A price elasticity of .36 is a middle ground estimate. Some authorities have estimated elasticities as low as .1, and others as high as .5.90 That range of elasticity estimates implies that welfare loss could be between four hundred million and two billion dollars annually. Based on 1980 demand projections at various prices reported in FEA's 1976 National Energy Outlook, the loss would be under $1 billion per year.91 Redistribution of wealth In addition to their efficiency effects, oil price controls transfer purchasing power from owners of oil properties to consumers of petroleum products and, possibly, to refiners. During 1975 that transfer amounted to about $14 billion.92 (=$7.50 price differential times 1.8 billion barrels of old oil production.) If price controls were continued to 1985, production of controlled oil would decline due to the natural deterioration of fields. Taking a high estimate of the decline rate (13.5 percent per year),93 old oil production in 1980 would be about 50 percent of 1975 production. The income transfer in that year would consequently be about $7 billion. From the point of view of consumers, the perhaps $2 billion efficiency loss was definitely overshadowed by the income transfer. An alternative view A recently developed school of thought holds that there are no efficiency losses on the demand side due to crude oil price controls, and that the only income transfer caused by those controls is from oil producers to oil refiners. This theory is based on the assumption that refined products are imported into all regions and that world refined product prices are independent of United States demand. The supporters of this view rest their argument on the fact that when the entitlements program became effective in early 1975, the expected drop in product prices did not occur. It is argued that if the entitlements program were effective in passing cost savings on to consumers, refiners would lower prices after its institution. In particular, refiners who had previously earned economic rents by selling their products manufactured from lower cost, controlled crude at the marginal cost of the higher cost refiners (who ran disproportionately large amounts of uncontrolled crude), would lower prices. What in fact happened is that refined product prices did not decline. In fact, they followed an upward course during 1974 and 1975, even with what was thought to be the mitigating effect of the entitlements program. This poses the question of what is the marginal cost of refined product. If marginal cost is determined by the highest cost domestic refiners, then it would be expected that prices would decline if that refiner's costs were lowered by $3 per barrel during 1975 via entitlements. However, product prices in fact rose. One explanation might be that the marginal cost of oil fuel is that of imported refined product, the 0 Pan Davidson. L. Falk and H. Lee, "Oil: Its Time Allocation and Project Independence." in Brookings Papers in Economic Activity, vol. 2. 1974, p. 438. Based on 1980 demand projections at various prices reported in FEA's National Energy Outlook-1976. Based on data provided by FEA entitlements program. 93 Oral Communication, William Carson, FEA. price of which is determined in the world market. Another explanation is that the refined product price control and allocation programs were holding prices down prior to the institution of the entitlements program. In this case the entitlements program could make the price ceilings ineffective without causing actual prices to fall. No contemporary evidence is available to confirm this alternative. theory. In general, domestic prices of gasoline and distillate fuel in most regions and seasons, are lower than world prices; but prices of residual fuel oil do appear to track world raised prices. On balance, welfare and distributional effects of crude oil price controls are probably smaller than those estimated in this chapter, but not negligible as the alternative theory suggests. Encouragement of imports When the vulnerability of imports to embargo or sudden price increases are taken into account, an additional potential economic cost of price controls appears. The price of imports probably underestimates their cost to the economy, in that they bear with them a risk of future economic harm. By adding to the price of imports a "supply interruption premium" equal to the expected present value of the harm that would be done by an embargo which made it impossible to obtain that barrel of oil, an estimate of the true cost of imports would be obtained. The complexities involved in determining that premium are beyond the scope of this report. But any such premium would increase the economic loss due to reduced domestic production and reduce the loss associated with released oil. The change would equal the premium times the amount of imported oil involved. As long as the effects of released oil on production are less than the effects of price regulations that tend to reduce production, introducing a supply interruption premium increases the economic loss due to price controls. PRODUCT PRICE CONTROLS Even if refined product price controls were completely ineffective, crude oil price controls could hold the cost of refined products to consumers below the levels that would exist in the absence of all price controls. Whether or not refined product price controls have any effect on the efficiency of resource allocation in oil refining, marketing or consumption depends on whether those controls do anything not also done by the crude oil program. Thus the first question that arises in evaluating refined product price controls is whether they are effective, in the sense of holding the prices received by a refiner below the levels that would be established in an unregulated refined products market given the existence of crude oil price controls and entitlements. There are three possibilities: all, some, or no refiners face effective price constraints. Consequences of effective controls If all refiners were forced to sell at prices below those that would clear the market, demand at the legal price would exceed supply. All refiners would be able to produce additional products at prices less than those consumers were willing to pay for the additional output. but refiners would find that production unprofitable at controlled prices. Such a situation represents a clear loss in economic efficiency. Some kind of allocation program would also be required to distribute the inadequate supplies among potential customers. 94 A less obvious type of problem could occur if effective price ceilings were high enough to balance supply and demand in the short run but failed to provide an adequate incentive to expand refinery capacity in the long run. Refinery capacity increased less than two percent between January 1975 and January 1976; some industry sources claim that limitations on the recovery of certain non-product costs prevent them from earning an adequate return on increased capacity. During 1974 and 1975 not all expenditures that an economist would consider costs could be used to revise price ceilings. The definition of "nonproduct" costs does not include all adjustments necessary to maintain a competitive rate of return. Although interest charges may be passed on, increased cost of equity capital (a less precise concept, to be sure) may not be translated into higher prices. With rising interest rates and difficulties of raising equity capital since 1973, that restriction adds up to difficulty in earning a sufficient return on investment in additional refining capacity to justify expansion. A similar problem arises from being unable to pass through increased depreciation charges occasioned by inflation or additional investment. According to testimony by an Exxon spokesman, FEA regulations in late 1974 would allow a new facility to earn a profit margin only about one-half as large as that required to provide a ten percent return on investment. Exxon concluded that: Price controls in their present form, which restrict refiners to historical margins plus an incomplete recovery of additional costs, are clearly inadequate to justify the higher level of investments and operating costs faced by refiners planning new facilities at this time." The same source pointed out another problem that could result from price ceilings based on crude oil costs: lower quality crudes normally cost less to purchase but require higher investment and operating costs to make the products required by consumers. The lower purchase price is normally the incentive to incur the costs. However, current regulations require the lower crude price associated with lower quality crudes to be passed through as lower product prices and at the same time, do not make adequate allowance for recovery of the higher investment and operating costs.9 There is, however, evidence that price ceilings are not effective for all refiners. FEA regulations provide for the "banking" of increased costs which refiners, for any reason, are unable to pass on to their customers. Subject to some restrictions, these banks can be applied to raise prices when market conditions permit. Consequently the existence of cost banks, data on which is provided in Table 7, implies that refiners could increase prices if they wished. Any refiner with cost banks would therefore be free of effective price controls. Some caution must, however, be exercised in interpreting the data in Table 7 as evidence that price controls are not generally effective. There is some seasonality in the size of banked costs, due to reasons other than market prices being at a level below statutory price ceilings. During late winter and spring, for example, some refiners in 24 FEA, "Trends in Refinery Capacity and Utilization." June 1976, p. 7. crease their gasoline output and store excess production for sale during the high driving season. Such refiners would build banks if, for example, crude oil prices increased during late winter and spring and would not recoup those cost increases ("draw down banks") until midsummer.97 TABLE 7.-UNRECOUPED COSTS FOR REFINED PRODUCTS FOR 30 LARGEST REFINERS 1 Prior to January 1976 refiners were not required to maintain separate banks for aviation jet fuel. Source: FEA Monthly Energy Review, July 1976, p. 66, and DOE Monthly Energy Review, June 1978, p. 62. Consequences of partial effectiveness Even if cost banks demonstrate that price ceilings are not effective on all refiners, they may be effective on some. This situation could Exxon, Oral Communication, July 20, 1976. occur if different refiners were to incur different cost increases or began with different base prices. To describe this situation it is necessary to begin with a general analysis of the effect of price controls on refiners' output decisions. If unit costs of refining increase as the output of a refinery of fixed capacity increases, a point will be reached at which the refiner would obtain reduced profits if output were expanded further. If the controlled price is below the market price, that point will be reached at a lower output than would be the case without price controls. Consequently, price controls-when effective-tend to reduce refinery output. Price ceilings above market prices do not affect output decisions. Unit costs of the refiner with a higher price ceiling will be greater than unit costs of the refiner with the effective lower price ceiling, because each refiner will adjust its output until the cost of increasing output by one barrel equals the price it receives for one barrel of output. Suppose, for definiteness, that one refiner faces an effective price ceiling of $10 per barrel, while the other is charging a price of $15 per barrel that is less than its price ceiling. Then the first refiner could increase its output a small amount at an average cost, per added barrel, of about $10. The second refiner would, if it reduced output a small amount, reduce its costs by about $15 per barrel of reduction. Thus by shifting some customers from the high cost to the low cost refiner, the same demand could be satisfied at lower total cost. Consequently, when some refiners face effective controls and some do not, supply of petroleum products is less, at the price paid by customers of the high cost refiner, than it would be without controls. Removal of controls would cause some prices to fall-in particular, those charged by refiners whose prices are below controlled levels. At the same time, removal of controls would allow prices received by other refiners to increase. The net effect of removing price controls would be to increase the economic efficiency of the refining sector, by reducing the share of high-cost refiners and increasing the share of low-cost refiners. This conclusion regarding refining efficiency must be qualified by noting that some refiners have relatively low costs, and may have low price ceilings, because they benefit from the small refiner bias in entitlements. Since their lower cost does not derive from more efficient operation, price controls that prevent such refiners from exploiting their lower cost to increase sales need not cause a decrease in economic efficiency. Because of the purchaser-supplier freeze, the low-cost refiner must first offer its output to its historical customers. Those customers are likely to purchase their entire allocation, because of its advantageous price. Customers historically associated with the high-cost refiner are unlikely to be able to obtain any products from the low cost refiner unless it has surplus product. Different consumers will thus face different prices for identical products. The result of such differential pricing is likely to be misallocation of products among customers: those assigned to the low cost refiner will be encouraged, up to the limit of their allocation, to make less valuable use of products than would be made by the customers facing the higher price of the second refiner. In the case of motor gasoline, discussed below, the situation is somewhat different because no purchaser-supplier freeze gives historical retail customers easier access to low priced dealers. 83-944-78- -51 |