Removing the 1970s Crude Oil Price Controls: Lessons for Free-Market Reform.

Author:Murphy, Robert P.
  1. Introduction

    "There's nothing more permanent than a temporary government program" is a common and cynical view among market-friendly economists. Ludwig von Mises (1949) and Robert Higgs (1987) both argued that initial government interventions into a sector of the economy will tend to grow. Public choice scholars certainly appreciate the difficulty of rolling back major policy changes when they involve massive flows of wealth to concentrated beneficiaries.

    US government intervention into crude oil markets during the 1970s seems a perfect example of this pattern. What started with Richard Nixon's general wage-and-price controls soon evolved--especially after the OPEC embargo--into an intricate system of price and allocation controls in the petroleum market. Lane (1981) summarized the episode: "From their imposition in January 1974 to their demise in January 1981, the controls were amended several hundred times, either by rule making, legislation or through issuance of 'interpretative guidelines' ... an examination of the major regulatory changes in that period illustrates a principal characteristic of this kind of detailed economic regulatory structure--changes made to 'fix' one kink in the system resulted in new kinks with different individuals or groups as the new winners and losers'" (p. xx, emphasis added).

    One might have predicted that once in place, such extensive top-down controls on the oil industry would have been impossible to repeal. And yet, as Lane's summary indicates, the controls were ultimately abolished. We no longer have the detailed top-down controls of the 1970s, and indeed the oil market was arguably freer by the late 1980s than it had been in the late 1960s.

    How was this possible? Why did the cynical pattern not play out as it has in so many other sectors of the US economy? Are there lessons for free-market reform that can be applied outside of the petroleum experience? I seek to answer these questions in this paper.

  2. Milton Friedman and the Nuances of Regulation

    In his May 1975 Newsweek column, Milton Friedman took on "two economic propositions affecting current policy which are wrong yet are treated as self-evident in essentially all public discussion." The first concerned tax policy; the second, crude oil price controls:

    Decontrol of the price of "old" oil would mean a higher price of gasoline and fuel oil to final consumers ... The price of so-called "old oil"--mostly that part of the oil produced from domestic wells which does not exceed in amount the precrisis level of output--has been fixed at $5.25 a barrel, while "new oil" and imported oil have been selling for more than twice as much. Elimination of the price ceiling as proposed by President Ford has been treated by opponent and proponent alike as a measure that would raise the price of gasoline and fuel oil to the consumer ... this is a fallacy, and again, it arises from looking at visible effects alone. The quoted price of "old oil" would unquestionably rise, which appears to raise the cost of gasoline, and--here comes the fallacy--therefore its price. But surely, the rise in the price of old oil would also give producers an incentive to produce more oil. How can more oil be produced yet the final price of petroleum products be higher? (Friedman 1975a, italics in original, bold emphasis added.)

    To paraphrase Friedman's argument: The federal government's crude oil price controls only locked in the "old" producers at a low price ($5.25 a barrel, at the time Friedman was writing), but allowed "new" domestic producers and foreign importers to sell at the world price. Even so, Friedman argued, the quantity of "old oil" brought to market would surely increase if its owners were allowed to earn the actual market price.

    Therefore, if the Ford administration were to get its way and eliminate this particular price control on crude oil, then total US crude output would rise. More total crude delivered to refineries would mean more total gallons of gasoline delivered to market. Since the shortages at the pump had disappeared in early 1974, an increased quantity of gasoline could only be sold (moving along the public's demand curve for gasoline) if the price at the pump fell.

    It was a beautiful analysis, but it was (probably) wrong. Federal regulations actually were holding down gas prices at the pump, because the price controls had been supplemented since November 1974 by the "entitlements" program. (1) Friedman admitted his mistake in a subsequent Newsweek column a month later, when he wrote that a former student "has informed me that my [earlier] analysis was incomplete and my final conclusion wrong. My mistake was in not realizing how perverse and irrational are the Federal Energy Administration's regulations" (Friedman 1975b, p. 75). It wasn't often that Friedman had to partially retract an argument he made to the public. Why did it happen?

    To understand just how complex the federal regulations were-and to see why Friedman was amazed at their perversity and irrationality--consider the structure of the original price control scheme. The key component of phase four of the Emergency Petroleum Allocation Act, which began in the late summer of 1973 and was codified in November 1973, "was a two-tier system of price controls on domestically produced crude oil" (Kalt 1981, p. 12). The price of "old oil" and the base production of stripper oil (from wells nearing the end of their useful lives) was "limited to the levels they were at on 15 May 1973 plus $0.35 per barrel," while "new, new stripper, released, and imported oil prices were not controlled" (Kalt 1981, p. 12). (2) The controls were meant to limit "windfall" gains to historical domestic producers coming from the sharp increase in world oil prices, while at the same time retaining incentives to develop new domestic sources as well as to bring in necessary imports.

    The two-tiered system caused problems immediately. With the domestic crude price at the wellhead of "new" oil averaging $10.13 in 1974, compared to $5.03 for "old" oil (Kalt 1981, p. 18), the obvious consequences ensued. There were reports of refiners paying domestic crude producers well above the world price for "new" oil in order to obtain tie-in contracts to purchase "old" oil at the controlled price.

    To prevent this type of maneuvering, on January 15, 1974, the Federal Energy Office (FEO) enacted regulations that "froze buyer-supplier relationships (at all stages except retail) into their 1972 status." Under these rules, "suppliers were required to continue to provide supplies to a customer in accord with the percentage of the supplier's total output provided to that customer in the base period" (Kalt 1981, pp. 12-13).

    Yet with one problem solved, a new one arose. By freezing the relationships between domestic crude producers and refiners in their pre-crisis configuration, the new regulations conferred an arbitrary advantage on those refiners who happened to historically have relationships with "old oil" producers. They were now guaranteed first dibs on barrels of crude selling at the controlled price, whereas the refiners who historically had purchased imports had to pay the full market price for their crude.

    The solution to this new problem was the old oil entitlements program, which became effective in November 1974. The program gave monthly entitlements to refiners, equal to "the number of barrels of controlled crude oil that that refiner would have used in the previous month had it operated using the national average proportion of controlled to uncontrolled crude" (Kalt 1981, p. 14). The refiners then had to turn in an entitlement for every barrel of controlled crude they used, and there was a market where refiners could buy and sell entitlements according to whether their operations were under or over their "fair share" of oil obtained at the artificially capped price.

    The overarching purpose of the old oil entitlements program was to equitably distribute the gains from artificially cheap old oil among all of the nation's refiners. (Small refiners received special advantages that I am neglecting for simplicity.) Under the program, it didn't matter what a refiner actually spent on obtaining barrels of crude; he would (retroactively) be either compensated or penalized to make his average cost equal the national average.

    However, even though the entitlements program sought to equalize average costs...

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