Job Name:2176590 Date:15-03-10 PDF Page:2176590pbc.p1.pdf Color: Cyan Magenta Yellow Black HORIZONTAL DIVESTITURE IN THE OIL INDUSTRY

A Conference Sponsored by the American Enterprise Institute for Public Policy Research

HORIZONTAL DIVESTITURE IN THE OIL INDUSTRY

Proceedings of a Conference Addressing the Question: Should Oil Companies Be Prohibited from Owning Nonpetroleum Energy Resources?

Edited by Edward J. Mitchell

American Enterprise Institute for Public Policy Research Washington, D.C. Distributed to the Trade by National Book Network, 15200 NBN Way, Blue Ridge Summit, PA 17214. To order call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries please contact the AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036 or call 1-800-862-5801.

The publisher wishes to thank The Twentieth Century Fund for per­ mission to reprint an excerpt from "The Role of I.G. Farben" (chapter 11) in George W. Stocking and Myron W. Watkins, Cartels in Action, The Twentieth Century Fund, New York, © 1946.

Library of Congress Cataloging in Publication Data Main entry under title: Horizontal divestiture in the oil industry. (AEI symposia; 78E) Conference held Jan. 27, 1977 in Washington, D.C. and sponsored by American Enterprise Institute for Public Policy Research. 1. Petroleum industry and trade-United States­ Congresses. 2. Corporate divestiture-United States­ Congresses. I. Mitchell, Edward John, 1937- II. American Enterprise Institute for Public Policy Research. III. Title. Series: American Enterprise Institute for Public Policy Research. AEI symposia; 78E. HD9566.H66 338.8 78-18367 ISBN 0-8447-2131-X ISBN 0-8447-2130-1 pbk. AEI Symposia 78E ©1978 by American Enterprise Institute for Public Policy Research, Washington, D.C. Permission to quote from or to reproduce materials in this publication is granted when due acknowledgment is made. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. Printed in the United States of America CONTRIBUTORS

Walter Adams Distinguished University Professor, Professor of Economics, and Past President Michigan State University M. A. Adelman Professor of Economics Massachusetts Institute of Technology Betty Bock Director, Antitrust Research, The Conference Board Adjunct Professor of Law, New York University School of Law Darius W. Gaskins, Jr. Director, Bureau of Economics, Federal Trade Commission Thomas E. Kauper Professor of Law, University of Michigan Law School Former Assistant Attorney General, Antitrust Division U.S. Department of Justice Richard Mancke Associate Professor of International Economic Relations Fletcher School of Law and Diplomacy, Tufts University Jesse W. Markham Charles Edward Wilson Professor Harvard Graduate School of Business Administration Edward J. Mitchell Professor of Business Economics University of Michigan Graduate School of Business Robert Pitojsky Professor of Law, Georgetown Law Center Former Director, Bureau of Consumer Protection Federal Trade Commission F. M. Scherer Professor of Economics, Northwestern University Former Director, Bureau of Economics, Federal Trade Commission Gary L. Swenson Senior Vice-President, The First Boston Corporation David I. Teece Assistant Professor of Business Economics Graduate School of Business, Stanford University I. Fred Weston Professor of Managerial Economics and Finance Graduate School of Management University of California at Los Angeles CONTENTS

INTRODUCTION 1 Edward J. Mitchell

PART ONE COMPETITIVE ASPECTS

Chairman's Remarks ...... 5 Thomas E. Kauper Horizontal Divestiture in the Petroleum Industry: An Affirmative Case ...... 7 Walter Adams Market Structure and Horizontal Divestiture of the Energy Companies ...... 21 Jesse W. Markham Commentaries M. A. Adelman 29 Darius W. Gaskins, Jr. 31 Robert Pitojsky 34 Richard Mancke 37 Discussion 41

PART TWO ECONOMIC EFFICIENCY ASPECTS

Chairman's Remarks...... 55 Edward J. Mitchell Horizontal Integration in Energy: Organizational and Technological Considerations ...... 57 David I. Teece The Implications of Divestiture on Investment in the Coal Industry ...... 73 Gary L. Swenson Commentaries Betty Bock 89 F. M. Scherer 91 J. Fred Weston 94 Discussion ...... 101 INTRODUCTION Edward /. Mitchell

The upsurge in oil prices of the past few years has restored the American oil industry to a financial health that it has not enjoyed for some time. However, it has also presented the industry with a serious problem. It must do something with the profits it is taking in. If that sounds like the kind of problem you would like to have, consider this exhaustive set of options available and their implications. • Option 1-The money could be reinvested in the petroleum busi­ ness by searching for more oil and gas. • Option 2-The money could be invested in nonenergy industries, such as department stores and circuses. • Option 3-The money could be paid out to stockholders in the form of dividends. • Option 4-The money could be invested in nonpetroleum energy sources, such as coal and uranium. President Carter, especially through one of his energy lieutenants, Mr. John O'Leary, has informed us that there is not much oil or gas to be found. Just in case the industry does not believe this, it is to be dis­ couraged from exploration by price ceilings on oil and gas. And just in case that does not work, the leasing of federal lands, notably the outer continental shelf, has been held to a snail's pace. In brief, • Option 1 is regarded as largely a waste of money by the adminis­ tration, and its energy policy has been designed to discourage it. • Option 2 is frowned upon by the Congress, some of whose mem­ bers regard it as "obscene" for an oil company to invest in some­ thing other than oil.

1 • Option 3 leads to the gradual liquidation of the oil industry. This choice seems to have met the least political resistance, but it is understandable that oil executives are not excited by the prospect. • Option 4 is the subject of this volume. Oil company investment in nonpetroleum energy resources has been met by vigorous political opposition on the grounds that the oil companies possess signif­ icant market power in the oil market; it is argued that their move into coal, uranium, and other energy resources would only extend that power. The argument against horizontal diversification of the oil companies is essentially an argument against monopoly. The central question is, Would expansion by the oil industry into non­ petroleum energy sources result in more or less production of energy? In addition to the monopoly issue there is the question whether the oil companies possess some unique attributes that would make them highly efficient producers of other forms of energy. Could it be that curtailment of oil industry investment would leave us with weaker, smaller, and less technically advanced coal and uranium industries? To answer these questions AEI brought together a group of the most knowledgeable economists, lawyers, and other experts on indus­ trial organization. Many of them have distinguished careers of public service as former Washington trust-busters. Others have patrolled the energy beat primarily from the universities. All are well acquainted with the horizontal divestiture issue and its ramifications. I think the reader will find that their varied perspectives give rise to a stimulating discussion.

2 PART ONE COMPETITIVE ASPECTS

Chairman's Remarks Thomas E. Kauper

On the issue of horizontal divestiture, as indeed on the issue of vertical divestiture, it is clear that, while we may talk in terms of competitive and economic aspects, we are also dealing with political and social issues. These will not be the major focus of this discussion, but they surely do playa major role in the present controversy. An observation one might make is that the very title of this program assumes a conclusion. The program refers to horizontal di­ vestiture. By my definition, that means relationships that are directly competitive, and we are, therefore, assuming a degree of interfuel com­ petition since horizontal divestiture proposals seek only to confine par­ ticular energy companies to particular categories of energy production. Hence, the title does assume an answer to one important question­ that there is considerable competition among the various fuels. Many of us do, indeed, assume that, but we may get some disagreement. We should also keep in mind, as we go through the program, that horizontal divestiture really involves divestiture in part and something else in part. While it is true that legislative proposals under discussion require divestiture of assets of companies currently operating in more than one fuel market, they also contain prohibitions on future entry into other fuel markets. Such prospective prohibitions cannot be char­ acterized as divestiture and may raise somewhat different issues. We may want to draw some distinction between these two, since divestiture may involve some costs that a future ban might not. Today we will not be directly discussing questions relating to vertical dissolution, though as we listen to some of the discussion, we may find that part of the case to be made for horizontal divestiture may rest on the presence of vertical integration.

5

Horizontal Divestiture in the Petroleum Industry: An Affirmative Case

Walter Adams

Legislation was introduced in the 94th Congress to prohibit the integrated petroleum giants from extending their control into other energy fields. I believe that such legislation is necessary to preserve interfuel competition and to protect the public from an exploitative multinational cartel. There are some who consider such legislation superfluous or undesirable. They contend that the petroleum industry is fiercely com­ petitive and that the incursion of Exxon, Gulf, Texaco, and their fellow oligopolists into substitute fuels has no more social significance than the decision of a local hot dog operation to diversify into hamburgers. Also, they contend that only the petroleum giants command the tech­ nical know-how and the vast capital resources to develop petroleum substitutes like coal, shale, uranium, and geothermal and solar energy. They insist that only the petroleum giants can help the United States achieve the goals of Project Independence. I disagree. I submit that the petroleum industry is neither com­ petitive in structure, nor competitive in behavior, nor competitive in performance. I submit that surrender of the substitute fuel industry to the petroleum giants will only solidify existing patterns of cartelization and retard rather than stimulate interfuel competition. I submit that our failure to assure effective competition in the energy industry will condemn that industry to private monopolization and eventual nation­ alization. I believe with Thomas Jefferson that in the economic as well as in the political arena "it is not by the consolidation or concentration of powers, but by their distribution, that good government is effected."l

Horizontal Control

At first blush, the concentration ratios in crude oil production do not appear to be overwhelming (see Table 1). Even so, it is noteworthy

1 Paul Leicester Ford, ed., The Writings of Thomas Jefferson, vol. 1 (New York: G. P. Putnam's Sons, 1904), p. 122.

7 COMPETITIVE ASPECTS

TABLE 1 LARGEST COMPANIES' SHARE OF U.S. CRUDE OIL PRODUCTION (percentage) 1955 1960 1965 1970 1973 4 largest companies 21.2 23.9 27.9 31.0 33.8 8 largest companies 35.9 38.2 44.6 49.1 53.8 20 largest companies 55.7 57.6 63.0 69.0 76.3

SoURCE: Federal Trade Commission, Bureau of the Census, company reports. that concentration has been steadily increasing since the mid-1950s, so that by 1973 the eighth largest companies accounted for almost as big a share of crude oil production as did the twenty largest in 1955. This trend is largely explained by the massive mergers during this period­ especially mergers between the very largest companies: in 1965, for example, Union Oil (assets of $916.5 million) acquired Pure Oil (as­ sets of $766.1 million). In 1966, Atlantic Refining (assets of $960.4 million) acquired Richfield (assets of $499.6 million). In 1968, Sun Oil (assets of $1,598.5 million) acquired Sunray DX (assets of $749.0 million). In 1969, Atlantic Richfield (assets of $2,450.9 million) acquired Sinclair (assets of $1,851.3 million). As a result, the twenty majors of 1955 have become the sixteen majors of today. Moreover, as Professor Walter Measday points out, concentration in reserve ownership is even more important, particularly for the future, than concentration in current pro­ duction. And the largest companies control most of the proved reserves. The Federal Trade Commission staff found that in 1970 our sixteen major companies controlled 77 per­ cent of the net proved oil reserves in the United States and Canada. The producer has effective control, however, over all of the oil he lifts including the shares for royalty owners and other nonworking interest holders. In terms of gross re­ serves, the sixteen majors may control more than 90 percent of existing proved reserves. 2 Finally, and most important of all, the petroleum majors are intertwined with one another through a seamless web of interlocking control. They do not function as independent or competitive, but as cooperative enti­ ties at every strategic point of the industry's integrated structure. They are meshed with one another in a symbiotic relationship, which almost inevitably precludes any genuinely competitive behavior.

2 See Walter Measday, ''The Petroleum Industry," in The Structure oj American Industry, Walter Adams, ed., 5th edition (New York: Macmillan, 1977).

8 WALTER ADAMS

Joint ventures are one manifestation of this symbiotic relationship. A joint venture establishes a community of interest among the parents and a mechanism for avoiding competition between them. It provides the opportunity for foreclosing nonpartners from access to supplies and/or from access to markets. It is a forum in which ostensible com­ petitors can meet to exchange information and coordinate plans with apparent impunity. Most important, perhaps, it is a device which (in the oil industry, at least) has sq far remained immune from antitrust attack. As Table 2 indicates, the major oil companies historically resorted to joint ventures in bidding for federal offshore lease sales. Thus Amerada Hess submitted 0 independent and 168 joint bids during the period; Getty, 0 independent and 281 joint bids; Phillips, 0 independent and 169 joint bids; Union, 0 independent and 245 joint bids; and so on. This, according to Professor Walter Mead, was tantamount to bid rigging: In any given sale, it is obvious that when four firms ... "each able to bid independently, combine to submit a single bid, three interested, potential bidders have been eliminated; i.e.,

TABLE 2 INDEPENDENT AND JOINT BIDDING IN FEDERAL OFFSHORE LEASE SALES, 1970-1972

Number of Number of Company Independent Bids Joint Bids Amerada Hess o 168 Amoco 6 321 Atlantic Richfield 12 293 Chevron 79 108 Cities Service 7 372 Continental 27 384 Exxon 80 o Getty o 281 Gulf 17 32 Marathon 24 214 Mobil 8 103 Phillips o 169 Shell 59 93 Sun 115 2 Texaco 15 32 Union o 245

SOURCE: Calculated from Senate, Subcommittee on Antitrust and Monopoly Hear­ ings, The Natural Gas Industry, 93rdCongress, 1st session, 1973, part I, p. 481.

9 COMPETITIVE ASPECTS

TABLE 3 TYPICAL JOINT VENTURES IN THE OIL PIPELINE INDUSTRY

Pipeline Company Percent Held (assets in millions) Co-owners by Each

Colonial Pipeline Co. Amoco 14.3 ($480.2) Atlantic Richfield 1.6 Cities Service 14.0 Continental 7.5 Phillips 7.1 Texaco 14.3 Gulf 16.8 Sohio 9.0 Mobil 11.5 Union Oil 4.0 Olympic Pipeline Co. Shell 43.5 ($30.7) Mobil 29.5 Texaco 27.0 West Texas Gulf Gulf 57.7 Pipeline Co. Cities Service 11.4 ($19.8) Sun 12.6 Union Oil 9.0 Sohio 9.2 Texas-New Mexico Texaco 45.0 Pipeline Co. Atlantic Richfield 35.0 ($30.5) Cities Service 10.0 Getty 10.0

SOURCE: Senate, Subcommittee on Antitrust and Monopoly Hearings, The Nat­ ural Gas Industry, 93rd Congress, 1st session, 1973, part I, p. 485.

the combination has restrained trade. This situation does not differ materially from one of explicit collusion in which four firms meet in advance of a given sale and decide who among them should bid (which three should refrain from bidding) for specific leases and, instead of competing among them­ selves, attempt to rotate the winning bids. The principal dif­ ference is that explicit collusion is illegal.3 Indeed, explicit collusion has been illegal per se ever since bid rigging was condemned in U.S. v. Addyston Pipe and Steel Co. in 1898.4 Similar joint ventures are employed by the major oil companies in their control of interstate pipelines (see Table 3) and their overseas

3 Walter Mead, "The Competitive Significance of Joint Ventures," Antitrust Bulletin, Fall 1967, p. 839. 4 85 F. 271 (6th Cir. 1898), aU'd 175 U.S. 211 (1899).

10 WALTER ADAMS

TAB·LE 4 SELECTED INTERNATIONAL JOINT VENTURES OF PETROLEUM COMPANIES

Petroleum Company Percent Held (1971 crude production) Co-owners by Each

Arabian American Oil Co. Texaco 30.00 ( 1.45 bi!. bbls.) Exxon 30.00 Chevron 30.00 Mobil 10.00 Iranian Oil Participants, Inc. Mobil 7.00 (1.3 bi!. bbls.) Exxon 7.00 Chevron 7.00 Texaco 7.00 Gulf 7.00 B. P. 40.00 Shell 14.00 Atlantic 1.67 Signal .83 Getty .83 Iraq:Petroleum Co. B. P. 23.750 (0.6 bi!. bbls.)a Shell 23.750 Exxon 11.875 Mobil 11.875 Kuwait Oil Co., Ltd. Gulf 50.00 ( 1.27 bi!. bbls.) B.P. 50.00 a This figure was omitted in the hearings. The Department of the Interior, 1971 Minerals Year Book reports crude oil production of 1,710,000 barrels per day. Translated to a yearly figure by multiplying by 365, the result is 624,150,000. SOURCE: Senate, Subcommittee on Antitrust and Monopoly Hearings, The Natural Gas Industry, 93rd Congress, 1st session, part I, PP. 493-495. production and marketing properties (see Table 4). In all, according to some estimates, these joint ventures provide upwards of 12,000 occasions per year for so-called competitors-the joint venture parents -to meet to discuss their common problems and the means for resolv­ ing them. Reinforced by top-level financial interlocks,5 they are the cement which binds together a loose-knit cartel into a cozy system of mutual interdependence. Without joint ventures, the dominion of Big Oil might be subject to recurrent competitive disturbances. Obviously, then, such concentration ratios as are shown in Table 1

5 See Stanley Ruttenberg, The American Oil Industry: A Failure oj Antitrust Policy (New York: 'Marine Engineers Beneficial Association, 1973).

11 COMPETITIVE ASPECTS seriously and systematically understate the pervasive horizontal con­ trol of the petroleum giants. And, in my opinion, it is downright silly to parade the low con­ centration ratios as proof that this industry is competitive in structure.

Vertical Control

Vertical integration reinforces this pattern of horizontal dominance by the petroleum giants. It is the mechanism for harnessing market power and transmitting it through the successive stages of production, refining, transportation, and marketing. It constitutes the primary bar­ rier to new competition, because specialized firms at anyone stage of the industry must live at the suffrance of the integrated majors­ vulnerable to the constant threat of price squeezes, the denial of sup­ plies, and the foreclosure from markets. The very fact of vertical integration, therefore, militates against workable competition in this industry. It relegates competition to the interstices and fringes of the marketplace. As the FTC concluded in its petroleum report, "The [vertical integra­ tion] system contained all the elements essential to a squeeze on refining profits and could be overcome only if the potential refining entrant could enter [the industry] on a vertically integrated basis."6 By thus raising the cost of entry at the refining stage, vertical integration in and of itself becomes a formidable entry barrier which few newcomers can afford to hurdle. It is also a barrier to the established independent re­ finers many of whom eventually give up the battle for survival and sell out to their integrated rivals. (Acquisitions of independent refiners ac­ counted for 40.7 percent of the increase in refining capacity among the top twenty oil companies between 1959 and 1969.) The control of pipelines by the vertically integrated majors has the same anticompetitive effects. It gives the majors the power to mollify, discipline, coerce, and exclude their nonintegrated competitors. It gives them the power to determine the conditions for entry and the rules for survival in the petroleum industry. Interestingly enough, Dr. Thomas G. Moore, a senior fellow of the Hoover Institution at Stanford and an adjunct scholar of the Amer­ ican Enterprise Institute, is on record in support of the foregoing analy­ sis. Writing in 1971, he stated: "With the largest four firms controlling

6Investigation of the Petroleum Industry, report of the Federal Trade Commis­ sion to the Permanent Subcommittee on Investigations of the Senate Committee on Government Operations, Committee Print, 93rd Congress, 1st session, 1973, p.26.

12 ·WALTER ADAMS less than a third of the refinery capacity, the petroleum industry is far from one of the more concentrated industries in the United States. Yet with their huge size and by being vertically integrated from exploration and development to refining and marketing, the majors are in a position to dominate the industry and perhaps to control it."7

The Role of Government

A word is needed about the role of government vis-a-vis the petroleum industry. Historically, the government has done for the oil companies what they could not legally do for themselves without clear violations of the antitrust laws. Under the guise of conservation and national de­ fense, the Bureau of Mines set national output quotas, the states authorized prorationing schemes, and Congress approved the Interstate Oil Compact, as well as legislating tariff protection and import quotas. In addition, it subsidized the multinational giants with special tax offsets, and both the domestic and the multinational producers with a magnanimous depletion allowance. It made the petroleum industry a government-sanctioned, government-protected, government-subsidized cartel, and enabled it to operate a finely tuned scheme to restrict output and maintain prices on a worldwide scale.

The Public Policy ChaBenge

Recent events, especially since the Arab oil embargo, have done little to diminish the market control of the petroleum giants. To be sure, the nationalization, tax, and royalty policy of some OPEC countries has had a devastating effect on the owned equity of the multinational giants, especially in the Middle East, but this has not loosened their world­ wide grip on refining, marketing, and transportation. Indeed, it may be quite reasonable to view the multinational majors, as Morris Adel­ man has repeatedly pointed out, as the marketing agents and tC:lX col­ lectors for the OPEC cartel-doing for the cartel what it appears incapable of doing for itself, namely, to prorate output among the car­ tel members in order to maintain an exploitative price level on a worldwide scale. Similarly, Project Independence, born in the wake of the oil embargo, is not likely to weaken. the control of the petroleum giants. On the contrary, Project Independence will make us more dependent than ever on the firms now dominating the energy industry. It will not

7 See Thomas G. Moore, ''The Petroleum Industry," in The Structure of American Industry, Walter Adams, ed., 4th edition (New York: Macmillan, 1971), p. 128.

13 COMPETITIVE ASPECTS only assure the maintenance of exorbitant petroleum prices but also yield to the owners of petroleum reserves a windfall gain in the value of those reserves. Moreover, it will strengthen the bargaining position of the dominant firms in obtaining concessions from a government in­ tent on procuring, at whatever cost, additional supplies for an energy­ starved economy. And this project may result in ad hoc antitrust exemptions, the relaxation of environmental standards, special con­ cessions with respect to the development of Alaskan and outer conti­ nental shelf deposits, deregulation of natural gas, and above all license to invade comp,eting energy fields. In short, Project Independence may well ·become the pretext for a further consolidation of control by the petroleum giants-not alone in oil and natural gas but in substitute fuels as well. The trend, as Table 5 shows, has already begun. This is a problem not just in economics but in political economy as well. Against this background, is it in the public interest to permit the major oil companies to move into those energy fields which, after 1985, will be increasingly vital to the nation's independence from for­ eign supplies? Specifically, should we, by a major policy decision today, permit· the petroleum giants to play a significant role in determining what energy substitutes shall be developed, at what rate, at what cost, and at whose expense? In other words, shall we delegate to a private power complex-subject neither to the discipline of competition nor to effective government regulation and with a record of public service that is not reassuring-the right to plan our industrial future? In shaping public policy, we must be mindful of two central principles: first, no person can serve two (or more) masters and be equally loyal to each; and second, no person can reasonably be expected to compete with himself. If this be so, can we place our faith in private profit maximization by the petroleum giants as the mechanism for promoting the public interest and protecting the general welfare? When a giant business firm is engaged in multidimensional operations and can choose among its various investments, retarding or suppressing some while favoring others, will its price and product policy be the same as that of many independent competing firms immune from any conflicts of interest? When investment strategies and price policies are shaped not by vigor­ ous and independent marketplace competition but rather by committees of top executives of Exxon, Gulf, Texaco, Mobil, SoCal, and the others, what guarantees are there that energy scarcities will not be intensified rather than moderated? Can we really expect these giant firms to under­ mine their stake in depletable oil and gas resources-the value and profitability of which are enhanced by their progressive scarcity-by

14 WALTER ADAMS

TABLE 5 DIVERSIFICATION IN THE ENERGY INDUSTRY BY THE 25 LARGEST PETROLEUM COMPANIES, 1974

Energy Industry 1974 Petroleum Assets Oil Ura- Tar Company ($ millions) Gas shale Coal nium sands

Exxon $31,332.4 X X XX X Texaco 17,176.1 XXX X Mobil 14,074.3 X X X Gulf 12,503.0 XXX XX Standard of California 11,640.0 X X XX X Standard of Indiana 8,915.2 X X X X X Tenneco 6,401.6 X X Atlantic Richfield 6,151.6 X XX X X Shell 6,128.9 X XX X X Continental 4,673.4 X X X X Sun 4,063.3 X X X X X Phillips 4,028.1 X XXX X Union of California 3,458.6 X X X Occidental 3,325.5 X X X X Getty 3,003.6 XX X Cities Service 2,897.9 X X X X Standard of Ohio 2,621.5 X XXX Amerada Hess 2,255.3 X X Marathon 1,799.9 X X X Pennzoil 1,797.9 X X Ashland 1,715.8 X XX X Coastal States Gas 1,696.9 X X Signal Companies 1,532.9 X Kerr-McGee 1,164.4 X X XX Murphy 1,041.6 X

SOURCE: National Economic Research Associates. investing the huge sums required to promote the rapid development of economically viable substitutes? Can these firms be realistically ex­ pected to unleash those Schumpeterian gales of creative· destruction which would signal an end to their market dominance? Before we convey control over the new, untested, and yet to be developed energy sources to the same giants which have geared their corporate policies to domestic and international cartelization, let us reexamine their track record. Have these firms fought against proration-

15 COMPETITIVE ASPEC"fS

ing and similar output limitation schemes in the United States? Have they waged war against the tariffs and import quotas that raised the price of oil to American consumers? Did they try to undermine or subvert the Arab oil embargo? During the years when they were undisputed masters of overseas production, did they maximize output in those areas where the American taxpayer subsidized their concession rights? Or did they do precisely the opposite? Did not these firms which now pose as the new champions of competition in energy dedicate them­ selves to production limitation by private means where possible, and by manipulation of governments where necessary, in order to maintain the price structure they considered palatable? Have they not come as close to cartelization, under government sponsorship, as any U.S. in­ dustry? Finally, what is there in the habits, history, temperament, and experience of these mammoth enterprises to lead one to predict a reversal of these monopoloid proclivities? In conclusion, I do not deny that substitute fuels will demand tremendous investments. But is the petroleum industry prepared to make these investments in the form of private risk taking? Or, is it not asking the government to do so, while it invests in the promotion of interfuel and intrafuel mergers, and in such nonenergy, conglomerate ventures as Marcor, Ringling Brothers, and the New York Knicker­ bockers? And, most important of all, where is the competition upon which we would have to rely if the patterns of cartelization and monopolistic exploitation are to be avoided? I respectfully submit that the Exxons of this world will not sud­ denly or voluntarily surrender their market control. Nor will they start competing against themselves in defiance of the laws of profit and power maximization. If the public interest is to be protected by com­ petition in the energy market, some form of horizontal divestiture legislation will have to be enacted to assure effective interfuel rivalry.

Appendix

Opponents of horizontal divestiture frequently contend that interfuel competition exists only at the margin, and that therefore the major petroleum companies, if permitted to invade the coal industry, would have no incentive to Uwithhold" production to protect their oil and gas investments. It i~ said that incursions of the petroleum giants into related energy fields can only promote output and efficiency, because of the superior R&D capability that these companies can bring to a competitiveindustry. Debate of this issue need not be confined to abstract theorizing.

16 WALTER ADAMS

The petroleum giants have a track record familiar to students of indus­ trial history. The following account, based on documents in the files of the u.s. Department of Justice 'and published by the Truman War Investigating Committee and the Bone Patent Committee, describes only one chapter of that history. It is taken from Cartels in Action, by George W. Stocking and Myron W. Watkins (New York: Twentieth Century Fund, 1946), Chapter 11, The Role of I. G. Farben, pp. 491-493.

The Standard-IG "Marriage"

IG considered itself too strong to "take unto itself" any chemical part­ ner except as a weaker half. Neither leI nor du Pont would accept such a subordinate position. Accordingly, IG selected for its mate, not a chemical company, but one of the world's most powerful industrial combinations-Standard Oil Company of New Jersey. The agreements of 1929 and 1930 between Standard and IG68 represented, first, a simple mutual commitment not to compete, by recognizing the primacy of the one in petroleum and of the other in chemicals. In chemical developments relating to production of the ordinary products of oil refining, such as motor fuels and lubricants, Standard was to have a majority interest but was to offer IG a minority interest. In developments relating to the production from oil or natural gas of chemicals not ordinary or necessary products of oil refining, IG was to have a controlling interest but was to offer Standard a minority share.6'9 To Standard, these agreements promised, first, ownership and con­ trol,' outside Germany, of IG'S hydrogenation processes and any future IG processes for making synthetically products having similar uses to those of the customary petroleum refinery products, from whatever raw material they might be derived;70 and, second, a junior partnership with IG, outside Germany, in the manufacture of new chemical products derived from petroleum or natural gas. In this way Standard (and ShelJ) removed the threat of competition from IG in the oil business,

68 See Chapter 3, pp. 92-94 [of Cartels in Action]. 69 Among the exceptions to the general arrangements was the reservation to IG of the German market. Standard obtained no rights to participate in, much less to control, the exploitation of new IG chemical or petroleum-refining developments in Germany. 70 Standard was to have exclusive ownership and control of such processes in the United States; in the rest of the world, outside Germany, it was to share control with Shell. For the international development, Standard and Shell organized two corporate subsidiaries, IHE and IHP. Bone, Pt. VII, pp. 3349-50.

17 COMPETITIVE ASPECTS and IG in tum fortified itself against any serious menace to its designs for international leadership in chemicals from oil.71

How Standard Benefited From Its Union. Standard's use of its exclu­ sive rights to IG'S processes in the oil industry shows clearly that its main object in acquiring them was to strengthen its control over the oil industry. For the purpose, the IG agreements performed a dual function-defensive and offensive. Acquisition of the hydrogenation rights eliminated the most serious threat ". .. which has ever faced the company since the dissolution," according to Frank Howard, the Standard official who played a leading role in the negotiations with IG.72 Once these rights were safely acquired, Standard and Shell showed little disposition to use them, or to encourage others to use them, in actual productive operations.73 Their acquisition .. forestalled the threat to the oil industry of liquid fuels and lubricants from coal. On the positive side, Standard persistently used the rights it obtained from IG, both as an inducement and as· a lever, to bring other petroleum-refining companies into comprehensive patent pools, extending far beyond the scope of the specific patent rights which it had obtained, and giving Standard a perpetually favored position in the use of the pooled tech­ nology. In this program it achieved considerable success. Standard and Shell did little to encourage widespread synthetic production of liquid fuels and lubricants from coal. They had acquired these processes primarily to protect their own vast interests in petro­ leum. Standard summarized its policy as follows:

IHP [International Hydrogenation Patents Company] should keep in close touch with developments in all countries where it has patents, and should be fully informed with regard to the interest being shown in hydrogenation and the prospect of its introduction ... It should not, however, attempt to stir up interest in countries where none exists. If the Man­ agement decides that in any country the interest in hydro­ genation is serious, or that developments in such country are likely to affect IHP'S position adversely, then IHP should discuss the matter actively with the interested parties, and attempt to persuade them that its process should be used. ... If coal, tar, etc., hydrogenation be feasible from an eco-

71 See Chapter 3. 72 See Chapter 3, n. 67. 73 Shortly after Standard acquired the patent rights, the opening up of the prolific East Texas oil field upset supply-demand relationships in the oil industry and put off the day of threatened oil shortage. This may have been a factor in Stand­ ard's withholding them from use.

18 WALTER ADAMS

nomic standpoint, or if it is to be promoted for nationalistic reasons or because of some peculiar local conditions, it is better for us as oil companies to have an interest in the de­ velopment, obtain therefrom such benefits as we can, and assure the distribution of the products in question through our existing marketing facilities. 74 Standard and Shell pursued precisely the same ,policy with other com­ petitive processes.75 Walter Teagle, Standard's president, wryly attested to the success of these policies in discouraging the adoption of hydro­ genation:

The IHP has very large investment [sic] in hydrogenation on which, up to date, it has secured a very inadequate return. There is little doubt in our minds but what, if other than oil companies had dominated the situation, the management's conduct of the business would have been along lines better calculated to secure the maximum return on the capital invested. In view of the rapid development of late in nationalism it is, of course, ,unfortunate that at its inception the IHP did not adopt a more active policy, as during the intervening time these other processes have, stimulated in part by the spread of nationalism and the disinclination of IHP to grant licenses, been now developed to the point where they are actually competitive.76

74 Bone, Pte VII, pp. 3354-55. Italics supplied. See also pp. 3357-58. 75 An I. G. Farben memorandum written in 1932 indicates that it had given IHP the right to manufacture and sell methanol for use in motor fuels. Standard and IG agreed on the correct policy for IHP to follow: "Such general line would seem to be not to push the licensing of the process but not to refrain from granting licenses in cases where people would otherwise go ahead themselves ..." Ibid., Pt. VIII, p. 4622. In Standard's efforts to participate in control of the Fischer hydrocarbon synthesis process, which was competitive with hydrogenation, the motive was revealed alike by its actions and by statements of its officials. In these negotia­ tions Frank Howard twice urged the desirability of Standard being in position to "guide or restrict" or "guide or limit commercial developments under such processes." Italics supplied. Ibid., Pt. VII, pp. 3700-01. 76 Ibid., p. 3731.

19

Market Structure and Horizontal Divestiture of the Energy Companies

Jesse W. Markham

From the point of view of the economics of the oil industry, the present preoccupation of Congress with wholesale horizontal divestiture of multienergy firms is at best obscure. Divestiture has long been under­ stood as the logical means of breaking up a firm that has attained monopoly power by actions judged to be less than honestly "industrial" or by business modus operandi described variously as "conscious paral­ lelism," "conjectural interdependence," "competitive forebearance," and "oligopolistic rationalization." Such practices are usually associated with highly concentrated industries consisting of a few large rivals. The conventional wisdom on the subject postulates that at some high level of concentration in a market, the firms will become aware that any price-competitive strategy they employ to their own advantage and to the disadvantage of their rivals will prompt counterstrategies, making all firms worse off. Once all the participants recognize this fact, they adopt only those strategies that are advantageous to all-in short, they function very much like a monopoly. This proposition has emerged as the basic tenet of oligopoly theory and the central hypothesis of empirical tests in a spate of industry studies since the early 1930s.1 As an active participant in these en­ deavors, I am no detached and unbiased judge of the extent to which they advanced the frontiers of knowledge. I shall therefore confine myself to a rather uncontroversial summary appraisal of these empirical works. They provided factual evidence that the probability of coopera­ tive behavior among oligopolists, at least on price, generally increased as the four-firm concentration index approached its upper limit of 100. They also demonstrated, however, that considerable variation in com­ petitive behavior characterized different industries at the same level of concentration. In short, the variation in behavior a~ high levels of con­ centration was much too great to accept the level alone as evidence of a need for divestiture generally, as was envisaged in the proposed

1 See Edward H. Chamberlin, The Theory of Monopolistic Competition (Cam­ bridge: Harvard University Press, 1933).

21 COMPETITIVE ASPECTS

Industrial Reorganization Act (the Hart bill),2 or for divestiture in specific Sherman Act cases. By analogy, it would violate the principles of statistical science, as well as our sense of justice, to declare a healthy seventy-five-year-old man dead because the actuarial tables show th~t, on average, the life expectancy of the U.S. male is seventy-three. To some extent, each industry must be judged on its own demerits before resorting to the harsh remedy of divestiture. This caveat notwithstanding, students of industrial organization and various congressional committees appear to have reached a some­ what uneasy consensus on the range of market concentration that might be of public policy concern. Professor Joe Bain, synthesizing much of the empirical work on the issue over the past several decades, found the probability of conjectural interdependence to be as follows: 3

Probability of Four-Firm Concentration Conjectural Interdependence 71-100 High 51-70 Moderately high 26--50 Moderately low 0-25 Very low

Bain's conclusions are reasonably consistent with others who have studied the issue. Under President Johnson, the White House Task Force on Antitrust Policy, a distinguished group of economists and lawyers, recommended a study of the possible restructuring by means of divestiture of industries in which four or fewer firms had had a combined market share of 70 percent in at least seven of the past ten years and four of the last five years. 4 Earlier, Carl Kaysen and Donald Turner, on whose work the task force relied heavily, had proposed a similar guideline for divestiture.5 The standards for divestiture set forth in the proposed Industrial Reorganization Act would make industries with concentration at the four-firm level of 50 percent presumptively subject to divestiture, but profits had to be at least 15 percent for four of the most recent five years and evidence of price competition must be lacking. The. presumptively unlawful high concentration could be rebutted, however, by a showing of economies of scale.

2 S. 1167, 93rd Congress, 1st session. 3 Joe Bain, Industrial Organization, 3rd edition (New York: John Wiley and Sons, 1972), p. 136. 4 The task force report is reproduced in Journal of Reprints for Antitrust Law and Economics, Winter 1969, pp. 633-828. 5 Antitrust Policy: An Economic and Legal Analysis (Cambridge: Harvard Uni­ versity Press, 1959), pp. 266-272.

22 JESSE W. MARKHAM

None of the yardsticks in these voluminous analyses would indi­ cate that large oil companies engaged in other energy sources are likely candidates for divestiture. If all U.S. industries were ranked by their concentration indexes in domestic production, the oil industry would be found well down in the bottom half of the list. The average con­ centration ratio for all manufacturing has been calculated to be between 40.0 percent and 46.2 percent, depending upon the particular weighting system used. 6 This means that approximately one-half of all U.S. indus­ tries have four-firm concentration ratios of 43 percent or higher. Ac­ cording to a Federal Trade Commission investigation of the petroleum industry,7 as of January 1, 1972, there were 129 independent crude oil-refining companies in the United States, with the largest 4 accounting for 33 percent of total refinery output. Concentration ratios for crude oil production and marketing were respectively 26 percent and 31 per­ cent. The level of concentration in crude oil reserves depends on whether government-held reserves are included in total reserves. Since the reserves in fact exist, and the government has a wide range of options in recovering them, there would appear to be no particular reason for excluding them from total proven reserves. If included, the largest 4 petroleum companies account for 27.3 percent of total re­ serves; if excluded, they account for 35.1 percent. But the important fact is, no matter how the level of concentration in the domestic oil industry is calculated, it falls measurably below the 43 percent level for U.S. industry as a whole. Moreover, since imports of both crude oil and refined products account for a significant share of total U.S. consumption (40 percent in the case of crude), the data in Table 1 tend to obviously overstate the market control implicit in the level of concentration. Since profitability is at least as much a function of good manage­ ment as of market structure, it is a highly unsatisfactory measure of monopoly. But the Industrial Reorganization Act would establish profitability as one criterion of market power so we may as well subject the petroleum industry to this standard on the pragmatic grounds that, while it rewards us little, it costs us nothing. Data appearing in the report of the FTC investigation cited earlier show that the weighted average rate of return on stockholders' equity for the eight largest petroleum companies over the twenty-one-year period from 1951 to 1971 was a scant 1 percent above the comparable

6 Frederic M. Scherer, Industrial Market Structure and Economic Performance (Chicago: Rand McNally Co., 1970), p. 63. 7 Investigation of the Petroleum Industry, report of the Federal Trade Commis­ sion to the Permanent Subcommittee on Investigations of the Senate Committee on Government Operations, Committee Print, 93rd Congress, 1st session, 1973.

23 COMPETITIVE ASPECTS

TABLE 1 CONCENTRATIONS IN THE PETOLEUM INDUSTRY, 1974 (percentage of total)

Crude Oil Reserves Crude Oil Private and Production Private government Refinery Marketing

4 Largest Companies 26.0 35.1 27.3 33.0 31.0 8 Largest Companies 41.7 54.2 42.2 58.0 55.0 20 Largest Companies 61.4 73.1 56.9 86.0 79.0

NOTE: Not adjusted for royalty oil. SOURCE: Management Analysis Center, Inc., Cambridge, Mass., computed from 1974 company annual reports and totals as reported by the companies to various government agencies.

average for all manufacturing. Percentage differences of this small mag­ nitude indicate no more than the obvious proposition that, in the compilation of any average, approximately one-half of all the items wiil lie above it. But more to the point, in no year after 1951 did the eight largest oil companies earn the 15 percent rate of return set forth in the proposed Industrial ·Reorganization Act as indicative of undue market power. Since the proposed legislation implies that oil and nonoil energy under the same corporate roof constitutes horizontal integration, the level of concentration in the energy industry as a whole becomes per­ tinent to the need for such a radical divestiture program. Concentration indexes for various alternative definitions of the energy industry are shown in ,Table 2. As would be expected, the broader the definition of the relevant market, the lower the level of concentration turns out to be. The share of market accounted for by the four, eight, .and twenty largest firms declines perceptibly as the market definition is enlarged to include gas and coal as well as oil, with the four-firm concentration ratio declining to less than 20 percent. Under this definition of the relevant market, the level of concentration in energy lies in the 0 to 25 percent range, where Bain and others have concluded that tacit coopera­ tion among rival firms becomes an extremely remote possibility. All this may suggest that I view it to be my role to aid the defense­ less energy companies in their struggle with an all-powerful and obdurate element in Congress. My response is that I have done neither

24 JESSE W. MARKHAM

TABLE 2 CONCENTRATION RATIOS OF THE ENERGY INDUSTRY, 1974 (percentage of total) Energy Industry Definition Oil, gas, Oil, gas, coal, ura- Oil Oil, gas coal and nium and Oila and gas and coal uraniumb geothermal 4 firms 26.0 25.1 19.1 18.4 18.4 8 firms 41.7 39.2 31.5 29.7 29.7 20 firms 61.4 59.0 49.6 47.8 47.8

NOTE: This table is based on production in B.t.u. equivalents as follows: oil, 5,620,900 B.t.u./barrel; natural gas, 1,102,000 B.t.u./thousand cubic feet; coal, 24,580,000 B.t.u./short ton; uranium (U30s), 430 billion B.t.u./short ton; geo­ thermal, 3,412 B.t.u./kilowatt hour. B.t.u. equivalents taken from Federal Trade Commission, Concentration Levels report.

a Net crude oil, condensate, and natural gas liquids.

b Uranium concentration (yellowcake) production. SOURCE: Calculated from raw data from: Federal Trade Commission, Concen­ tration Levels and Trends in the Energy Sector of the U.S. Economy (Washington, D.C., 1974), p. 452; selected corporate annual reports; u.S. Coal Production by Company-1974, published by Keystone Coal Industry Manual (New York: McGraw-Hill, 1975); unpublished data from House Interior Subcommittee on Mines and Mining provided to author.

more nor less than to apply standards of economic analysis historically accepted by congressional committees and antitrust agencies to the structure of the energy industry and its components. This analysis has led to the conclusion that divestiture by industry-specific legislation cannot be squared with these standards. My search of the public record for the views of recognized antitrust authorities on the issue has proved both rewarding and consoling. The FTC'S 1974 report, Concentration Levels and Trends in the Energy Sector of the U.S. Economy, reached the following conclusion: The information reported in this study appears to suggest that petroleum company acquisitions into coal companies up to 1970 may not have had a severe impact on energy produc­ tion concentration. Consequently, this study does not provide any positive support to the proposal that petroleum com­ panies be banned from acquiring coal or uranium companies; nor does it suggest that petroleum companies be banned from acquiring coal or uranium reserves.8

8 Federal Trade Commission, Concentration Levels and Trends in the Energy Sector of the U.S. Economy, Washington, D.C., 1974.

25 COMPETITIVE ASPECTS

In an appearance before the Joint Economic Committee, Frederic M. Scherer, then chief economist of the Federal Trade Commission and the author of one of the most widely used industrial organization text­ books, stated that the levels of concentration in the combined energy market "do not yet approach the peril point.''9 And, Thomas E. Kauper, head of the Department of Justice Anti­ trust Division, stated before the Senate Committee on the Judiciary in June 1976: The petroleum industry appears to be one of the least con­ centrated of our nation's major industries. This data calls into question the propriety of massive structural reorganiza­ tion. If the present structure of the industry does not exhibit the characteristics associated with excessive market power, then a solution based on that premise may be both unavail­ able and counterproductive.10 I attach considerable importance to these conclusive statements not simply because they are broadly consistent with my own analysis. Leading antitrust officials may on occasion, like the rest of us, make pronouncements that do not entirely square with an objective analysis of all the pertinent facts. Now and again they too remind us that the old saw "to err is human" applies even to experts. But it is reasonably safe to conclude that neither the Federal Trade Commission nor the Antitrust Division has become a sanctuary for apologists for monopoly. Nor has either of them been placed under the leadership of those pre­ disposed to err in favor of the large oil companies. Indeed, those identified with the sponsorship of the Interfuel Com­ petition Act have publicly recognized that their single-minded preoccu­ pation with divestiture of the oil companies is fraught with ambiguities. The late Senator Philip Hart in his luncheon speech at the Airlie House Conference on Concentration on March 2, 1974, observed with his characteristic candidness that, by most standards with which he was familiar, the oil industry was not among our more concentrated indus­ tries. Dr. Walter Measday, staff economist for the Senate committee sponsoring the legislation, stated in his address to the Stanford Uni­ versity Conference on Divestiture in September 1976 that "available statistics provide a surface appearance of moderate concentration ...

9 Horizontal Integration of the Energy Industry, Hearings before the Subcom­ mittee on Energy of the Joint Economic Committee, 94th Congress, 1st session, p.75. 10 The Petroleum Industry, Hearings before the Senate Committee on the Judici­ ary, 94th Congress, 2nd session, p. 60.

26 JESSE W. MARKHAM far less, for example, than we can find in a number of other industries."11 Since virtually everybody agrees that no persuasive case can be made for the Interfuel Competition Act on economic grounds, it may very well be that we all, including the act's strongest supporters, are using irrelevant language. The language of profits, rather than the more quantitative analyses of economics, may provide the raison d'etre for the single-minded preoccupation of Congress with divestiture. The divestiture movement followed quickly on the heels of the October War in the Middle East. The OFEC oil embargo on the United States, which increased gasoline and home fuel oil prices and resulted in long waiting lines and Sunday closings at service stations, left the American public with a sense of frustration. Politicians generally welcome the oppor­ tunities popular issues afford; they can promise solutions. In this case the root cause was obviously OPEC, but our antitrust laws cannot be applied to cartels beyond our shores. A culprit had to be found. Why not the oil companies? In comparison with motorists, they are few in number, and, in any popularity poll, they would rank at least as low as they do in the order of concentration of U.S. industries. I would like to add a few comments on Walter Adams's paper. Much of what he said reflects the ineffectiveness of government. It is not the role of the oil industry to persuade the government to lower tariffs on oil any more than it is the role of the milk producers' associ­ ation to persuade the relevant government bodies to lower the price of milk. We should insist that government officials operate in the public interest. If they cater to special interests, that is the fault of the govern­ ment officials and not of those who may benefit by such public action. I would also like to say something about the trend in concentra­ tion. Professor Adams happened to pick 1973. The data from 1955 through 1974 would have developed a somewhat different picture. It is quite true that concentration rose, largely for the reasons he gave, through mergers from 1955 to 1970. There was a perceptible decline in concentration between 1970 and 1974. As the Du Pont-General Motors antitrust case clearly indicates, there is nothing wrong in reexamining anyone of those acquisitions. As far as I know, the statute of limitations does not hold on any of them. They can be challenged, if the merger violated Section 7 of the Clayton Act. Perhaps the preventive law has not been used as forcefully as it might have been, but that would not be sufficient grounds for the wholesale dismemberment of the present entities in the energy industry.

11 "Feasibility of Petroleum Industry Divestiture," in David J. Teece, ed., R&D in Energy: Implications of Petroleum Industry Reorganization (Stanford: Insti­ tute for Energy Studies, 1977), p. 178.

27

Commentaries

M. A. Adelman

The two papers constitute a hard act to follow, but I would like to carry out the rather pedestrian, pedantic task of defining the areas of agreement and of disagreement. The area of agreement is that competition consists in independent actions by individual firms, each seeking its own advantage even if that costs something to the group as a whole. In a competitive industry, no individual firm can do anything to serve the group as a whole. It cannot, for example, do anything about the price. It must take a price as given and outside of its power. If the price of a product exceeds the cost of putting a little more of it on the market, then the firm, in order to increase its own profits, will expand toward that point. For this kind of independent action to occur (again, I think there would be agreement here), numbers are a suffi­ cient condition, though, Professor Markham would add, not a necessary condition. Hence the importance of canvassing the numbers. Numbers are a rough and imperfect measure of both true market dimensions and true market shares. Hence, Professor Markham is orthodox enough in defining the market in a number of alternative ways-the narrowest possible, the widest possible-to see what difference it makes. The truth perhaps lies in that famous area somewhere between the extremes. The disagreement centers on how good these numbers are as a representation of the underlying reality. Here, I will contribute my own thoughts, and I will confine them to just one area--crude oil production in the United States. The true concentration ratios are really considerably less than what is indicated in either Professor Markham's or Professor Adams's con- . centration table. The reasons for this are, first, imports, and, second, joint ventures. Imports are provided by independent owners-namely, the governments of the oil-producing states. There has been a rather substantial vertical divestiture since about 1970 in the Persian Gulf

29 COMPETITIVE ASPECTS

and other such unsalubrious places, and, not unconnected with this, there has been an increase in price by a factor of ten. If our foreign policy makers continue to be ruled by myths, those prices will keep going up. There are governments that receive $11 a barrel in return for just about nothing, and there are companies in this country with profit rates that hardly diverge from the average. Yet such fury is directed at com­ panies and not governments that I am reminded of that notorious rabbi who marveled how some folks strain at a mosquito and swallow a camel. Getting back to numbers, however, if 40 percent of American oil consumption is imported, that means the true concentration ratio must be reduced from around 34 percent to around 20 percent (or from 26 to 16 percent) . My second correction cannot be made into a numerical correction. Joint ventures in the United States reduce the impact of any given degree of concentration. (In anticipation of what Darius Gaskins will say, I will bypass the question whether the bidding process shows much divergence from purely competitive behavior.) But, if we stay at the oil production stage, the pattern of ownership in these joint ventures is scrambled, with each producing lease managed as though it were an individual pure competitor. The partners really have no options either economically or legally except to push output to the point where mar­ ginal cost is equal to price. Past that point, drilling more wells or trying to pull more out of the reservoir would simply raise costs above price. There is nothing else they can do legally, because the landowner has a right to sue. More important, there is nothing else they can do eco­ nomically because there is no way they can tailor production to serve the interests of any of the individual owners or even the industry as a whole. The reason for state prorationing-the sort of thing Walter Adams has very properly drawn attention to-is that oil companies could not do it for themselves. The state had to do it. I want to make just one more point, about the basic purpose of competitive independence. It touches on the diversified ownership of coal and uranium. Any individual company in, say, the coal industry benefits by expanding its own output. Assume a company has 10 percent of the coal and 10 percent of the oil markets, and suppose it puts an advantageous new property into operation. It gains by taking business away from other companies-it will profit, and the others will lose, without necessarily lowering the price level throughout the industry. Professor Adams's question was quite relevant: Can we trust these companies to unleash the gal~s of creative destruction? First, they have to find the key to the closet where those winds are kept. If they can

30 DARIUS W. GASKINS, JR. find the key, it is in the interest of their pocketbook to unleash them before somebody else does. Let's define the issue not as a question of fact but rather as follows: Can integrated companies restrain compe­ tition? The answer has to be no. Would a prohibition on integration increase competition? Apart from the transition costs, such a prohibition would block entry into the field and would not do much else. Maybe that is not quite all­ passing a law like this would make a lot of people feel better, and that is a public good that I do not take lightly. I am reminded of Lord Chesterfield's remarks about sex, that the position is ridiculous, the pleasure is momentary, and the expense is prohibitive. [Laughter.]

Darius W. Gaskins, Jr.

First, I would like to make a disclaimer: I am speaking for myself and not for the Federal Trade Commission today. And, second, I would like to apologize to the illustrious people who have spoken before me, because I disagree in some way with almost everyone here. I will make a couple of major points and then some minor points about the two papers. My first major point is that, over the intermediate period, there will be no meaningful interfuel competition between coal and oil. For that reason, Professor Markham's concentration ratios for all energy are unimportant and insignificant and tell us nothing. If we calculated all the resources in the world on a B.t.u. basis, we would find that North America has 49 percent of all the B.t.u. in the world. Asia, Africa, South America, and Oceania-which include all the countries that are currently in oPEc-have only 27.5 percent of all the B.t.u. If the competition is between different fuel sources, we should have those nations over the B.t.u. barrel rather than vice versa. Obviously, there is some problem with that kind of simple analysis. Beyond that I will make the following proposition: In the inter­ mediate future in the United States, the prices of coal and uranium will not be determined by the price of oil, but by the costs of extracting those minerals from the ground. My second major point concerns withholding, which is implicit in this whole discussion. If the owner of a natural resource can benefit by withholding a unit of production, even when the cost of its extraction is less than the current market price, then we have reason to be con­ cerned. Since the speakers have misstated or misunderstood the argument about withholding, I would like to make this general proposition.

31 COMPETITIVE ASPECTS

Whenever there is a rising supply curve involving energy resources and someone holds a finite portion of the reserves and also a unit at the margin, he will benefit by withholding the marginal unit. The reason he will benefit is that, by withholding the marginal unit, he drives up the price. And that price, of course, will be the price he will get for the production from his finite resources. With a rising supply curve, there is always the theoretical possibility of withholding. The important point is that there is a rising supply curve. If we could assume that the Arabs or others would sell all the oil we wanted at $11.50 per barrel, or $3.00, or some other price, then, of course, we would not be faced with a rising supply curve and withholding would not profit anyone. Withholding the marginal unit would have no effect on domestic prices. It is my contention that, because of the vast reserves and resources in coal and uranium held by the federal government and other land­ holders, we have an essentially horizontal supply curve for the inter­ mediate future, and the withholding argument has no merit. But the withholding argument mayor may not have merit with regard to the oil industry because we recognize-and Professor Adelman made this point strongly-that the price of oil in the world market is artificially held up by the OPEC cartel. Most statements about limiting our de­ pendence on foreign sources through Project Independence or other means implicitly assume that domestic production of oil has something to do with the stability of that cartel. As I interpret that, the domestic production of oil is related to the expected future selling price of oil. If that is true, the withholding argument is theoretically possible once more, because withholding oil at the margin from domestic pro­ duction may affect the selling price of all the rest of the resources in a company's portfolio. Theoretically at least, withholding is possible, though I will not discuss whether or not it is empirically relevant. If it is theoretically possible, Professor Adelman is mistaken be­ cause a large number of producers is no longer sufficient to assure competition. In fact, numbers are irrelevant. The key to withholding is the holding of finite reserves. The characteristics of all natural resources is that they occur in large lumps. Finding them is a stochastic process, and individual producers have substantial reserves. When people hold lumps of reserves, withholding is theoretically possible as long as an upward sloping supply curve prevails. I am very uncomfortable with the idea that, if there are enough firms in any resource business, there is no potential for withholding. ,I am even more uncomfortable, as 1 indicated before, with citing concentration ratios as indicia of competition.

32 DARIUS W. GASKINS, JR.

Those are my two major points. I would also like to make some specific comments about the two papers. Professor Markham discusses concentration ratios with some skep­ ticism, and then he cites the low profitability of the oil industry over the past twenty years as evidence of competition. My question for Professor Markham is, Is that the right issue? Weare discussing not the past but what the future holds. The question then is, What about profit­ ability for oil companies over the next twenty years? And the issue is, Are the past twenty years a good precursor? Do they tell us what will happen? I would say they do not. The world energy situation has changed dramatically, and profitability in the future will be quite different from profitability in the past. Without making any predictions about excess profits, I want to point out that looking backwards from this particular time in history tells us very little about the future. Regarding Professor Adams's paper, I feel beholden to make several points. The first point concerns his discussion of joint bidding. The question here is the effect of joint bidding on the disposition of the economic rent-whether the government gets more or less for the property it sells. This is an extremely complicated problem. I think the following three things are true. First, the total effect of joint bidding on the disposition of the economic rent for all property sold-that is, how much the government gets-is unclear. It is not known whether the government benefits or loses in total from joint bidding. Second, I would argue that joint bidding may have a pernicious effect on the price received for specific properties sold. The empirical evidence is muddier than I once thought, and it remains an unsettled issue. Finally, it should be clear that a total ban on joint bidding activity canno~ be justified. There are obvious benefits in allowing companies that lack the geophysical expertise or financial resources to participate in this auction. If we want resources held in small portions in many hands, then joint bidding should not be totally prohibited. My second point concerns the significance of government policy in terms of resource leasing. In the coal and uranium markets, the federal government has an enormous hold on unexplored territory, the regions where we may find vast quantities of uranium and coal. Leasing policy is really important to future competition in coal and uranium. Unfortunately, some people in the public sector seem to believe that, if the government leases substantial portions of this land, it benefits major oil companies or the major bidders. Probably just the opposite is true. If the government withholds its vast holdings from the market,

33 COMPETITIVE ASPECTS

it actually increases the. profits of the existing holders of reserves. Th~ general public has this story upside down. Personally, I think there are many good reasons to allow de novo entry by oil companies into coal and uranium mining, but I will leave that to the afternoon session because there are strong proponents of those arguments then. Professor Adams's disapproval of investment by oil companies in nonenergy business strikes me as inconsistent with his basic position. If there really is strong substitutability between these energy sources and if it really is undesirable for oil companies to buy coal and uranium, then they should be encouraged to buy other properties. Put another way, they should buy properties whose risks are negatively correlated with the price of oil. An oil company that owned a large ranch in Southern California or a major retail chain would have an attitude toward the future price of oil more like that of the nation as a whole. Ideally, the financial incentives of the oil companies should be aligned with those of the American public, if they have the ability to influence the future price of oil. It would be an erroneous policy to prevent them from investing outside the energy area. When Professor Adams discussed Project Independence, I thought he said that it would result in a windfall to owners of existing reserves in the United States. I do not understand the logic of that argument. If Project Independence causes us to produce more oil and gas in this country, or to use less and thereby reduce our imports, it should lower the future price of oil. If so, the value of the oil reserves would also be lowered. My final point is the general conclusion that a horizontal divesti­ ture bill or some restriction on entry by major oil producers into coal and uranium production as a whole would be a serious mistake. I have an open mind, however, about restrictions on oil companies that would prevent them from investing heavily or dominating coal liquefaction or shale oil. There is direct substitutability between oil and both liquefied coal and shale oil. Since the withholding argument may have merit, I would not categorically rule out any restriction on entry into those activities.

Robert Pito/sky

As the only antitrust lawyer on this panel other than our chairman, I will look at this question of horizontal divestiture in the oil industry from that viewpoint. As I would frame the issue, any policy of barring or discouraging oil company ownership of alternative energy sources must turn on the prediction that oil companies would develop those

34 ROBERT PITOFSKY resources in a different way from other owners. That could be measured in terms of output decisions, in research and development, and perhaps even in the way prices are established for these competing or marginally competing energy products. The question an antitrust court would immediately ask is, How do we make that prediction? Is it on the basis of theoretical probability, that is, a prediction on the basis of market structure? Or, should we compare the way oil companies have handled their coal companies and other energy resources with the way nonoil companies have handled their coal companies and other energy resources? Professor Adams relies on structural inferences, though he does point to some elements of historic behavior. But when he says no one can reasonably be expected to compete with himself, and when he ques­ tions whether an oil company's price and product policy will be the same as that of an independent competing firm, immune from any conflicts of interest, he suggests a kind of inference based on structure­ that is, based on the simple conflict of interest within a company own­ ing both oil and coal resources in the market. Professor Markham raises some useful warning flags about whether or not there is concentration in the oil industry, and also whether profits in the oil industry are excessive. But Professor Teece's paper in Part Two of this conference approaches the question in the alternative way. He looks at what the oil companies have actually done with their coal holdings in terms of investment, production, research and development, and so forth, compared with companies that own such resources and are not in the oil business, and he concludes that there is not much difference. I am not as interested in the conclusion as in the formulation of the issue. I searched the antitrust literature to find out how the courts would look at this question if it were in an antitrust context. I found some loose language in a few Supreme Court cases-for example, in Penn­ Olin (United States v. Penn-Olin Chemical Co., 378 U.S. 158 [1964]), which involved the legality of joint ventures-to the effect that a parent can never be expected to compete with its progeny. But the Court was not really focusing on the issue. The case that comes closest, in my mind, to the issue as I have framed it here was a merger case which began in 1956 involving Con­ tinental Can and Hazel Atlas (United States v. Continental Can Co., 378 U.S. 441 [1964]). Continental Can, the second largest producer of metal containers, acquired Hazel Atlas, the third largest producer of glass containers. The Supreme Court concluded that metal and glass containers competed across a broad range of uses and then addressed

35 COMPETITIVE ASPECTS

the question whether competition was likely to lessen if a glass com­ pany fell into the hands of a can company. The district court approached the question on the basis of proof of whether competition was likely to lessen. In finding no lessening of competition, the trial court saw no evidence that as a result of the merger, Continental would lose the incentive to push can sales at the expense of glass. The government had introduced no evidence showing that there either had been or was likely to be any slackening of effort to push can sales. In the light of the record and competitive realities, the court later concluded it was patently absurd to expect Continental to cease to innovate in either line. The approach of the district court was to ask what the companies actually did. The Supreme Court, however, reversed the lower court's findings and its conclusion. First of all, it made the fairly sensible point that the lower court was influenced by evidence of the way the new company actually conducted its business after the merger, but the company was under the gun during that period. The company knew the merger would be challenged under Section 7 of the Clayton Act. Therefore it would be unwise to draw any inferences from the way the can company and its glass company were run at that time. But that left the record in a neutral state on the question of how the combined company would be run. The next question was how the government would prove there was a lessening of competition. The Supreme Court answered that question as follows: It would make little sense for one entity within the Continental empire to persuade the public of the superiority of metal over glass for a given end use while the other entity plans to increase glass container output for that same end use. Thus, at least during the period of the Warren court, there was powerful authority at the Supreme Court level to support the ap­ proach Professor Adams has taken here. I would add, however, that I am troubled by that approach. I would like to raise several points in regard to whether it should be pursued in connection with oil company divestiture of coal and other energy resources. First, it is not difficult to compare the wayan oil company runs a coal company with, for example, the way Kennecott (a nonoil com­ pany) ran Peabody Coal. Often, critics of antitrust enforcement who demand evidence on the record rather than theoretical inferences really do not want any enforcement at all. For example, with respect to a merger of two 10 percent companies, the government could scarcely prove a likelihood of a lessening of competition because a lessening of competition is such an elusive notion. But that is not true here. In-

36 RICHARD MANCKE vestment, output, research and development, and so forth can be examined for evidence of how oil companies run their energy sub­ sidiaries compared with how nonoil companies handle the same man­ agement decisions. Second, these conglomerates, in two or three fields of energy, have existed long enough so that no one could say they were "under the gun" in the sense that they were running their subsidiaries in an un­ characteristic way. That disposes of the issue that was influential in the Continental decision. Finally, as Professor Markham's paper indicated, concentration is not high in either of these industries. The oil companies appear to own only 20 percent, for example, of coal companies. Therefore, there is no solid theoretical reason to expect the oil companies to run their coal companies to protect their oil investment rather than to advance their competitive interest in coal. My conclusion is not to answer the question whether or not oil companies should be denied the right to own competing energy sources. I do not know how oil companies have run their subsidiary energy companies. But I do believe, contrary to existing legal authority in some adjacent areas, that this question should be addressed on the basis of evidence, and that it would be very dangerous to address it on the basis of inferences from structure.

Richard Mancke

I have three points. The first is on the significance of joint ventures by oil companies on a firm's market conduct. The only reason oil com­ panies engage in joint ventures is to share risks. When bidding for rights on the outer continental shelf, oil company joint ventures have frequently spent tens of millions of dollars more than necessary (that is, their top bids have sometimes been much higher than the second highest, or to use the industry expression, they have left a lot of money on the table). That fact confirms that joint ventures have not given rise to monopolistic behavior. In this context, the story of the Destin anticline is well known. A consortium that included Exxon and the Union Pacific Railroad bid something like $600 million for petroleum rights to part of the Destin anticline. About $300 million of that was money "left on the table." If they had been engaged in some kind of conspiracy, they would not have left $300 million on the table. The other interesting thing about the Destin anticline is that it shows how risky the oil business can be-oil was never found there. Indeed, after drilling about fourteen dry wells, the whole drilling program was simply

37 COMPETITIVE ASPECTS abandoned. The failure to find oil at Destin has justly been called a debacle. It led to a sharp fall in the price of stock of at least one com­ pany, the Union Pacific Railroad. The only area where oil company joint ventures may raise a monopoly problem is in pipelines. That is an area that probably should be investigated further. But oil pipelines are already regulated by the Interstate Commerce Commission. I would like to pose to Professor Adams a hypothetical situation about oil company joint ventures. Suppose the majors did not engage in joint bidding for the expensive and risky rights to outer continental shelf properties, such as the Destin anticline and Alaskan North Slope oil lands. Then only the very largest oil companies-the top eight or nine -could afford to bid for such rights, and oil company critics like Walter Adams would then complain that the large oil companies-by refusing to take part in joint ventures-were foreclosing smaller com­ panies from this part of the oil business. My second point is, I agree with Dr. Gaskins that the key unit for analyzing monopoly issues is the marginal unit. That is something we too often ignore when we analyze markets. However, it is important to emphasize that-certainly in coal and probably in uranium mining­ no firm or cohesive group of firms has control over the marginal unit. Hence, it is hard to make a case that either industry is (or can be) monopolized. Dr. Gaskins would probably agree that the key empirical issue in the oil area is whether or not one firm or group of firms can control the marginal unit and thereby determine the price of crude oil. I would like to discuss with him the empirical plausibility of that. Given the inability of academics to predict oil price behavior over the past twenty years, would any oil company seriously believe that it could control the market's marginal unit? Professor Pitofsky raised a third issue: Will oil companies operate their coal or uranium businesses or investments differently from nonoi! companies engaged in these businesses? The only way oil companies either can or will operate their coal or uranium businesses differently is if they have monopoly power, and so one should first address the issue whether they can have monopoly power. If one looks at coal and uranium mining, it is very hard to make a case that there is a monopoly. There are many nonoi! companies that are in coal and uranium, and they are not just coal or uranium companies. They are companies such as U.S. Steel and Bethlehem Steel-which I believe run the nation's sixth and seventh largest coal companies-and Ameri­ can Electric Power. All three of these companies are very large coal

38 RICHARD MANCKE consumers, and all have an interest in lower rather than higher coal prices. Also, all of these companies ;have expertise in the coal business. In short, it seems obvious that there is no monopoly case in these non­ oil energy businesses. Hence, I ,would concur with the sentiment of three of the panelists that we should encourage any firms willing to invest in coal and uranium. The more firms that invest in these busi­ nesses, the more competitive they will be.

39

Discussion

PROFESSOR SCHERER: I would like to comment on Professor Mancke's discussion of joint ventures and money left on the table, which included several valid observations. In the oil industry, however, there are many, many different dimensions of competition. One of them is competition in the bonus bidding for oil tracts. The structure of that particular competition makes collusion very difficult without risking serious trouble with the federal government. And, without collusion, there may be an immense spread between the top bid and the second bid. There are, however, other ways in which competition might either occur or break down in the oil industry. There is, for example, the matter of setting a price for the product after it comes out of the well. There, it seems to me, the spirit of cooperation that comes out of joint ventures might well have an effect that differs from its effect on bonus bidding. We should not focus simply on one mode of conduct and not on the others.

PROFESSOR TEECE: Some of my points hav~ already been discussed, but I want to discuss the withholding-of-production argument. The argument is essentially that horizontal integration is motivated by the desire of coal and uranium producers to hold back production of alter­ native fuels in order to keep up the price of oil. As Professor Adams put it, we can scarcely expect these giant firms to undermine their stake in depletable oil and gas resources by investing the huge sums required to develop a substitute. Dr. Gaskins was correct on many points and, in particular, in pointing out that there is little interfuel substitution. If that is the case, no one can affect the price of oil by holding back on the production of coal. Clearly, to make the withholding argument support the divesti­ ture case, one has to show interfuel competition. Dr. Gaskins, however, presented a narrower view of the withholding argument; he discussed how withholding one fuel could impact on the price of that fuel. Large reserve owners of a fuel may indeed be able to impact the price of

41 COMPETITIVE ASPECTS that fuel, in the manner he suggests, if the industry supply curve is inelastic. But that does not make the case for horizontal divestiture, for one would still need to establish that if one firm were to manipulate the production of one fuel it could affect the price of another. We have here an interesting development in the withholding argu­ ment; yet no one has been able to show that the version necessary to support horizontal divestiture is empirically relevant.

DR. BOCK: I have been troubled by two questions. First of all, if Dr. Gaskins is correct that, at the margin, one will withhold as long as the supply curve is rising, what would make the oil companies ever sell? The price may well continue to go up, so why would they sell the oil? With respect to the joint venture argument that Professor Pitofsky raised, I agree that the Penn-Olin case may not be a good precedent. Of course, I am not a lawyer, but I would like to point out that in Penn­ Olin the Supreme Court was concerned about two companies getting together, and in the Continental Can-Hazel Atlas case, it was also concerned about two companies getting together. But in Hazel Atlas, one community might have suffered severe unemployment and severe social disruption without the merger, so Continental Can was permitted to keep the glass plant in that community. No matter what we have to say about joint ventures in oil and about oil and other energy sources, we must be concerned about effects other than the direct economic ones.

.I PROFESSOR SCHERER: As a footnote to Dr. Bock's comment on the Continental Can divestiture, Continental Can was allowed to keep those two plants in Pennsylvania, but it was divested of the rest of the plants. They were acquired by Brockway Glass Company, roughly doubling Brockway's market share to 20 percent, in a merger that clearly would have been illegal had it not resulted from a government­ supervised antitrust divestiture.

MR. SWENSON: I have had a little experience in connection with the joint ownership of pipelines by oil companies. We investment bankers have handled the financing for many of these joint venture pipelines over the last ten years. In addition to the economic advantages of these ventures, it makes sense to have one pipeline run between the field and the various refineries located in one area, rather than having sixteen pipelines running to that area. This was recognized by the government and everyone else some time ago. A system was set up to enable oil companies to invest in joint venture pipelines. If a company had in­ sufficient capital or credit to invest in a joint venture pipeline, it could

42 DISCUSSION ship on the pipeline anyway and have equal priority with the owner-shippers. That particular point was challenged by Senator Hart's committee, and I testified during that time. The consensus was that joint ventures for oil pipelines and supertanker ports worked well for everybody­ for the country, as well as for the oil companies. In the case of super­ tanker ports, it would make no sense for each company to build its own supertanker port in the middle of a harbor. Each joint venture should be considered on its own merits. It seems clear that pipelines ought to be allowed to continue as joint ventures.

PROFESSOR KAUPER: I am not sure I agree with everything I have heard about the totally benign quality of joint ventures. It is one thing to say that nonowners have equal access to a joint pipeline, for example, but it may be something else in practice. There are a number of questions on the joint pipelines that still remain unanswered. The joint pipeline investigations have not been among the finest efforts in antitrust enforce­ ment history. It is amazing how long those investigations can go on. Apart from the economic impact of joint venture activity there is little doubt that the political climate surrounding the vertical and horizontal divestiture bills is strongly colored by the presence of joint ventures in the petroleum industry. Clearly the public perceives the petroleum industry as being tightly interlocked, and regardless of eco­ nomic impact somewhat incestuous. Indeed, no other industry has as many interlocks. These interlocks may not have an adverse competitive effect, but certainly the public perceives them as having one. There is a history of interlocking in the petroleum industry, and the question Professor Adams raised is, Can we expect such interlocking as the petroleum companies expand into other areas of energy production? Although nobody has really addressed that question, some of us, per­ haps, ought to have some concern with it.

PROFESSOR MARKHAM: I would like to take up one or two points that Darius Gaskins made. He implied that the computation of concentra­ tion ratios on an energy basis was a futile exercise. He also said that past data may not provide much of a clue to the future. A bill that is designed to shape the course of the energy industry and that is called the Energy Competition Act, might reasonably be expected to lead to margins of competition that are somewhat wider than they have been. I submit that my computations are not entirely irrelevant to the purposes of this bill, which contemplates something like national energy deconcentration.

43 COMPETITIVE ASPECTS

My second point has to do with the withholding argument. Dr. Gaskins seemed to be saying that concentration data are irrelevant to the issue of withholding. I am not clear on just what that means. If a single company held an energy monopoly it might withhold one line of business because of the interdependence of the market. If companies control only 5 to 7 percent of one market and 2 to 3 percent of another, however, the market impact of withholding must be directly related to the level of concentration. That conclusion is inescapable. A farmer (who deals with more perishable products) might as­ sume that wheat prices will double in the next year and therefore keep his crop from the market until then. Would that vitally affect the market for wheat? We have not generally thought so. Indeed, the only option open to a wheat grower (if the government were out of the picture) is to sell it or to hold it. We have never regarded withholding as being anticompetitive, and that raises the question, Why haven't we? The answer is that what one farmer does simply makes no difference. It does make a big difference-to me, at least-what percentage of each market is controlled by a firm. This consideration cannot be evaded merely by saying that concentration ratios (which, after all, measure this) are irrelevant to the withholding issue. I would like to look at the entry of petroleum companies into non­ oil energy in terms of their past history of joint ventures and other in­ terrelations. A credible argument might be made that the entry of oil companies into other sources of energy is likely to break: up the sym­ metry that has existed among oil companies over past decades. If a company that ranks, say, second in oil and twentieth in coal competes with one that ranks second in coal (which does happen to be an oil company) and eighteenth in oil, then their community of interest may somehow be broken up by a certain asymmetry between those com­ panies. The opportunities for operating as a little fraternity in oil are somewhat less when the companies operate in different markets with a different percentage of their sales going into those markets. On the issue of joint ventures, which has been brought up here in a number of contexts, I would agree that we really do not know how they work. I have run more correlations than I care to admit on the whole joint bidding process. Some of the facts are the following: there is a positive correlation between the estimated value of tracts and the number of bids; and there is a positive correlation between the total number of bids and joint bids. That does not help us very much. That is almost like correlating A plus B with A. We would expect some cor­ relation. This is where one runs into almost an unsolvable statistical problem. We would like to know whether joint bids on the whole tend

44 DISCUSSION to increase the total number of bids or decrease them-that is, are they a substitute for solo bids or not? No one has yet answered that question satisfactorily. A fact not brought out very clearly in Walter Adams's tables was that the ratio of independent bids to total bids runs much higher for five of those companies included in the FTC case-Chevron, Exxon, Gulf, Shell, and Texaco-than for all the rest. Indeed, if Sun Oil Com­ pany is eliminated, there is rough correlation between the size of the company and the incidence of independent bids. To this extent, there­ fore, joint bidding helps medium-sized and small companies. The data show that these companies engage in joint bidding proportionately more than the big oil companies do. Sun Oil is an exception. As a matter of strategy it bids often and seldom wins. It puts in low bids on the chance that it might be lucky, a perfectly sound business strategy. In any case, joint bidding is one way that smaller companies get into offshore oil reserves. Since 1970 there have been far more joint bids coming from large, integrated oil companies with medium-sized and small partners than from partners within the top ten or the top twelve. Before this conference is over, I hope we raise the question of what light can be shed by economics on this controversy. A respectable case can be based on Professor Adelman's statement that, while he sees no particular gain in deconcentration or divestiture of the oil com­ panies in nonoil energy, it might still make many people happy. That raises the question whether we should have had political scientists around the table rather than economists and lawyers. Politicians react to such things as price increases for gasoline, long lines at gas stations, Sunday closings, and rising home heating fuel bills. A frustrated Con­ gress could not reach the source of all this. It could not extend the antitrust laws to OPEC. Everybody knows that, but many citizens still write letters lamenting that the costs of two of their principal purchases are rising. Senators and congressmen, being what they are, understand­ ably had to pick a culprit at hand. It makes political sense, whether or not it makes economic sense, for them to tell their constituents that they are proceeding against the large oil companies. The large oil companies have never been at the top of any popularity poll. As I mentioned in my paper Senator Hart stated that his bill would not affect the oil companies, which are in an industry with low con­ centration, and Walter Measday said a superficial examination of data on the oil industry show the concentration to be rather low. If dissolu­ tion is indeed the implied remedy for high concentration, it should fol­ low automatically that it is not the cure for deconcentrated industries.

45 COMPETITIVE ASPECTS

The real questions are Why deconcentration? and Why divestiture? If these questions are cast in political terms, a good deal becomes ex­ plicable. Maybe much of our economic testimony and other discussion misses the essential point.

PROFESSOR ADAMS: Let me confess at the outset that I, too, can see many business reasons for joint ventures. They make very good sense. They offer risk sharing and risk reduction. Of course, the least risky kind of market structure from a firm's point of view would be a monop­ oly. Public policy, however, is not designed simply to reduce risk for private firms. Public policy is designed to protect the public. And the essence of competition, as I see it, is a competitive market that performs the regulatory function on behalf of society. People are given individual freedom not for its own sake but for the instrumental purpose of serving the public good. We should ask ourselves what kind of system would keep that central objective of public policy in mind. There may be good reason for joint ownership of pipelines, for joint bidding on offshore leases, for joint ownership of ARAMCO, for joint ownership of Iranian participation, and so forth. The point re­ mains, however, that when ,two people sleep together, they do not walk out of the bedroom unaffected by what has happened. The liaison has consequences in terms of their attitudes and their behavior with respect to one another. I have simply tried to indicate that joint ventures are one element of structure to be considered in interpreting the low concentration ratios. Professor Markham says that the fault of wrong government policies is attributable to government, not to the pressure groups that urge governments to take those policies. I view this problem not as an economic problem but as a problem in political economy. In my view of the world, the oil industry, an economic unit, cannot be put into one hermetically sealed bag, and the government into another. The two are related to each other. Now, that is an understatement-possibly the only one I'll make today. [Laughter.] One of my favorite characters in American industrial history was Walter Carpenter, the chairman of the board of Du Pont, an old-style businessman who had not been "cosmeticized" by attending the great law schools and business schools of this nation. In a private conversa­ tion, he once said to me, "Of course, the goddam chemical industry is a cartel, but how else would you want to run it?" Now that's the kind of man I can talk to. [Laughter.] But I cannot talk to the petty apologists who say, in effect, "Look

46 DISCUSSION here, it ain't happening." When a giant oil company buys·a coal com­ pany, the coal company will behave in the same way it always has, the way economists assume firms behave, namely, it will look at marginal costs and marginal revenue. They say that short-run profit maximization is the guide to the behavior of a company like Exxon. That claim taxes my credulity. In the real world, Exxon does not behave that way. Exxon is a power organization. It is aware, as it should be, of cross-elasticity of supply. Given the markets in which it operates the company is being perfectly rational in considering the implications of the individual decisions it makes. Professor Markham referred to the failure of antitrust policy to challenge oil company mergers. That nonaction by the government does not imply that the existing structure is in the public interest. Indeed, I would argue that it is not. How have antitrust decisions been made? In dealing with the oil industry, antitrust has been a graveyard of failure. Those who are old enough to remember or who have read things other than simultaneous equations are aware of this. In 1957, twenty-nine U.S. oil companies were accused of using the Suez crisis as an opportunity to raise U.S. gasoline prices. A federal grand jury was impaneled in Virginia, and it returned an antitrust price-fixing indictment. The case was then transferred to Tulsa. [Laughter.] There, Judge Royce Savage dismissed all charges against the oil companies, even though executive diaries showed that telephone meetings were taking plac~ and that the companies knew each others' forthcoming price levels prior to the public announcement. One year after that decision, Judge Savage resigned from the bench to become a vice-president of one of the major defendant companies in the case.1 How can all that be explained in any credible fashion without a conspiracy theory? Professor Pitofsky said that we should not make inferences from structure but rather should see what actual behavior has been. Let me cite some actual behavior. In 1929, Standard Oil, New Jersey (now, Exxon) entered into a marriage with I. G. Farben of Germany in order to divide the world. Oil was given to Standard, and chemicals were given to I. G. Farben. [EDITOR'S NOTE: See Appendix to Prof. Adams's paper.] The oil companies do have a record. We do not have to make wild inferences from structure, in the form of either concentration ratios or joint ventures.

1 For the details of this incident, as well as a comprehensive analysis of the record of antitrust versus Big Oil, see Senate Committee on Interior and Insular Affairs Hearings, Market Performance and Competition in the Petroleum In­ dustry, 93rd Congress, 1st session, 1973, part I, pp. 370-398.

47 COMPETITIVE ASPECTS

The antitrust laws may not be a good instrument for resolving the kind of problems found in the oil industry. It does not follow, how­ ever, that the current structure, conduct, or performance of the oil industry is in the public interest. From a public policy point of view, the basic questions remain. This is my concern-the point of view of the public rather than that of the individual companies. Again, I do not criticize the companies for what they are doing. If I were president of Exxon, I would probably follow the same policy that company follows, perhaps with even more aggressiveness because I understand the power implications involved. No personal criticism or personal animus is involved in my statements. From a public policy point of view, the questions remain, Who makes what decisions on whose behalf and at what cost in a society? Is society prepared to dele­ gate the decision-making process in the energy industry to the major oil companies? My answer to that would be no, and there is ample legal precedent for that answer. We do not have to rely on Hazel Atlas and Continental Can, which is just a footnote in antitrust that does not deal with the basic power problem confronted here. We have the Public Utility Holding Company Act of 1935, which tells electric companies to stay in their own backyard, and gas companies to stay in theirs. I would point out to Professor Teece that there was interindustry com­ petition between the two only at the margin. The Glass-Steagall Act keeps investment banking and commercial banking separate, even though there might be competition between them only at the margin. The railroads were told they could not go into the trucking -industry broadly speaking for the same reasons. In designing an economic system that is supposed to function in the public interest, we must ask how power should be distributed so that it cannot be abused if grasped by presumptuous hands. We must worry about safeguards, and we cannot know all the answers ex ante. We might know ex post that we made a mistake, but the arguments about that could be interminable. From a political point of view, our discussion here today may be totally irrelevant, because the political choice probably will not be between the status quo and horizontal or vertical divestiture. The choice will be between the status quo and nationalization of the oil industry. That is the solution the man in the street seeks as a response to his hatred of the oil companies, and there is personal hatred there. From a public policy point of view, nationalization of the oil industry could be the greatest disaster we face.

PROFESSOR ADELMAN: Walter Adams said that oil companies do not equate marginal cost and marginal revenue, but that they do take

48 DISCUSSION elasticities into account, and act rationally. He rejects six and embraces half a dozen. It is a distinction without a difference. Darius Gaskins raised a point about withholding, which touches on a peculiarity of operating costs or costs generally of extracting minerals. There are two kinds of costs. One is the cost of increasing the rate of exploitation, and, as Dr. Gaskins pointed out, in a situation of rising costs, drilling more holes, opening up new leases, building more pipe­ lines, and so on, will increase average costs. The other kind of cost is that of bringing up a barrel or a ton today, rather than keeping it and selling it one, two, or ten years hence. Selling it today is not necessarily a sacrifice-it may be a gain if the value ten years from now allows for the cost of holding the mineral (essentially, the discounting process) . If the two kinds of cost are added together, the result is the cost at the margin. If the cost is rising, we have an industry of increasing costs. Having said this, it seems to me we are right back to square one. A firm acting under the rule of competition can operate only on its own operations and on its own costs. The price is an outside fact. The firm can push its rate of exploitation until the total cost threatens to exceed the price. At that point, the firm must hold back. But the only way the firm can affect the price-whether it is called withholding, or restraint, or reduction, or whatever-is either by controlling so large a part of the market that its decisions make a difference or by collusion with others. These considerations compel us to redefine costs to answer the basic questions Professor Markham emphasized: What are the mar­ ket shares of the companies? and, What is the degree of concentration? If concentration is low, then price must be equated with marginal costs. Life may be less rich for a competitor than for a monopolist, but it is also more simple: he does not have to worry about setting the price.

PROFESSOR ADAMS: The contention is often made that the identity of the players in a game is of no behavioral consequence; that is, when an oil company operates in the coal market, for example, it behaves as if it were a coal company, and that the rationale of that particular industry in that particular market is imposed on it. To my naive, unsophisticated mind, that argument does not wash, so I pose this question. Suppose in a basketball game among a bunch of eleven-year-olds the whistle blows, and a substitution is made. One of the eleven-year­ olds is taken out of the game, and the substitute trotting onto the court is Kareem Abdul-Jabbar. The concentration ratio has not changed. Each team still has only five players. Kareem is only one out of five. His market share is only 20· percent.

49 COMPETITIVE ASPECTS

PROFESSOR MARKHAM: But it should be measured in terms of basketball skill not numbers. And Kareem Abdul-Jabbar has a much higher share of the basketball skill on that floor.

PROFESSOR ADAMS: However you want to interpret it, there will be behavioral and performance consequences of that substitution, even if the game is still being played by five players on each side. The question is, Professor Adelman, would you agree that Kareem Abdul-Jabbar would make a difference?

PROFESSOR ADELMAN: Suppose the biggest oil company acquires a coal-producing property, what kind of instructions will it give to the managers of that subsidiary? Will it tell them to make a dollar wherever it can for the glory of the company, or will it tell them to tailor their plans and their output to the price and output of oil? If we agree with Darius Gaskins that there is no relationship between the coal and oil prices-the simplest case-then ownership by the oil company would not make the slightest difference. I am not convinced that the case is quite as strong as that. Let's suppose that a larger supply and lower price of coal would make a difference to the oil industry. If this hypothetical coal company accounts for about 10 percent of the market, there is still no call to change the operating instructions because a 10 percenter can do nothing to change the price of coal. Let's indulge in the pleasant fantasy that there is something the company can do to increase the supply of coal significantly, such as developing all of the Western coal reserves-despite the efforts of the governor of Wyoming and the Western congressional delegations. All of those profits would redound to the subsidiary. Only the indirect effect on the price of coal and even more remotely on the price of oil would subtract from the profits of the oil company. If this oil company's executives have any common sense or if they hire the right kind of accountants, economists, and systems analysts, they still will tell the coal subsidiary managers to make a dollar for the company and never mind the price of oil: act like a competitor.

PROFESSOR ADAMS: Is the objective really to make a dollar for the company? I would submit that it is not. These companies are not going for short-run profit maximization.

PROFESSOR ADELMAN: They are going for long-run profit maximization. These are investment decisions, for the long run.

50 DISCUSSION

PROFESSOR ADAMS: The issue turns on the company's perception of its power position in the energy industry. Indeed, this was pointed out to me back in 1953, but I did not quite understand the implications of it at the time. At an indoctrination session at Standard Oil of New Jersey in New York, we were addressed by the chairman of the board, who told us that Standard was not an oil company but an energy company. Suppose an oil company is working on hydrogenation, or suppose it finds a technique for liquefying coal or gasifying coal. At that point, Dr. Gaskins and Professor Teece would have to agree, there would be some interfuel competition. And suppose the company decided not to use up any of its coal at that time but to save it, trying to maximize whatever returns it could from its existing investment in oil. Then, at the proper time, it could use the hydrogenation process on the coal it has accumulated. What about that scenario? It might make a lot of sense.

PROFESSOR GASKINS: I feel a responsibility to clarify my argument about withholding in relation to what various people have said. First, Professor Markham's point is that concentration is related to collusion in the literature on industrial organization. When I talk about withholding, however, I am not talking about collusion. I am talking about a company that in its own interest withholds something from the market which increases the value of the other things it sells in that market. If I am not talking about collusion, then it is irrelevant how many other companies are in the market.

PROFESSOR MARKHAM: But would the share of each of these two fuel energy sources also be irrelevant?

PROFESSOR GASKINS: If they are direct substitutes at the margin, if a change in coal production affects the price of oil, it is relevant. Let me pursue my general explanation, and maybe I can make myself clear. Let's talk: about phosphates and assume that the industry faces ~n upward supply curve. Let's view every point on that supply curve as a mine that could be opened to produce phosphate. And let's assume that the industry has a downward sloping demand curve. A mining company owns a finite number of those mines and it also owns the marginal mine. The company must recognize that, if it produces from that mine, that production will affect the market price of the rest of the company's phosphate. That is the simple logic of what I am talking about. If we apply that logic to any resource industry with an upward sloping supply curve,

51 COMPETITIVE ASPECTS then a company that has a finite bundle of the resources it sells and that also owns the marginal unit can influence the price. If the com­ pany recognizes that fact, it could increase its profit by withholding some of those resources. Professor Bock asked why such a company would produce at all. The answer is, it would engage in balancing. It would make no money on that which it withheld in the current period, but by withholding it, the company would make money on the other part of the resources in its portfolio. Eventually, withholding would cost the company enough to make it stop withholding. The theoretical point is that some withholding is possible in this situation, and the simple logic of it makes concentration ratios ir­ relevant. All that matters is how much of the reserves and how much at the margin are controlled, and that determines how much is withheld. The question whether or not there are four people with 20 percent of the market is irrelevant. Let me go one step further. Concentration ratios are quite mis­ leading. With the same concentration ratio, there can be a much dif­ ferent story in terms of withholding. The simple stories I am telling show that the more asymmetric the market shares are for a given con­ centration ratio, the more withholding there will be. If each of the four largest companies has 20 percent of the reserves in that market, any individual company gets only 20 percent of the benefit when it with­ holds the marginal unit. But if one firm has 79 percent, that firm will get 79 percent of the benefit from withholding. Therefore it is quite misleading to look at the concentration ratio. The reserves a company holds and its control of the marginal unit are the critical factors. Professor Adelman raised a question that does complicate this approach, I admit. He asked about the next period, because, of course, the company would have the opportunity to sell in the next period. It should be remembered, however, that when a company withholds some­ thing that benefits its portfolio in the current period, it has something to sell in the next period. But this is a complicated area, and-I am telling a very simple story. I just want to point out that the withholding story is theoretically possible. Then we have to look at the supply curve to see if it is really upward sloping or horizontal. If it is horizontal, then the price cannot be raised by withholding.

52 PART TWO ECONOMIC EFFICIENCY ASPECTS

Chairman's Remarks

Edward J. Mitchell

The primary new issue for attention in this session is whether the energy industry becomes more efficient and has lower costs if horizontal integration takes place. Even if one concludes that the industry would become less competitive if horizontal integration is permitted, it is still possible to decide on public policy grounds that horizontal inte­ gration should be allowed because of the cost savings that would result from improved efficiency. This other side of the issue, the economic efficiency side, is a separate matter, although we may find the discussion going back and forth between competition and efficiency. The papers by Professor Teece and Mr. Swenson reflect this orientation toward questions of economic efficiency, as opposed to competition.

55

Horizontal Integration in Energy: Organizational and Technological Considerations

David J. Teece

If we really wish to come to an understanding of the evolving structure of the energy industry, then we must identify the driving forces at work. I do not believe that the evidence supports the monopoly power inter­ pretation Professor Adams presented earlier. However, besides showing that the monopoly argument is contrived, I wish to present an alter­ native explanation of horizontal integration, one based on efficiency considerations, and one that I believe is more firmly substantiated by the available evidence. This task is clearly an important one, because divestiture proposals are based upon the implicit assumption that horizontal integration is a vehicle used by the oil companies to spread an already entrenched monopoly position from oil and gas to alternative fuels. The alleged behavioral consequence is the withholding of alternative fuels in order to drive up (or at least maintain) prices for oil and gas, thereby en­ hancing the value of the firms' oil and gas reserves. If this implicit assumption is incorrect, then divestiture could not be expected to pro­ vide the benefits that its advocates anticipate. Let me present, therefore, an efficiency interpretation of horizontal integration, and let us see to what extent it squares with the facts. 1 In an imaginary world of frictionless markets, complex forms of business organization-such as vertical and horizontal integration­ 90uld well be devoid of a compelling efficiency rationale. Frictionless markets with complete information and zero transactions costs could handle every conceivable kind of transaction. However, the nonexist­ ence of many markets and the high transactions costs of using others provide opportunities for the displacement of markets by hierarchies, of which the modern corporation is a particular example. Coase made

1 This paper represents a preliminary and abridged version of my analysis of this topic. A more recent and more complete analysis can be found in my monograph, Energy Company Diversification and Innovation, Research paper no. 432, Graduate School of Business, Stanford University (and forthcoming from the American Enterprise Institute).

57 ECONOMIC EFFICIENCY ASPECTS

this point explicit in his well-known article in 1937.2 Because markets and hierarchies can perform similar functions, it is important that their relative efficiencies be appreciated. The integrated energy companies can, I believe, be examined in this context. Divestiture proposes to expand market exchange where currently internal exchange prevails, so focusing on the comparative efficiency properties of firms and markets seems entirely relevant. I wish to argue that "market failure't3 con~iderations, together with certain institutional features of the U.S. economy, and the chang­ ing natural resource base explain, in large measure, the incentives for conglomerate or "horizontal" integration as it is known in this context. The market failures to which I refer occur in the market for capital and technological know-how. Clearly, I do not wish to present a blanket indictment of market processes for transferring technology and for allocating capital; nor do I wish to present a blanket endorsement of conglomerate business organization, as some conglomerates cause genuine public policy concern. However, the evidence suggests that the energy conglomerates do not fall into that category. In order for conglomerates to have the potential for important efficiency properties, they must be "appropriately" organized. By this I mean the following: first, responsibility for operating decisions must be assigned to operating divisions or quasi firms; second, an elite staff must be attached to headquarters to perform both advisory and audit­ ing functions; third, headquarters, not the divisions, must be responsible for strategic decision making, planning, appraisal, and control, includ­ ing allocation of capital between the divisions; fourth, the research establishment must be centralized or there must be close formal ties between separate laboratories. The resulting structure can display both rationality and synergy. Following Williamson, firms organized in this fashion are denoted as "m-form" firms. 4 I wish to argue that conglomerates organized as m-forms have the potential to improve the functioning of the capital market by more assuredly assigning cash flows to high-yield users. The reasons why this is possible is that conglomerates can offer a wide spectrum of

2 Ronald Coase, ''The Nature of the Firm," Economica, November 1937. 3 I am using the item "market failure" in a very special sense. I do not mean to imply that markets are not operating efficiently. The term merely refers to the inability of markets to work according to the frictionless caricature we sometimes assume. When markets involve substantial transactions costs of various kinds, institutional responses, such as horizontal integration, can be expected to result. These organizational responses can in turn "restore" the efficiency of the market economy. In fact, if the adjustment is almost instantaneous, departures from Pareto optimality can be expected to be minimal. 4 Oliver Williamson, Markets and Hierarchies (New York: Free Press, 1975).

58 DAVID J. TEECE investment opportunities, and the corporate headquarters typically has more detailed information on some potential investments than the ex­ ternal capital market has. (The firm's managers excel with respect to possessing depth of information whereas the external capital market excels with respect to breadth of information.) Management can make detailed evaluations and audits of each of the firm's operating parts, and can make adjustments to the operating parts in response to per­ formance failure. This is particularly important when we realize that the differential tax treatment of dividends tends to create a strong reinvestment bias. Of course, for this reassignment capacity to be beneficial, cash flows must be subject to an internal competition, and investment pro­ posals from the various divisions must be solicited and evaluated by general management. In this way conglomerates can act as miniature capital markets. Grabowski's and Mueller's empirical work on rates of return to plow-back suggest that reassignment is particularly important for firms with a maturing product portfolio.5 Such firms tend to generate a low return on plow-back because external capital market discipline tends to weaken. Assuming that reinvestment proclivities cannot readily be changed, efficiency considerations dictate the establishment of a competitive internal capital market, and this in turn indicates the desirability of including new products and new ventures within a matur­ ing firm's investment portfolio. I extend the hypothesis to include failures in the market for tech­ nology. While synergy in a conglomerate need not depend on tecl,no­ logical considerations, as the above discussion indicates, technology transfer considerations can breed additional sources of synergy. Inte­ gration can facilitate the technology transfer process by improving the coupling between user and supplier, and by overcoming contractual problems involved in the buying and selling of technological know-how. The information asymmetry which necessarily exists between the buyer and the seller of technology means that the sale of technology must take place under conditions which do not satisfy the assumptions of the competitive model. For this and other reasons, the market for technology is often faulted. 6 Under such conditions, internal technology transfer, by checking opportunistic proclivities, can be a superior mode for technology transfer.

5 Henry Grabowski and Dennis Mueller, "Life Cycle Effects of Corporate Re­ turns on Retentions," Review of Economics and Statistics, November 1975; and Dennis Mueller, "A Life Cycle Theory of the Firm," Journal of Industrial Eco­ nomics, July 1972. 6 I elaborate on these arguments in Energy Company Diversification and Innova­ tion (American Enterprise Institute, forthcoming).

59 ECONOMIC EFFICIENCY ASPECTS

The above are essentially affirmative statements that can be made on behalf of appropriately organized conglomerates. They must be balanced against potential anticompetitive effects, such as reciprocity, predatory cross-subsidization, and interdependence. This last factor implies that competition is restrained out of a mutually recognized interdependence, and could result in less aggressive competition in markets where interfaces exist, or in a reduction in potential competi­ tion in markets where entry might otherwise occur. In the context of the energy industries, the first aspect has been emphasized. I have outlined a theory of business organization in which the superiority of appropriately organized conglomerates over specialized firms is indicated. The relevance of the theory to the energy companies depends on the occurrence of a number of factors: first, a maturing product portfolio within the firm which is generating a substantial cash flow; second, attractive investment opportunities in allied industries; third, technology transfer opportunities from established to allied activi­ ties; and fourth, a multidivisional structure in the oil companies. These factors are sequentially examined below in the context of the U.S. energy industries. I wish to make apparent that the new endeavors embraced by the oil companies appear to be quite consistent with the competitive theory of corporate development that I have advanced. Consider, first, the nation's changing natural resource base. Re­ serves in the lower forty-eight states have been declining since about 1966, and the Prudhoe Bay discoveries, which have added almost 10 billion barrels, amount to only three extra years supply at current rates of production. Future discoveries will most probably involve more steeply increasing costs than some alternative fuels, such as coal. Hence, it is to be expected that even aside from the effect of anticipated gov­ ernment policy changes designed to reduce dependence on oil, the shares of alternative fuels in U.S. energy consumption will increase as the price of energy increases. This implies that resources must flow into alternative fuels if risk corrected rates of return to investment are to be equalized across fuels. It is predictable that the oil companies will be among the first to respond to these new investment opportuni­ ties, assuming that the managerial and technological synergies are greater for the oil companies than they are for firms with no experience in the energy business. Horizontal integration can be viewed as a vehicle to assist in the resource allocation process by permitting a quick response to new investment opportunities on the part of firms that already possess the requisite capabilities. The FEA estimates that between 1975 and 1984 an additional $44 billion of investment will be needed in coal, synthetic

60 DAVID J. TEECE fuels, and the nuclear fuel cycle. The oil companies, because of their large cash flows and low debt-equity ratios, are well placed to respond. By investing in the coal industry, for instance, the oil companies can help .moderate price increases, augment production, and assist in driv­ ing imported OPEC oil out of the United States. The oil companies can also bring technological know-how and an R&D capability to the alternative fuels activities. It is also worthy of note that the exploration and drilling for geothermal resources are not altogether unlike those processes for oil. Pipeline technology from the oil industry has been important in bringing about the coal-slurry pipe­ line. Discoveries of minerals such as uranium are facilitated by knowl­ edge of sedimentary basins. The oil companies have such knowledge because of their exploratory activities in oil and gas. Coal liquefaction technology under development by the oil companies is being based on catalytic processes similar to those developed for refining petroleum. Retorting shale similarly involves processes like those used in refining. Of course, once oil is produced from coal or shale, the storage and transportation problems are just the same as those encountered with conventional crude. The importance of the management skills which can also be com­ mitted by the oil companies should not be underestimated. The oil companies-like the chemical companies and the steel companies­ have had experience managing and coordinating huge, capital-intensive investments that require a long gestation. These skills will become increasingly critical to the coal and synthetic fuels industries. For in­ stance, it is estimated that plants to produce oil from shale could well cost over $1 billion. It is hard to identify firms currently in the alterna­ tive fuels industries which possess the relevant resources. Consider, finally, the organizational structure issue. A prerequisite of my theory is that the energy conglomerates display a multidivisional structure of the variety I described earlier. R&D must also be cen­ tralized in some fashion. It is into these divisionalized structures that the new ventures are absorbed, eventually as separate divisions. A life-cycle process may be involved if entry is via internal growth rather than acquisition since the new ventures may be located first within existing divisions and become separate divisions only after these opera­ tions exceed threshold proportions. Table 1 lists twenty-seven of the thirty-two petroleum firms in Fortune's 500 largest corporations. Of these twenty-seven firms, twenty-one were organized as m-forms. All of the "majors" had an m-form structure. Furthermore, Table 2 indi­ cates that all of the majors have some centralized R&D with the excep-

61 ECONOMIC EFFICIENCY ASPECTS

TABLEt ORGANIZATIONAL FORM CLASSIFICATIONS, 1975 PETROLEUM FIRMS IN THE FORTUNE 500

company m-/orm other

American Petrofina x Ashland Oil x Atlantic Richfield X Belco Petroleum X Cities Service X Clark Oil and Refining x Commonwealth Oil Refining X Continental Oil x Exxon X Getty Oil X Gulf Oil x Kerr-McGee X Marathon Oil X Mobil Oil X Murphy Oil X Occidental Petroleum X Phillips Petroleum X Shell Oil X Standard Oil (California) X Standard Oil (Indiana) X Standard Oil (Ohio) X Sun Company X Superior Oil x Tenneco X Texaco X Union Oil of California X United Refining x

NOTE: Firms were defined as petroleum firms if more than 50 percent of their total revenues were derived from petroleum industry activities. There were thirty­ two petroleum firms in the Fortune 500 in 1975. Twenty-seven made sufficient data available to permit the classifications presented here to be carried out. Note that Gulf's organizational structure was in a state of flux in 1975, but it essentially had an m-form structure since 1958. It is also apparent that the non­ m-form firms in 1975 are the smaller companies for which the m-form structure may not be optimal. For a more detailed discussion of the m-form classification see Henry Armour and David Teece, "Organizational Structure and Economic Performance: A Test of the Multidivisional Hypothesis," Bell Journal 0/ Eco­ nomics, vol. 9, no. 1, Spring 1978. SOURCE: 10K's, company announcements, and direct correspondence with the corporations.

62 DAVID J. TEECE

TABLE 2 ORGANIZATION IN OIL FIRMS, 1975

Company Centralized Decentralized

Texaco x Gulf X Sohio X Kerr-McGee X Sun X Conoco X Marathon X Mobil X X Arco X Phillips XX Ashland X X Chevron X Getty X Shell X Damson X Offshore Co. X Exxon X X

NOTE: If an X appears in both columns, the firms R&D is partially centralized and partially decentralized. Typically, this notation will reflect the fact that ex­ ploration and production research is conducted in one organization while refin­ ing and other R&D activities take place in a separate R&D organization. SOURCE: Questionnaire data supplied by the companies enumerated.

tion of Atlantic Richfield, which is decentralized but has strong linkages among its various laboratories. Thus the case for oil company participation in other segments of the energy industry rests upon competitive principles and the important contributions the oil companies can bring. Imposing barriers to entry via legislative restrictions would seem to be an entirely inappropriate policy. What objections, then, are raised against horizontal integration? As I mentioned earlier, to the extent that an economic rationale has been articulated to support horizontal divestiture, it has been predicated on the argument that monopoly power results in the withholding of supplies of alternative fuels and the retardation of their development. The basis of the argument is that an energy conglomerate will suffer opportunity costs if production of alternative fuels reduces potential profits from its oil reserves. Energy conglomerates internalize costs that in a competitive economy would be external to an independent pro­ ducer of a substitute energy source, to paraphrase Professor Davidson,

63 ECONOMIC EFFICIENCY ASPECTS an active proponent of this theory.7 Or to quote from the paper Walter Adams presented earlier: "Can we really expect these giant firms to undermine their stake in depletable oil and gas resources ... by invest­ ing the huge sums required to promote the rapid development of economically viable substitutes?" I interpret this argument to mean that horizontal integration results in the production of substitutes being withheld below levels that would be generated with an economy of independent rather than integrated firms. Let us examine the logic of this argument. Consider the determination of the optimal private rate of resource extraction. A rational resource owner will compare,the expected profits of selling a unit of the resource today with expected profit, appropriately discounted, of selling the same unit at some future date. Thus if a resource owner expects the difference between the price and the cost of production to increase at an annual rate which exceeds the resource owner's rate of discount, there is an incentive to reduce current pro­ duction and keep the resources in the ground as inventory. The seminal question is how the state of competition and the degree of horizontal integration influence the firm's optimal rate of resource extraction. I wish to argue that whereas the state of competition affects the resource extraction decision, the level of integration has essentially a neutral effect in a competitive market. Assume, to begin with, that there is no horizontal integration. Now under competitive conditions all firms are, by assumption, price takers. Accordingly, no matter their individual production decisions, resource owners have absolutely no influence on the price of their own resource or its substitute. On the other hand, if monopoly power is imputed to the resource owners, then by changing the level of produc­ tion, the current price, can, by assumption, be manipulated. Professor Davidson has claimetl that even without monopoly power, the withholding of production could take place, arguing that "it does not require covert collusion. What is required is that they all view the future the same." Two points should be noted about this. First, it is not an indictment of horizontal integration since there is no reason to believe that independent companies will view the future any differ­ ently from conglomerates, as both presumably have the same informa­ tion. Second, it is not clear that the withholding so generated is socially undesirable.8 Nevertheless it is apparent that, in order to argue that

7 Paul Davidson et aI., "Oil: Its Time Allocation and Project Independence," Brookings Papers on Economic Activity, 2, 1974. 8 How is it different from a wheat farmer who withholds this year's harvest in storage in anticipation of a future shortage?

64 DAVID J. TEECE horizontal integration affects the rate of resource extraction, both strong interfuel substitution and monopoly power must be assumed. Otherwise, the source of differing expectations between independents and conglomerates must be specified. All of these conditions must hold before the argument makes theoretical sense. For the withholding theory to have any empirical validity, the above analysis suggests that at a minimum the following conditions must hold: (1) There must be strong interfuel substitution. (2) There must be monopoly power in the energy market. (The requirement of interfuel substitution implies that the relevant market is the energy market and not the market for individual fuels. Note that Jesse Mark­ ham's concentration statistics show that concentration declines as the market is broadened to include alternative fuels. Hence to be internally consistent, advocates of this theory cannot logically draw implications from concentration in the crude oil market.) (3) Despite OPEC, U.S. oil companies must be able to control the world price of oil. If this control cannot be established, then how can the integrated firms change the value of their reserves of oil by manipulating the production of alternative fuels? The validity of each of these assumptions must be established before the withholding theory can provide a viable explanation of pro­ duction behavior. I do not believe that they can be supported. On the demand side, interfuel substitution possibilities are essentially limited to the electric utility sector. In my previous work on the petroleum in­ dustry I found it to be workably competitive.9 The petroleum industry is about as competitive as sensible public policy can make it. I have not been able to discover evidence to render claims to the contrary at all convincing. Professor Adams's paper presented earlier certainly does not make the case. Nor do appeals to prewar petroleum industry be­ havior have much to do with the current policy issues. By laying out the assumptions of the withholding theory in this fashion, the contrived nature of the argument is made apparent. Its assumptions do not seem to be relevant to the situation currently pre­ vailing in the U.S. energy markets. The relevance of the theory is further brought into question when the performance of the oil com­ panies in alternative fuels is examined. Consider the coal industry. The withholding theory would predict that after acquisition by oil companies, the output of coal companies would be "withheld." By contrast, the alternative theory of integration I have advanced in this paper would

9 See David Teece, "Vertical Integration in the U.S. Oil Industry," in Edward J. Mitchell, ed., Vertical Integration in the Oil Industry (Washington, D.C.: Ameri­ can Enterprise Institute, 1976).

65 ECONOMIC EFFICIENCY ASPECTS

predict that after the completion of a merger, investment-and hence production-will increase in the acquired company over the level that would have occurred had the new subsidiary remained independent. This prediction is difficult to verify, as data on the investments and production levels which would have taken place without the merger are not available. One way to approach the problem is to assume that investment and output in the independent companies would have followed the national trend. On this assumption, increases in production and invest­ ment greater than the national average would indicate support for the theory. The relevant production data is available for the coal industry. Table 3 presents production data for the four largest coal firms acquired by oil companies: Pittsburg & Midway (Gulf), Old Ben (Sohio), Con­ solidation (Conoco), and Island Creek (Occidental). The production statistics indicate that in each case the five-year increase after acquisi­ tion was greater than the overall U.S. increase. This does not square with the prediction of the withholding theory, but it is consistent with the alternative theory I have advanced. With respect to capital investment it is hard to argue that the

TABLE 3 OUTPUT OF COAL COMPANIES BEFORE AND AFTER ACQUISITION BY OIL COMPANIES (comparison of five-year averages before and after dates of acquisition)

Output Company U.S. (000 tons, Percentage Percentage 5-year average) Increase Increase·

Consolidation 43,858 (1962-66) 35.0 16.6 (Conoco--9/15/66) 59,218 (1967-71) Island Creek 22,514 (1963-67) 16.8b 12.2 (Occidental-l/ 29/68) 26,293 (1968-72) Old Ben 8,287 (1964-68) 37.2 10.3 (Sohio--8/30/68) 11,372 (1969-73) Pittsburg & Midway 4,869 (1959-63) 73.9 24.6 (Gulf-late 1963) 8,465 (1964-68) a In each case the U.S. percentage increase is measured over the same time period as the oil company affiliate. The U.S. percentage increase also refers to a com­ parison of averages over five-year periods. b If the production of Island Creek's maust coal properties (acquired in 1969) are substituted, then this figure falls to 2.8 percent. SOURCE: Keystone Coal Industry Manual for respective years.

66 DAVID J. TEECE effect of acquisitions has been to curtail investment, at least in coal. Table 4 shows the absolute level of investment has increased for each of the four major acquisitions. The percentage increase in investment for the five-year post-acquisition period as compared with the five previous years was 267 percent for Pittsburg & Midway, 139 percent for Old Ben, 325 percent for Consol, and 460 percent for Island Creek. These sizable increases in investment are also inconsistent with the allegation

TABLE 4 CAPITAL EXPENDITURES OF COAL COMPANIES BEFORE AND AFTER ACQUISITION BY OIL COMPANIES (000 dollars)

Pittsburg Old Island Year and Midway· Benb ConsoZC Creekd

1956 3,017 1957 5,803 1958 3,602 1959 1,522 1960 1,357 1961 2,376 1,849 1962 4,416 2,130 2,600 3.8 1963 8,216 2,390 6,000 5.7 1964 11,1078 2,358 18,000 3.3 1965 5,109 4,544 19,900 5.6 1966 12,561 4,092 20,100 16.3 1967 11,048 5,634 44,2008 25.1 1968 8,004 8,064 42,500 40.78 1969 6,027 4,9548 57,800 62.0 1970 6,065 3,491 38,900 55.0 1971 11,560 3,849 33,100 61.0 1972 14,184 16,313 30,800 38.9 1973 11,081 5,692 14,000 18.0 1974 13,862 20,351 30,600 31.1 1975 22,218 29,464 40,100 69.8

A Data are on "capital expenditures for coal operations" and are from Gulf Oil Corporation. Figures on preacquisition years are based, in some instances, on fiscal years and in others on calendar years so that there is some overlap in the early per year data. b Data refer to "expenditures for property, plant, and equipment" and are taken from annual reports.

C Expenditure refers to "outlays for new mines and expanded capacity" and was provided by Conoco. As such, these figures exclude much in the way of other coal mine capital investment. d Data on total coal capital expenditures are taken from Occidental annual reports, SEC registration statements, and other sources.

8 First complete post-acquisition year of operation.

67 ECONOMIC EFFICIENCY ASPECTS that the oil parents attempt to withhold production. Rather, the data support the capital reallocation argument that I advanced. With respect to research and development, the theory I have ad­ vanced predicts that oil firms integrating into alternative fuels will engage in R&D projects related to the further development of those fuels. (By contrast, the withholding theory would imply that the inte­ grating firms would not engage in any R&D activity in alternative fuels, since their interest is allegedly in restraining production, not enhancing it.) Table 5 presents data on coal R&D spending by the oil companies

TABLES COAL R&D EXPENDITURES BY OIL COMPANIES WITH COAL RESERVES, 1975

1975 Coal R&D Expenditures per Thousand 1975 Coal 1975 Coal R&D Tons of Coal Reservesb ExpendituresC Reservesd Oil (millions (arithmetic (arithmetic Company· of tons) mean) mean)

Conoco 13,350 Exxon 8,400 Occidental 3,400 Kerr-McGee 2,800 Top four reserve holders $6,199,800 $.87 Gulf 2,600 Mobil 2,500 Sun 2,271 Arco 2,200 Fifth through eighth $2,318,800 $.96 Texaco 2,000 Phillips 2,000 Shell 1,460 Ashland 900 Sohio 837 Ninth through thirteenth $ 945,000 $.90

• Oil company is defined as one that receives SO percent or more of its revenue from petroleum industry activity. b Coal reserves from Keystone Coal Industry Manual, 1975, Company Annual Reports, House Interior Subcommittee on Mines and Mining.

C R&D expenditures on coal obtained from each company's RD-l, submitted annually to the Census Bureau (on behalf of the National Science Foundation) and made available to the author by the oil companies. d Total R&D expenditures for category divided by total coal reserves for category.

68 DAYID J. TEECE holding coal reserves. The top four oil firms (ranked by their coal reserves) spent an average of $6,119,800 on coal R&D in 1975; the next spent $2,318,800 on average; and the remaining five spent an average of $755,800. R&D expenditures per ton of coal reserves were almost constant for the reserve classes identified. Since the independent coal companies are spending practically nothing on coal R&D, how can one entertain the notion that the oil companies are retarding the development of coal? Let me conclude by discussing what I believe would be the most likely consequences if horizontal restructuring were imposed. I wish to abstract from short-run adjustment costs and simply focus on in­ dustry performance after divestiture. I begin by pointing out that divestiture essentially involves a redefinition of the legitimate boundaries of the firm. The consequences are determined by the behavioral re­ sponses of the firms involved. These behavioral responses cannot be predicted unless an understanding of the determinants of firm behavior and industry structure and the firm's internal organization are first established. My discussion so far has been directed to this end. This framework will now be used to examine some probable effects on research and development, competition, investment, production, and import dependence. I discuss the impact on R&D at some length simply because I have not heard much attention given to it by others. Changes in the structure of R&D and in the total amount of R&D performed in the economy can be predicted, and technology transfer among the various energy industries would most likely be hampered by restructuring. Corporate research-that component of R&D which is centralized and involves long-range pioneering efforts-would be substantially eliminated. Corporate R&D Jaboratories possess equip­ ment and perform services which divestiture would render too expensive for the individual divisions to support; or, if they could support them, it would only be at higher cost. These corporate laboratories also con­ duct the long-range, high-risk projects that make sense only as part of a diversified portfolio of research activities. Forced to stand alone, the divisions would find less merit in sponsoring the long-range, high­ risk R&D projects. This would be especially unfortunate in that the externalities from this type of research are generally considered to be greater than for the kinds of problem-solving R&D that could be per­ formed in the divested remnants. R.C.O. Mathews and Kenneth Arrow have both remarked that the degree of appropriability is less for major innovations than for minor ones because major innovations are more

69 ECONOMIC EFFICIENCY ASPECTS likely to be imitated quickly.10 With respect to appropriability, Edwin Mansfield has shown, using a very conservative methodology, that the lower bound on the social rate of return from a large energy company's R &·D was 23 percent for new products, and 55 percent for new proc­ esses. (The private rate of return was closer to 15 percent.) 11 Hence any decline in R&D expenditures and innovation activity should be viewed with far greater concern than might be indicated by whatever dollar reduction in R&D spending might take place. Of course, a legitimate question to ask is whether R&D activities could be sustained after divestiture by licensing arrangements in which the divested oil companies would maintain essentially the same com­ mitment to R&D and support it by offering innovations for sale under licensing arrangements. While this may not be impossible, several problems are likely. First, as Arrow has remarked, the sale of tech­ nology under license seldom yields a return equivalent to that which can be obtained through internal use. 12 Second, incentives for R&D may be greater if an ownership position can be obtained in those re­ sources which would be enhanced in value by the innovation. Preventing resource ownership could therefore reduce incentives for R&D. An additional reason why oil company R&D in energy could be jeopardized relates to the complementarity between production and R&D. It is tremendously difficult to transfer technology before first commercialization. My Ballinger study showed that the cost of transfer is often halved after at least one manufacturing start-up.1S Another problem is that the market for technological know-how, as I mentioned earlier, works inefficiently because of information impaction and in­ formational asymmetries between the parties. Perhaps these debilitating effects could be overcome by allowing the oil companies to engage in production of synthetics while prohibit­ ing them from holding a reserve position. This reduces to a vertical integration question, and on the basis of preliminary information on the nature of coal-synthetics technology, it appears that vertical integra-

10 R.C.O. Mathews, "The Contribution of Science, Technology to Economic Development," in B. R. Williams, ed., Science and Technology in Economic Growth (London: Macmillan, 1973), p. 14, and K. Arrow, "Economic Welfare and the Allocation of Resources for Invention," in National Bureau of Economic Research, The Rate and Direction of Inventive Activity (Princeton: Princeton University Press, 1962), p. 622. 11 See Edwin Mansfield et aI., "Social and Private Rates of Return from Indus­ trial Innovations," Quarterly Journal of Economics, vol. XCI, no. 2, May 1977. 12 See Kenneth Arrow, "Comments," in Universities National Bureau of Eco­ nomic Research, The Rate and Direction of Inventive Activity (Princeton: Princeton University Press for NBER, 1962).' 13 See D. Teece, The Multinational Corporation and the Resource Cost of Inter­ national Technology Transfer (Cambridge, Mass.: Ballinger, 1976).

70 DAVID J. TEECE tion could well provide important efficiency advantages, at least for coal. The incentives for vertical integration stem from the high degree of coal variability and the high transportation costs involved in moving coal. The variability in coal feedstocks is much greater than it is for the crude streams which a petroleum refiner encounters. The ash con­ tent in coal typically varies from 2 to 50 percent, the oxygen content from 3 to 10 percent, and the water content varies from 1 to 50 percent. The caking qualities also differ markedly. These variations are so great that major process changes would be required to accommodate them; hence the possibility of substituting alternative coal supplies in a syn­ thetics plant will be very limited, since a coal-fed synthetic fuels plant will probably be tailored to the characteristics of a specific coal deposit. High transportation costs will further constrain the availability of feed­ stocks. As a result the most likely location of a synthetics fuel plant will be at the mine mouth. If the synthetics producer does not own the coal, a bilateral monopoly situation could emerge once the plant is in place. Contractual risks suggest the prudence of vertical integration.14 The effects which divestiture would have on competition are some­ what easier to identify. First, barriers to entry would be erected by the legislation. Second, interfuel competition would not be enhanced, since synthetics development would be retarded because of a reduction in the R&D effort. As a result, divestiture would tend to fossilize the current structure of the alternative fuels markets by keeping out the winds of competition. With respect to investment responses, it is predictable that the oil companies would invest in the next most profitable investment. Oil and gas are unlikely to benefit unless the current investment climate im­ proves. Increased investments outside the energy sector are a strong possibility. Another possibility is that rather than reinvest, the oil companies might increase dividends to stockholders if the firms' searches for attractive alternative investments are unsuccessful. The stockholders could in tum reinvest their dividends in other companies, including independent coal and shale companies. However, because the cost structure of the divested alternative fuels companies (many of which will be fledglings) will be higher than otherwise (by virtue of the loss of managerial and technological spillovers from oil), opportunities for investment will be diminished, and the capital costs to the fledgling firms will be higher. The net result would seem to be that the production of coal and

14 For a much fuller treatment of the effects of divestiture on R&D, see David Teece, ed., R&D in Energy: Implications of Petroleum Industry Reorganization (Stanford, Calif.: Stanford University Institute for Energy Studies, 1977).

71 ECONOMIC EFFICIENCY ASPECTS synthetics will be lower than otherwise and the dependence on imports and OPEC will increase. The demand curve facing OPEC will be more inelastic than otherwise, and the OPEC cartel will have thereby been strengthened. Since I know of no policy maker prepared to embrace this scenario with enthusiasm, I recommend much closer attention to the economic rationale underlying the divestiture proposals. We must diligently pursue the study of complex business organization lest we are tempted to impute monopoly interpretations and advocate policies to restructure socially beneficial organizational developments that we do not understand.

72 The Implications of Divestiture on Investment in the Coal Industry

Gary L. Swenson

From my perspective as an investment banker concentrating on com­ panies in the energy field, I believe that limiting, or eliminating, oil company participation in alternative forms of energy would seriously delay the development of our domestic coal reserves. Most knowledgeable people would agree that the following goals are critical to a sound national energ~ policy: • to increase production of steam coal (the kind of coal used as boiler fuel for generating electricity and other basic energy needs) • to keep steam coal prices as low as possible • to make coal more competitive with oil and gas as boiler fuel • to preserve oil and natural gas for "higher" end uses and • to reduce dependence on foreign energy sources. As is well known, our country has significant coal reserves. They con­ stitute 90 percent or more of our domestic energy reserves. The fol­ lowing table shows the ownership of these reserves, with the U.S. government owning approximately 30 percent.

TABLE 1 EsTIMATED U.S. COAL RESERVES, 1974

Reserves (billions of tons) Percentage

Total Coal Companies 100 40 Open Acreage under no Coal Lease 75 30 (Nonfederal) Open Acreage under no Coal Lease 75 30 (Federal) Total Estimated U.S. Reserves· 250 100 a Based on the recoverable portion of the u.s. Bureau of Mines estimated resource base. SOURCE: Submission of Exxon Corporation before the House Judiciary Subcom­ mittee on Monopolies and Commercial Law (Sept. 11, 1975).

73 ECONOMIC EFFICIENCY ASPECTS

TABLE 2 ESTIMATED U.S. COAL RESERVES HELD BY COAL COMPANIES

Reserves Percentage (millions Total U.S. Coal Operating Company Parent Company of tons) Reserves·

Burlington Northern 11,400 4.6 Consolidation Continental Oil 10,800 4.3 Rocky Mountain Energy Union Pacific 10,000 4.0 Peabody Kennecott Copper 8,900 3.6 Monterey Exxon 7,000 2.8 North American North American Coal 5,000 2.0 Island Creek Occidental Petroleum 4,400 1.8 AMAX AMAX 3,100 1.3 United States Steel 2,700 1.1 Pittsburg & Midway Coal Mining Gulf Oil 2,600 1.0 Pacific Power & Light 2,500 1.0 Atlantic Richfield 2,200 0.9 Sun Oil 2,200 0.9 Bethlehem Mines Bethlehem Steel 1,800 0.7 Texaco 1,700 0.7 Fifteen Company Total 76,300 30.7

ft Based on the recoverable portion of the U.S. Bureau of Mines estimated resource base. SOURCE: 1976 Keystone Coal Industry Manual.

The problem our country faces is not a shortage of coal, but a potential shortage of capital to develop new mines to meet increased demand. To achieve the goals I have mentioned, without massive gov­ ernment and costly taxpayer support, we obviously must have a coal industry capable of raising the large amounts of capital necessary to increase coal production. However, as I will seek to demonstrate, I believe the legislation proposed to curtail oil company alternate energy development will reduce the capital available to the coal industry: ( 1) by limiting entry into this important industry; (2) by eliminating the considerable finan­ cial support which oil companies can provide; and (3) by creating smaller, less well capitalized, and hence less efficient units. As a result, such legislation would: • delay expansion of production capacity • impair ability to meet future production goals • raise coal prices beyond what they would be otherwise • make coal less competitive with other energy sources

74 GARY L. SWENSON

• increase reliance on oil and gas for boiler fuel • increase dependence on foreign energy sources, and • slow the development of coal gasification and liquefaction.

Ambitious Production Goals Require Large Capital Outlays

Our country's coal production goals for the next ten years are, by all measures, ambitious. Most demand estimates for coal in 1985 are in the range of 900 million to 1.2 billion tons per year, an increase of 50 to 100 percent over 1975 production of 600 million tons. This is a 4 to 7 percent compound annual growth rate, substantially above the ten-year historical compound annual growth rate for coal production of about 2 percent. To reach the production level of 1.2 billion tons per year by 1985 we must replace depleted capacity of about 300 million annual tons, and add new capacity of 600 million annual tons. Table 3 gives a

TABLE 3 COAL COMPANY PRODUCTION

1975 Percent Tonnage of Total Group or Company Parent Company (millions) Production

Peabody Group Kennecott Copper 73.1 11.4 Consolidation Group Continental Oil 54.9 8.6 AMAxGroup AMAX 21.8 3.4 Island Creek Group Occidental Petroleum 19.4 3.0 Pittston Group Independent 18.6 2.9 U.S. Steel United States Steel 17.1 2.7 Arch Mineral Group Ashland Oil; 13.5 2.1 Hunt Petroleum; Hunt Industries Bethlehem Mines Bethlehem Steel 13.4 2.1 Peter Kiewit Group Peter Kiewit Sons 11.7 1.8 North American Group Independent 9.6 1.5 Old Ben Standard of Ohio 9.3 1.5 American Elec. Pwr. American oElectric Power 08.3 1.3 Westmoreland Coal Independent 7.9 1.2 Eastern Associated Eastern Gas & Fuel 7.8 1.2 (Indepen.) Pittsburg & Midway Gulf Oil 7.3 1.1 Fifteen Company Total 293.7 45.8

SOURCE: 1976 Keystone Coal Industry Manual.

75 ECONOMIC EFFICIENCY ASPECTS

breakdown· of 1975 production by the fifteen largest domestic coal producers. Most government and industry estimates of the total capital ex­ penditures needed to reach the 1.2 billion ton annual production level are near the National Coal Association's estimates of $18 to $22 billion in constant dollars, as shown in Table 4. For each individual project, "front-end" capital requirements are expected to continue to grow, because of the increased costs of capital equipment, larger mine size and a longer mine development period. Larger mines are becoming increasingly significant; there are more planned, and they will produce a larger percentage of total output. These larger mines take advantage of economies of scale, in mining and in power generation. The Bureau of Mines estimates that the optimum output of an underground mine is 3.8 million tons per year. There are increasing numbers of larger power plant projects. The average coal consumption for a 1,OOO-megawatt electric power plant is also around 3 million tons of coal per year. Front-end costs for these larger mines will require long-term outside financing. Estimates of the costs required to bring a new deep mine into production vary from $25 to $40 per annual ton, and from $12 to $22 for a new surface mine. Thus, a new 3-million-ton-per-year deep mine

TABLE 4 PROJECTIONS OF AGGREGATE CAPITAL NEEDS FOR COAL INDUSTRY, 1976-1985 (billions of dollars)

AMAX Coal study cited in FEA Energy Outlook 15.4-16.4 (same basis as FEA) Bankers Trust Company, 22.6 Capital Resources for Energy through the Year 1990 (includes $11.1 for transportation) Consolidation Coal Company, 40.0-50.0 Speech by Jarvis B. Cecil, executive vice president, April 9, 1976, Phoenix, Arizona (excludes coal conversion plants, transportation) FEA Energy Outlook 17.7 Reference Scenario (includes mine costs only) National Coal Association, C. Bagge, 18.2-22.1 Address to the Southern Governors' Conference, St. Louis, Mo., June 15, 1976

76 GARY L. SWENSON would cost from $75 to $120 million, and a surface mine from $36 to $66 million. The timing of capital investment is also important, since it now takes six to eight years to bring a large new mine up to capacity. In order to meet the ambitious production goals by 1985, expansion must commence as early as next year.

Independent Coal Companies Alone Cannot Meet Production Goals

If coal companies are to invest $18 to $22 billion in new capacity over the next ten years, they will require outside financing. The capital re­ quired for single large coal-mining projects are beyond the resources an individual coal company can normally be expected to generate from earnings. There are only sixteen mines in the country p~oducing more than 3 million tons per year; such a mine can require an initial capi!al investment of $70 to $100 million or more. Yet a typical independent, Rochester and Pittsburgh Coal Company, the fifth largest independent coal company, had capital expenditures in 1975 of only $15 million, which was double its net income of $7.5 million and greater than its $13 million cash flow. Even if coal company earnings were to remain at their 1975 record levels, as, in many cases, they have not, companies would be forced to seek large amounts of outside capital, by selling debt or equity securi­ ties, in order to expand capacity significantly by 1985. Not every company, however, has access to the public capital market. The competition for investors' funds is intense, and only the strongest, most profitable, most promising companies are able to obtain funds in the public market. One reason for this is the important role quality-conscious institutional investors play. These institutions own approximately one-third of New York Stock Exchange equity securities (stock), and three-fourths of publicly held debt securities (bonds) of corporations and account for an even greater percentage of new capital raised. Because of their fiduciary responsibility, they are generally unwilling to invest in companies which are small, cyclical, and whose securities have limited marketability. Furthermore, state and "federal laws such as "ERISA" (the Employee Retirement Income Security Act of 1974) limit investments by institutions to those of the highest in­ vestment quality. Access to the public market can differ substantially from year to year depending on market conditions (supply and demand for funds). At times available funds are limited or investors perceive greater finan­ cial risk. For example, during periods of capital shortage when interest

77 ECONOMIC EFFICIENCY ASPECTS rates are high, even companies which normally have access to the public market are unable 'to raise new capital. This was the situation in 1973 and 1974. Many investors believe that mining, particularly coal mining, is risky compared with other businesses, and that the expected return, in terms of dividends and price appreciation of the stock, is not sufficient to cover the perceived risks. Investors are particularly concerned that earnings in the coal in­ dustry will continue to be volatile and unpredictable. Factors which are largely uncontrollable by coal companies, such as wide swings in coal prices, strikes, and operating problems inherent to the business, will probably continue to impact coal companies' profitability. Furthermore, the uncertain status of legislation concerning divestiture, surface min­ ing, pollution standards, and other matters of vital importance to the coal industry make it extremely diffcult to predict future earnings with any degree of confidence, and thus discourage investment. Oil company earnings, on the other hand, have been quite stable. This can be seen from the earnings-per-share histories in the appendix to this article. In order to raise money in the public bond market, it is generally necessary to obtain debt ratings from Moody's Investors Service, Inc., and Standard & Poor's Corporation, the two leading bond-rating agen­ cies. These credit ratings largely determine the interest rate to be paid, and whether capital is available at all. The predominant purchasers of debt securities are financial institutions, many of which are prohibited from purchasing securities rated less than A. Issuers with unrated debt or debt rated below A thus have more limited access to the public debt market, as can be seen from Table 5. Table 6 gives the debt and equity ratings of independent coal companies and oil companies involved in the coal industry. Among the independent coal companies, only Pittston and Eastern

TABLES OUTSTANDING LONG-TERM INDUSTRIAL DEBT, DECEMBER 31,1976 (billions of dollars)

Aaa 12.9 Aa 16.5 A 24.1 Baa 7.6 Other 7.9 Total 69.0

SOURCE: Tabulated by First Boston's Fixed Income Research Department.

78 GARY L. SWENSON

TABLE 6 DEBT AND EQUITY RATINGS OF SELECTED COMPANIES IN THE COAL INDUSTRY

Value Line Safety Moody's S&P S&P Rating Debt Debt Stock (1-5, high Rating Rating Rating to low)

Independent Coal Companies Pittston AI. AI. A 3 North American NR NR B+ 4 Westmoreland NR NR B+ 4 Eastern Gas & Fuel Ab Ab B+ 3 Rochester & Pittsburgh NR NR NR NR Falcon Seaboard NR NR B 5 Alabama By-Products NR NR A- NR Carbon Industries NR NR NR NR Oil Companies Involved in Coal Exxon Aaa AAA A+ 1 Gulf Aaa AAA A 2 Mobil Aaa AAA A+ 2 Shell Aaa AAA A+ 2 Texaco Aaa AAA A 2 Atlantic Richfield Aa AA A 2 Continental Aa AA A 3 Kerr-McGee Aa AA A 2 Phillips Aa AA A 3 Sun Aa AA A 2 Ashland A A A- 2 Quaker State A A A 2 Standard of Ohio A AA- A 3 Occidental Baa BBB B 2 MAPCO NR NR A- 3 NR-securities of the company are not rated. a Convertible bonds. b Eastern Associated Coal Corp.

Associated Coal have rated debt. In contrast, the debt of all the major coal-producing oil companies is rated, with all but one A or above, and five receiving the highest triple A by both Moody's and Standard & Poor's. Standard & Poor's stock ratings and the Value Line rating of the safety of common stock issues show a similar preference for oil company common stocks. In judging the credit of a coal company, the rating agencies, in­ vestors, and investment bankers try to determine how much money will

79 ECONOMIC EFFICIENCY ASPECTS be available in the future to pay interest and principal, and the cer­ tainty of such payments. They therefore place considerable weight on the predictability and stability of earnings levels. They also consider the size of a company. Generally, the larger a company's equity base, the more money it can raise, other factors being equal. Pittston, a producer whose output is largely metallurgical coal, is the independent with the largest equity base at $496 million on December 31, 1975, which is considerably smaller than the equity bases of the major coal-producing oil companies. By comparison, Continental Oil, which owns Consolidation Coal, has equity capital of $2.1 billion. As a result of the public market's preference for larger, more stable

TABLE 7 SHAREHOLDERS EQUITY OF SELECTED COMPANIES IN THE COAL INDUSTRY

December 31, 1975 Company (millions)

Independent Coal Companies Pittston $ 496 North American 44 Eastern Gas and Fuel 284 Oil Companies Westmoreland Coal 152 Rochester and Pittsburgh 34 Falcon Seaboard 31 Carbon Industries 70 Ashlanda 726 Atlantic Richfield 3,664 Continental 2,135 Exxon 17,024 Gulf 6,458 Kerr-McGee 808 MAPCO 163 Mobil 6,841 Occidental 1,201 Phillips 2,424 Quaker State 125 Shell 3,911 Standard of Ohio 1,461 Sun 2,391 Texaco 8,675 a Year ended September 30, 1975. SOURCE: Company Annual Reports.

80 GARY L. SWENSON companies, only Eastern Associated ,Coal and Pittston, among the inde­ pendent coal companies, have raised debt in the public market during the past ten years. This is in contrast to the frequent offerings by oil companies that own coal companies. Most coal companies owned by oil companies rely heavily on their parent for capital. Clearly coal producers can obtain more capital from parent oil companies than would be available to them through the public and private securities markets even under good market condi­ tions. They also benefit from the ability of most parent oil companies to raise equity and debt on more favorable terms than the coal com­ panies could obtain independently. In fact, the recognition of capital requirements was a major con­ tributing factor to the mergers in the industry in the late 1960s and early 1970s. In 1968, I was involved on behalf of First Boston in advising Peabody Coal Company on its proposed acquisition by Kennecott Copper Corporation. At that time, Peabody was considering major investments in the coal mines associated with the Four Comers generat­ ing station and the Crows Nest project in Canada. Even though Peabody was the largest independent coal company at that time, it was concerned about its ability to raise sufficient capital to finance these and other projects under consideration. 'This concern led Peabody's management to seek the financial strength which Kennecott could provide. Independent coal companies have come to rely increasingly on several forms of off-balance sheet and secured financing: leasing, project financing, and production payments. These techniques have been developed because investors needed more security than the pro­ jected earnings stream alone. Such borrowings tend to be more expen­ sive than debt sold in the public'market because of the tailor-made nature of the financing. They are usually of shorter maturity, or, in the case of leasing, tied to the productive life and dollar value of the equipment. These borrowings are generally secured by assets of the coal company or even the stock of the operating company, which may be forfeited if the company is unable to live up to the terms of the agreement. Because of the risks involved in mining coal, creditors are rarely willing to provide capital based on the security of one mine's cash flow. They expect additional support for the financing, through the pledging of additional coal mines to secure supply, or through outside contractual credit backing. Such outside backing might be supplied by a guarantee from a parent company, from the purchaser of the coal, or from a third party.

81 ECONOMIC EFFICIENCY ASPECTS

In the past, electric utilities, the major users of steam coal, have on occasion provided credit backing to coal suppliers, through loan guarantees, advance payments, and "take or pay" contracts assigned as security for loans. I think it would be a mistake, however, to rely upon them to continue to provide substantial additional financial support to the coal industry. Most electric utilities prefer not to take on the sub­ stantial operating risks involved in coal production. Furthermore, the utilities' credit ratings and price-earnings ratios, and consequently their ability to finance, have been deteriorating, while their need for funds to finance their own heavy capital expenditures continues to grow. Thus, independent coal companies alone cannot realistically be expected to raise the enormous amounts of capital which will be needed to reach national coal production goals, as long as their volatile earnings and relatively small capital bases prevent them from raising significant equity or debt capital in the public markets.

Effect of Divestiture on Coal Operations of on Companies

Legislation such as we are discussing today could have several effects, none of them consistent with our long-range national energy goals. Perhaps the most critical result of horizontal divestiture legislation would be to jeopardize the future of a number of our major coal­ producing companies which are owned by oil companies-including Consolidation Coal Company, Island Creek Coal Company, Arch Mineral Corporation, Old Ben Coal Company, and Pittsburg and Mid­ way Coal Mining Company. If it becomes apparent that these coal assets must be divested, the affected coal companies would immediately encounter serious diffi­ culties in raising capital. Outside investors would be reluctant to invest in the coal subsidiaries of oil companies, ,particularly where it appeared that the funds might be used, not to increase productive capacity, but to substitute for oil company investment. Secured borrowing might be arranged in specific instances, but certainly in more limited amounts and on more onerous terms than previously encountered. These coal companies would also find themselves cut off from parent funding, which historically has been their most important source of capital. Oil company parents would be understandably reluctant to put more money at risk in these subsidiaries without assurances that these amounts would be recovered in selling or spinning off their coal companies. I believe that oil companies, if forced to divest themselves of their coal interests, would not recover their investment. With all the oil

82 GARY L. SWENSON companies forced to divest their coal subsidiaries at or about the same time, they would probably be forced to divest at substantial discounts. An American Petroleum Institute survey of oil companies last year came up with a value of over $6.5 billion for coal assets which would have to be divested by oil companies under horizontal divestiture legislation. By comparison, total public industrial and utility equity financings in 1975 amounted to $8.8 billion. Again, I refer to my experience with Peabody Coal Company and the efforts made by Kennecott to divest Peabody under an order of the Federal Trade Commission. Only after several years of active search was a suitable buyer for Peabody found. Although it now appears likely that the Newmont Group will purchase Peabody for about $1.2 billion, the transaction still awaits approval by the FTC. Several points are particularly relevant to our discussion here. In the first place, we did not feel that Kennecott would come clpse to recovering its investment if it were to sell the Peabody stock to the public, or distribute its Peabody stock to Kennecott shareholders through a 100 percent "spinoff." We judged that the public market price for the Peabody common shares would be significantly below the value a private buyer would be willing to pay. For a public investor, the stock of Peabody was not particularly attractive, because of Peabody's poor earnings history and its limited ability to pay a dividend. In addition, the "near-term" profit prospects did not appear particularly favorable. We also felt that it would be some time before Peabody, as an independent company, would have access to the public markets for the required outside capital necessary to expand production and profits. Furthermore, we were concerned that under the circumstances an inde­ pendent publicly owned Peabody would be vulnerable to a takeover at a bargain price. We therefore advised Kennecott to seek out private purchasers with sufficient resources to make the capital investments necessary to expand production and increase profitability and to wait for the eventual cash flows from the expanded operations. There were no individual companies in the final bidding for Pea­ body. In order to raise sufficient funds, purchasers had to join together in groups. The Newmont Group, for example, consists of Newmont Mining Corporation, Texasgulf, Inc., the Williams Companies, Fluor Corporation, Bechtel Corporation, Equitable Life Assurance Company, and the Broken Hill Proprietary Company, Limited. There was also considerable concern that interpretation of existing antitrust laws would rule out as purchasers other mining or oil com­ panies, which would otherwise be logical candidates to purchase a coal company.

83 ECONOMIC EFFICIENCY ASPECTS

Public utility companies, another group of potential purchasers of Peabody, were concerned that a utility's purchase of a supplier coal company might be considered illegal vertical integration. As a result of my experience with Kennecott and Peabody, I believe that if oil companies are forced to divest themselves of coal interests all at the same time, they will not find buyers willing to pay enough to allow the oil companies to recoup additional investments. Thus the threat alone of divestiture will act as a real deterrent to oil companies considering further capital investments to increase coal production. At the moment coal companies owned by oil companies produce approximately 20 percent of our nation's coal. The Keystone Coal Industry Manual for 1976 shows that oil company coal subsidiaries plan to expand capacity by 119 million annual tons through 1983; this is 26 percent of the total announced expansion by all companies. Some versions of horizontal divestiture legislation would prevent oil companies 'from even developing coal reserves on a start-up basis. It is worth noting that while entry into coal mining in the 1960s and early 1970s was through acquisition of companies already producing coal, more recently companies such as Exxon, Mobil, Shell, and Texaco have entered through the purchase of reserves, which will add to our nation's productive capacity when they go into production. We need this coal-producing capacity, and, rather than discour­ aging potential investors, we should be encouraging oil and other companies to follow through on plans to invest the large amounts of capital required by these projects.

Conclusion

At the present time many oil companies are participating in the coal industry either by owning coal reserves or by operating a coal company. Future entry is expected to be mainly on a start-up basis, with oil companies investing significant resources to develop new capacity. Such investment in new coal capacity is critical to our country's ability to meet ambitious production goals. It will increase the supply of coal and thus keep prices low, increase the use of coal versus oil and gas as boiler fuel, and reduce our dependence on foreign energy sources. Oil companies are willing and able to make a substantial financial com­ mitment to develop our coal resources. In order to meet the objectives of coal production, legislation should be designed to encourage rather than prohibit the necessary investment in coal production capacity. Such legislation should focus on:

84 GARY L. SWENSON

• decreasing the uncertainty and risk by resolving promptly issues such as surface mining restrictions and pollution control standards • supporting the development of new productive capacity • encouraging entry into coal production by firms with substantial financial strength. Legislation such as the proposed horizontal divestiture bill should be rejected as totally contrary to our nation's energy needs. Horizontal divestiture would cripple the coal industry, and do immeasurable harm to our country's energy goals.

85 ECONOMIC EFFICIENCY ASPECTS

APPENDIX PRIMARY EARNINGS PER SHARE HISTORIES OF SELECTED COMPANIES IN THE COAL AND OIL INDUSTRIES

1966 1967 1968 1969

Independent Coal Companies Pittston $ 0.36 $ 0.46 $ 0.46 $ 0.49 North American 1.04 1.46 1.23 0.77 Eastern Gas & Fuel 0.54 0.65 0.61 0.51 Westmoreland 0.60 0.60 0.39 0.26 Rochester and Pittsburgh (2.84) (1.12) (0.80) (2.81) Falcon Seaboard (0.17) (0.83) 0.14 0.12 Carbon Industries N.A. 0.74 0.77 0.65 Oil Companies Ashland $ 2.47 $ 2.41 $ 2.41 $ 2.42 Atlantic Richfield 1.81 1.62 1.92 2.08 Continental 1.27 1.38 1.44 1.39 Exxon 2.53 2.68 2.97 2.89 Gulf 2.44 2.74 3.02 2.94 Kerr-McGee 1.46 1.41 1.59 1.47 MAPCO 0.33 0.32 0.43 0.43 Mobil 3.51 3.80 4.26 4.50 Occidental 0.71 1.04 2.32 3.00 Phillips 2.07 2.37 1.78 1.73 Quaker State 0.46 0.48 0.57 0.71 Shell 4.19 4.66 4.72 4.32 Standard of Ohio 2.32 2.53 2.64 1.43 Sun 2.50 2.83 3.03 2.75 Texaco 2.56 2.79 3.02 2.83

NOTE: Data are for the year ending December 31.

86 GARY L. SWENSON

1970 1971 1972 1973 1974 1975

$ 0.96 $ 0.98 $ 0.67 $ 0.70 $ 3.11 $ 5.47 1.16 0.76 1.71 2.40 2.97 4.71 0.90 0.69 0.75 0.82 2.09 2.73 1.48 0.65 0.75 0.69 5.30 8.82 2.60 0.76 2.85 3.05 7.99 8.22 0.00 (1.62) 0.31 0.58 3.26 3.60 0.70 0.63 0.57 0.47 2.80 4.39

$ 2.09 $ 1.50 $ 2.63 $ 3.37 $ 4.45 $ 4.42 1.85 1.87 1.70 2.38 4.18 3.08 1.53 1.39 1.69 2.41 3.24 3.25 2.96 3.39 3.42 5.45 7.02 5.60 2.65 2.70 2.15 4.06 5.47 3.60 1.57 1.77 2.14 2.52 4.64 5.15 0.49 0.57 0.70 1.05 2.21 2.64 4.77 5.33 5.65 8.34 10.28 7.95 2.92 (1.26) 0.01 1.10 4.74 2.64 1.62 1.78 1.98 3.05 5.66 4.50 0.84 1.03 1.09 1.36 1.68 1.61 3.52 3.63 3.86 4.94 9.21 7.59 1.78 1.61 1.63 2.02 3.44 3.42 2.35 2.64 2.75 4.51 7.84 4.20 3.02 3.32 3.27 4.75 5.84 3.06

87

Commentaries

Betty Bock I want to begin by paying homage to Walter Adams because-although I am logically persuaded by David Teece and Gary Swenson-I know, as Walter says, that what happens in terms of public policy is going to depend to a very great extent upon how people feel. And it is easier for feelings to attach themselves to what Walter is saying than to what Teece and Swenson are saying. I don't really know why this is so. Perhaps the Teece and Swenson arguments seem to be more difficult. But essentially David Teece is saying that there are real economies to be obtained if an oil company, or any other complex company, is managed in a decentralized way. But at the same time, a company that is putting up the major capital for decentralized businesses that it owns must engage in centralized decision making with respect to investment and R&D. If the R&D patterns of the decentralized businesses are related and if there is wisdom in the investment judgments, this combination of decentralization and centralization will result in better national risks for the development of alternative energy sources than if we were to require each energy source to be developed independently. Mr. Swenson seems to be backing up this reasoning with a set of facts concerning the bridging relationships that have grown up between oil and coal companies. He has looked carefully at the problems facing Kennecott Copper as it has sought to find a new partner for Peabody Coal. I think that a major problem we face is the fact that many Amer- icans have strong feelings about "bigness" and "power"-although I am not sure what either of these terms means in any precise sense. And these feelings have propelled us toward a divestiture and containment policy for the oil companies without employing careful analyses, such as those presented by Professor Teece and Mr. Swenson. We should focus on what can be gained-as well as lost-by horizontal integration and what real alternatives there are for the oil companies, or other

89 ECONOMIC EFFICIENCY ASPECTS companies, who must divest themselves of actual or potential energy resources in which they have already made substantial investments­ at a time when their own energy bases are in jeopardy. If you look at this problem squarely,what you find worrisome is that many people have not begun to consider to whom the oil com­ panies would sell or by whom alternative energy companies would be financed. There is a spectrum of energy policy alternatives. At the one ex­ treme, we could have one national energy company holding a monopoly position in all energy resources. Such a company could be organized and owned by the federal government. But if we set up such a company, it would have a wide range of responsibilities and no direct price indi­ cators to guide it: it would bave to establish prices; it would have to establish an allocation system for various stages of production; it would have to layout a priority system for uses; and it would have to do all of this, not only on the basis of inadequate information, but in terms of standards which many observers would be bound to feel were arbitrary. During World War II, we managed to have price control, alloca­ tions, and rationing because we had one clear goal-and, therefore, a single claimant for all scarce resources-the winning of the war. We don't have that kind of unitary goal now. In fact, one of the essential purposes of competition is to serve as a mechanism that will allocate scarce resources without the definition of a single specific goal. There are, of course, other alternatives, if we do not intend to let the presently unsatisfactory energy situation go on and do not want the federal government to own and control all energy resources. We could, for example, regulate the energy industry. There are numerous possible patterns of regulation-but we know that regulation has given us today's railway system and today's airline problems. Still another alternative would be to expand government control over energy investment, energy R&D, and energy wages and prices; we could then allocate crude, refined, and perhaps the most critical petroleum products, while leaving companies in private hands. I don't know how viable this would be-because to go through such an exercise, we would need a bureaucracy dedicated to making, monitoring, enforcing, and modifying rules for the dollars to be in­ vested, the amounts of crude to be produced" imported, and refined, and the amounts of crude and refined to be sold to various customers, or classes of customers, during specified periods, at specified prices. This does not represent a reassuring situation. Or we might develop government trading in crude oil, in dollars

90 F. M. SCHERER or in kind-but after we had done this, we would still have to go through the same procedures with respect to allocations, priorities, rationing, and pricing, as well as exploration and R&D, and other forms of investment. Or, of course, we could continue as we have, developing ad hoc solutions as problems appear. That is, we could let matters drift. I don't know how many of you live in parts of the country where plants are now shut down because of problems in the supply of natural gas-and the difficulties of obtaining alternative fuels. For example, where the alternative is higher-cost propane, there still seems to be trouble in getting the propane delivered in snowbound parts of the country. The trucks aren't getting through. And so one comes out at the other end of the line of alternatives: if we are truly concerned with competition, I believe we must decide whether we are not in need of a more clearly articulated energy policy than we now have. It would be impossible to begin to make proposals for such a policy in this space, but I am hopeful that a policy will emerge and that it will be one in which the government and private companies are not adversaries, but collaborators, with respect to some of the most difficult problems that confront all of us. We should want as much competition as we can get, but we must understand that competition will in some cases require consortia, col­ laboration, and guidelines. However we balance out our policies among our various trade-offs, I hope we will not start to destroy before we have considered appropriate alternatives and have analyzed the by­ products of destruction.

F. M. Scherer

I am essentially in agreement with the policy conclusions of Professor Teece and Mr. Swenson. Among various possible divestiture policies, the worst possible one is to limit new entry into alternative energy in­ dustries such as coal, uranium, oil shale, and the like. That is the worst possible policy. The next-to-worst policy would be to shut off the flow of cash into the development of alternative natural resources from companies that happen to have a very large casl?- flow, such as the petroleum companies. Some kind of vertical disintegration would be much more palat­ able. Even more palatable would be a traditional type of horizontal divestiture, for instance one that would break Exxon's refining opera­ tions into, say, five different segments. In the present environment, however, it makes very little sense to

91 ECONOMIC EFFICIENCY ASPECTS limit the flow of funds into alternative energy resources. This belief embodies a couple of assumptions. One is that the most likely entrants into the field of alternative energy resources are, in fact, the petroleum companies. I agree with Professor Teece that they do have the kinds of expertise that make them much better qualified than, say, Procter and Gamble would be. I do have some qualms regarding Walter Adams's problem about competitive repercussions. Some oil companies probably would like to work out a cozy arrangement in coal. They tried that, for example, in oil shale. Most of the large petroleum companies went into a joint venture to develop oil shale processes, and it was a flop. Occidental went in alone, having always been a maverick, and it may have a pretty good thing. The oil companies would be subject to maverick behavior in coal as well as in oil shale. There would be sufficient heterogeneity so that the kind of coordination Walter Adams worries about would not be forthcoming. If any clear and present danger of such coordina­ tion did emerge, then the antitrusters should do something about it. In general it makes little sense either to impede the entry of most favored entrants into alternative energy resources or to impede the flow of capital into alternative energy resources. Although I do not disagree with the basic conclusions of Professor Teece and Mr. Swenson, I would like to speak to what I think are the real problems. To some extent, Mr. Swenson has pointed them out quite well. Let us assume that in fact there is a good market for an expanded coal supply. If that is true, why is it that the coal companies as coal companies cannot raise funds for capital investment and for expansion? There must be something fundamentally wrong in our capital markets. Mr. Swenson tells us that those wonderful people on Wall Street who gave us Ling-Temco-Vought, Automatic Sprinkler, Litton Industries, funny money, and all the rest cannot provide the funds to expand our production of coal. Maybe investors have been so burned by the conglomerate-merger antics of the 1960s that they will not go into new ventures. That is one possibility. Professor Teece may be correct, however, in believing that there are many little investors who lack the information that an Exxon or a Gulf or a Mobil has about alternative investments. These small in­ vestors may be afraid to put their money into a specialized coal com­ pany. But that should not defeat us. There are solutions to that problem, and we ought to be looking for those solutions. One disturbing fact is that our capital market institutions do not follow the random portfolio selection theories that have been shown

92 F. M. SCHERER again and again to be the best way to choose securities. Instead, we have "go-go" mutual funds, high turnover, big fees, and other gimmicks that do the investor no good. Now the investor is gun-shy of risk­ diversification opportunities too. What is to be done about it? I would propose, very, very seriously, that Congress pass a law allowing any bank to sell shares in mutual funds, provided that those mutual funds .engage in random stock­ portfolio selection. That would open up the capital markets enormously. It would cause the little man on the street to pour his money back into common stocks. The little firm that cannot now go to Mr. Swenson for financing could then begin raising new equity issues again." I make this proposal in all seriousness because I think we have a radical failure in our capital markets. A second thing that seems clear from Professor Teece's analysis is that the tax laws should be changed so that companies with big cash flow but with unattractive internal investment opportunities can pay that cash in dividends. Then it could be reinvested through the market. We should restructure the double taxation situation so that there is not a premium placed on companies that diversify in order to use those cash flows internally. Finally, the federal government, the state governments, and the courts ought to make a basic policy decision that we really do need to plow resources into alternative energy sources, and, in particular, coal. We should stop wasting time arguing whether we should or should not begin exploiting rich coal deposits. We should simply go ahead and do it. If those three policy measures are adopted, many problems facing us today will evaporate. Let me say just a few disagreeable words about Professor Teece's paper. I agree with his conclusions, but he does not argue his case very well. He forces questionable facts onto a Procrustean bed of shaky economic theory. It would be much more effective if the facts were simply laid out, rather than being forced into theoretical molds. Furthermore, a number of his facts turn out not to be facts when looked at closely. He asserts that companies have to be m-form organi­ zations if they are to exploit these new possibilities in an optimal way. That is inconsistent with the facts. Gulf recently reorganized itself into an m-form organization, and a recent issue of Business Week said that the reorganization threatened to become a disaster ("Gulf Oil Goes Back to What It Knows Best," Business Week, January 31, 1977, p. 78). Organization alone does not solve such problems. Professor Teece also says a particular organization of research and development is necessary-that vertical integration is needed for

93 ECONOMIC EFFICIENCY ASPECTS the proper incentives for research and development. That, I would maintain, is nonsense. Joy Manufacturing Corporation has done a beautiful job of developing automatic coal-mining machinery. It is not integrated into coal mining. Universal Oil Products is not integrated into crude oil extraction and refining. It has done a good job in developing processes. Professor Teece talks about the need for revolutionary research and development in oil companies. Maybe there is a need, but it surely is not being met. I attended a seminar in Washington two weeks ago which was addressed by the vice president of research of Mobil Oil Corporation, who made it very, very clear that Mobil had cut back sharply on its long-range research in recent years. Just saying that the oil companies must do it will not bring high-risk, revolutionary research and development. Professor Teece has a case to make, but he could make it more effectively by sticking to facts, rather than by trying to force those facts into shaky organizational economic theories.

J. Fred Weston Let me begin by addressing a couple of points in the area of financial markets. Professor Scherer asks why the capital markets cannot raise funds if there is a good market for an expanded coal supply. That is a good and fundamental question. No one has argued, however, that the capital markets cannot do the job. Mr. Swenson's argument is that there are relative advantages in raising the funds under more favorable terms by some other segments of American industry than coal. In other words, it is simply cost-efficient for some other segments of the economy to fill a part of that need. That does not imply that the independent coal companies cannot fill the need from the capital markets. If the need were solely financial, there would be no concern that the oil companies might achieve a dominant position over the other energy industries because there would be a wide range of competition from all other parts of industry. If the need is just for money capital, there is a big list of triple-A-rated companies that could be sources of financing. With regard to the weaknesses of the capital markets-which I have argued do not exist-the proposal to make all mutual funds index funds would be self-defeating. There is great diversity in the way mutual funds operate. Different philosophies of investment are found, some succeeding in one period and some in another. It is through these proc­ esses of the free markets that the securities markets work. Because thousands of people probe the market for information

94 J. FRED WESTON all the time, none of them has an advantage over the others. None really outperforms the market because all of them are the market, and they make index funds possible. A number of financial institutions have brought out index funds. If the public wants the opportunity to invest in index funds, it already has it. I believe in free markets, particularly in the financial markets. Considerable empirical evidence has demonstrated them to be highly efficient. Government-imposed restrictions constitute the frictions in the financial markets. The Glass-Steagall Act limits entry into com­ mercial banking and savings institutions, and it creates an undue fear of failure among financial institutions. If government participation were limited, even these frictions would be removed. My point is that, if the many triple-A-rated firms outside the energy industry constitute potential sources of capital, why has the oil in­ dustry become the actual supplier of funds? The answer is the carry­ over of managerial and technological capabilities, which increases the confidence of investors that these large investments will be managed well. Something that emerges from all of our discussion is that the energy industry comprises high-risk areas. Many institutions have de­ veloped because of this high risk in the energy industry. These institu­ tions limit the risk of individual participants and thereby stimulate the flow of capital into the energy field~ To the extent that more than money is involved, Professor Teece has strengthened his argument for the transfer of managerial and technological capabilities from the oil industry into other energy segments. As the segments of the energy industry develop, needs for oil company capabilities in the form of capital, technological, managerial, and research and development expertise may be great or small. Where they are great, there will be important economic advantages in keeping entry open for the oil comp;anies. The advantage of oil companies in other segments of the energy industry may be smaller, and their par­ ticipation in such segments is likely to be smaller. The oil industry has capabilities that would appear to be readily transferable to the coal industry. These include experience in the management of the extraction of mineral resources, in transportation and distribution, and in the research and development related to all of these activities. This analysis of the advantages of diversification from the oil in­ dustry into the coal industry illustrates the potential for augmenting the flow of capabilities and resources into other segments of the energy field. These advantages indicate not a failure of the financial markets, but rather a recognition of potential carryover capabilities. The oil industry is scarcely the only source of advanced R&D in

95 ECONOMIC EFFICIENCY ASPECTS the energy field. In giving examples such as Joy Manufacturing and Universal Oil as sources of technological advance, Professor Scherer does not reverse the arguments that Professor Teece makes. The oil industry is one source, not necessarily the only source but a useful one for augmenting the supply of resources. Of course, using Joy Manu­ facturing and Universal Oil as examples reinforces Professor Teece's point that companies with technological experience are likely to make the advances. A pure conglomerate form of diversification may not be required for the advantages Professor Teece sets forth, but that fact strengthens Professor Teece's arguments rather than weakening them. When Oliver Williamson developed the theoretical mode of the m-form, he was dealing with problems of effectively 'managing organiza­ tions that were growing larger and larger and involving greater spans of control. The conglomerate-merger movement, coming when it did, reflected a fundamental, technological revolution, in addition to the financial tricks that were a temporary aspect of the movement. This revolution, which occurred from the late 1950s through the 1960s, saw a shift in relative importance from specific management functions, such as production and marketing, to generic management functions, par­ ticularly in planning and control. This is the fundamental reason why there were opportunities for a greater degree of efficient diversification in the American economy than had ever existed in the past. There were excesses, and the markets again efficiently weeded out the good from the bad. There were spectacular successes among the conglom­ erates, but as financial theory would predict, the conglomerates as a group behaved no differently from any other broad group of firms in terms of market performance. Now conglomerates are just another part of the American business scene. Elimination of double taxation might not diminish or eliminate the motive of diversifying when a firm's opportunities, in its traditional lines of activity, become less favorable. It is fundamental in organization theory that a firm has to offer an expanding environment for promo­ tions and increased responsibilities to attract and retain able executives, so that these motives for diversifying into new attractive areas would remain, even if double taxation were removed. It would be desirable, however, to remove double taxation which stimulates retention of earnings. I see the movement of oil companies into the broader energy industry as part of a general phenomenon. The boundaries of industries are going beyond products. Strategic planning in business firms is be­ coming more important. Emphasis on the missions of the firm is

96 J. FRED WESTON increasing, along with the recognition that a firm consists of a set of capabilities. Since firms are defined more by capabilities than by prod­ ucts, the broadened dimensions of industries must be recognized. There are a number of important principles involved here. Increas­ ingly rapid changes in economic environments require that firms move sets of capabilities to the areas where they may have application. Such widened application of the capabilities of firms contributes both to the efficiency and to the growth of the economy. The dimensions of compe­ tition have been augmented, and the movement of capabilities into the areas in which they may be efficiently used is critical to the health and vigor of the American economy. Thus horizontal divestiture is not an issue of the energy industries alone. It is a basic issue affecting our posture toward the sociolegal environment in which all of American industry will operate. Proposals for horizontal divestiture in the oil industry reflect a distrust of bigness. But all of our major industries with complex technologies involve high capital intensity and large capital investment. Capital intensity measured by value-added per worker is ten times as high in the most capital intensive industries as in the average of all manufacturing. Our un­ happiness with the increase in oil prices and the pressures of energy shortages will be joined by other irritations involving the operation of our economic system. This is readily predictable. Tremendous developments in transportation and communication have made the world more interdependent. There has been a lag in the development of institutions to manage these interdependencies effec­ tively. A number of breakdowns will occur before institutions will meet the pressing needs for them. The basic factors, therefore, that have led to proposals for horizontal divestiture in the oil industry, though un­ sound and misplaced, will have equal applicability across major Ameri­ can industry. Rather than freedom of entry and the extension of capabilities into industries whose boundaries have been broadened by essential factors in the economic environment, barriers will be thrown up to impede the free movement of economic resources. Competitive processes required in the rapid dynamics of current industrial develop­ ment will be circumscribed by government action. The fundamental principles of antitrust that had been used to maintain competitive be­ havior will be replaced by government restrictions on the flow of economic resources most critically needed for a dynamic economy.

Conclusions

The proponents of horizontal divestiture in the oil industry have not addressed the fundamental questions involved. Are there possibilities

97 ECONOMIC EFFICIENCY ASPECTS

of control over alternative energy sources similar to the control estab­ lished by the OPEC nations over oil? If there is a possibility of such control over supply, does the main threat come from the large domestic oil companies? Is there any evidence that controls over supply have occurred without actions by governments? Does the greater threat to control over energy and mineral supplies come from foreign govern­ ment cartels or from control over multiple energy sources by domestic oil companies? Do greater risks confront our nation from control over multiple energy sources by domestic oil companies or from the failure to develop domestic multiple energy sources in the United States? Shouldn't U.S. policy give the highest priority to increased freedom to develop multiple energy sources from the flow of resources? It is not argued that all phases of alternative energy sources will be most effectively developed by the large domestic oil companies. Individual oil companies have different advantages in the diverse seg­ ments and phases of energy industry. But imposing restrictions on the flow of resources and capabilities, when our needs are to enhance that flow in order to develop multiple energy sources, is clearly the wrong policy. Such a policy would aggravate the energy supply problems we face. Divestiture actions are not easily reversible, and the consequences will be lasting. Furthermore, restrictions on resource flows involve more than the energy industries. Divestiture represents a principle that has as much application to all other major U.S. industries as to the energy industry. All that is required are the irritations that would make an extension of horizontal divestiture proposals politically popular. Ironi­ cally, such an extension to other industries would come during a phase of international economic development when the boundaries between industries are becoming increasingly indistinct and traditional industries increasingly overlap each other. It would come at a time when business firms are defined !D0re by the managerial capabilities required to make efficient use of financial resources to guide the flow of real resources. Thus, proposals for horizontal divestiture impose restraints on the flow of economic resources at a stage of the development of the world economy when the flow of such resources should be as free as pos­ sible. The management of technological change is complex, difficult, and risky. A dynamic world economy needs greater productivity and new breakthroughs in the supplies of energy. In developing new energy potentials, strong encouragement, rather than suspicion and hostility, should be accorded to competition from all sources. Restrictions beget

98 J. FRED WESTON more government intervention. Our best guarantee of sound solutions to the problems of long-term energy supply will come from the free flow of capabilities and resources to the energy activities where they may be used effectively.

99

Discussion

PROFESSOR SCHERER: Professor Pitofsky noted that Professor Teece's paper showed little difference in coal mining and investment activities between traditional coal companies and oil companies that had moved into coal. In fact, Professor Teece's Table 3 shows that oil companies with coal companies had a rate of output growth appreciably higher than average for the coal industry generally. This fact seems to support the hypothesis that the oil companies moving into coal have performed well-if they are to be judged by an ex post facto standard. After reading Mr. Swenson's paper, however, I would argue that this argu­ ment suffers from what economists call the simultaneous equation bias. Mr. Swenson suggests in his paper that mergers between coal companies and oil companies tend to occur when the coal company plans an ambitious program of capital investment but cannot raise the funds to carry it out. If that is true, the coal companies that seek mergers with oil companies to obtain capital differ in their investment expectations from the run-of-the-mine (if you will excuse the expression) coal company. Therefore, one finds that, after the merger, investment is more vigorous than it is in the industry generally. An average shows only that the merger may have been arranged precisely for the spurt of investment.

PROFESSOR WESTON: This point underscores evidence that the motive of the oil company is to provide funds to expand production. The in­ herent conflict-of-interest argument would therefore seem to break down. If the withholding argument made sense, the oil companies would not enter into such mergers. Theoretically, one might formulate conditions under which withholding might occur.' That is a far cry, however, from establishing that those conditions have any counterpart in reality in the energy industry.

PROFESSOR TEECE: In response to Professor Scherer's comments, the simultaneous equation bias applies only if my paper is combined with Mr. Swenson's. My paper does not argue that the reason for integra-

101 ECONOMIC EFFICIENCY ASPECTS

tion is that these companies are on the verge of making large invest­ ments. Instead, a lot of these mergers can be explained in terms of the search by oil companies for investments that are preferable to those in the oil business. I would also like to reply to Professor Scherer's remarks concern­ ing R&D. I did not say a resource position was a necessity for doing R&D but rather that it enhanced incentives for R&D. Professor Scherer pointed out that various companies such as Universal Oil Products do R&D for the oil industry. The kind of R&D they do, however, is very specialized. It relates almost entirely to improvements in refining technology. There is no indication that they are prepared to back the high-risk projects, such as oil shale or coal liquefaction, that are necessary for a viable synthetics industry.

PROFESSOR SCHERER: Professor Teece noted the importance of a com­ pany's having a resource base to do research in such things as oil shale. It is worth noting that the company that has come up with the most promising in situ process, Occidental, was notoriously poor in shale land. Only after its process looked promising did Occidental enter into a joint venture to get oil shale lands to exploit this process. Professor Teece's generalizations do not hold up.

PROFESSOR TEECE: I am actually correlating reserve position in oil shale with oil shale R&D, and the data support my argument. The argument is also true in the coal industry-the oil companies that do most of the R&D in the coal business are those with the largest reserves.

MR. SWENSON: One point that should have been mentioned at the out­ set is the nature of the coal business in the past. The steam coal business was not a good business from the financial point of view until the fourth quarter of 1973, when the price of oil and gas suddenly started to go up. Before that, most people in the industry-even those who owned coal reserves-felt that coal was almost noncompetitive and that it had to scramble for its markets. That is why coal companies entered into long-term production contracts, which now severely hurt their earnings. That is the reason investors have not had much interest in steam coal properties-because it has not been a very good business. When the price of oil went up significantly in 1973 and 1974, some windfall profits were made by certain coal companies. Most of them were smaller companies with mines not committed under long­ term contracts, and most of them were in metallurgical coal. The spot

102 DISCUSSION market for metallurgical coal tripled and remained high for a short period of time. It is back down now. That caused the earnings of many smaller coal companies to spurt up. Over any sustained period, how­ ever, the earnings of coal companies and their return on investment have been insufficient to attract new capital from the investment com­ munity. What the coal industry needs is higher profits and a more secure return on investment. Then it could raise a lot of money. In order to do that, it needs higher coal prices or larger margins. With the risks in the business and the relatively low profitability, independents cannot attract as much capital as they could if they were tied to larger corporations.

PROFESSOR MITCHELL: We will now go to the audience for questions.

FREDERICK M. ROWE, attorney, Washington, D.C.: My question is addressed to Professor Pitofsky, Professor Kauper, and Professor Mancke. Everything seems to be predicated on the substitutability of the fuels and the energy sources in question-the nomenclature of the legislation (that is, the so-called horizontal divorcement or interfuel competition bills), the theory of withholding, the precedent of the Continental Can-Hazel Atlas case. With respect to oil and coal, there are federal policies that either preclude or limit the use of oil by utilities for boiler fuel and that are designed to encourage a shift to coal. In view of this fuel separation by government edict, is the legislation on horizontal and interfuel competition a misnomer, is the Supreme Court decision relevant, and does the withholding theory have any merit?

PROFESSOR PITOFSKY: The point that Mr. Rowe makes is very sound. If coal, oil, and nuclear energy cannot compete as a result of govern­ ment intervention, then the notion that the ownership of one would lead to restraint in the development of another, obviously is false. In Continental Can, however, the Court took a long-term view of compe­ tition. It was concerned not that glass and cans would compete day-to­ day for sales to individual companies but that they would compete over the long term, in the packaging of broad categories of products, such as beer, baby food, and so on. I could imagine that energy companies might influence legislation in order to isolate markets. I could imagine that government policy might require modification. I cannot imagine, however, that companies in one portion of a segmented market would restrain development in another.

103 ECONOMIC EFFICIENCY ASPECTS

PROFESSOR KAUPER: This is the same question I raised in my intro­ ductory remarks this morning because the bill itself, of course, speaks of interfuel competition." This conference also raises exactly that question. In terms of the short run, the degree of competition has perhaps been overemphasized today. In making short-run decisions, such choices between fuels may not be available. In assessing this bill, we are looking to a policy not for today or tomorrow, but for what may evolve over a great many years. On any long-term basis, certainly, the potential for competition is there. I give less weight than is implied in the question to the fact that the govern­ ment at this moment in its history has drawn some lines between two fuels. One has to look at their physical characteristics and their cost and not place a great deal of emphasis on temporary government policy. It is extremely temporary. There is no assurance at all that those divisions will continue. Some of those policies are based on environ­ mental considerations or a variety of other things that may be set aside from time to "time. What the government decides the markets are, at any given moment, is less important than what the actual physical characteristics are. The potential for competition in the long run is considerable.

"PROFESSOR MANCKE: The key premise of the withholding argument is that the oil companies-in this case the alleged withholders-have the power to prevent entry by other companies into the coal business. Absent such power, the oil companies could not restrict coal supplies effectively. All evidence seems to suggest that the oil companies do not possess such power. Most important, in addition to oil companies, there are at least three types of firms that are obvious candidates for entry into the steam coal business. First are the large steel companies, which already possess coal mining technology from their interests in metal­ lurgical coal. Second are many of the large electric utilities, which already produce some of the coal they need. Third are companies­ like Bechtel, Newmont, Kennecott, and so on-that are in related businesses and have both the size and the technical expertise to handle large-scale coal investments. In short, I just cannot accept the premise that oil companies can prevent other firms from entering the coal business, and so I cannot accept anything else in the withholding argument.

PHILLIP WHITE, U.S. Energy Research and Development Administra­ tion: I have a general question about the simple physical arrangements

104 DISCUSSION that dictate what will happen. (The following remarks are my own views and not the administration's.) The pipelines necessary to transport fuels are all in the hands of the oil companies. The distribution facilities and the retail outlets are in the hands of the oil companies. As a practical matter, our nation cannot possibly afford to duplicate these facilities. We could confiscate them but, otherwise, we are tied to the present physical set-up. It would be wishful thinking to believe we could change matters simply by changing the ownership of coal. Once it is mined, it will have to be turned over to the people who have the facilities to convert the coal. Another point is that the job of creating the hundreds of power plants, coal conversion plants, and shale plants in the next twenty-five or thirty years, is so mammoth that it will strain the country to the fullest. It would be ill-advised to put any impediment in the way of our best expertise in doing this. People may have some sense now that we have an energy crisis, but they have no concept of the mammoth job it will be to build a new energy supply system for alternative fuels in the next several decades. My question, however, is, Will physical limitations be a controlling factor to a greater extent than has been indicated in the discussion so far?

PROFESSOR WESTON: This question ties into my argument that an in­ dustry cannot be artificially cut off when it moves with the dynamics of industrial development. It cannot be told arbitrarily to cease here. There are interactions between the segments of an energy industry that would make tight compartments unrealistic.

MR. LEONARD SHAMBON, staff member, House Judiciary Committee: Suppose Congress, for good reasons or bad, did order divestiture of existing alternative fuel holdings by oil companies. How difficult a task would it be to accomplish that divestiture, and how long a time frame would be required?

PROFESSOR SCHERER: That is a question that should be answered by the lawyers. They are adept at extending two-year time frames into ten-year time frames. Physically, it would not be a terribly difficult job. The real problem is one of providing incentive. Now it is natural to scream that it cannot be done, and that it will destroy the American way of life, and so on. It is like surgery. If someone does not want an operation, kicking and thrashing about are ways of deterring the surgeon. But if the surgeon

105 ECONOMIC EFFICIENCY ASPECTS

holds the patient down on the table and starts cutting, the patient should calm down rather quickly in his own best interest. The lawyers should design a system to make it clear that there will be surgery and the best should be made of it.

MR. SWENSON: Among the related fuels, the only one of importance to the oil industry is coal. Gulf Oil has a little uranium, and Exxon and others have some, but the most important alternative fuel to the oil industry right now is coal. Only two companies have major coal operations: Continental Oil has Consol, and Occidental has Island Creek. In other than these two cases, the divestiture of coal operations, whether by sale or spin-off would not have a major immediate impact on the oil companies or their shareholders because the coal operations are a small part of the oil companies' activities. The oil companies could find something else to do with their money; they could invest in other businesses. However, I do not think this would be good for increased coal production.

PROFESSOR KAUPER: Being a lawyer, I take a less sanguine view than some others. We can all agree that physically divestiture would not be difficult, but let me give you a scenario. First, we would have a con­ stitutional attack on the statute. That would take some years to resolve. We would have a constitutional attack whether or not there was any merit to that attack. Second, before values could be placed on proper­ ties-in terms of sale or pass through-a great many questions con­ cerning contractual obligations and other matters would have to be resolved. All of that would be preliminary to the order to divest-at least those questions probably would be resolved prior to that order. At that point, it would become a question of how adroit the company would be at delaying. That, in turn, might depend on such questions as the state of the market and its projections for the future. The Kennecott-Peabody case was cited as an example today. I do not view that case quite the same way as it was described. If a company really does not desire to divest, there are many ways to avoid it for some time, even though it may be inevitable. Much was hidden under Mr. Swenson's statement that a satisfactory buyer could not be found. Satisfactory to whom, and by what standard? Does he mean simply that not enough money was offered? Or did the company think it could get more money a year and a half later and therefore delay? Even in the simplest divestiture case, delays are inevitable, costs are high. Our own experience is colored by the attempt to make ITT divest itself of certain

106 DISCUSSION companies. It was an exceedingly painful, slow process, ending in the hands of a trustee with power to sell. As I have said before, I despair of divestiture. If Congress went at it in the right way, perhaps it could avoid the frustrations. But it would take a considerable period of time and a lot of expense. If there can be harm in permitting mergers in this field, it should be dealt with in a proscriptive way, without trying to undo what has already occurred. I can see very significant differences between those two approaches in terms of cost. Perhaps Professor Pitofsky disagrees with that.

PROFESSOR PITOFSKY: I agree almost entirely with what Professor Kauper says. If the companies are bent on delay, the opportunities for delay are enormous. On the other hand, if the bill were drafted in such a way that it attached significant penalties to delay, no enormous problems would be encountered. There would be a massive divestiture. Questions would be raised whether it would threaten the viability of the whole stock market, but those arguments are always made. When DuPont was ordered to divest itself of 23 percent of the stock of General Motors, the very same arguments were made. The fact is, the DuPont divestiture went through rather easily, without the dire stock market consequences that were predicted. Divestiture need not be un­ manageable or entail enormous hidden costs. If the companies wanted to resist it, however, they could drag it out for a long time. Professor Kauper made a distinction worth noting between retro­ active divestiture, which has enormous problems attached to it, and a policy of examining the legality of future mergers between energy firms and either enforcing current statutes or enacting new preventive legis­ lation. Right now, oil companies-I gather from the data disclosed here -control only 20 percent of coal production. Under these circum­ stances the oil companies would not retard the development of their own property in the face of all the outside competition and potential entry. But we prevent excessive concentration in this country because there does come a point at which concentration has dangerous conse­ quences. A statute aimed at the prospective problems of continued interrelationships between energy firms would prevent some of the problems of the divestiture statute that we have heard discussed today.

PROFESSOR KAUPER: I do not want to be understood as saying that divestiture has to be unworkable. There is no logical reason, in my own judgment, why it has to be. Perhaps our tools just are not effective

107 ECONOMIC EFFICIENCY ASPECTS enough to accomplish it. Under a statute that required a company to file a plan of divestiture and have it approved and then to divest, the opportunities for delay will be enormous. We will have to be more precise in dealing with divestiture than that, it seems to me.

Ms. DEBORAH ASHBY, Foster Associates, Washington, D.C.: Professor Teece or Mr. Mancke might like to answer a question which has to do with the future, when we will be going-I hope-more and more into liquefaction and gasification. There may be no incentive now for oil companies to delay development of their coal reserves as coal, but, if prices are to be high enough to make these alternative technologies feasible, will there be any motivation for the oil companies to reduce price?

PROFESSOR TEECE: It is true that if the price of oil rises, the oppor­ tunities for profit increase. But there are also strong incentives to bring the price of liquefaction processes down, and it is not clear which moti­ vation would prevail. If I were an oil company manager, I would lower the cost of production rather than rely on my ability to keep the price up.

Ms. ASHBY: But if you managed a steel company or some other com­ pany rather than an oil company, would you not have an even greater incentive to bring the cost of liquefaction down?

PROFESSOR MANCKE: The real problem right now with liquefaction and gasification is that they are not currently economical. Therefore, it seems to me there are two issues. First, should the nation make a com­ mitment to develop a commercial coal synthetics industry? Second, assuming such an industry is judged desirable, what is the best (that is, the most efficient and equitable) way of subsidizing its development? Given the status of the commercial technology, a viable coal synthetics industry seems so far in the future that I cannot really answer your question.

MR. DOUGLAS THOMPSON, American Petroleum Institute: I enjoyed listening to what Mr. Adams had to say. I wish I had a degree in struc­ tural economics, behavioral economics, and behavioral psychology, and perhaps structural psychology as well. I am sure there is a relationship between all of these, but I am not sure that a structural remedy in any industry will necessarily prompt the kind of behavior we want. I am not sure that divestiture, either vertically or horizontally, will turn the

108 DISCUSSION petroleum industry into a society of angels, in view of the evidence of conspiracies and price-fixing in times past. The petroleum industry has exhibited less than moral behavior, as have many other industries.

PROFESSOR ADAMS: I cannot comment on morality-that is a problem for the divinity school. The question I tried to pose this morning (and I will try to reformulate it) is, How can we devise a regulatory system that will give companies the greatest possible freedom and still constrain them to behave in such a way that their private interests, whether they like it or not, will conform to the public interest? That is the question. I am not wise enough to devise a set of simple rules, ten easy ways of accomplishing that objective, but that is the problem we face. Professor Weston, for example, said this afternoon that the conglom­ erates of the 1960s, by and large, did no worse ·than the average American industry. But the question is, Did they do any better? What about "synergism," and '''m-forms'' of organization, and all those fancy apologetics that were manufactured by the academic community in response to market demand? [Laughter.] What reason do we have to believe that, if the petroleum com­ panies come into the coal industry, they will revolutionize R&D in coal? Is it not true that the overall 'R & D expenditures by oil companies is relatively low? Something like 0.7 percent of the revenues of the four largest petroleum companies is ·spent on R&D. And isn't much of the oil companies' R&D concentrated in chemical operations rather than in petroleum operations? In other words, the oil companies engage in R&D when they must, in order to be competitive in an industry that has a relatively high expenditure on R&D. Isn't it also true that 75 percent, roughly, of the R&D funds cur­ rently expended on work in gasification and liquefaction come from the government? Wouldn't that continue to be true, if the oil companies did not enter the coal industry? Mr. Swenson's paper, if I may say so, is the one that I found most persuasive. It was the clearest of all the papers given today-including my own. Mr. Swenson told us that the investment bankers, the securities market, and others look with greater favor upon. a company that has market power than upon one that has no market power. Therefore, if a company wants investment funds, it should get some market power first, and then it will get funds from the capital market. The ills of the coal industry that he talks about might be summed up as follows. Coal has traditionally been a competitive industry, pre­ sumably, the kind of industry we want in this system of free enterprise to which we pay so much lip service. But now the capital market

109 ECONOMIC EFFICIENCY ASPECTS

appears to be telling the coal companies that, if they want investment funds, they should get some monopoly power. Then the investment banking community, the securities market, and others will give all the money that is needed in order for them to survive and expand. On that point, I am quite in agreement with Professor Scherer.

MR. SWENSON: Maybe it means the same thing, but the way I would put it is, given all the risks and factors involved in the coal industry, investors want a higher return, higher profits. Professor .Adams is saying that, in order to get higher profits, a monopoly situation is required.

PROFESSOR ADAMS: It is certainly!better than a competitive situation, you will admit that.

MR. SWENSON: I'll take your word for it. But maybe there is too much competition. That ,much competition will not add 400 million tons of new capacity because those companies will not be able to raise the capital.

PROFESSOR WESTON: Mr. Swenson pointed out that the coal industry has 'a history of great instability, with low returns in relation to risks. Then he said that if it were joined with another activity that offered some real carry-overs with a relationship between the two segments that reduced the risk, the reward-risk ratio would be improved and, therefore, there would be a greater flow of resources. This ties in with what Professor Teece said. Professor Adams asked why the conglomerates did no better than the average. My answer is that they did no better than average because there was a competitive market in acquisitions. The competitive market in acquisitions worked, so the conglomerates made only normal returns. Oil firms will not revolutionize the coal industry. They will make R&D outlays up to the point where there are normal returns. Given the carry-overs involved, there will be a greater supply of resources in the economy, where they are greatly needed, than there would be otherwise. This is not a matter of competition versus market power­ quite the contrary.

PROFESSOR TEECE: On the R&D question, it is true that the oil in­ dustry spends a total of something like $700 million on R&D annually, and if that amount is normalized by sales, it is not as great as other industries. In that sales dollar, however, is a big OPEC tax, so that normalizing by sales tells us little.

110 DISCUSSION

What tells us more is which companies spend most on R&D. Essentially the largest companies are spending proportionately more. This is something that should be recognized in this divestiture debate. These large firms are the candidates for divestiture action. It is true that in coal the government pays for some R&D, but private sector R&D is of a different quality. It is related to the market and to consumer needs. Government R&D has not been successful in doing that.

PROFESSOR ADAMS: In other words, private sector R&D seeks to de­ velop gasoline additives and to "put a tiger in our tank," rather than developing gasification and liquefaction, the truly revolutionary break­ throughs that we need in R&D.

PROFESSOR TEECE: There are many petroleum products markets, of which gasoline is just one. Research on gasoline additives is now essen­ tially a small part of the R&D budget of most major oil companies. R&D on oil and gas now accounts for only about 60 percent of the industry R&D budget.

PROFESSOR SCHERER: Just one very brief point. When there is a doubling of demand in the coal industry-as I perceive in some of the data presented here today-why doesn't this competitive industry re­ spond by inducing the investment to meet that demand. I do not under­ stand that.

111

AEI Studies & Special Publications

In-depth examinations of government programs and major national and international issues, written by independent scholars

Nuclear Strategy and National Security: Points of View Robert]. Pranger and Roger P. Labrie, eds. This voluminous reader brings together official documents, policy statements, and informed analyses of nuclear weapon policies and .their relationship to U. S. national security objectives. The rationale for current nuclear strategy and doctrine, the increasing vulnerability of fixed land-based missiles, and the feasibility of civil defense are examined, together with the impact of these issues on·the Strategic Arms Limitation Talks. Official documents and congressional hearings illuminate current strategy and doctrine, while the articles and commentary present the underlying debate over American nuclear policies. This book is part of a series of publications by AEI's Public Policy Project on National Defense. Robert J. Pranger, director of AEI's foreign and defense policy studies, is adjunct professor in Georgetown University's School of Foreign Service and professorial lecturer at The George Washington University. Roger P. Labrie, an AEI research associate, specializes in defense policy. 1977 / Defense Policy Study /515 pp. /3275-3 $6.75

To Empower People: The Role of Mediating Structures in Public Policy Peter L. Berger and Richard John Neuhaus The authors propose a lively alternative to the conservative fears and liberal disillusionment about public policies designed to meet human needs. Berger and Neuhaus focus on the "mediating structures" of family, neighborhood, church, voluntary associations, and ethnic and racial subcultures-the institutions closest to the control and aspirations of most Americans. Public policy not only should refrain from weakening or undercutting these structures, they suggest, but also should use them to advance legitimate social goals, in the areas of education, child care, law enforcement, housing, social justice, and health care. To Empower People introduces the guiding principles of a three-year AEI project on mediating structures, directed by the authors. Peter L. Berger is professor of sociology at Rutgers University and author of Pyramids of Sacrifice: Political Ethics and Social Changes (1975). Richard John Neuhaus is senior editor of Worldview magazine and author of Time toward Home: The American Experiment as Revelation (1975). 1977 / Political and Sodal Processes Study /45 pp. /3236-2 $2.50 AEI Contemporary Economic Problems 1977 PUBLICATIONS William Fellner, ed. This is the second annual volume of an AEI project directed at problems of significance for contemporary economic policy. The studies in this volume are concerned with the structural and institutional factors that affect the sustainable level of resource utilization in the Uhited States. The individual studies are: "The Reduction of Inflation and the Magnitude of Unemployment," by Phillip Cagan; "Spending and Getting," by Herbert Stein; "Money Supply and the Budget: Current and Future Problems of Demand Management," by William Fellner; "Lessons of the 1973-1976 Recession and Recovery," by Geoffrey H. Moore; "Wage and Price Behavior: Prospects and Policies," by Marvin H. Kosters; "Resource Adjustment in American Agriculture and Agriculture Policy," by D. Gale Johnson; "The International Monetary System after Jamaic~ and Manila," by Gottfried Haberler; "Coordination and Management of the International Economy: A Search for Organizing Principles," by Marina v. N. Whitman; and "The Income Transfer System: Impact, Viability, and Proposals for Reform," by Barry R. Chiswick. 1977 1Special 1428 pp. 11326-0 $6.75

Participation in American Presidential Nominations, 1976 Austin Ranney Comparing voter turnout in the 1976 primaries with that in the general election, Ranney concludes that the proliferation of primaries has so far failed to increase the rate of participation in the political system. He reviews the ideas held by American academics and politicians about who should participate in choosing the major parties' presidential candidates and finds the view of the "party regulars" increasingly overborne by those of the "issue candidate enthusiasts" and, even more, by those of the "ordinary voters." Austin Ranney, a former president of the American Political Science Association, is an AEI resident scholar and a member of the Democratic National Committee's Commission on the Role and Future of Presidential Primaries. "Expert analysis . ... Ranney is certain to influence his awn party's think­ ing-and perhaps Republican thinking, too." J. F. TERHORST, columnist 1977 1Political and Social Processes Study 137 pp. 13246-X $2.25

Energy-A Crisis in Public Policy Melvin R. Laird The report of the chairman of AEI's National Energy Project contends that the country faces not an energy crisis, but a crisis of public policy. Laird assesses this crisis with respect to oil, natural gas, coal, nuclear R&D, and world oil markets, and he then outlines a simplified energy policy for the United States. An appendix to the work details the research of the AEI National Energy Project. Melvin R. Laird, a former congressman, secretary of defense, and domestic counsellor to the President, and now a senior counsellor for Reader's Digest, served as chairman of the AEI National Energy Project. 1977 1Energy Policy Study 123 pp. 13255-9 $1.25 The Legislative Veto: Unseparating the Powers AEI John R. Bolton PUBLICATIONS Giving one or both houses of Congress a "veto" over proposed executive branch actions is an idea that has won widespread support. In the author's view, the legislative veto could result in a misallocation of power among the branches ofthe federal government and an overall increase in federal power. He argues that the veto violates the constitutional doctrine of separation of powers, whether substantive measures or reorganization acts are involved. * "Excellent John R. Bolton, a counsel for James Buckley and Eugene McCarthy in volume . .. their suit against the Federal Election Campaign Act and its recommended. " amendments, is the author of The Hatch Act: A Civil Libertarian Defense PERSPECTIVE (AEI, 1976). 1977 / Legal Policy Study /50 pp. /3245-1 $2.25 *Australia at the Polls: The National Elections of 1975 Howard R. Penniman, ed. The massive victory of the Liberal-National Country party coalition in Australia in 1975 was preceded by a constitutional crisis, culminating in the governor general's unprecedented dissolution of Parliament and dismissal of a sitting government, the Labor government of Prime Minister Gough Whitlam. The essays in this volume examine this crisis, the campaigns, the media coverage, and the shift in public opinion during the month between the government's dismissal and election day, together with the elections' impact on foreign policy and on constitutional and political issues. Contributors are Terence W. Beed, Margaret Bridson Cribb, Leon D. Epstein, Michelle Grattan, Owen Harries, Colin A. Hughes, C.}. Lloyd, D. W. Rawson, Paul Reynolds, R. F. I. Smith, and Patrick Weller. In appendixes, David Butler treats the constitutional crisis and Richard M. Scammon provides statistical data. Howard R. Penniman, an AEI adjunct scholar, is professor of government at Georgetown University and author and editor of other AEI election studies. "Here in one volume, in finite detail, is the complete outline of the 1974-75 political crises which fashioned Australia's future." CANBERRA TIMES "Excellent volume . .. recommended as both a detailed analysis of a national election and an insightful commentary on Australia's political and constitu tional experience." PERSPECfIVE 1977 / Political and Sodal Processes Study /373 pp. /3239-7 $5.00 A Discussion with Herbert Giersch: Current Problems of the West German Economy 1976-1977 The distinguished German economist shares his observations of recent developments and prospects in his own country and the United States in this edited transcript of a discussion held at the American Enterprise Institute. Healthy economic growth, according to Dr. Giersch, "will depend on the innovative spirit of the business community and the cooperation of the labor unions," and further policy should concentrate on measures that stimulate long-term investment. Herbert Giersch is director of the famous Institute of World Economics in Kiel and professor at the university there. 1977 1Economic Policy Study 130 pp. /3244-3 $2.25 AEI Problems to Keep in Mind When It Comes to Tax Reform PUBLICATIONS William Fellner The author agrees with many critics of the present tax structure that the provisions concerning exclusions and deductions in the derivation of the personal tax base should be scrutinized periodically. Yet the claim that such revisions could lead to significant tax cuts or could support expensive new programs seems greatly exaggerated to the * "A timely author. He offers positive suggestions for the systema"tic elimination of study." the tax-raising effect of inflation and the termination of the double taxation of dividends. FOREIGN William Fellner, an AEI resident scholar, is Sterling professor of AFFAIRS economics emeritus at Yale University, a former member of the Council of Economic Advisers, and a past president of the American Economic Association. 1977 / Tax Policy Study /26 pp. /3266-4 $2.25

*Arms in the Indian Ocean: Interests and Challenges Dale R. Tahtinen, with John Lenczowski Numerous sources of potential conflict exist between the littoral states of the Indian Ocean. The author assesses their modern weapons arsenals, discusses whether there is a power vacuum there, and examines the possibilities of external intervention, particularly by the United States and the Soviet Union. He concludes that immediate negotiations can prevent an arms race in the area between the United States and the U.S.S.R. and perhaps achieve a mutual withdrawal. Dale R. Tahtinen, assistant director of AEI foreign and defense policy studies, is the author of several AEI studies (see Index). John Lenczowski, a doctoral candidate at the Johns Hopkins School for Advanced International Studies, is a research assistant at AEI. "Deserves the wide consideration of interested Americans." ASIA MAIL "A timely study." FOREIGN AFFAIRS "Necessary, well-documented research; replete with comprehensive reference tables. " ORBIS 1977 / Defense Policy Study / 84 pp. / 3242-7 $3.00

Oil Industry Profits Shyam Sunder Using data from accounting reports and stock prices, Sunder shows that the oil industry has been no more profitable than other industrial firms during the past fifteen years. His analysis of the stock market data indicates that the risk-adjusted profits to the investor during this period have been slightly greater than the average profits for all firms listed on the New York Stock Exchange. Any abnormal profits realized over the fifteen-year period may be attributed to a small improvement in the prospects of the industry over these years: because of the competitive nature of the stock market, stock prices reflect the investors' assessments of an indUStry's future prospects, and abnormal profits appear only in periods when those prospects change. Shyam Sunder is assistant professor of accounting at the University of Chicago. 1977 / Energy Policy Study / 74 pp. / 3269-9 $2.75 Italy at the Polls: The Parliamentary Elections of 1976 AEI PUBLICATIONS Howard R. Penniman, ed. The Italian Communist Party (PCI) sharply increased its share of the popular vote and of the seats in Parliament in these elections, while the Christian Democratic Party (DC) only maintained its share of the popular vote and saw its representation in the Chamber of Deputies decline slightly. The impact of these developments on Italy's domestic and foreign policies is explored by Samuel H. Barnes, Guiseppe Di * "A succinct but Palma, Stephen M. Hellman, Joseph LaPalombara, Robert Leonardi, masterly Gianfranco Pasquino, William E. Porter, Robert D. Putnam, Giacomo survey." Sani, Richard M. Scammon, and Douglas Wertman. Howard R. Penniman is professor of government at Georgetown THE University, an AEI adjunct scholar, and the author or editor of a ECONOMIST number of election studies. 1977 / Political and Social Processes Study / 386 pp. / 3268-0 $5.75

*Britain Says Yes: The 1975 Referendum on the Common Market Anthony King The British political tradition has always been one of "government of the people, for the people, and with-but not by-the people." Britain has no history of direct democracy. Yet, on June 5, 1975, the British people went to the polls to decide the single issue of whether or not the United Kingdom should remain a member of the European Community. This book explains how such a major constitutional innovation came about and also explains the remarkable outcome of the referendum. For nearly seve'n years, the opinion polls had reported that a large majority of the British people was hostile to Britain's Common Market membership. Yet, on the day of decision, the voters said "yes" to Europe, by a margin of two to one. Anthony King, an AEI adjunct scholar, is professor of government at the University of Essex in England. He contributed to Britain at the Polls (AEI, 1975) and comments on elections for the London Observer and the BBC. "A sucdnct but masterly survey of the entire development of Britain's relations with continental Europe between 1945 and 1975." THE ECONOMIST 1977 / Political and Social Processes Study / 153 pp. / 3260-5 $3.75

Evolution of the Modem Presidency: A Bibliographical Survey Fred I. Greenstein, Larry Berman, and Alvin S. Felzenberg, with Doris Lidtke No institution of American government has changed so drastically and with such profound consequences for American society as has the presidency since 1932. This volume--eonsisting of approximately 2,500 bibliographical entries, several hundred of them briefly annotated-identifies and classifies significant works bearing on the evolution of the American presidency during this period. An introduction- presents the general contours of this historical change, analyzes why systematic study of the presidency has not flourished, and outlines the volume. Fred I. Greenstein is Henry Luce professor of law, politics, and society, Princeton University. Larry Berman is assistant professor of AEI political science, University of California (Davis). Alvin S. Felzenberg is PUBLICATIONS an advanced graduate student in the Department of Politics, Princeton University, and Doris Lidtke is a computer specialist at Towson State University. 1977 / Political and Social Processes Study /385 pp. /3251-6 $4.75

Scandinavia at the Polls: Recent Political Trends in Denmark, Norway, and Sweden Karl H. Cerny, ed. The strikingly unusual parliamentary election outcomes of 1973-as well as concomitant socioeconomic developments-are analyzed in this volume with a view to determining whether Scandinavian political party systems are undergoing significant long-term change. These outcomes are also related to the politics of the welfare state. The Scandinavian and American experts who contribute essays are Ole Borre, Henry Valen and Willy Martinussen, Bo Sarlvik, Daniel Tarschys, Erik Allardt, Steen Sauerberg and Niels Thomsen, C. G. Uhr, Goran Ohlin, and Walter Galenson. Karl H. Cerny is professor of government and chairman of the Committee on Studies in German Public and International Affairs at Georgetown University. "An excellent compilation . .. gives the research a sharp focus." CHOICE 1977 / Political and Social Processes Study /304 pp. /3240-0 $5.75

Inheritance and the State: Tax Principles for a Free and Prosperous Commonwealth Richard E. Wagner The taxation of inheritance is advocated primarily as a means of promoting equality. Yet, Wagner argues, by harnessing the natural partiality of parents for their offspring, inheritance plays an important role in raising material standards of living from generation to generation and in maintaining and increasing the total wealth of society. While exposing the destructive tendencies of the egalitarian imperative, the author also examines the taxation of capital gains, the impact of transfer taxation upon total tax revenues, the liquidity problems of closely held businesses, charitable deductions, and the taxation of wealth transferred through trusts. Changes introduced by the Tax Reform' Act of 1976 are also discussed. Richard E. Wagner, professor of economics at Virginia Polytechnic Institute and State University, is the author of Death and Taxes (AEI, 1973). 1977 / Economic Policy Study /95 pp. /3252-4 $2.75

The Electoral College and the American Idea of Democracy Martin Diamond At a time when Congress is considering a constitutional amendment to eliminate the Electoral College in favor of the direct national election of the President, Diamond examines the charges that it is "archaic, undemocratic, complex, ambiguous, indirect, and dangerous" and refutes them point by point. He argues that cJitics of the Electoral AEI College employ as' a standard ofjudgment an idea of democracy that is PUBLICATIONS too simple and too centralized. If more subtle and more complex American traditions are invoked, Diamond argues, the Electoral College can be defended comfortably by all friends of democracy. Martin Diamond was professor of government and held the Thomas and Dorothy Leavey Chair o~ the Foundations of American Freedom at Georgetown University. 1977 / Political and Social Processes Study / 22 pp. /3262-1 $1.25 * "These articles poin t ou t some *Civil-Military Relations of the major philosophical Andrew /. Goodpaster and Samuel P. Huntington, with Gene A. Sherrill and and political Orville Menard concerns." This volume comprises several views on the all-important question of the role of the military within American society. Samuel P. Huntington, MILITARY REVIEW Frank G. Thomson professor of government at Harvard University, concludes that a military establishment in a liberal society must be different from but not distant from the society it serves. Andrew J. Goodpaster, former supreme allied commander in Europe, underscores the importance ofeducation in assisting all of American society to meet challenges that will require high dedication to national ideals and goals. Gene A. Sherrill, a U.S. Air Force lieutenant colonel, analyzes civil-military problems in a foreign setting, and Orville Menard, professor of political science at the University of Nebraska at Omaha, discusses the role of education in cultivating civilian values and traditions in civil-military spheres. Herbert Garfinkel, provost and vice chancellor for academic affairs at the Omaha campus, contributes an introduction. "Goodpaster's wise and sound contribution on educational aspects of dvil-military relations is of special interest." FOREIGN AFFAIRS "These articles point out some of the major philosophical and political concerns and, in so doing, illuminate them." MILITARY REVIEW 1977 / Defense Policy Study / 84 pfJ. / 3238-9 $2.50

Transporting Natural Gas from the Arctic: The Alternative Systems Walter J. Mead, with George W. Rogers and Rufus Z. Smith The three major systems proposed to transport Prudhoe Bay natural gas from Alaska-the Arctic Gas, the Alcan forty-inch, and the EI Paso systems-are evaluated in this study. Construction of a natural arctic gas transportation system is shown to be beneficial both for the nation and for private investors. An analysis of twelve major construction projects shows that an overrun of their average magnitude would leave net benefits for the nation. The author offers two alternative proposals, designed to create an incentive to minimize overruns. Walter J. Mead, professor of economics at the University of California, Santa Barbara, served with the Ford Foundation Energy Policy Project. George W. Rogers is professor of economics at the University of Alaska at Juneau. Rufus Z. Smith, during his career with the U.S. Department of State, organized the first Office of Canadian Affairs. 1977 / Energy Policy Study /111 pp. /3270-2 $3.25 Cover and book design: Pat Taylor