Fifty-Sixth Annual Convention
Gas Processors Association
March 21-23, 1977
GENE T. KINNEY
The Oil & Gas Journal
Divestiture of the petroleum industry is destined to become a major issue in Congress again this year.
Encouraged by stronger-than-expected support in the previous Congress, when a divestiture amendment was defeated by the narrow margin of 54-45 in the Senate, supporters of breakup of the major integrated companies have introduced legislation again this year.
In view of the makeup of the judiciary committees of the House and Senate, divestiture legislation will not have an easy time. In the Senate there is no sign of stronger sentiment either for vertical divestiture, requiring breakup of major integrated companies into separate production, refining, marketing, and transportation operations, or horizontal divestiture, barring the major companies from owning any nonpetroleum energy resource. Sentiment in the House is unknown, since the issue has never come to a vote there.
However, the political climate for horizontal divestiture certainly is more favorable under the Carter administration. Whereas the executive branch in the Ford administration was solidly against any kind of divestiture, the situation under President Carter is reversed. His Federal Energy Administrator and Secretary of Interior have endorsed horizontal divestiture. President Carter himself during the election campaign gave qualified if ambiguous endorsement to such legislation. He could vastly increase the odds for passage in Congress by actively throwing his weight behind a divestiture bill.
The sponsors of divestiture bills claim that a breakup of the 20 largest integrated companies into separate functional divisions would promote competition within the petroleum industry. Barring oil companies from producing and selling other forms of energy, they contend, would promote competition among all types of energy.
These arguments are disputed by supporters of integration and diversification. They point out that under integration, independent refiners and marketers have increased their market shares relative to majors. Furthermore, they cite figures showing that oil-company ownership of coal and nuclear energy has led to increased production of those fuels. The petroleum industry passes all objective tests of a competitive industry - rate of return, price levels, ease of entry into the field, according to opponents of divestiture. A breakup of major companies, they conclude, would not increase competition, but rather would impair the industry's ability to expand supplies of energy needed by the nation.
If concentration is the problem, should Congress break up the 26 industries that are more concentrated than petroleum? If integration is the problem, should Congress break up the dozen industries which are more fully integrated than petroleum? The panel will address these and other questions as it examines the factual case for and against divestiture.
DR. WALTER MEASDAY
Senate Anti-Trust & Monopoly Subcommittee
Washington, D. C.
I am here today as an academic economist. I do not speak for the Subcommittee or anyone else. In fact, right at this moment we have a chairman, but we do not have a committee. The Senators are still hassling about who is going to be on it. They have been doing this for three or four weeks now. It is, I suspect, one of the reasons why I suspect the government.
Let me just give you a picture of the industry the way people who have favored vertical and perhaps horizontal divestiture see it. I will grant, along with Bill Johnson and Mike Halbouty, that concentration is very moderate in the industry. In 1975, of the ten thousand producers, the eight largest produced more than half the crude, the twenty largest about 75 percent. This is moderate concentration. It is not huge.
I'll grant that there is a number of other industries that are more concentrated. I can think offhand of automobiles, computers, men's underpants, paper napkins, and Christmas cards that are more concentrated. But that is really beside the point. What has happened in the oil industry is that there has been a very rapid rise in concentration over the last twenty years. I would trace a large part of that rising concentration to the effect of government intervention in the import control program.
Refinery concentration, the eight largest have been pretty steady for twenty years at 56 percent, the twenty largest at 84 percent. I will grant that gasoline marketing has been reasonably competitive.
It is not so much the concentrations. The concentration ratios don't prove monopoly, or the absence of monopoly, or anything else. They simply give you a descriptive picture in one form of an industry. In the case of the oil industry what we are concerned about is a variety of institutional arrangements which in effect, regardless of concentration ratios, give the leading firms a dominant position in the industry.
One of these is vertical integration. The firms which are dominant at any level of production are dominant in every one of them. The independent refiner in most cases has to get his crude oil from a major competitor. The independent marketer gets his product from an independent refiner who gets his crude oil from a major. In the past this has been possible. We found out what this meant in 1973 so far as the supply of crude oil was concerned.
The reason that Congress passed the Emergency Petroleum Allocation Act of 1973 in December was because of the steady stream of independent refiners who came in and said, "We have been cut off from our crude supply. The companies that have been supplying us with crude for twenty or thirty years have cut us off. I am thinking of one company in particular in the Mid-West. They told us on December first that we get the last barrel on December 31. We are out of business." So, we still have an independent refining sector, but it exists by the grace and favor of the government.
In addition the control of the crude market goes beyond this. We have got a variety of arrangements here. A large part of your independent production is on farm-outs, which is a good thing. It gives the firm that can't afford the financial resources to get a lot of lease acreage, gives it a chance to get in. But every farm-out agreement that I have ever seen gives the lease holder, the original lease holder, a perpetual call on the oil so long as he will meet any competitive price. In other words, the lease holder gives up the right to produce the oil but he retains the right to control its disposition. The crude pipeline system we have is controlled by the majors. There is no question about that. This is the essence of control in this market.
In 1974 and 1975, as well as today, more than 90% of the crude oil going into the ICC system goes into lines controlled by the sixteen majors, either individually or as joint ventures. Typically as far as I can see, you don't move crude on a pipeline on a real common carrier basis. In all too many cases you sell it to the owner of the line. Now he may or may not sell it back to you on the other end. What you get is a general recognition of the fact that control of the crude pipeline system is the next best thing to owning oil reserves themselves.
You have an exchange system, simultaneous purchases and sales of crude oil among the majors. The effect of this basically is to create barriers to people who do not have crude oil to exchange. I suppose a classic case here was a letter sent by the President of Kerr-McGee to Senator Rogers Morton back in 1974. The Interior Department had directed Kerr-McGee to supply some of its government royalty oil from its off-shore Gulf production to some independent refiners.
Kerr-McGee was objecting vociferously. They said, "We already have this royalty oil committed on an exchange agreement which we need to get crude oil into our Wynnewood refinery. We will have to cut our refining operations back sharply if we can't use this crude ourselves." What he said here was that it used to be with an exchange arrangement when there was plenty of oil around that your exchange partner did not require you to make delivery, but that is no longer the case. There has not been a free barrel of crude oil in the United States for several years.
What I am trying to say is there is no real crude oil market in the United States! The independent refiners exist at the pleasure of the major refiners except to the extent that the government intervenes. The independent marketers exist on the same sort of a basis. The whole purpose of vertical divestiture is to try to create a real, honest to goodness crude oil market, a market in which producers will offer their oil to all refiners large and small according to their refining capacity and their desire to bid for that oil. We think this is a feasible thing.
There is a lot of talk about the legal problems in breaking this up. The courts, every day of the week courts are involved in bankruptcy proceedings, involuntary merger proceedings, court ordered spin offs, divestiture and things of that sort. There is nothing new here. Let me give you an example of a court-ordered divestiture, the El Paso spinoff of Northwest Pipeline. This was an enormously complicated thing if you listen to the opponents of divestiture.
Actually, it was handled very easily. Twenty-seven issues of debt were involved according to the controller of Northwest. Twenty-seven separate issues, yet they were split up very easily. The court said all you have to do is set up two separate issues for each of these original issues. They are going to be in proportion to the taxable basis of the assets which are spun off. We will throw in an extra one-eighth of a percent as a kicker to make it nice. The whole thing was handled very easily. So far as equity is concerned, stock spinoffs happen all the time, and it is not a great problem.
In the interests of time I am just going to cut down to a couple of things. One of them is the whole question of OPEC. We have heard that if we break up the major oil companies, vertically or horizontally, we won't be able to deal with OPEC. Well, looking at the historical record of the past few years I am a little concerned if the major oil companies are the only hope we have. The fact is that the major oil companies have not a particularly great incentive to fight OPEC for lower prices. What happens is every time the OPEC price rises by a dollar the value of the reserves that the major oil companies still hold increases. These are book values but every banker knows about them.
Let me give you a particularly good example. The North Slope would have been an economic disaster if it had not been for OPEC. With the escalation of the pipeline costs, it would have been absolutely impossible to move that oil from the North Slope down to any domestic market if crude oil prices had not gone up to $10, $12, $15 a barrel. The result is today that according to the Petroleum Intelligence Weekly the oil companies are probably going to make something like $2 a barrel on the oil that they move from the North Slope. But if we still had oil at $4 or $5 a barrel, that oil would never have come to the lower forty-eight.
Again, just figure out how much a dollar increase in OPEC prices means to the value of 10 or 20 billion barrels of reserves for ARCO, BP's Ohio, and Exxon, and the other companies that have smaller interests up there. It is an incredible sort of thing. So, they do not really have any vested interest in holding down prices. Now, with vertical divestiture the OPEC countries would be faced by the largest refiners in the world who would be trying to exist on the basis of getting oil at the lowest possible price. Now, so far as OPEC breaking up I don't think that there is any possibility of this. I don't expect this to happen, but I do think that with vertical divestiture you would get a market discipline there.
I'll get off on one other thing which is one of my favorite kicks. Back in the early 1930's we went through the big fight over whether there would be state prorationing or federal prorationing. The good people of Texas said, "We're not going to let a bunch of bureaucrats in Washington, probably from Massachusetts, or Michigan, or someplace like that, decide what the level of production in Texas is going to be. We are going to control our own oil." So we ended up with state prorationing. We ended up with a number of key states doing their own prorationing.
I will submit that prorationing could not have worked had it not been for the major oil companies developing a price structure through the posted price system and actually balancing their liftings among several states. If you ever had a situation in which Louisiana was going at 85% of capacity while Texas was down at 25-35% of capacity, prorationing would have lasted about six weeks at the most. As it was it lasted until 1972 when it became moot. I think what we are having now is the same sort of thing. I think the major oil companies are in effect balancing their liftings among the OPEC countries. You can argue all you want to about adjusting the price structure of everything else but it is still a balancing of liftings.
How else do you explain the fact that Saudi production hasn't gone sky high with a differential of 50, 60, or 70 cents a barrel between Saudi oil and Iranian oil? The answer of course is that I think the oil companies here are not going to risk getting thrown out of Iran, or out of Kuwait, or any place else. Perhaps under the gun they are still going to in effect carry out a prorationing function for OPEC. Now, again divestiture would break this. Now I don't think it would break the OPEC cartel. What I think it would do though would be to create a market discipline which will make prices in 1980 or 1985 lower than they would have been without divestiture.
Now I want to get to one more point. I am concerned about government intervention. I really don't like it. Most of you have had more experience with FEA than I have and you know what has happened here. The FEA started as a temporary emergency organization. One ofmy friends who was working there in 1975 said that at that time there were two books of regulations. Most of you have seen the books, I think. Two loose leaf binders have made an awful lot of money for the Commerce Clearing House which publishes them and an awful lot of money for a bunch of lawyers who interpret them. There are now six of these books, I think.
Every time FEA issues a regulation it turns out that there are some complications involved which they hadn't foreseen, and they have to come out with two additional regulations. It is a geometric progression going up and up. It is rather an appalling thing to see. At the marketing level for example, there is a regulation which states in effect, if you want to open a gas station you must run a survey of all the other gasoline stations within a radius of a mile or something like it. You have to go around to all the competitors and say, "Will this new gas station hurt your business? Will it endanger your supply of gasoline?"
About the only thing FEA regulations have done is to be published. Bill was talking about new refineries, the one really big grass roots refinery which was scheduled to come on stream last October 1, the only one in the last 25 years was John Canabb's operation, Echol. What happened? The FEA, in effect, put him out of business. A week before he was supposed to go on stream, he had to sell the refinery, simply because he couldn't afford to operate under FEA regulations.
This was a regulation that was designed to bailout the Caribbean refiners who were as they felt, experiencing unfair competition from Leon Hess. This is the sort of thing that happens in a regulated economy, this is the thing which keeps me very upset. I think really, that Paul Davidson and I are the honest conservatives here. We are the people who have read Adam Smith. We have read John Stuart Mill, Alfred Marshall, all the way up to Henry Simon. We are the ones that really believe in the virtues of a competitive free enterprise system. What we are trying to do is develop something like a last gasp against the alternatives of a completely regulated system or worse.
I think probably the title of this session, Divestiture, and I may be reading it a little bit different than you people are, Competition or Nationalization is probably the best description I have heard yet of the alternatives facing us. Competition or nationalization with something in between. We can try to restore a competitive society and get government out of the act. We can let FEA go by the board and rely on competition. But to do this we have to have competitive markets. We have to have crude markets and product markets that are reasonably competitive. The alternative to this and the way that I am afraid that we are going to go is either an extension of regulation or nationalization. We can't go back to 1920, 1950 or even 1970. There is no way to do it. I think the key to this was back in 1975.
You may remember that FEA was scheduled to run out in early 1975, and Congress extended it for a month, and then they extended it until July 31. Congress was very leery of this and I think they were perfectly happy to let FEA disappear. They left for their August recess without having done anything about FEA. Technically for the month of August, 1975 FEA did not exist. Controls did not exist. All of you who were in the business went through tortures. Should prices be raised? What is going to happen? Will trouble develop if we do that, or should we keep our prices where they are and wait and see what Congress is going to do? It was a period of absolutely tremendous confusion. Congress came back and immediately jammed through another extension of FEA. They did it because they had gone back home and they talked to the people back home, and they found that the price of energy was a matter of tremendous public concern.
I saw a cartoon a couple of weeks ago with a little old lady and little old man sitting in their living room. The lady is reading the paper and says, "Oh! President Carter is going to give us a fifty dollar refund. Now we can afford to drink coffee and heat the house next week." This is the way the public has reacted really to energy prices, and it is not your fault. It is the fault of the government and OPEC. You could place the blame in a million different places. You can say we have to get used to high energy prices. As an economist I will agree, we have to get used to much higher energy prices than we have had in the past. Whether they have to be as high as they are now is another question, as Professor Davidson pointed out.
But all I can tell you is that the public sensitivity to this area is such that government is not going to go away. Regulations are not going to go away. I think there is the danger in some sectors of ultimate nationalization. The Energy Policy and Conservation Act, if I am not mistaken, now gives the President the right to take over complete control of all imports. There were proposals here that we set up a government corporation to bring in all of the imported oil and products. The President has the right to do that now. He has never exercised that right, and I trust he never will. But the power exists, and if that kind of power exists what is apt to be the next step?
This is why again conservatives like Davidson and myself say for "heaven's sakes, let's give competition a whirl before we go all the way to a regulated industry." I will say one more thing. The problem with regulation is that the companies who live on it tend to get accustomed to it. The oil industry has been a regulated industry. It has had government support for forty odd years now, and I think in a lot of areas you are used to it.
The independent marketers keep telling us "take off these controls on prices. Let's stop controlling the price of gasoline at the pump, but make sure you still leave us some security of supply. Make sure you require the refiners to go ahead and supply us." The independent refiners say, "for heaven's sakes, let's get rid of all this government regulation, but make damn sure you keep an allocation system in effect so that the majors can't cut us off." The attitude of the industry towards continued regulation I think is really ambivalent, and this is one thing that worries me. I'd like to get rid of the regulation before you get too comfortable with it. That is the reason I yell out for competition.
I am sure that you have learned an awful lot this morning that you did not know before. Some of you have learned for example that you haven't been competing with each other all of these years, and I'll bet some of you didn't know that.
The first question is directed first to Dr. Johnson, and then to Dr. Measday. Would the divestiture of oil and gas companies require a bigger government bureaucracy than exists today to monitor all of their activities?
That is an issue that I hadn't even thought about, but my guess is probably yes. It would certainly require under the various versions of the divestiture bills that have been drafted, a very much expanded Federal Trade Commission, which would be responsible for looking at divestiture proposals by the various companies that would have to be divested. There would be established a special Judiciary system, that would handle the litigation that would result from the divestiture order.
That certainly would result in a substantially increased government bureaucracy during the period of transition. If Walter is correct, which I don't think he is, that we would be able to get rid of all price and allocation controls, the FEA, the Federal Power Commission, and perhaps others who are presently involved in regulations, then over the long run maybe it would be less. But I doubt very much if that will happen. I think government regulations unfortunately, are here to stay, and that you gentlemen willy nilly slowly, and surely are becoming government employees of one sort or another .
Surprisingly, I think I find myself in substantial agreement with Bill, although I don't think that the increase in the bureaucracy necessary to handle divestiture would be large in government terms. I mean we wouldn't be creating something like HEW, or anything like that. The reason by the way for the extra court is to expedite the whole thing by creating a court with special expertise in handling these matters. It would be a temporary thing. The FTC would require a substantial growth in employment. But again, this is fairly modest by the usual standards. I don't know how many people, of course. Bill, what did you start out with in FEA, three hundred?
What is it now? About three to four thousand? I think we could avoid this because it would be a temporary experience. I'm saying because there is a time limit fixed here and in all the legislation I have seen.
Thank you Walter. I am not sure you made them feel very much better about that. The next question is directed to Mr. Halbouty. If major companies are divested, would independent producers stand to gain or lose? Your opinion please.
Well, before I answer that question I want to make an observation that if Walter Measday and Paul Davidson classify themselves as conservatives, I know that we are going to have to come up with another word for people like me. Walter's subtlety is just about as soft as a train wreck.
To answer the question whether or not if divestiture occurred would the independents be hurt or helped? There is no question in my mind that I can answer that in just about one second, and I doubt very seriously whether or not a lot of the independents left in the fold today would exist. I want to go back and make the statement that I have made over and over again. In 1956 and 1957 we had forty thousand independent operators working in the United States. Not all of them drilled wells, but they got together and helped each other drill wells.
Today, contrary to some of the statements that are made there are ten thousand operators. There are less than four thousand independent operators actually engaged in the drilling of wells as wild catters. That is a drop of over 90%. I think if divestiture occurred that the full four thousand would also drop. How much I don't know.
They talk about proration in the thirties. The reason why it was prorated by states in the thirties was to get away from Federal control. That was the reason, but the main reason for proration was not to get together and set prices as was indicated here today. The reason was because there was a glut, and I mean a glut, of oil on the market in the United States. These two gentlemen should realize that at that time we were exporters of oil. We had so much of it that we were sending it out. That was the reason why we were prorating.
Paul Davidson, you are not getting off without a question yourself. How is divestiture to break up the OPEC cartel? Be specific please.
As I said in my statement, I recommended a nine-point national economic policy for energy. Divestiture is a necessary but not a sufficient condition. If you just did divestiture by itself this is not going to break up OPEC, or even dent it significantly. What you have to do is create a whole set of market incentives which give people an incentive to undercut OPEC. And in doing so, this leaves OPEC with no alternative but to have lower prices.
Let's take Walter's question of the liftings among the OPEC nations. How is this accomplished? As far as we can tell, OPEC itself does not prorate the monthly demands. I was on a panel with Mr. Coffman, President of Exxon, a couple of weeks ago before the Joint Economic Committee. Senator Kennedy asked Mr. Coffman, "Now that the Saudis have a different price than some of the other OPEC members what is Exxon going to do? Are you going to change your liftings and so on? Would the consumer benefit?"
Mr. Coffman stated, "Yes, but we still don't have the details how the Saudis are going to work this out. Exxon anticipates increasing its liftings from Saudi Arabia vis a vis Venezuela, and changing the allocation between these two sources of supply."
Now how much of this has actually occurred? I think Walter's point that somehow or other the Saudis' production did not go up is an interesting question. There were some news comments, that Kuwait and Iran were filling [sic] the pinch because of the producers lifting more from one part than the other. This was part of the pressure the Saudis were able to put on the other OPEC nations in order to get them back into line.
Now, just ask yourself this question. Suppose all the OPEC nations which do have excess capacity in total had a single price? The vertically integrated company has some power allocating, so suppose we did just that? For one or two months we added tremendous demands from Saudi Arabia and cut back on our purchases from Iran, just to create some dissension. In other words if there is excess capacity, find a weak link, cut back on your purchases from that one, and move your purchases to the others who have excess capacity and could meet it.
Could OPEC survive that kind of thing? Well, I don't know, but obviously this would involve collusion by the integrated oil companies in order to achieve such an effect. I think the alternative that Walter is suggesting is to have an open market in crude where none of the producing nations are certain as to how much they can buy. If some of the suppliers have a cash flow problem and they find that they are not selling sufficient crude, they may be willing to cut their price. That is how the cartel may break.
So divestiture might be an alternative, you see, because there is excess capacity in OPEC for putting pressure on some of the weaker members of the OPEC group. It certainly would not harm anything and it might improve it. I again indicate that divestiture is only one of nine proposals which I would have, all of which would have an impact and effect on the market to make it harder for the Saudis to know what to do.
Marketing information is an important job. Someone says, "The Saudis can raise the price of oil to $25." But, how does he know? The only people presently who have some feeling are the major oil companies, who have some expertise in marketing. The OPEC nations, at the first blush, wanted to start their own marketing organizations. All of that has disappeared, and you might ask yourself "Why?" Has somebody else taken over that function to protect the cartel? And I think the answer is yes. Whether you like it or not.
Thank you. To Dr. Measday. You say there is a growing segment of the oil industry that is eager to speed the development of a centrally planned economy. What proof do you have to back up that statement?
It is not a centrally planned economy, but I am saying I think a growing number of oil people are willing to accept regulation. The only thing I can say here is that we have had talks. People have come in from one or two major companies and have said, "Well, you know the regulation is irritating, but we are doing pretty well financially with it. We are getting along." What happens here is you get this type of regulation over a period of years and you run into things like the hearings we had last December on regulatory reform.
The principal opponents of regulatory reform when you talk about the ICC or the CAB are the airlines and/or the trucking companies. When you talk about FPC reform the public utilities are the first ones to start objecting. You know they love the idea of existing in a regulated environment. They have learned how to live with and to prosper with it. What they are afraid of is that the absence of regulation would create the type of competition which would give them real problems. This is the sort of thing that worries me.
Thank you. This one is addressed to anyone, and I will address it to Bill Johnson. Solar power has been touted as a viable alternative to fossil fuels, but a recent study out of Washington says that it will cost $10,000 to install conversion equipment. How can the average consumer afford this?
I hate to tell you, but you have addressed it to the wrong person. I know very little about solar power, other than several observations. One is that it is a favorite of the politicians. They love it. They just think that solar power is the greatest thing, and these politicians in Congress vote multiples of money, multiples of what has been asked by ERDA, and the Solar Energy Research and Development.
It is almost as if they have gone up to the top of the Washington Monument, and just thrown dollar bills off the Washington Monument to anybody who will go out and create a solar energy project. I have in fact turned down participation on two such projects which were formed precisely to lift some of the monies that ERDA had been given by Congress, over and above what ERDA had asked Congress to give them.
There is this grand illusion that the sun will solve our problems. I have every expectation that by the mid-twenty first century that we will see fairly significant development of solar energy, but we are not going to see it for a long time. The bonus draft version of the FEA's latest Federal Energy Report (I can't remember the title) has estimates of just how much of our energy sources will be supplied by solar energy in the year 2000.
If it is a modest development maybe at the best it might supply 1 or 2% of our total energy needs. If it is substantial development with a crash effort, perhaps it will supply three to four percent of the energy supply. I would argue that one of the real problems with solar energy is the front end costs. There is a substantial cost of putting in an active solar energy unit, but there is also a still greater cost. That is the cost of self delusion that solar energy is going to solve our problems.
I think that the problems that we face are in the 1980's, and 1990's, and not just the year 2050 or whenever solar energy will come in.
Thank you. To Paul Davidson, and I would like to ask that this be a round-robin question because it is worthy of comments from others after Paul answers. I would like Mike Halbouty to follow and then Bill Johnson if he wishes to. In your opinion what is the replacement cost of energy on a barrel of oil basis? If we don't charge for replacement when selling current supplies how will future energy supplies be financed?
This is a question of capital investment, and is a very good question. It is a question of who pays at what point of time. It does not have an obvious answer. Now suppose for example we can bring up oil profitably at, just to take a number, $5 a barrel today. But we know to replace it in 1980 when these wells run dry is going to be $10 a barrel, and then let's say five years later it will be $15 a barrel and so on, that kind of simple minded example.
Should you ask the consumers in 1975 to pay $10 for the oil that will be available to consumers in 1980, and the consumers in 1980 pay $15 for the oil that will be available in 1985? Or should you ask the consumers in 1980 to pay the $10 plus the return on capital? In other words, are we supposed to be paying today for the higher priced oil that the consumers in the future are going to have?
Now the mark of the free enterprise capitalist system was that people invested their own funds in the future, and made the profits when they brought them on stream. This required men of vision who were willing to put up their equity to bring on stream things which were not necessarily profitable when they started on them, but were profitable by the time they were able to market them.
What you are asking in essence is an equity question. Should we ask the consumer in 1975, those poor old people in Walter Measday's cartoon, to buy and pay for 1980 fuel today? Pay $10 for fuel which can be gotten out of the ground with a profit of $5 today so that if they are alive in 1980 they can pay $15 for $10-fuel that is available in 1980.
If that is your answer it seems to me that you ought to give them an equity as well as if they were making an investment. If it is their funds that you are using to pay for next year's higher prices, then you ought to give them the equity in the situation. I do not think that is the way the capitalist system is supposed to work, and I would argue that if you can make money, and it is a problem, I admit, and it is a problem of building the incentive right. But you can design a market that operates like a classic textbook free enterprise market where people invest today their own equity to make profits in the future. It can be done and I think it should be done.
Mike Halbouty, would you respond to that?
Well you know it is just like I have always said when I read these reports by economists. Some of this stuff you just can't understand because it just goes round and round like a circle. I am going to turn it over to Bill in a minute, but one thing I want to say in answer to the question in observation.
In two solid swipes of the axe in 1975 and 1976, 7.5 billion dollars per year was taken away from industry, of which about four billion would have been used for exploration. The depletion allowance, and that monstrosity of a bill that Ford signed December 23, 1976 took away those billions of dollars in my opinion. When you talk about regulation and control, when you talk about capital funding, how can the industry continue the exploration program regardless of whether you have divestiture or whether you leave it like it is, conduct an exploration program without the necessary funds?
If the government keeps taking away the funds each year by tax controls and regulations, we are not going to be able to find the oil and gas for the future. Now, I don't look at it from the economist's viewpoint that was just brought out, that the person today pays for something to be given to those persons living in 1980 or 1990. I am so realistic that I feel that whatever we do today we do it because we have to today, and what it costs in 1980 we don't know. We don't know what the situation is going to be in ten years from now, or five years from now, or even tomorrow.
So what we have to do is find the oil and gas that we know exists in this country today, and we have got to do it with capital that we really and truly do not have but must find some way. They take it away from us in taxes, that means less exploration and more imports. It is a vicious cycle. Divestiture takes away the very essence to find oil and gas which is our only, only immediate source of energy for the country today.
Now Bill has said what Paul was just saying about the economist's viewpoint was wrong. I am going to turn it over to Bill and let him refute that.
You have really put me to it now. I would take exception to what Paul said about what was good economic theory. I am going to throw jargon around and I apologize for it in advance.
The price will be determined in the long run by the marginal cost of production. In the long run the marginal cost of production is going to be determined by the incremental source of oil or gas. There has always been a situation where lower cost producers have been able to earn what economists call "producer's surplus." It happens in a competitive market, it happens in a monopolistic market. It is a natural, normal state of affairs, and no one has ever questioned it as far as I know among economists until recently whether or not producers should indeed get that surplus.
When they have to replace their production it has to be replaced with a high cost alternative. It costs money to develop a high cost field for production. The replacement costs are going to be higher. They are going to reflect the long run marginal costs as opposed to the short term costs of production on a particular field.
We have to remember when we talk about oil and gas, reserves are like inventories. A businessman must replace his inventories at the replacement cost. Similarly those in the oil business must replace their reserves at the replacement cost. And those replacement costs are going to be higher not only because of inflation, but because the cheaper sources of oil and gas have already been exploited and the new sources of oil are more expensive. So it makes every sense in the world to allow those producers now operating at relatively low cost to earn a price based on the long run marginal cost of oil.
I think Paul has put his finger on something that has begun to happen in the United States. The notion exists and it is implicit in the Federal regulations that producers should not receive the producer's surplus. This means that prices would have to be set for each and every producer on the basis of cost or some rough approximation called the two tier or three tier price system. What you end up doing is creating an artificial economy, where the incentives to develop new sources are greatly curtailed. We simply will not develop the new replacement sources as rapidly as possible because of the lack of investable funds, and the lack of providing adequate profit incentive to the companies who have done it.
Now the question was what will be the replacement costs? The Saudis and the other OPEC countries in 1973 were clearly looking at shale oil. From my conversations with them they thought the price of shale oil might be the long run marginal cost of oil, and therefore the bench mark they could use in establishing their price of oil in order to gather in all the economic rents that their oil would provide them. I think it is equally clear that the Saudis and the OPEC countries have misjudged the economy. I think the notion that shale oil is on the margin is probably questionable.
I would guess that the margin is going to be provided by more extensive development of alternative oil and gas deposits in the next ten years or so. The incremental source of oil and gas will be working over existing wells and more secondary and tertiary development measures.
The final question before we end up this session is directed to Dr. Measday. Wouldn't divestiture, vertical that is, result in the world's greatest refiners bidding up the price of the limited supply of crude oil in the United States to keep their facilities loaded?
Assuming again, hopefully that we would get out from under regulation, and again with imports at this point being the marginal oil, then there is no question but what U. S. oil prices would go up to the price of imports. This would be a free market solution. Now, the hope here is given in the fact that there is a world surplus of oil, not a world shortage of oil at this point. Again I go back to the fact that vertical divestiture would create a market discipline on the OPEC countries.
By putting this market discipline on them you would at worst slow down further OPEC price increases. At best I think you might actually get some modest reductions. The domestic price for crude would increase to meet the price of imports with transportation differentials but wouldn't go any higher. You wouldn't bid above the delivered cost of foreign oil, because then it would pay you to use the foreign oil.