Planned Chaos: U.S. Petroleum Policy Remembered

A half-century ago this October, the Arab members of the Organization of Petroleum Exporting Countries (OPEC) announced a production cut and embargo against the United States. The consequences represent a case study in the perils of economic intervention by government. Wrong-headed public policy can turn market challenges into a full-blown crisis—and did so with petroleum in the 1970s. Worse, a false narrative emerged about energy security that would plague U.S. policy for decades.

The crisis did not begin with the five percent production cut and embargo. It began with the passage of the Economic Stabilization Act of 1970, which gave the President authority to enact wage and price controls. Richard Nixon invoked this power on August 15, 1971, setting a 90-day freeze on all wages and prices in the U.S. economy. Monetary expansion, the real culprit behind price inflation, was conveniently ignored.

The controls shocked Milton Friedman and other free-market economists but attracted wide business support. The “temporary” program, it was said, would quell inflationary expectations to check rising prices. But the first peacetime price control program in U.S. history would go through five phases over the next 33 months—Phase I (Freeze I), Phase II, Phase III, Phase III 1/2 (Freeze II), and Phase IV—and it would distort the petroleum market more than any other major industrial sector.

Oil shortages at the wholesale level and spot gasoline lines by late 1972/early 1973 resulted in Congressional hearings on energy-use conservation, another peacetime first. Growing petroleum problems led Nixon to create three successive bureaucracies over oil policy. On the legislative front, a major energy bill was working its way through Congress to deal with petroleum prices and allocation. All this was before the October 1973 announcement by OPEC (itself created in 1960 in retaliation for U.S. oil import quotas).

The Arab OPEC actions against the United States in fourth-quarter 1973 worsened Nixon’s oil crisis. But it was pre-existing federal regulation that fathered the panic at the pumps. As Ayn Rand noted at the time:

The U.S. on-and-off oil crisis persisted until decontrol and market adjustment set-in during 1981.

EPAA of 1973

The Emergency Petroleum Allocation Act of 1973 (EPAA), which Nixon had opposed for months, was enacted the month after the Embargo. EPAA linked price and allocation controls. “The creation of Part 210,” stated the Federal Energy Office, “recognizes the compelling necessity of viewing both allocation and price problems within the context of a single regulatory framework.”^[1]

Intervention-begetting-intervention marked the seven-year reign of EPAA. A higher price cap for “new oil” than (physically identical) “old oil” was introduced, a price schema that grew to three categories in 1976, five in 1977, and eight and finally eleven in 1979.

With downstream parties differentially impacted by wellhead price categories, distortions reigned on the distribution side. Two regulatory programs, the supplier/purchaser rule and the buy/sell program, continually amended, tried to address price inequities between independents and integrated majors.

Another distortion was U.S. refinery purchases given multi-tiered domestic price ceilings and unregulated import prices. Specifically, inland refineries tied to domestic oil capped at $5.25 per barrel in 1974 were greatly advantaged over coastal refineries paying a world price approaching $10 per barrel. The result was the Old Oil Entitlements Program of 1975, which required refiners with an average crude acquisition cost under the national average to write a monthly check to an oppositely situated refiner.

Entitlements “equalization” was quickly politicized. The “small refiner bias” awarded bonus entitlements to refine low-cost oil without obligation to subsidize inefficient “tea kettles,” some of whom suddenly entered the market. Exemptions also rewarded the politically astute at the expense of their more efficient rivals—and consumers.

Oil Reseller Boom

The refiner-entitlements program was the most visible and criticized program under the EPAA. But an almost invisible regulatory episode grew up alongside oil price and allocation controls—the oil reselling boom—that ranks as one of the most bizarre in U.S. history.

The nation suffered through several major petroleum shortages during the 1970s. But for most of the price-controlled period, supply and demand meshed at retail without queues. Why did U.S. consumers pay record-high prices—even approximating the price of world oil—despite maximum price regulations at every transaction point to ensure the opposite result?

Part of the answer was that domestic refiners purchased uncontrolled imports to price-blend with (underpriced) domestic regulated crude, increasing the cost of imported oil by an estimated 10–20 percent.^[2] Second, a swarm of nouveau oil resellers profitably bought and sold price-regulated (underpriced) oil—a regulatory gap that energy planners could not plug despite regulating margins per transaction. While physical transportation, refining, and retailing involved a limited number of markups, resellers could buy and sell the oil repeatedly with the quantity and location physically undisturbed.

Back-to-back trading (“daisy chaining”) became commonplace to capture the margins and prices that, by law, were denied at the wellhead. So long as the refiner could buy crude and make its maximum profit, and so long as the retailer could sell the churned product at full margin, the opportunists could bid up the price to “market” levels.

Hundreds of resellers consummated hundreds of thousands of transactions in this way. The good news was that the resulting price increases kept motorists out of gasoline lines for most of the price-control period; the bad news was that domestic oil producers were prevented from producing an estimated one million (additional) barrels per day.^[3]

The revenue that would have gone to oil producers (and royalty owners), in other words, went to foreign petro-states and to fly-by-night resellers, a number of which became “regulatory millionaires.” This example of superfluous entrepreneurship was an unintended consequence of intervention.

[1] The summary to follow is taken from Robert L. Bradley, Jr., Oil, Gas, and Government: The U.S. Experience (Lanham, MD: Rowman & Littlefield, 1996), chapter 9, chapter 12 (pp. 667–710), chapter 20 (pp. 1194–1228), and chapter 27.

[2] Joseph P. Kalt. The Economics and Politics of Oil Price Regulation: Federal Policy in the Post-Embargo Era (Cambridge, MA: MIT Press, 1981), pp. 286–87. This represented a regulatory subsidy to OPEC and other exporters to the U.S.

[3] Kalt, The Economics and Politics of Oil Price Regulation, p. 287.