The Crazy Crude Oil Price Controls of the 1970s

In August 1971, President Richard Nixon enacted comprehensive wage-and-price controls in a misguided effort to contain inflationary pressures. (Contrary to the faulty memories of some Americans, this initial round of controls wasn’t due to the OPEC oil embargo, which didn’t occur until 1973.) Free-market economists like to use the long lines at the gas pump as a great teaching example of the problems with price controls. Yet the controls at the consumer and employee level were relaxed, and didn’t interfere with the market as much as, say, we are seeing in Venezuela today.

However, the federal government’s controls on crude oil (and natural gas) were not relaxed. In fact, as problems kept popping up with each round of interventions, the government would enact a new flurry of rules and regulations. Yet perhaps surprisingly, by the end of the decade President Jimmy Carter signed a deal to (gradually) liberalize energy markets, and President Ronald Reagan accelerated the process when he took office.

In the Spring 2018 issue of the Journal of Private Enterprise, I have an article detailing some of the major events and causes in this fascinating chapter of energy history. In the present blog post, I’ll relay just one of the stories, which I learned from the research of Robert Bradley (founder of the Institute for Energy Research).

Specifically, I will tell the story of the “reseller boom,” in which financiers in the oil market made phony trades in order to evade the spirit (and sometimes the letter!) of the price control rules. Thus, clever traders instead siphoned off the ostensible margin of profit that was supposed to go to the American public. The episode was just one of the reasons that even Congress threw in the towel and realized that price controls were a very poor instrument.

The Context: Price Limits on Crude Oil

Due to a combination of factors, including aggressive U.S. monetary printing (Nixon had abandoned the gold standard back in August 1971, along with his other shocking announcements) and the OPEC embargo, the world price of crude oil increased sharply during the 1970s. The U.S. government slapped price ceilings on crude oil in an effort to prevent the price of gasoline skyrocketing for American motorists.

However, the problem was that the U.S. was a net importer of crude oil. Importing refiners had to pay the world price for crude; otherwise, exporting countries would sell the barrels elsewhere to the higher bidders. In order to keep it profitable for refiners to obtain foreign crude and process it into gasoline, American firms needed to be able to charge a high enough price on that crude and related products.

However, the authorities thought they could still compel older, domestic American crude suppliers to continue providing their barrels at a lower, controlled price. The point was to limit the “windfall gains” that these U.S. owners of oil fields would experience, simply because the world price had jumped up. Since they had been perfectly happy to supply oil to refiners in the 1960s at a much lower price—so the thinking went—it shouldn’t cripple supply from these old, domestic sources if they were only allowed to charge a below-market price.

Now we have to add another twist. The process of obtaining crude oil, refining it, and distributing it to retail gasoline stations could involve several different players in the market. As different parties took legal possession of the oil or product and passed it along to the next stage, they would naturally need to be able to earn a “mark up” along the way, or else it wouldn’t be worth doing. So the detailed price controls contained provisions for such mark-ups.

Armed with this context, we can appreciate the reseller boom that Bradley described in his 1996 treatise, Oil, Gas, and Government: The U.S. Experience, which is the definitive text on this topic.

The Phony Trades of the Reseller Boom

Bradley informs us that “[o]ver 100 new firms, the great majority of which did not have storage facilities or transportation equipment, would enter in the 1973–77 period” (p. 690). This is interesting, because ostensibly the function of these firms was to trade oil. But if they didn’t have storage or transportation abilities, what was going on?

Bradley explains with the following hypothetical “daisy chain” of trades, which is fictitious but based on plausible numbers. (Note that “old oil” means oil coming from established, domestic producers who were subject to the price ceiling, while “new oil” referred to either imports or oil from new producers who were able to charge the world price.)

Assume that Class A gathering margins are $0.15 per barrel and Class B telephone-trading margins are $0.50 per barrel in August 1974, at which time old oil was at $5.25 per barrel and new oil was at a market price of $10.00 per barrel. The following scenario was typical:

Step one: Gatherer A buys old oil at $5.25 per barrel at the lease and transports it to a pipeline connection point where it is sold to Reseller [B] for $5.40 per barrel.

Step two: Reseller B sells to Reseller C for $5.90 per barrel.

Step three: Reseller C sells to Reseller D for $6.40 per barrel. . .

Step eight: Reseller H sells to Reseller I for $8.90 per barrel.

Step nine: Reseller I sells to Gatherer A for $9.40 per barrel.

Step ten: Gatherer A ships the crude in his facilities to [a refiner] who purchases it for refining at $9.55 per barrel. (Bradley 1996, p. 690)

In the above sequence, the only truly “economic” transactions were Gatherer A getting the oil and transferring it to the pipeline, through which it can be delivered to a refiner. But because of the price control regime in place, this move would only allow Gatherer A to reap 15 cents of a markup, with the windfall gain—the difference between the world price of crude at $10 and the controlled domestic price of $5.25—accruing mostly to the refiner (and possibly the consumers, depending on how much was passed along).

Rather than let this large gap in potential mark-ups get away, financiers came up with a clever way to “trade” barrels of “old oil” around in a circle, without physically moving them. These were all telephone transactions on paper. But technically, each change of possession allowed for a 50-cent markup. Thus, rather than Gatherer A turning over the barrels to the refiner at $5.40 each, he can instead charge them $9.55. He and the other paper-traders have pocketed the gap between the “old oil” controlled price and the world market price of crude.

Conclusion

The crude oil “daisy chain” reseller boom is just one example of the absurdity of the 1970s price controls on the oil and gas sector. For more, consult my article. Price controls always carry unintended consequences, but in this episode, the tradeoffs were particularly disastrous. Far from taking “windfall profits” from domestic oil producers and distributing them to the consumers, the price control regulations instead gave opportunities to shrewd speculators to reap income from “regulatory arbitrage.”

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