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TABLE V-1.-Net income after taxes as a percent of stockholders equity for the eight largest integrated petroleum firms
12. 6 11. 2 13. 4 10. 2 8. 7 9. 6 6. 9 10. 4 11. 1
12. O 10.6 13. 1 10. 4 8. 7 9. 3 7. 4 9.8 10.8
13. O 10.5 15. 4 13. 2 12. 3 10.1 11. 0 10. 7 12. 4
9. 7 1. 4
9. 3 1. 5
11. 5 -.7
13. 4 - 1. 3
15. 8 15. 2
Net difference 3.
3 Weighted average return for the 8 companies less that of all manufacturing.
1 Based on "Moody's Industrial Manual.”
? "Economic Report of the President," January 1973, p. 280. The Federal Trade Commission is cited as the source.
Ordinarily such a rate of return pattern would not be much cause for concern; however, the petroleum industry has been given a plethora of special tax advantages not equally available to all other manufacturing firms. For example, the oil depletion allowance enables petroleum companies to deduct 22 percent of the value of crude production from gross income. To the extent that this procedure leads to “writingoff” assets more than once, it provides crude producers with substantial “unreported profits.” A preliminary attempt to adjust company rates of return for the impact of the depletion allowance showed that it raised rates of return by about 4 percent. In addition, these companies may expense, on a current basis, investments made in drilli operations rather than treating such investments as long-term capit which would be depreciated over time. Further, they receive a foreign investment tax credit and foreign royalty credit which may be used to offset their domestic tax liability. No quantitative adjustment to rates of return to allow for these factors has been possible. However, again these tax provisions tend to cause an important understatement of profitability. Thus, there is considerable reason to believe that the after tax .# shown understates the true profit of the companies. Evidence accummulated thus far—including materials obtained through surveys of independent crude producers, refiners, and marketers—indicates that (1) crude oil production is highly profitable although profits are undoubtedly overstated because the oil depletion allowance leads companies to try to “report” refinery profits at the crude level since crude profits are effectively taxed at a lower rate; (2) refinery profits have been during the past decade below the competitive level at least for independents so that entry has been deterred; and (3) marketing profits appear to be highly variable with the major firms doing less well than large independents although the present gasoline o is imperiling the existence of some independent marketers. Two additional observations about industry performance need to be made. First, the pattern of refinery margins over the past two dec. ades is analyzed with the relationship between refinery margins and . especially scrutinized. Second, the cost to consumers in terms of inefficient marketing operations is examined. Refinery margins were generally lower in the sixties than they had been in the fifties. In the early fifties refinery margins were well over $1 per barrel. While we cannot compute completely accurately the margin required to earn a competitive rate of return in this period, the range must have been on the order of 40 to 70 cents a barrel. Thus, there is little doubt that in a normal industry entry would have been profitable and would have taken place. Toward i. late fifties and throughout the sixties rising crude prices were not fully offset by ris. ing product prices and margins were “squeezed.” Margins in the sixties were generally below $1, while capital costs had probably doubled. Estimated refinery investment costs per daily barrel were $888 in 1960." By 1970 the figure had risen to $1,500. Annual capital costs rose sharply from 1960 to 1970. It is also likely that operating costs have risen with rising fuel prices and wage rates. Thus, while we cannot say with complete certainty whether refinery margins in the sixties
*Adelman, op. cit., p. 377.
were sufficient to yield a competitive rate of return on refinery operations, we can say that entry into refining was less attractive in the sixties than the fifties for non-integrated firms.
Thus, during the term of the import quota which gave the majors greater control over crude oil prices, refinery margins diminished even though demand for refined product was growing rapidly and the economy was enjoying rapid, recession-free growth. Average margins for refined products from 1952 through 1972 are given in Table 10. It has been widely reported that independent refiners were not earning competitive profits during the 1960's. Therefore, the absence of independent entry during the 1960's is not at all surprising. In fact, the changes in margins suggest that the majors were capable of exercising a “product squeeze" on independent refiners to create a barrier to entry.
TABLE 10.-Refinery gross margins, 1952–72 1
1 Source : “U.S. Wholesale Prices of Crude Petroleum and Principal Products,” Independent Petroleum Association of America, 1973. Because invested capital grew rapidly over the period, margins as a percent of capital fell much more dramatically. * A voluntary import quota program was initiated in 1957. * A mandatory import quota program was initiated in 1959.
Perhaps the most serious deficiency in performance, however, occurs at the marketing level. The largest major companies (1) tend not to sell gasoline to independent marketers, and (2) seek to gain brand identification by operating or leasing many stations so that motorists will always be within close proximity of the major company's stations. The result is that the number of independent stations is limited by the availability of refined product from sources other than the leading major firms, particularly independent refiners. If no independent refiner exists in a particular area, there will invariably be fewer inde
pendent retail outlets than in areas where considerable independent refining capacity is present. On the other hand, major integrated companies apparently seek to expand sales through their branded outlets partly by locating stations densely through their natural marketing areas. This strategy means that motorists will on average encounter more of a company's branded stations than a given independents' outlets for any given distance along a street or highway. Presumably the proliferation of branded stations encourages motorists to obtain major company credit cards since the probability of encountering a particular type of branded station of any given type is increased. By inducing consumers to obtain credit cards and by locating stations densely, the majors are able to increase total sales.?
This strategy, however, leads to the erection of many branded stations with low volumes. It is clear that some of these stations have such small volumes of gasoline sales that they are neither efficient nor profitable. This supposition is supported by the very high turnover rate among major station dealers (approximately 25 percent per year), by the fact that the majors are closing small stations and building large-volume "fighting brand” outlets now that there are strong incentives to earn profits at the refining and marketing levels rather than at the crude oil level.: At the same time that low-volume branded stations proliferated, efficient independent operations were limited by the lack of availability of refined gasoline. In 1970, over 35 percent of major stations had volumes less than 17,000 gallons per month while independents averaged a much higher volume sometimes rising to the 450,000 gallons per month."
At any given time consumers will demand a certain mix of branded and unbranded stations. Some will seek a combination of low-priced gasoline and little service by going to independent outlets. Others will wish a different consumption package including high-priced gasoline and more service and amenities. These consumers will grant their custom to branded stations. In recent years, consumers have increasingly demanded the package provided by independents as evidenced by the rapid growth of these types of outlets. However, that growth has been limited especially in areas where little independent refining capacity exists. Therefore, consumers are provided less of the independent prod. uct mix than they want in certain geographic areas (e.g. Maine and other New England states) and more of the branded product than they desire. Thus, real cost is imposed upon consumers by denying them the product mix they seek,
2 It is important to point out, however, the proptability of integrated oll companies ia gasoline marketing is not necessarily as high as independent marketers. This is so because there are indications that the integrated oil companies are less efficient than the independent gasoline marketers. To some extent, the lack of equal efficiency may be due to an historical lack of effective price competition among the major integrated firms. As inde pendent gasoline marketers became
more of a competitive threat to the major oll com panies, these major companies, in addition to restrictive devices previously discussed, began to close inefficient stations, retreat in marketing territory, and even market some gasoline through independent” type high volume, minimum service gasoline stations, However, it is not clear that even under competitive circumstances, the major oll come panies could operate as efficiently
as independent gasoline marketers because of the large number of retail stations which they operate. That 18, it is possible that beyond a certain Dumber of retail outlets, diseconomies of management and rising transactions costs cause the per outlet
cost of operation to rise substantially. Thus, the ability of the major oil companies to earn rates of return in gasoline marketing equal to independents exists only to the extent that they can be forced to operate as efficiently.
3 See discussion of changing incentives in the oil industry, infra at VI-7 et seq. • Fred C. Allvine and James M. Patterson, Competition Ltd.: The Marketing of Gasoline (Bloomington, Ind. 1972), pp. 30, 78, and 86.
Ordinarily when consumers wish more of a particular product, they bid its price up and thereby induce suppliers to produce more of the product. In gasoline marketing, though, independents cannot fully respond to consumer demand unless they can obtain access to additional gasoline. In an open market the independents would get more gasoline by bidding up its price. In the petroleum industry, however, transactions are typically not “arm's length” open market transactions. Rather, gasoline and crude oil are transferred largely by exchange agreements or processing agreements or are simply retained within the confines of vertically integrated firms. Thus, the misallocation of resources associated with having too few independents and too many branded stations is a result of (1) the eight major integrated companies’ refusal to deal with independent marketers and (2) the absence of a genuine market.
In the next section, attention will be given to recent developments in the industry which have changed the profit incentives of major integrated firms and have seriously imperiled the existence of independent marketers.