concerning monopoly and in proposed remedies.

Is there an element of monopoly in the petroleum industry? Of course there is. But, two more important questions are the following: (1) Is the industry monopolistic for the reasons set down in the indictments, and (2) Does the theory of monopoly that these legal actions implicitly accept, or the remedies for monopoly that these suits demand, make any objective sense?

Orthodox economic analysis would have you believe that the most important determinant of "competition" is the market structure of the industry under consideration. Structure most importantly relates to the relative size of the leading companies in the industry and the degree of vertical integration of those leading companies. Now although there are thousands of firms in what is called the "petroleum industry", there are less than a dozen, both domestically and internationally, that do a high percentage share of the business in the important phases of that industry. For instance, the largest eight integrated crude oil firms ship roughly 50 percent of all crude output, refine almost 60 percent of all refined product and market about 45 percent of all gasoline in the United States. Internationally, there is even more concentration with seven major companies (the domestic giants: Exxon, Gulf, Texaco, Standard Oil of California, and Mobil, in addition to British Petroleum and Royal Dutch-Shell) dominating crude and transport. And it is this structural concentration and the subsequent conduct and performance that allegedly flows from it that causes the monopoly problem.

Economists argue that industries so concentrated bestow "monopoly power" on the exalted industry leaders. And with that power the firms can and do misallocate economic resources, earn "monopoly" rates of return, forego technical change and intense price competition, and ruin (if and when they choose) smaller independent competitors dependent on the majors for crude oil and pipeline transport of their product. In a word, it is alleged that competition "in the public interest" is not possible with such concentrations of power, and hence legal dissolution, which would decentralize the industry and its alleged power, is both a logical and appropriate solution for these economists.

But as this author (and others) have argued elsewhere, this view of competition and monopoly power is completely incorrect. The entire position is premised on the notion of something called pure competition as a standard against which one can judge the conduct and performance of flesh-and-blood corporations. According to this mischievous theory, real firms automatically misallocate resources, and the larger they are the greater the "misallocations." Even worse, if such firms have specific cost advantages over other (smaller) firms, the advantages create so-called "barriers to entry" which—in antitrust legal jargon—restrain trade and ultimately violate the law. Indeed, any economic advantage possessed and employed by such firms could be so interpreted as "limiting competition." Hence, one ends up with the nonsense position of condemning the very firms in society that one ought to be praising, in the name of preserving "competition." Antitrust is a myth and a hoax, and so is the theory of competition upon which it ultimately rests.

The only rational definition of monopoly, or monopoly power, or monopoly price, pertains to a grant of governmental power to a business, usually to exclude or restrict competitive production. Such grants "decrease competition" by law and do indeed "misallocate resources" if by this we mean that producers are prevented from allocating resources in the most efficient manner as determined by free consumer choice. To understand monopoly in the petroleum industry, we must examine the most important governmental grants of monopoly with respect to this industry. In addition, we must attempt to determine the role played by business in obtaining these grants of privilege.

PRORATIONING

The most important element of monopoly in the petroleum industry is state prorationing. Even a freshman economics student knows that the essence of monopoly is control over market supply, control over the raw material that goes to make the product. And that same student ought to know that such monopolistic control has never been achieved in a free market by any one firm or group of firms.

Prorationing in the petroleum industry, however, achieves such monopoly control over crude oil by law. Started in the early 1930's, purportedly as a conservationist remedy to the "wastes" of competition in crude oil production, prorationing developed smoothly and logically into a scheme to restrict supplies to estimated demand, that is, to stabilize prices at existing levels. In Texas, the largest oil producing state, it works as follows: once every month the three-person Texas Railroad Commission meets to determine how many days oil producers will be allowed to operate their wells that month. The Commission "coordinates" demand estimates from crude oil buyers ("nominations") and other estimates from the Federal Bureau of Mines and sets output quotas per well ("allowables") to fill that anticipated demand. And since the demand is estimated at existing prices, the effect of the regulation is to stabilize prices for crude and for petroleum products generally. Most of the other oil producing states have similar regulatory mechanisms.

In addition to fixing prices higher than the free market would, prorationing leads to gross inefficiency in crude oil drilling and production. Because of the artificial output restrictions, the average American crude oil well pumps an incredibly low 15 barrels a day compared to 4,300 barrels a day per Middle East well. And, worse, because until 1965 the regulatory "allowables" were determined per well, and since the depletion allowance encourages exploration and drilling, still additional economically unnecessary crude wells have been drilled. This sort of irrational economic over-drilling has frequently led to a premature dissipation of the "gas cap" pressure in the underground oil reservoir, lowering the efficiency of all the wells in the field. Ironically, it was this same "wasteful" situation that supposedly prompted prorationing in the first place!

Actually, it was a crucial court decision in 1889 concerning property rights to underground crude oil that spawned the entire controversy. Question: Who owns the crude oil that exists underneath more than one property owner's land? Answer by the 1889 court: No one! Instead, the court legalized the famous "rule of capture" principle which, simply stated, means that anyone who can pump the crude oil out owns it. And it was the subsequent economic effects of this decision, coupled with the illegality of most private agreements to limit production and output, that eventually ushered in government regulation.

BUSINESS RESPONSIBLE?

The ushering in of government, however, was not some spontaneous act of nature; business took an active part in the process. Business groups representing both smaller independent operators and large integrated companies were in the forefront of the "social forces" pushing for "enlightened" regulation. Beginning with World War I, oil men had come to the realization that government was to be a permanent and not entirely unwelcome partner in the oil business. Though there were bitter disagreements (and scandals) over "naval reserves" (oil land set aside for purposes of national security) and rights to offshore oil, and certainly bitter differences between independent and major oil companies over precisely what domestic oil policy ought to be, there was little disagreement after 1919 over the fundamental principle of regulation. The details were always in doubt, but the idea of a regulatory policy was a much a part of the oil industry's grand design as making profits or paying dividends. As A.C. Bedford, the president of the newly divested Standard Oil Company, put it in 1918:

Government control does not necessarily signify disaster to an industry. If zonal distribution of petroleum products is necessary to supply national needs, zonal distribution will be accomplished. If pooling of tank cars and ships will more efficiently meet national demands, those facilities will be pooled. If well drilling supplies must be allocated…if licensing of jobbers and others is necessary…everything that is necessary will be done.

And it would be clear from subsequent events that this statement was not meant to apply solely to wartime conditions.

Business thrusts toward a permanent regulatory arrangement were at first hesitant and unsure, but the direction and intent of the thrusts was unmistakable. When World War I ended, strong sentiment among oil people existed for continuing the National War Service Committee's spirit of cooperation and "supervised competition" with respect to the petroleum industry. Somewhat later, they heartily approved creation of President Coolidge's Federal Oil Conservation Board in 1924, and most endorsed that board's early recommendations for compulsory conservation and even state prorationing. The American Petroleum Institute (API), formed in 1919 to "afford a means of cooperation with the government in all matters of national concern," was consistently advocating cooperation among oil companies, relaxation of the antitrust laws, and self-regulatory schemes to limit production to demand. A majority of the API directors actually favored federal regulation of production in 1927. More explicitly interventionist, the Independent Petroleum Association of America (IPAA) never even pretended to hide behind the mantle of free enterprise; it consistently advocated strong state regulatory control over crude oil production and a tariff on foreign crude oil, and even sanctioned the declaration of martial law and the use of National Guard troops to make prorationing work in Texas and Oklahoma during the early 1930's. Much to the delight of the "independents," by the way, the price of crude oil rose from 10¢ a barrel in August of 1931 to 85¢ a barrel in June of 1932.

But it was during the Depression of the 1930's, and particularly with respect to the National Recovery Act of 1933 (NRA), that all measure of pretense concerning "free enterprise" was abandoned by oil businessmen. Under the separate oil code section of the NRA (which was actually written by the American Petroleum Institute), the production of crude was to be legally coordinated with demand. State prorationing laws were to receive federal support. Interstate and foreign shipments of oil were restricted to quotas determined by Secretary of the Interior Ickes and a Petroleum Administrative Board. The Reserve Act of 1932 had already imposed import duties (taxes) on crude and even higher duties on refined products mostly at the urging of the IPAA. By the end of 1933, in summary, government and business interests had succeeded in cartelizing crude petroleum production. As one Standard of California vice president put it in 1933: "If you do not give us price regulation, you can make codes from now to doomsday and you will get nowhere." By 1933, the petroleum industry had gotten somewhere.

Four problems that would have made the cartel unstable were all eventually solved. In 1935 the Interstate Compact to Conserve Oil and Gas was created to coordinate and dovetail prorationing decisions in the different states. When the Supreme Court swept the entire NRA away in 1935, the Congress—without hearings—passed Texas Senator Connally's bill (dubbed the Connally "Hot Oil" Act) that made it illegal to transport interstate oil produced in violation of state prorationing requirements. And finally the courts, including the Supreme Court, declared prorationing to be perfectly constitutional since its intent was "conservation" of resources in the public interest with only an incidental effect on price!

The last loophole in the prorationing monopoly was eventually closed by Republican President Eisenhower in 1959. At the intense urging of small independent crude oil producers—and, by the way, in bitter opposition to the position of large oil companies, especially Gulf—mandatory import quotas were imposed on "foreign" crude. Thus, the last vestige of "laissez-faire" in crude production and selling was eliminated, and the industry-government arrangement creating monopoly was virtually complete.

Prorationing is not, of course, the only interventionist arrangement in the oil industry, though it is the most important. There are many other instances where the oil business has been far from a "persecuted minority" when it comes to governmental policy. Some of those instances may have exaggerated the monopoly discussed in the first part of this paper; most clearly have not. Some are condemnable from a libertarian point of view; others are, perhaps, justifiable. In all of them, however, for one reason or another, the industry has not argued consistently for laissez-faire or nonintervention but has sought the help and aid of the state to further its own goals. And, of course, the state has attempted to use the oil industry to fulfill its particular vision of political power and influence throughout the world. Just as in free trade, it is only mutually satisfactory agreements which are renewed and extended, certainly both parties have had something to gain from intervention and regulation.

Take the issue of the depletion allowance, for instance. There is no question whatever that the tax "allowance" enacted in 1926 was created by and for the very same oil industry under discussion here. And there is also no question that some of the very money that escapes taxation through the allowance, comes back in the form of campaign contributions to, among other things, extend or perpetuate that very "loophole." Thus this device, as usual, serves the interest of both industry and "politics."

Now it is not being argued that paying less taxes for whatever reasons is condemnable in any way; far from it. The point, however, is that far from being helpless victims of state action, businessmen, and in particular oil businessmen, have learned to manipulate the political machinery of the state to their own advantage. And the examples can easily be multiplied to discussions of shipbuilding (tanker) subsidies, special zoning exemptions for refineries, federal insurance against foreign expropriation, federal statistical data, and numerous other "advantages" afforded the petroleum industry.

GOVERNMENT RESPONSIBLE?

And yet all that has been said so far is not to argue that business, and business alone, is responsible for government intervention in the petroleum industry. From Wilson's Administration through Coolidge, Hoover, Roosevelt and down to the present moment, the federal government has pressured industry increasingly for such "cooperation." Certainly one of the overriding issues for the government in this developing partnership has been military preparedness—particularly Navy fuel oil requirements. As an indication of the importance of oil to the Navy during the formative years of this policy, Navy Secretary Daniels actually advocated the nationalization of U.S. petroleum reserves in 1920! Increasingly throughout the early 1920's, the American State Department was diplomatically active in attempting to obtain exploration rights for U.S. oil companies in the Dutch East Indies, the Middle East, and especially in Mexico and Venezuela. Rightly or wrongly, the U.S. policy planners feared a domestic oil shortage and frantically encouraged development of foreign crude oil reserves under U.S. corporate control. Given the financial interests of the oil corporations, they could hardly have been expected to discourage this sort of governmental activity.

And, finally, the existence of the antitrust laws undoubtedly played a significant role in bringing business and government together. There is evidence to indicate that voluntary attempts to restrict uneconomic crude oil production and further attempts at "unitization" of oil fields to limit waste and increase efficiency were abandoned in the face of antitrust challenges that make such "restraints of trade" illegal. With voluntary cooperation illegal the door was opened to state and then federal "conservation" regulation.

Seen in this light, prorationing and the other restrictive devices were the inevitable climax of an already mixed system of enterprise. Many oil people who fought regulation initially and argued for laissez-faire were eventually persuaded that their efforts were entirely futile and that regulation would come anyway. Rather than be molded by the legislation that was to determine the course of their industry, they decided to do the molding themselves in their own interest.

To be "enlightened," they were told—and eventually came to believe—was to go along with increased governmental regulation of industry; there was no turning back now. So much the better that the enlightenment would prove "practical" and eventually turn a profit for the stockholders.

CONCLUSION

In summary then, certain influential businesspeople and business associations did play an extremely active role in creating regulatory monopoly in crude petroleum, though the particular circumstances of that support are not totally unambiguous. The only thing that is not ambiguous is that the present antimonopoly actions against the oil companies will not solve the monopoly problem in that industry; it is part and parcel of the problem itself. To that extent, the businessmen involved are victims, but victims, ironically, of the very same interventionist policies that they have continually supported for almost 70 years.

D.T. Armentano received his Ph.D. in economics from the University of Connecticut and currently teaches at the University of Hartford. His book, THE MYTHS OF ANTITRUST, was published in 1972 by Arlington House. His articles on economics and public policy have appeared in a number of journals, including several prior issues of REASON.