“When President Reagan decontrolled prices in January 1981, the regulatory arbitrage was over…. The strangest regulatory episode in US history was done.”
Economist Robert Murphy has summarized what I believe is the most unique, confounding, consequential regulatory episode in American history in his piece: “The Crazy Crude Oil Price Controls of the 1970s.” [1]
Yes, it happened some decades ago. But if you want to know why no economist in recent history has espoused price controls for crude oil and petroleum products, this experience rings loud today.
Basically, a large group of opportunistic middlemen seized profits that federal price and allocation regulation kept from the rightful industry parties (wellhead producers, in particular). It is the story of the unintended consequences of government intervention. Or entrepreneurial gaming in the face of regulatory constraints (with positive social outcomes in this case)–what Israel Kirzner called superfluous entrepreneurship.
And as far as me personally, discovering this episode in the business world was responsible for my ensuing interest and work in energy history and public-policy.
Background
I was the one that, so to speak, broke the story. Joe Kalt and Kenneth Arrow at Harvard (the latter would win the Nobel Prize) wrote on the same subject but missed the crude-oil and petroleum-product reseller boom.
There was a paradox at work. Just like current climate scientists are befuddled about the “missing heat” (anthropogenic warming that “should’ be near the earth’s surface but does not seem to be there), energy economists wondered why US motorists were not in the gasoline lines for most of the price-control period.
The US regulatory program was geared to negate OPEC price hikes (per-and post-Arab Embargo) by getting the price “savings” from the controlled wellhead price all the way to the pump (or furnace). Yet if prices were truly below world price levels, then motorists should have been queuing all the time, not just in late 1973/early 1974 and in the summer of 1979.)
What regulators did not understand was that cost-plus pricing at each industry stage could not prevent new parties from entering into the (regulatory) arbitrage, even with (or because of) the limited markups along the way.
The smaller the margin, the more the number of trades needed to exhaust the economic rent (what producers should have gotten in the first place sans the price controls). Many “regulatory millionaires” resulted.
My Luck at a Houston Bank
Enter me. I had recently completed my Masters in economics at the University of Houston and, with a heavy heart, entered the business world rather than struggle with mathematical economics for a PhD. to enable a teaching career. (I wrote a sad letter to Walter Grinder, then with the Institute for Humane Studies, explaining why I was abandoning the burgeoning free-market, Austrian School movement.)
I went to work for a mid-size Houston bank, Capital Bank, in 1979. I had an economics background, so my training program manager asked me to investigate and explain the incentives that allowed the bank to profit so much from a group of customers that it had not seen before–the oil resellers.
The resellers were not the traditional gatherers who picked up oil at one point and transported it to another (the early Koch Industries made money in this way), although many of the new resellers had previously worked for these companies. The new breed owned little more than telephones and fax machines, and they bought and sold oil in “back-to-back transactions.”
As such, the pure resellers needed letters of credit from a bank to execute their trades. Needing surety to buy and sell, the bank guaranteed performance and provided documentation. The same customers had nice big balances at the bank for collateral to make it all very easy.
Capital Bank where I joined the training program was number one in this business in Houston. which meant the world. The reselling business started in the early-to-mid 1970s and was roaring. How long would this business last, the bank wanted to know.
I visited with the resellers, but the real source of information was from the lawyers who defended them from the US Department of Energy whose lawyers were furiously trying to reduce the regulatory arbitrage. DOE knew what was going on and did not like it: it defeated the very essence of their program.
(Only very late in the game did DOE pass the “layering rule” to disallow any trade where physical transportation was not involved. That was too little, too late. And can’t you imagine the resellers finding ways to satisfy this requirement with a little movement, a bit more superfluous entrepreneurship?)
I ran up a large legal bill to write the study. But I described something all the hot-shot energy economists had missed (they were not privy to the information of the secretive, private companies in this trade).
Beginning a New ‘Career’
Excitedly, I applied to the Cato Institute for a book grant to write a history of US oil and gas regulation. They agreed, paying $5,000 (this was in 1980). I figured that if I could comprehend the labyrinth of federal price and allocation controls in the 1970s, I could understand the rest of it.
I took a leave of absence from the bank for what I thought would be a 12-to-18-month project. I was quite wrong! Five years of full-time, dedicated effort later, I had my book (and dissertation, it turned out), which would later be published as a two-volume, 2,000-page treatise, another story.
I also got to know one reseller, Bud Hadsell (deceased), who was buying large advertisements in the Wall Street Journal touting his activity and the free market system. I was so impressed that I wrote a letter to him asking for $500 to support my book project that became Oil, Gas, and Government: The US Experience. A week later, I got a $2,500 check from Fuel Oil Supply & Terminaling, Inc. (FOSTI), his company, with a nice note from him.
Under federal price controls, Bud could get all of his costs back dollar-for-dollar. There was more margin than he could legally take, so cost-maximization was a way to game the system. He had a chef cook for his employees with groceries from the most expensive grocery store in Houston at the time, Jamail’s. He also had many buckets of complimentary golf balls with FOSTI printed on them. Employee and promotional expenses–just subtract it from revenue as a cost-of-goods-sold to make your legal margins.
Conclusion
You can read Robert Murphy’s summary to fill in some of the blanks.
Suffice it to say that a number of “regulatory millionaires” were created from the extra-market opportunities created by federal oil price controls between 1971 and 1981. And even a “regulatory billionaire,” Robert Sutton, a former shoe salesman who found out he could buy very cheap price-controlled oil and relabel it unregulated “stripper oil” and make something like $20 a barrel (about $75 today).
When President Reagan decontrolled prices in January 1981, the regulatory arbitrage was over. The survivors were the traders who owned assets to physically move and upgrade the crude oil and the petroleum products. It was back to gathering, the pre-1970s where expertise and physical assets were required to get oil from one location to another. (Speculative trading was very risky, and small-ball arbitrage could be found here and there.)
The strangest regulatory episode in US history was done.
As for me, my oil-reseller paper began my career in energy. Without being at Capital Bank and being assigned that project, I would not have come to specialize in energy regulation and everything that followed. I would not have founded IER in 1989. And just maybe I would have continued with a banking career, quite nondescript but making a living.
Wow, for the power of fortune. But being in Houston, Texas, the energy capital of the world, increased my chances of lucking into political economy of oil and gas. And a lot that has followed as I grew from this beginning to study electricity, sustainable development, and corporate governance.
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[1] Dr. Murphy’s summary is taken from his Spring 2018 essay in the Journal of Private Enterprise, Removing the 1970s Crude Oil Price Controls: Lessons for Free-Market Reform. Dr. Murphy is an economist at Texas Tech University and a senior fellow at the Institute for Energy Research.
Because they were never participants in markets, a frighteningly large number of academics, journalists, politicians, lawyers and bureaucrats simply do not comprehend how they work.
A most delightful read !! This is just another example
of how government units interference in the free markets;
creates no solutions, but more issues and impairments.