Structure Matters: Oil Markets Enter the Adelman Era.

• Author: Verleger, Philip K., Jr.
• Position: Report

INTRODUCTION

Professor Adelman would have been aware of the very complicated, brilliant attempts to model oil market behavior by Hamilton, Kilian, and others. Some of us who knew him can well imagine him remarking that such efforts are excellent and exquisite and worthy of academic recognition but useless for policymaking, planning, or predicting. At the same time, he would likely have recognized that economic practice had long since moved beyond his research approach. Today, central banks and international organizations regularly rely on elaborate, relatively rigid modeling approaches to project oil prices, often with disastrous results. To their credit, International Monetary Fund researchers Beidas-Strom and Buitron (2015) make a valiant but ultimately futile effort to explain why modern econometric models failed so badly at the end of 2014 (pp. 36-38). After examining various econometric analysis techniques in detail, they conclude simply that "demand and supply factors played a role in the oil price collapse of 2014." The authors do not, however, mention Saudi Arabia anywhere in their paper.

Professor Adelman would have had a different explanation for the 2014 decline. The phrase "economic expectations of Saudi Arabian leaders" would have been part of it. He also would have described how the Saudis' perception of the global energy market's changing structure prompted them to act as they have. He most likely would have shunned statistical methods entirely. Consequently, his analysis probably would have received little traction among the major central banks or multinational organizations such as the IMF, where econometric models are now the "WORD." As Wolf (2014) puts it, economists such as Adelman and Kindleberger "were far below the salt where the princes of academic economics sat" (p. 195). Wolf writes of macroeconomists such as Bernanke who relied on dynamic computable general equilibrium models to project the path of economic growth. He adds that these models failed to predict the 2008/2009 economic collapse. Yet, despite such deficiencies, academics, central banks, and influential global organizations such as the IMF continue to use the techniques.

Indeed, oil market analysis is also dominated by the "princes of academic economics" and their elegant econometric models. The literature is full of complicated explanations for the present oil price collapse. These studies have attempted to modify existing models to account for current events and failed. In my view, the academic economists might do better if they step away from their computers and take a close look at the importance of market structure and the actions and motives of market participants.

The organization of this paper is simple. I first discuss Professor Adelman's "structural approach" to economic problems, beginning with his writing on the Great Atlantic & Pacific Company (A&P). That work focuses on the economic structure of retail grocery marketing. I then note that many of his writings on oil markets followed the global oil industry's evolution from oligopoly to cartel to quasi-competitive markets, then back to a cartel, and finally to a competitive structure where producers with the lowest costs produce at maximum rates. The market's path forward today seems less constrained by fossil fuel supply than by impending limits on fossil fuel use, limits dictated not by markets but by governments. Adelman seems to have anticipated this "final" outcome in his work.

WHY STRUCTURE MATTERS

Hamilton (2014) published a paper on the world oil market structure just nine months ago that concluded "hundred-dollar oil is here to stay." Ironically, the prevailing crude oil price fell below $50 per barrel within weeks of its publication. Hamilton reached his conclusion by concentrating on five factors he considers to be the exclusive determinants of oil prices:

* Economic growth in emerging economies

* Increased production of low-quality hydrocarbons

* Stagnation of crude output

* Geopolitical disturbances holding back investments

* Resource limitations

What did Hamilton and the many other economists (such as the IMF forecasters) who espoused the "hundred dollar" view fail to see? Ironically, Professor Adelman could have answered this question because he made a similar forecasting error following the 1973 oil shock:

In March 1971, I said, "the genie is out of the bottle. The oil producing countries had a great success using the weapon of a threatened concerted stoppage and they cannot be expected to put it away." [NYT 3-29-71:49] A year later: "I would expect prices to describe a parabola in the 1970s--first rising, then falling" [NYT 4-10-72:53]. The parabola took much longer than I expected. The world price of oil, inflation-adjusted, rose to fourteen times the 1970 level, then declined by 1993 to somewhat lower three times. (Adelman 1995, p. xxi) Hamilton and Adelman's errors differ in one fundamental way. Hamilton did not allow for a change in market structure in preparing his 2014 paper or in any of his earlier studies. Adelman, on the other hand, saw the price rise following the 1973 embargo as resulting from a change in structure, a shift he expected would be reversed quickly. His forecast, as he humbly admitted, was wrong.

INDUSTRY STRUCTURE AND MARKET PRICES

Industry structure affects how prices are determined in a market. Adelman recognized this from the start of his career. His thesis on the A&P antitrust suit is a classic study of how structure affects market prices. Indeed, his analysis was awarded the Wells Prize by Harvard's Economics Department, an honor bestowed on the best thesis each year. Other winners include Nobel Laureates Paul Samuelson, Robert M. Solow, and Michael Spence.

Adelman's 1959 study examines the antitrust suit brought against A&P by the U.S. Justice Department. The case has been described by Levinson (2011) as the climax of "decades of effort to cripple chain stores in order to protect mom-and-pop retailers and the companies that supplied them." A&P was the largest retailer in the world at the time of the suit. The issue being argued reflected competing visions of society: one favored corporate efficiency, the other autonomous farmers, craftsmen, and merchants. It is a debate that continues today.

A&P had been attacked by antitrust regulators for its size. The company was the first to introduce the supermarket model. Because of its integrated structure, which included bakeries, large warehouses, and manufacturing plants, A&P could achieve lower costs than any competitor. Adel-man showed that the firm's aggressive approach and unified structure allowed it to achieve an expense rate for sales that was one third lower than that of any other store (1959, p. 98). The company passed its cost savings on to consumers, seeking a twenty-five percent share of any market in which it competed.

A&P's efforts to build market share and pass benefits to consumers were frustrated, though, by antitrust officials. The Justice Department

... complained that A&P had an unfair competitive advantage because its vertical integration, including manufacturing, warehousing, and retailing, allowed it to charge lower prices. Prosecutors also complained that A&P refused to buy from food companies that insisted on selling through brokers or refused to give A&P advertising allowances. (1) The Justice Department filed its suit against A&P during the Franklin Delano Roosevelt administration, a time when large companies were not favored by politicians. The government prevailed and the company was ordered to sell its manufacturing divisions. President Eisenhower reversed the ruling. By that time, though, other companies had caught up and the momentary advantage achieved through opening supermarkets had been lost.

Adelman shows that the grocery business in which A&P competed was highly fragmented, often with large sellers offering products to smaller buyers at prices that exceeded marginal costs. Established suppliers were also allowed to set retail prices. Professor Adelman also demonstrates that A&P was a relatively small participant in every regional market where it had a presence. The firm enjoyed larger profits, though, because it circumvented the price maintenance schemes imposed by large suppliers such as Lever Brothers by investing in its own manufacturing facilities or hiring third parties to produce equivalent goods. A&P was an "integrated manufacturer-wholesaler-retailer" (1959, p. 405). The gains from this approach, though, were limited.

In a telling comment that would weave through all his later research on the energy industry, Adelman wrote that the benefits of diversification into various business lines were vastly overrated:

The greater number of profit centers, the greater the insurance. But even an infinite number of profit centers would do nothing to raise the average profit over any particular time period; all this kind of insurance does is protect again crippling loss in any one short time period (1959, p. 407).

Forty years later, the importance of this message was heard by the world's integrated oil companies. Over the first fifteen years of the twenty-first century, integrated oil companies divested refining and retail assets to focus on fossil fuel production.

Adelman was also harshly critical of public policies adopted "to strengthen the local monopoly position of the retailer" and effectively preserve oligopoly (1959, p. 424). His comments on the effects of energy policy written over the following decades echo this thought.

Ultimately, the young Adelman focused on policies that widen markets and promote competition. With regard to the European Common Market, which was just forming, he wrote that the "treaty of six nations will, if successful, greatly widen the market and thereby exclude inefficient business concerns which are today sheltered from competition; their resources will be put to better use" (1959, p...