The Paremont Center for Economic Policy Studies

1"s---

The paremont Center for Economic Policy Studies_

Working Paper Series

GIANNIN1 FOUNDAT ON AGRICULTURAL •• 0M1CS LIB ,AO"\ ,101_ 8 1987

Department of Economics The Claremont Graduate School Claremont, California 9171 1-6 165

The Claremont Colleges:

The Claremont Graduate School; Claremont McKenna College; Harvey Mudd College; Pitzer College; Pomona College; Scripps College

The Center for Law Structures The Lowe Institute of Political Economy LK e_

The Lclaremont Center for Economic Policy Studies_/

Working Paper Series

"Studying Firm-Specific Effects of Regulation with Stock Market Data An Application to Oil Regulation"

Rodney T. Smith, Michael J. Bradley and Greg A. Jarrell Claremont McKenna College University of Michigan IT q corvirri t oc ri Fr-srrh an C missirin

GIANNINI FOUNDAT ON OF AGRICULTURAL OMICS LIB 4.1e .101_ 9 1987

Department of Economics The Claremont Graduate School Claremont, California 91711-6165

The Claremont Colleges:

The Claremont Graduate School; Claremont McKenna College; Harvey Mudd College; Pitzer College; Pomona College; Scripps College

The Center for Law Structures The Lowe Institute of Political Economy "Studying Firm-Specific Effects Regulation with Stock 'Market Data,: An Application to Oil Regulation"

Rodney T. Smith, Michael J. Bradley and Greg A. Jarrell Claremont McKenna College 'University of Michigan U.S. Securities and Exchange Commission STUDYING FIRM-SPECIFIC EFFECTS OF REGULATION WITH STOCK MARKET DATA: AN APPLICATION TO OIL REGULATION

Rodney T. Smith Claremont McKenna College

Michael J. Bradley University of Michigan

Greg A. Jarrell U.S. Securities and Exchange Commission

Earlier versions of this paper were presented at the December 1984 American Finance Association Meetings in Dallas, Texas, and at the Graduate School of Business, Washington University at St. Louis. The authors express their gratitude for comments received from participants at those seminars, and discussions with John Binder and Jess Yawitz. Financial support for this research has been provided by the Center for the Study of the Economy and the State, University of Chicago, and Center for the Study of Law Structures, Claremont McKenna College.

May 1985 Abstract

Regulations are oftentimes introduced, or reformed, in response to unanticipated changes in market forces. For example, in late 1973 OPEC quadrupled the world price of oil and U.S. policy-makers responded by imposing oil price regulation. This fact poses a fundamental problem of interpretation for studies which use stock prices to identify the economic effects of regulation. What portion of the capital gains or losses experienced by investors in regulated firms is due to regulation, and what portion is due to unanticipated economic events?

This paper addresses this question by using micro-economic theory to derive hypotheses about how the capital gains and losses from OPEC and oil regulation are related to the underlying characteristics of petroleum firms. The hypotheses are tested by integrating a model of firm-specific abnormal returns into standard market models of stock returns earned by investors in petroleum firms. The estimated coefficients are consistent with micro-economic theory, and comparison with other methods illustrates that there are substantial pay- offs from integrating into one's analysis more detailed economic knowledge of regulated firms than is found in simple classification schemes, such as those based on Standard Industrial Classification (SIC) industry definitions. 4

Economists are applying the research tools of modern finance theory to study

the economic effects of regulation (see Dann and James, 1981; Schwert, 1981;

Maloney and McCormick, 1982; Spiller, 1983; Binder, 1985). Which firms gain

and which lose from a regulation are identified by studying how the introduc-

tion or reform of that regulation creates capital gains or losses--that is,

positive or negative abnormal returns--for investors in regulated firms.

A fundamental problem of interpretation confronts such studies. Are the

estimated abnormal returns due to regulation, or are they due to other concur-

rent, unanticipated economic events that commonly accompany, if not precipi-

tate, the introduction or reform of regulation? This problem is exemplified

in late 1973 when OPEC quadrupled the world price of crude oil and U.S.

policy-makers responded by imposing oil price regulation. If -a researcher

used the finance methodology developed by Fama, Fisher, Jensen, and Roll

(1969), how does he decompose measured abnormal returns into a portion related

to a higher world price of crude oil versus a portion related to the intro-

duction of U.S. oil price regulation? Which, if any, portfolios should he

construct to summarize his results? These questions must be answered if

modern finance theory is to become an important tool for analyzing the econom-

ic consequences of regulation.

This paper addresses the above questions. Micro-economic theory provides

hypotheses about how higher world oil prices and U.S. regulation in late 1973

should have differentialy affected the market value of common stock in petro-

leum firms according to five characteristics: foreign and U.S. oil production,

foreign and U.S. refining, and access to price-controlled crude oil under

early oil regulation. These hypotheses', in turn, specify an econometric model

which explains differences among firms in abnormal returns earned by investors

1 during late 1973. Economic theory identifies which coefficients in the model

capture the effects of higher world oil prices, and which coefficients measure

the effects of oil regulation.

The model of firm-specific abnormal returns is estimated by integrating

firm-specific operating characteristics into multivariate regression.models of

stock returns, which have been proposed and implemented by many researchers

(see Schipper and Thompson, 1982; French, Ruback, and Schwert, 1983; Hughes

and Ricks, 1983; Binder, 1985; Madeo and Pincus, 1985). The coefficients for

the firm-specific operating characteristics are identified econometrically by

imposing across-equation restrictions in a system of seemingly unrelated

equations which explain market returns of petroleum firms. These coefficients

test sharper hypotheses about the effect of regulation than simpler ones of

whether or not abnormal returns are earned when the market learned about the

implementation of regulation.

The major empirical findings are two-fold. First, the estimated coeffi-

cients which measure the relation between abnormal returns and firm-operating

characteristics are consistent with hypotheses derived from micro-economic

theory. Second, direct study of firm-sOecific effects is preferable to con-

structing portfolios for separate Standard Industrial Classification (SIC)

industry definitions. There is substantial pay-off from integrating into

one's analysis more detailed economic knowledge of regulated firms than is

. found in simple classification schemes.

Finally, the model of firm-specific abnormal returns provides a conve-

nient framework to cope with a significant problem confronting the use of

finance models in the study of regulation. It is oftentimes difficult, if not

impossible, for a researcher to identify the time periods in which the stock

market discovered new information about the creation or reform of regulation.

This uncertainty raises the distinct possibility that measured abnormal

2 returns may be due to other economic factors which occurred during the sus-

pected event period, but were unrelated to regulation. If the variation of

those abnormal returns across firms is related to underlying firm character-

istics in accordance with economic theory, however, then that evidence would

support the contention that at least part of ,the abnormal returns were related

to regulation.

I. THE WEALTH EFFECTS OF HIGHER WORLD OIL PRICES AND U.S. OIL REGULATION

This section derives the economic hypotheses that will provide the foundation

for specifying the model of firm-specific abnormal returns. The discussion

begins by analyzing how higher world oil prices would have affected the market

value of petroleum firms in the absence of U.S. oil regulation. It then

considers how regulation modified the wealth effects that would have occurred

in an unregulated market, and created new wealth effects as a result of the

rules adopted to allocate price-controlled crude oil among U.S. refiners. The

decomposition of abnormal returns into a portion due to higher oil prices and

another portion due to regulation will build on the interaction among the

various wealth effects.

How higher oil prices and regulation affected the value of a petroleum

firm, of course, depended on how those forces changed the present value of

future cash flows that were generated by the firm's activities. The analysis

considers four activities: foreign and domestic crude oil production, and

' foreign and domestic refining. The change in a firm's value from its crude

oil production activities will be found by applying the Hotelling Valuation

model (see Miller and Upton, 1985). The change in a firm's value from its

refining activity will be found by using a simple two-factor, single product

model of the refining industry (see Phelps and Smith, 1977).

3 A

Higher World Oil Prices without Regulation

During the last three months of 1573, a dramatic change occurred in the rela-

tions among host governments in oil exporting countries and the multinational

firms with oil concessions in those countries (see Blair 1978, Chapter 11).

On October 6th, the representatives from the Organization of Oil Exporting

Countries (OPEC) repudiated the earlier pricing agreements they had made with

the oil firms. OPEC negotiators also rejected industry offers to raise by 15

percent the posted price of oil--upon which royalty payments to host govern-

ments were calculated. As company negotiators returned to consult with the

consuming nations' governments, OPEC announced on October 16th an immediate

increase from $3.00 to $5.11 per barrel in the posted oil price. Shortly

thereafter during a meeting in Tehran, OPEC raised the posted oil price to

$11.65 per barrel, effective January 1, 1974.

These actions, of course, affected world markets for crude oil and re-

fined products. The analysis views the higher posted price for OPEC oil as an

increase in an extraction tax paid by the multinational oil firms (see Smith

1982, pp. 432-435). The incidence of this tax on world prices of crude oil

and refined products created the wealth effects experienced by investors in

petroleum firms.

Viewing the posted price system as an extraction tax abstracts from the

production control mechanisms that were instituted by the original oil conces-

sion agreements, and how those mechanisms were changed in concert with the

increase in OPEC posted oil prices. These simplifications should not invali-

date the subsequent analysis. The original production control mechanisms

specified voting rules used by the multinational firms when deciding on total

production from each concession (see Blair, 1978, Chapter 5). Such rules, of

course, did not obviate the fundamental goal of multinational firms, wealth-

maximization. Whatever changes in the rules that occurred during nationali-

4 zation, multinational oil firms still had an economic incentive to bargain for

output rates which maximized their wealth, given the rules governing royalty

payments and taxes paid under the posted price system. This point is illus-

trated by the recent reluctance of multinational oil firms to exercise fully

their production rights during the current ",weak" international spot market

for oil--much to the displeasure of host governments.

Crude Oil Production

Equation (1.1) presents the Hotelling Valuation formula for the value of 1 foreign oil production activity to oil firms. The market value of foreign

oil reserves (V ) equals the quantity of foreign oil reserves (R ) multi- f ,c f plied by the market price of crude oil (P ), net of per unit foreign extrac- c tion costs (C ) and the per unit tax paid to host governments (T). As f discussed in Miller and Upton (1985), equation (1.1) holds exactly only for

the special case where marginal extraction costs are constant and there are no

front-end costs of exploration. The sensitivity analysis reported in their

study indicates that the errors are small for the case of non-constant per

unit extraction costs. The discussion would be unaffected by adding upfront

exploration costs to the valuation formula.

V = CP - C - T) R f,c c f f The increased posted oil prices imposed by OPEC governments was an im-

plicit mechanism by which OPEC governments coordinated increased export taxes

, on their crude oil. Multinational oil firms, under this view, did not possess

any market power because nonconcessionary firms--such as excluded U.S., Japan-

ese, European--would be willing to take over existing U.S. operations in OPEC

countries. Firms with producing interests in OPEC countries would suffer

standard income losses from increased excise taxation, because the world price

of oil would increase by less, not more, than the increase in per unit extrac- 2 tion taxes levied by OPEC governments: see equation (1.2). According to

5 r

standard incidence analysis, if per unit extraction costs were approximately

constant for oil firms in OPEC countries, then the loss in market value of

foreign oil reserves would be small, because the elasticity of demand for oil

from OPEC reserves would be small, in absolute value, relative to the elastic-

ity of supply. Most, if not all, of an excise tax would be shifted onto

buyers of OPEC oil and little, if any, of the tax would be absorbed by multi-

national oil firms.

(1.2) 9V /aT = ta(P - C )/ aT - 1) R < 0 f,c c + f — In formal terms, of course, equation (1.2) holds only for small changes

in the tax rate. The four-fold change in the level of posted prices was

clearly not infinitesmal, so the analysis must consider the implications of

adjustments in the scale of activity by petroleum firms. The true change in

value which resulted from a finite change in the tax rate can be estimated, to

a second-order approximation, by substituting the simple average of reserves 3 before and after the change in taxes for Rf in equation (1.2). The subse-

quent discussion shall ignore this substitution, in order to avoid further

complications in our notation, but the discussion should be understood to

include these adjustments.

The outcome would be quite different for the market value of oil reserves

located in the United States--see equations (1.3) and (1.4). The market value

of oil firms' reserves located in the United States (V ) equals the quantity d I c of domestic oil reserves (R ) multiplied by the market price of crude oil, net d of the per unit domestic extraction costs (C ). U.S. firms would receive the d higher world oil price without paying higher extraction taxes to OPEC govern-

ments. The value of their domestic oil reserves would increase, but not by

the full amount of the increase in the world oil price. The increased produc-

tion and exploration activity would bid up the prices of industry-specific

factors of production, which in turn would raise per unit extraction costs.

6 Standard conditions for market stability, however, guarantee that the world

oil price would rise faster than per unit extraction costs. Any bidding-up of

factor prices requires that more, rather than fewer, resources be employed in

the final equilibrium after factor prices had adjusted. Higher employment

would occur only if the world oil price increases by more than marginal

extraction costs at the original level of employment.

( 1.3) V = iP - C ) R d,c c d d

(1.4) PV /aT = C (P — C )/aT ) R 0 d,c c d d

Oil Refining

The market value of refinery capital also would be affected by a higher world

oil price. The empirical implications result from identifying the effect of

oil prices on the demand for capital services from the existing stock of

refinery capital. The discussion relies on a simple two-factor (crude oil and

refining capital) one product model of the refining sector (see Phelps and

Smith, 1977). That model assumes that there is a world-wide, competitive

market for refined products. In the short run, refining capital is immobile

geographically, and the supply elasticity of capital services from the exist-

ing capital stock is assumed to be finite.

The relation between the world oil price and the demand for refinery

capital services depends on two conflicting forces. First, a higher oil price

• provides refiners with an incentive to substitute non-oil factors of produc-

tion--refinery capital--for crude oil in the production of any given quantity

of refined products. This substitution among factors of production would

increase the demand for capital services from the refinery capital stock.

Second, a higher world oil price would increase the prices of refined products

which, in turn, would reduce the quantity of refined products purchased by

consumers. The lower scale of output requires fewer refinery capital ser-

7 vices. Evidence suggests that the demand for refinery capital will decline on

balance, because consumers are more willing to substitute between refined

products and other goods than producers are able to substitute between crude

oil and other factors of production (see Phelps and Smith 1977). That refin-

ery utilization fell dramatically in concert with increased world oil prices

in late 1973 and early 1974 supports the proposition that the demand for

refinery capital services was reduced by higher world oil prices.

This predicted decline in the demand for refinery capital services would

lower the equilibrium value of services forthcoming from the existing stock of

refinery capital. Under the reasonable assumption that the higher world oil

price was unanticipated, the lower value of capital services would result in a

lower market value for refinery assets.

Equal proportionate capital losses would be sustained on investment in

refinery capital located in the United States and in foreign countries, for

reasons established by the following example. Assume that the market for

refinery capital was in long-run equilibrium prior to the increase in the

world oil price--that is, capital services earned an ex post, competitive rate

of return on investment in refining assets. In the Phelps-Smith model, the

of refinery capital services (P ) is related to the market value of a unit k

price of refined products (P), and the cost-minimizing input/output coeffi-

cients for crude oil and refinery capital services (K c and "k respectively)—

, see equation (1.5). Arbitrage in international markets for crude oil and

( 1. 5) P = (P -P1/K k cc k

refined products would have equated the market value of capital services in

the various countries, provided that all countries had access to the same

refining technology. This equality follows because, facing common prices for

oil and products,. domestic and foreign refiners would select the same

8 input/output coefficients and, therefore, each term in equation (1.5) would be the same for domestic and foreign refiners before the increase in world oil and product prices. After prices increased, refinery operations worldwide would suffer the same decline in the market value of services forthcoming from their capital stock, because refiners would experience the same changes in product and crude oil prices, regardless of their location, and engage in the same factor substitutions due to their access to the same technology. Due to their common original market value of assets, refiners would experience the same proportionate reduction in the market value of their refinery operations.

The Effect of U.S. Oil Regulation

Congress attempted to modify the economic effects of higher world oil prices on U.S. petroleum markets by adopting oil regulation in late 1973. Price ceilings were placed on domestic crude oil to limit the capital gains enjoyed by owners of crude oil producing assets. Direct controls were also placed on

U.S. refiners to redistribute the gains that refiners received from "cheap" price-controlled crude oil.

The discussion concentrates on how these regulations would affect the market value of petroleum assets located in the United States at given world prices for crude oil and refined products. This procedure will isolate how

U.S. regulation differentially affected the market value of assets according to whether they were located in the United States or overseas, because the value of foreign assets would be unaffected at initial world market prices.

Undoubtedly, world market prices would be influenced by oil regulation as U.S. crude oil producers and refiners altered their production decisions in response to the new incentives created by regulation. However, these effects generally offer no new testable empirical implications. The predictions about the change in the market value of petroleum assets did not involve the magni-

9 tude, but only the qualitative change, in world prices of crude oil and refined products.

U.S. Crude Oil Production

U.S. crude oil production activity was subjected to a multiple-tier pricing scheme which placed different price ceilings on some types of crude oil while exempting other types altogether from regulation. The discussion consolidates 4 the various tiers into two categories: exempted oil and controlled oil. The market value of exempted properties, of course, would experience the same capital gains as would have occurred in an unregulated market.

The presence of price controls does not invalidate the Hotelling Valua- tion formula for the market value of properties producing price-controlled crude oil. Expected future prices, however, would depend both on the anticipated future uncontrolled market price, and the probability that regulation will be repealed (see Smith and Phelps, 1978). As long as a price-controlled property produced any oil during regulation, the discounted marginal value of anticipated future oil extractions must have equaled the marginal value of 5 current oil extractions. So the increase in the value of price-controlled properties in the face of higher world oil prices can be found by applying equation (1.4) with one important substitution: the change in the uncontrolled world market oil price must be replaced by the difference between the oil price ceiling and the level of oil prices prevailing before OPEC increased its posted prices.

The introduction of regulation, therefore, altered how higher posted oil prices in OPEC countries affected the market value of U.S. oil reserves--see equation (1.6). The first term shows that higher OPEC extraction taxes in-

(1.6) 9V/aT = (a(P — C)/aT ) R + (a(P C)/aT R d,c c d u,d r d r,d creased the market value of reserves exempted from price controls (Ru,d) by an amount equal to that which would have been experienced in the absence of

10 regulation. The second term shows that the market value of reserves with

production subject to price controls (R_ ,) changed according r ,a to whether the

increase in the price ceiling (Pr), above the market price prevailing prior to

late 1973, exceeded the increase in per unit extraction costs. As the price

ceiling grew at a slower rate than unregulated oil prices, firms with larger fractions of their reserves exempted from regulation would have enjoyed a greater increase in the market value of their reserves, than firms with smaller fractions of their reserves exempted from regulation.

U.S. Oil Refining

The Crude Oil Allocation Program apportioned price-controlled crude oil extracted by each oil producer among contracting U.S. refiners in proportion to each refiner's historical purchases from that producer. So the Allocation

Program fixed the quantity of price-controlled crude oil to which each refiner was entitled. The economic consequences of this property right scheme led to controversy about which parties ultimately benefitted from U.S. oil regulation.

The refiner benefit hypothesis argues that the Allocation Program provided U.S. refiners with a lump sum subsidy. Price controls "reduced" the price that refiners paid for domestic oil, but only for the quantity provided under the Allocation Program. Uncontrolled oil remained the marginal source of oil supply, and therefore all resource decisions were dictated by the uncontrolled oil price. U.S. refiners received an income transfer equal to the difference between the uncontrolled and controlled crude oil prices for each barrel of price-controlled oil received under the Allocation Program.

The market value of this transfer, of course, would have been the present value of the anticipated future stream of these gains, and would depend on-- among other considerations--market expectations about the duration of regula-

11 tion and the stability of OPEC.

Some analysts have stressed that ceilings on U.S. refined product pricer prevented refiners from retaining the lump sum transfers postulated by te refiner benefit hypothesis (see U.S. Senate, 1975; and FTC, 1981). According to refined product price regulations, refiners had to average the cost of controlled and uncontrolled crude oils in computing the maximum allowable prices for their reiined products. If these regulations were binding, then

U 6. refiners were required to reduce their prices for refined products to reflect their savings from the receipt of price-controlled crude oil. Under this view consumers, not refiners, were argued to be the ultimate beneficiaries of oil price regulation.

That view neglects the likelihood that ceilings on refined product prices could have allowed higher prices than would have been sustainable under market forces (see Phelps and Smith, 1977, at 19-33). The maximum product prices allowed under regulation were computed to provide U.S. refiners with the same return on their refinery capital investment as they earned prior to the acceleration in world ail prices. But if, as argued above, higher world oil prices would have reduced the return earned on refinery investment in an unregulated market, then product price ceilings would have targetted a greater return to refinery investment than would have been earned under competitive market forces. As long as U.S. refiners' gains from access to price-controlled crude oil did not exceed their economic losses from higher world oil prices, U.S. refiners would have earned a smaller return on their refinery investment than was targetted by the product price regulations.

If U.S. refiners had earned a smaller (ex post) return on their refinery investment after the increase in world oil prices, then refined product price ceilings would not have been binding. In that case, the price ceilings could not have prevented U.S. refiners from capturing the lump sum transfers iden-

12 tified by the refiner benefit hypothesis. While the receipt of price-control-

led crude oil would reduce legal maximum prices, those ceilings would remain

above market prices for refined products. Testing the empirical implication

of the refiner benefit hypothesis--that rights to price-controlled crude oil

increased the market value of refiners--will discriminate between that hypoth-

esis and the presumption that refiner price ceilings were binding.

Summary of Hypotheses

The above hypotheses specify the following regression model to explain the

capital gains and losses experienced by investors in petroleum firms when OPEC

increased world oil prices and U.S. policy-makers imposed oil regulation--see

equation (1.7). The proportionate change in firm i's value of common stock * (V .) is related to its firm-specific characteristics, divided by its value of 1 commonstock(V.)before the increase in world oil prices and the introduction 7 of oil regulation. * (1.7) V = + 8 (R /V). + 6 (R /V). 1 f 1 2 u,d 1 ▪ 8 3r,di(R /V) • 84fi (K/V) S (K /V). + 8 (R/V). + e. 5 d 1. 6 1 1 where R is the firm's foreign oil reserves, f R is the firm's domestic oil reserves exempted from regulation, u,d

R d is the firm's domestic oil reserves subject to regulation,

K is the firm's foreign refining capacity, f K is the firm's domestic refining capacity, d R is the firm's rights to price-controlled crude oil under the

Allocation Program.

e. is the residual of the regression model. 1 Economic theory identifies six hypotheses about the coefficient struc-

ture: 1) foreign oil reserves possibly suffered a loss, but certainly no

increase in market value--8 < 0. 2) domestic oil reserves exempted from 1 — '

13 regulation enjoyed an increase in market value--62> 0; 3) domestic oil reseves subject to regulation enjoyed smaller gains (and possibly losses) in comparison to domestic reserves exempted from regulation--63 < 62; 4) domestic and foreign refining lost the same proportionate value--64 = 65 < 0; 5) domestic refining enjoyed an increase in market value from the receipt of price- controlled crude oil--66 > 0; and 6) U.S. refiner gains from their rights to price-controlled crude oil should be less than their losses from higher oil prices--6 K + 6R < 0. The constant term captures common abnormal returns 5 d related to the other operations of petroleum firms. The residual term captures how the abnormal returns randomly varied among the firms.

The change in OPEC pricing policy, and the introduction of U.S. oil regulation, are safely assumed to have been unanticipated--see Section III. So the regression model explaining the proportionate change in the market values of common stock are predictions about the pattern of abnormal returns among petroleum firms at the time the stock market responded to OPEC pricing policy and the imposition of U.S. oil regulation. The possible effects of regulation and OPEC pricing on the financial risk of petroleum firms are considered in

Section III.

II. MARKET MODELS OF STOCK RETURNS WITH FIRM-SPECIFIC EFFECTS FROM OPEC PRICING AND U.S. OIL REGULATION

Studies employing modern finance theory use the estimated residuals from the market models of stock returns to measure the abnormal returns earned by shareholders during a specified time period. Following tradition, the testing would combine firm returns into portfolios, but this approach would confound the likely gains and losses from regulation as well as the independent economic effects from events which motivated regulation in the first place. An alternative method would regress abnormal returns computed from market models for petroleum firms on firm characteristics. This section outlines some

14 weaknesses in the use of ordinary least squares, and shows how they can be overcome by integrating the model of firm-specific effects into standard multivariate regression models of stock returns.

The Problem with Portfolios

Early studies employing modern finance theory have constructed portfolios of returns for the firms affected by the studied economic event (see Fama, Fis- her, Jensen, Roll 1969; Jaffe 1974; Mandelker 1974). There are two sound statistical reasons for that procedure: 1) to average over the "random noise" which occurs in stock returns in order to provide an efficient estimate of abnormal returns, and 2) to avoid misstatement of standards errors due to possible contemporaneous correlation of returns among the firms in the constructed portfolio (see Schwert 1981, at 130).

In the case of regulation, the use of portfolios can obscure important differences among firms in their gains or losses from regulation. Oftentimes, regulation transfers income among firms, which may be "averaged-out" by inadvertly including the winners and losers in the same portfolio (see McCor- mick and Maloney 1962, at 105-106; Binder 1985). This problem seems acute for the study of U.S. oil regulation. Under: some hypotheses, regulation trans- ferred income between crude oil production and refining activities which are commonly found even within the same firms. Furthermore, the activity which is hypothesized to benefit from regulation--U.S. refining--simultaneously experienced capital losses due to the unanticipated increase in world oil prices, which would have occurred in the presence or absence of regulation.

Analyzing Firm-Specific Abnormal Returns

An obvious way to avoid the problem with portfolios would be to explain firm- specific abnormal returns by the regression model posited in equation (1.7).

While appealing, this procedure suffers from statistical problems due to two

15 ways in which the residual term violates the standard asssumption of ordinary least squares that the residual be identically and independently distributed.

The first problem is that firms differ in the magnitude of their diversiable risk (see Fama 1976, at 129-130). This suggests that the residual variance will vary across firms, or the observations, in the posited regression model.

The second problem is that regulation and market events will obviously occur at the same time for all firms. As there is well known non-zero contemporaneous correlation among abnormal returns of firms, the variance matrix for the residual can not be assumed to be diagonal. As those correlations are likely to be positive, estimating equation (1.7) by ordinary least squares will understate the true standard errors of the parameter estimates.

These statistical problems can be avoided by estimating a system of seemingly unrelated market models which integrate the firm-specific abnormal return model as interaction terms with the dummy variable, Et, which signifies the event period--see equation (2.1). Estimating these equations as a system

(2.1) =. a.. e. r + E (6 + 6 (R /V). + 6 (R /V). + mt t o lf 2 u,d 1 + 6(K/V)4 f i + 6(K/V)5 d i + 6(R/V).)6 + e. 63(R/V)i r,d 1 it explicitly allows for unequal residual variances and non-zero contemporaneous correlation among the residuals. Identification of the parameters, 6 , of the i firm-specific model is obtained by exploiting the across-equation variation in deviations from each firm's market model during the event period. For example, if each firm's equation were estimated separately, then it would be impossible to identify the separate coefficients for the variables measuring the firm's characteristics. It would be asking one observation to identify six coefficients.

16 III. EMPIRICAL RESULTS

This section provides evidence on how equity-owners of petroleum firms were

affected by the economic and regulatory events outlined in Section I. It also

compares the findings from the study of portfolios with those from the study

of firm-specific abnormal returns, in order to demonstrate the advantages of

integrating formal hypotheses derived from economic theory with the empirical

tools of modern finance theory. The analysis concludes with a brief discus-

sion of whether the evidence studied below and the conclusions reached could

be confounded by either varying firm risk not captured by the specification of

the market model, or by oil regulation or OPEC pricing policies changing the

financial risk of petroleum firms.

Sample Selection

The subsequent analysis will concentrate on the abnormal returns earned by

petroleum firms during the fourth quarter of 1973. October-December 1973

witnessed the most dramatic reversal of earlier relations among OPEC govern-

ments and multinational oil firms--see Section I. Congress passed on November

14th and the President signed on November 27th the Emergency Petroleum Alloca-

tion Act that implemented oil regulation. While alternative versions of this

legislation were considered in the Spring of 1973, their progress was stymied

by dissatisfaction expressed by the petroleum industry and administrators of

economy-wide price controls (see Cowan 1973). The Arab-Israeli War on October

' 6th, the subsequent increases in world oil prices, and the attempted oil

embargo transformed a divided Congress into a virtually unanimous supporter of

oil regulation. To the extent that disruptions in international oil supplies

and OPEC pricing were unanticipated, it seems safe to assume further that U.S.

oil regulation also was unanticipated by the stock market.

17 Examination of summary measures of stock price performance of petroleum firms substantiates the presumption that significiant, unanticipated stock

price movements occurred during the fourth quarter of 1973. Figure 1 plots

cumulative abnormal monthly returns earned on selected portfolios of petroleum s firms listed on the New York Stock Exchange during 1972-74. These firms

accounted for the bulk of U.S. crude oil production and oil refining activity,

as they produced 75.1 percent of the crude oil and refined 95.4 percent of the

total products within the United States during this time period.9 Four portfolios were constructed in order to divide the firms into the broad categories

of activity identified by the earlier economic analysis: 1) 7 domestic crude

oil producers, 2) 21 integrated refiners, who both produced and refined crude

oil, with little foreign activities, 3) 5 U.S. integrated refiners with sub-

stantial foreign activity, and 4) 4 foreign integrated refiners with no U.S. activity. Comparison of cumulative abnormal returns across these portfolios

indicates that OPEC pricing and U.S. regulation differently affected the

market values of petroleum firms.

Domestic oil producers earned large abnormal returns during the 4th

quarter of 1973, as illustrated by the jump in their cumulative abnormal

returns from 15.57. to 46.27. during October-December 1973. These gains were

partly lost in early 1974, as Congress seriously considered many proposals to

increase taxation of crude oil extraction and other laws which would have

reduced the value of petroleum reserves. The defeat of such proposals quickly

reversed those losses so, by year-end, the cumulative abnormal return on this

portfolio returned to the level reached at year-end 1973.

Domestic integrated refiners with little foreign activity also earned

considerable abnormal returns during the 4th quarter of 1973, when their

cumulative abnormal returns increased from 26.47. to 48.87.. While modest

abnormal gains were earned prior to September 1973--the bulk of the pre-4th

18 - Figuire 1 Cumulative Abnormal Returns for Selected Portfolios 60 50 -

•***** 0• ...... 40 - .- .... .- 30 - .- : : .. .. 20 - A I ii • a 4 JP „,gi e..11,11.0.11,...•.. Ae . • .. .t ...I .. •• • ;'• I. i' • .▪ ...... 4. 4...amiwimi,.. .0 ..1 ...... • 10 - ii.... :40,.. lidia" .. 0 ,4. AP. N ‘....,"'".....•...... / .."...... ,.--- -- `i ...., ...... _ .0 ..... 'Z.::r------..: —...... • N...... — 10 - 'S. _____20 ..... '%.▪ ..,"•-•

—30 - 11 li %

—40 - \ /‘

16.... Ibitift —50 - N,t —60 - —70 7201 7207 77/ '01....) 7307 7401 7407 Month U.S. oil CO U.S. integrated (2) multinational (3) foreign (4)

...... quarter cumulative abnormal return of 26.4X was earned in September--their magnitudes pail in comparison to those earned in the key months when there were changes in OPEC pricing and adoption of U.S. oil regulation. Further- more, the relative constancy of the cumulative abnormal return index during

1974 suggests that the events subsequent to the 4th quarter of 1973 were relatively minor in their influence on stock prices, in comparison to the events which occurred during the 4th quarter of 1973.

The portfolios of firms with foreign oil activities illustrated markedly different behavior. U.S. integrated refiners with substantial foreign acti-

vities, the so-called U.S. multinational oil firms, were relatively unaffected

by the events leading to, occurring during, and happening after the 4th quarter of 1973. In contrast, foreign integrated firms without U.S. activities

suffered modest losses before the 4th quarter of 1973, which grew during that

quarter. Note that the cumulative abnormal losses continued, especially

during the last half of 1974 when U.S. regulators introduced the entitlement 10 program.

Table 1 summarizes the portfolio findings for the 4th quarter of 1973.

Domestic oil producers gained the greatest proportionate amount, almost 30

percent, or $1.5 billion for the seven firms in this portfolio. Domestic

integrated refiners gained almost as much in proportionate terms, or $10.9

billion for the 21 firms in that portfolio. U.S. multinational oil firms

enjoyed modest proportionate gains, or $3.4 billion for the 5 firms in this

portfolio. The four foreign integrated refiners without U.S. activity lost

small proportionate amounts, equal to $1.5 billion in market value. With the

exception of the domestic oil producer portfolio, the difference between equal

weighted and value weighted returns indicates that larger firms experienced

slightly greater proportionate effects than smaller firms in the same port-

folio.

19 Table 1

Cumulative Abnormal Returns for Selected Portfolios Fourth Quarter, 1973

Portfolio Average Return (7.) Net Bain ($ millions) Equal weighted Value weighted

Domestic Oil Producers 29.88 29.24 1,393.9

Domestic Integrated Refiners 22.75 26.00 10,891.5

U.S.-Foreign Inte- grated Refiners 4.70 6.07 3,404.2

Foreign Integrated Refiners -4.94 -9.0 -1,507.7 Firm-Specific Abnormal Returns

Two data problems confront the estimation of the firm-specific abnormal return

model. First, information on oil reserves were not reported in SEC 10-K

reports until the late 1970s. In its place, oil production rates were used.

Second, only fragmentary and incomplete information is available on each

firm's status under oil regulation. Information on each firm's access to

price-controlled oil was not available until the implementation of the Enti-

tlement Program in November 1974. So the annual rate reported under that

program's first year of operation was used which provides, at best, an impre-

cise estimate of the price-controlled oil obtained under the Crude Oil Alloca-

tion Program.'' No data has been found on firm-specifjc production of con-

trolled oil, so the hypothesis about the differential effects of exempted

versus controlled oil on stock market value can not be tested.

These data problems inevitably introduce statistical bias into the subse-

quent tests, which operate against the hypotheses derived in Section I. The

use of 1975 instead of 1974 access to price-controlled crude oil creates an errors-in-variable problem, and biases the estimated coefficient for the

price-controlled crude oil variable towards zero. The quantitative significance of the bias need not be large provided that 1975 access is highly correlated with 1974 access, so that the variance of the measurement error is small relative to the variance in rights to price-controlled crude oil among

petroleum firms.

The use of oil production rates in place of oil reserves generates an

even greater downward bias in the estimated coefficient for the U.S. oil

production variable than that created by simple random measurement error. For example, suppose that firms A and B had the same refining activities and identical rates of current oil production, but A had twice the U.S. oil reserves as B. Due to its greater oil reserves, firm A would have greater

20 market value than B before the quadrupling of world oil prices and the imposition of U.S. oil price regulation. Therefore, the ratio of oil production to market value would be lower for firm A than it would be for firm B, and the specified model would predict that higher world oil prices generated a pro- portionately smaller increase in value for firm A than firm B. Actually, the opposite is the case since firm A enjoyed capital gains on twice the U.S. oil 12 reserves as did firm 8. So the use of oil production rates in place of oil reserves biases the estimated coefficient not only towards zero, but also towards the opposite sign.

Table 2 reports the available data on firm-characteristics, the assignment of firms to portfolios, and the cumulative abnormal monthly returns for the 4th quarter of 1973 that are estimated from separate market models for 13 each firm. The distribution of operating characteristics across firms exem- plifies the common difficulty encountered when studying industrial firms-- there are few, if any, firms which specialize in one of the separate activities affected by regulation or the market events under study. For example, the bulk of U.S. refining and the allocation of price-controlled crude oil is found in integrated firms, which also engaged in oil production, both in the

U.S. and overseas. Also, the relative importance of these various activities varied widely among the firms, which implies that combining these firms into a portfolio can not assume that, except for random error, the proportionate change in their market values should have been identical.

While there are firms whose petroleum activities are specialized in the production of crude oil in the United States, there is substantial variation in the importance of their oil production activities relative to their overall activities. For example, Superior Oil produced 70 thousand barrels/day (TBD) of crude oil, while Belco produced 35 TBD. However, Superior Oil's production activity, relative to its market value of equity, was lower than Belco's

21 Table 2 Firm Characteristics, Abnormal Returns (4th Quarter, 1973), and Equity Values (September, 1973)

Firm Portfolio CAR Oil Production Oil Refining Old Equity U.S. Foreign U.S. Foreign Oil Value

Amerada Hess 2 -3.684 95 136 444 0 76 996 APCO .0 -5.334 6 16 35 0 11 64 Ashland 2 -2.195 24 22 327 0 62 746 Atlantic Richfield .0 27.765 401 251 713 39 169 3,626 AZTEC 1 19.868 3 0 0 0 0 140 BELCO 1 33.847 35 0 0 0 0 108 British Petroleum 4 -3.358 0 4,830 0 2,400 0 5,984 Cities Services 2 36.583 215 10 269 11 110 1,289 Clark 2 -.811 0 0 105 0 17 196 Contintental 2 55.639 220 368 322 94 116 1,532 Diamond Shamrock 2 27.997 18 0 46 0 16 312 Exxon 3 7.043 970 4,039 1,029 4,117 370 19,588 Getty .0 28.242 231 113 114 0 13 1,754 Gulf 3 5.653 561 2,653 767 1,178 303 5,254 Helmerich & Payne 1 36.897 1 0 0 0 0 140 Kerr-McGee 2 30.378 39 3 37 0 63 1,646 Louisiana Land 1 28.123 79 0 0 0 0 1,567 MAPCO 1 47.770 15 0 0 0 0 682 Marathon 2 37.673 181 273 231 55 104 1,068 Mesa 1 13.266 8 0 0 0 0 733 Mobil 3 -6.082 394 1,517 856 1,378 234 7,537 Murphy 2 26.969 17 33 72 53 31 738 Pacific Petroleum 4 13.597 0 59 0 19 0. 895 Pennzoil 2 32.938 35 0 33 0 16 641 Phillips 2 29.522 268 96 545 77 98 3,359 Royal Dutch 4 -9.200 0 3,846 0 3,082 0 5,410 Shell 2 36.140 638 0 986 0 354 3,696 Shell Transport 4 -20.818 0 2,564 0 2,056 0 4,471 Skelly 2 18.353 85 3 80 0 25 730 Standard Oil of Calif. 3 13.937 462 2,698 815 1,232 253 13,523 Standard Oil of Ind. 2 24.852 469 300 908 81 311 12,215 Standard Oil of Ohio -) 16.154 30 20 400 0 77 2,543 Sun 2 22.320 281 138 481 45 157 1,616 Superior 1 29.644 70 0 0 0 0 1,397 Tenneco 2 2.025 58 9 90 0 26 1,978 Texaco 3 2.955 918 3,113 1,014 1,946 321 10,196 Union 2 . 36.374 263 64 440 6 172 1,141 Total 7,090 27,174 11,159 17,869 3,505 119,511

Notes: 1. Portfolios are: 1 (domestic oil producers, SIC 1311), 2 (domestic integrated refiners, SIC 2911-12), 3 (US-foreign integrated refiners, SIC 2913), 4 (foreign integrated refiners, SIC 2913). 2. CAR is the cumulative abnormal monthly return (percent) during 4th quarter 1973. 3. Production and refining measured in thousand barrels per day, 1972 levels. 4. Old oil is 1975 levels reported under the Entitlement Program. 5. Equity value measured in $ million, end of September 1973. because, while Superior had twice the oil production, it had fourteen times

more equity value than Belco. Changes in world oil prices and implementation

of U.S. oil regulation would not affect the returns to those firms by the same

proportionate amount.

The model of firm-specific abnormal returns, summarized in equation

(1.7), provides a convenient framework to cope with the heterogeneity of

economic characteristics of firms in the same general industry classification.

By utilizing the model specified by economic theory, the researcher can

"pierce the veil" which the construction of portfolios enshrouds around the

differential effects of regulation on the market value of firms in the same

general industrial classifications.

Ordinary Least Squares Results

Table 3 reports the regression results from relating the firm-specific

abnormal returns estimated by separate market models for stock returns to the

available data on firm characteristics. The findings support the major eco-

nomic hypotheses derived in Section I.

First, price controls did not prevent domestic oil production from bene-

fiting from the increase in world oil prices. The estimated coefficient

implies that a petroleum firm's stock value increased by $1.66 for each repre- 14 sentative (mix of controlled and exempt) barrel of domestic oil production.

Whether or not the magnitude of the coefficient seems economically reasonable

depends on how a variety of considerations balance with each other. The $7

. increase in exempted oil prices was only received on about 35 percent of

domestic oil production, so the average price received by U.S. oil producers

increased by $2.45. However, the expansion in U.S. drilling and oil produc-

tion activity sharply increased costs for domestic oil production and explora-

tion, so the price received net of increased costs would rise by substantially

less than $2.45. Finally, the stock market would consider the increased value

22 Table 3

Regression Model of Abnormal Returns Computed from Separately-estimated Market Models

Variable Coefficient Standard Error 1-statistic intercept 24.25 3.50 6.93 domestic oil 165.52 85.95 1.93 foreign oil -7.94 71.56 -0.11 domestic refining -291.01 77.49 -3.76 foreign refining -204.02 110.85 -1.84 old oil 689.09 304.13 2.27

firm characteristics measured in millions of barrel per $ million of equity value.

Summary Statistics:

R- = .643 a = 11.44 F(6,31) = 11.16

Dependent variable-- mean = 18.68, standard deviation = 17.77

Hypothesis tests:

1) difference between coefficients for domestic and foreign oil production variables: t(31) = 1.52, which is significant at 6 percent level, one-tail test.

2) difference between coefficients for domestic and foreign refining variables: t(31) -.66. of the firm's oil reserves, rather than simply its current rate of oil output.

Therefore, if the firm had oil reserves equal to six years of production, then the increase in market value of the firm would equal six times the firm's oil production multiplied by the increase in the price received net of increased costs of production and exploration. With the fragmentary information available, the safest conclusion is that the estimated coefficient is not apriori 15 unreasonable.

Second, foreign oil production activity was not a source of increased market value for petroleum firms. This finding supports the "tax hypothesis" about the effect of OPEC oil pricing on multinational oil firms, if one believes that the elasticity of demand for OPEC oil was considerably less, in absolute value, than the elasticity of supply of OPEC oil. The difference between the estimated coefficients for domestic and foreign oil is statistically significant, indicating that the economic distinction drawn between domestic and foreign oil production activities is indeed valid.

Third, both U.S. and foreign refining activity suffered capital losses during the 4th quarter of 1973. The implied loss of $2 to $3 per barrel is close to independent estimates of the long-run capital costs of refining (see

Adelman, 1972). In economic terms, higher world prices probably placed refiners near their shutdown condition because the implied value of capital 16 services generated by the refinery capital stock approached zero. The difference between the coefficients for the domestic and foreign refining variables is statistically insignificant, supporting the strong implication of the Phelps-Smith model of world refinery markets.

Finally, refiner's with access to price-controlled crude oil enjoyed substantial financial gains which raised the market value of their firm. Each barrel of old oil received under the Crude Oil Allocation Program was worth 17 about $7 in increased stock market value.

23 These firm characteristics explain 64 percent of the variance in the

pattern of abnormal returns earned by the 37 petroleum firms in the 4th

quarter of 1973. The firm-characteristic model outperforms analysis based on

simple classification schemes, such as those which use SIC codes(see Sundar

1977). Table 4 reports the analysis of variance of abnormal returns for the

37 firms according to a classification scheme following the definition of

portfolios provided in Table 2 and used in Figure 1. The classification

scheme only explains about 40 percent of the variance in abnormal returns,

implying that within group variance is more important than between group

variance.

System Estimates

Finally, the results from the simple regression analysis are upheld when the

full seemingly-unrelated system is estimated by non-linear least squares--see

Table 5. The magnitude of the estimated coefficients are comparable to those

obtained by the use of ordinary least squares. The statistical significance

of the foreign refining and access to price-controlled oil variables improves,

while that of the domestic oil production variable declines substantially.

The major economic implications for hypotheses about OPEC and oil regula-

tion remain intact. Firm's with greater access to price-controlled crude oil

enjoyed greater gains in market value than firms with little access. While

each are statistically significant and negative, the differences between the

coefficients for the domestic and foreign refining variables remain statisti-

cally insignificant. The lower coefficient for the domestic oil production

variable does not destroy the finding that the difference between the coefficients for the domestic and foreign oil production variables are statistically

significant.

24 Table 4

Analysis of Variance of Abnormal Returns, 4th Quarter 1973

Sum of Squares:

Between group 4,442.4 Within group 6,922.8

Total 11,365.2

Test statistic for significance of between group variance:

F(4,33) .= 7.059 Significance level = .0005 Table 5

Regression Model of Abnormal Returns from Seemingly-Unrelated Model Estimated by Non-Linear Least Squares

Variable * Coefficient Standard Error 1-statistic intercept 15.16 4.03 3.76 domestic oil 96.48 77.10 1.25 foreign oil -26.84 47.65 -0.56

domestic refining -304.95 84.09 -3.63 foreign refining -188.19 69.33 -2.71

old oil 836.64 258.21 3.24

* firm characteristics measured in millions of barrel per $ million of equity value.

Hypothesis tests:

1) difference between coefficients for domestic and foreign oil production variables: t(31) = 1.46, which is significant at 7.6 percent level, one-tail test.

2) difference between coefficients for domestic and foreign refining variables: t(31) = -1.12, which is significant at 27.2 percent level, two-tail test. Financial Risk of Petroleum Firms

Both the analysis of cumulative abnormal returns computed from firm-specific models of stock returns, and the system estimates of equation (2.1) assumed that each firm's beta was constant over the estimation period. If oil price regulation changed each firm's beta, or if the firms' betas were unstable between 1967-1973, then the estimated abnormal returns would reflect these 18 changes in the betas of petroleum firms. Neither potential problem, however, is likely to invalidate the interpretations given to the empirical findings.

Considerthepotentialeffectofregulationonthebeta,8.,of a petroleum firm. Following Fama (1976, at 312-318), $ depends on the covariance i between the future value of firm and the future value of the market portfolio 2 (a ) the variance in the future value of the market portfolio (a 0 im ), and the ratio of the current value of the market portfolio (Pm) to the current price of stock for firm i (P1)--see equation (3.1). Assuming that the economic 2 (3.1) = . i m m m effects of regulation on publically-traded firms are primarily experienced by firms in the petroleum industry, then regulation would not affect the current value of the market portfolio, nor the variance in its future value. There- fore, regulation will affect ei , only if regulation changes the current price of stock for firm i, P. or the covariance between the future values of the firm and the market portfolio, a. . in Any change in a firm's beta which results from a change in the price of its stock, of course, is properly attributed to the change in the firm's market value. For example, a regulation which increased the market value of a firm by 20 percent would reduce its beta by 20 percent--see equation (3.1).

So reliance on pre-regulation "betas" to estimate abnormal returns--as used by the firm-specific market models and the seemingly unrelated system which did

25 not accomodate a regulatory-induced shift in beta--properly computes the

capital gains experienced by share-holders from regulation affecting the value

of the firm.

In contrast, if regulation changed the covariance between the future

values of the firm and the market portfolio, then shifts in ei would reflect

changes in the financial risk of owning equity in the firm. Such effects are

likely to be minor, relative to the change in stock prices, for petroleum

regulation; because the value of the income transfers under price controls is

likely to have a low corelation with the value of the market portfolio, while

the magnitude of the income transfers were large relative to the pre-regula-

tion value of petroleum stocks. Therefore, models which estimate abnormal

returns with pre-regulation betas properly capture the effect of oil regula-

tion on the market value of petroleum firms.

Instability of firm betas could be another confounding factor in the

interpretation of the abnormal returns. While theoretically possible, there

is no evidence of unstable betas over the estimation period. If betas were

significantly unstable over 1967-1973, then the forecast errors from predic-

ting actual market returns of firms from models estimated on 1967-1971 data

should have been correlated with the return on the market portfolio, because

the forecasted returns for firms would have used a biased estimate of beta.

Yet the monthly abnormal returns for the four portfolios displayed in Figure 1 19 are uncorrelated with the monthly return on the market portfolio. That

' evidence supports the specification used by both the individual market models

and the seemingly unrelated system of firm stock returns.

26 IV. CONCLUSION

For the study of oil regulation, at least, the model of firm-specific abnormal

returns provided greater insight into the beneficiaries of regulation than

would have been found by constructing portfolios of abnormal returns. This

section concludes with additional applications to the study of oil regulation,

and discusses how the firm-specific model of abnormal returns can cope with

other modelling problems which are commonly encountered during the use of

modern finance theory in the study of the economic effects of regulation.

Further Insights into Oil Regulation

The test of the fundamental hypotheses about OPEC and U.S. oil regulation re-

quired the use of the firm-specific model of abnormal returns. By its nature,

the refiner benefit hypothesis of the Allocation Program specified that U.S.

refiners with more rights to price-controlled crude oil would lose less from

higher world oil prices than U.S. refiners with fewer rights to price-

controlled crude oil. The analysis of the effect of higher world oil prices

on the return earned by refinery capital predicted that U.S. and foreign

refinery operations would suffer the same proportionate loss, given their

differential access to price-controlled crude oil. The analysis which inter-

pretated the OPEC posted price system as an export tax predicted that foreign

oil operations would not gain, while domestic oil operations would gain from

the increased posted oil prices in late 1973. Given the diversity in these

economic effects and the overlapping distribution of operating characteristics

' across petroleum firms, any simple classification scheme which may be used to

construct portfolios is doomed to obscure the effects of OPEC pricing and U.S.

oil regulation on stock returns earned by investors in petroleum firms.

The estimated coefficients of the firm-specific model of abnormal returns

support a fundamental interpretation of oil regulation advanced by Phelps and

Smith (1977): the large gains U.S. refiners received from oil price controls

27 offset partly, but not fully, the standard economic losses which the U.S. refining sector would have suffered from higher prices of crude oil in an

unregulated market. For the 37 firms listed in Table 2, their gains from their rights to price-controlled oil equalled $10.7 billion (a = $3.3 billion), while their losses sustained from U.S. refining activity per se total- 20 led $12.4 billion (a = $3.4 billion). The amount that the loss from higher

world oil prices exceeded the gains from regulation is $1.7 billion (a = $1.8 21 billion). As discussed in Section I the finding that, despite their gains from the Allocation Program, U.S. refiners sustained capital losses also supports the general proposition that legal ceilings on product prices at the refinery level were not binding. By defining maximum prices which targetted the return to refinery capital to its pre-OPEC level, price regulations allowed higher prices for refined products than would have been sustainable under an unregulated, competitive market for U.S. refined products.

General Thoughts on the Use of Modern Finance Theory

Like all event studies, the success of this study hinged critically on the ability to identify time periods in which the market learned of new information about the firms' economic and regulatory environments. The unanticipated acceleration of world oil prices and the unforeseen reversal in the political popularity of oil price regulation defined obvious event periods. Unfortuna- tely for researchers of regulation, the unfolding of regulation does not normally follow obvious .paths.

As known by students of the politics of regulation, policies are the outcome from pressures exerted by competing interest groups. While not cer- tain, participants have strong indications about which laws are politically viable and when, and lobbyists are paid to predict, as well as to influence, legislative and executive decision-making. It is difficult to believe that such information is withheld from the stock market. The researcher is faced

28 with the difficult task of deciding when these professionals first deemed it likely that the introduction or reform of a regulation was likely to succeed.

Simple transference of the procedures used in the study of corporate mergers, tender offers, or other policies does not seem promising. For example, such studies have used successfully the date of the first public an- nouncement of the merger, tender offer, stock split, or other actions taken by management. What is the analog for the political sector? Certainly not the formal adoption of legislation, because key political hurdles have been cleared long before legislation normally reaches Senate-House conference committee or the President's desk for signature. Even so-called "key votes" on amendments may not be promising, unless the voting outcome was close. The fate of bills or amendments which are adopted or defeated by wide margins must 22 have been known prior to the formal casting of votes.

These difficulties in identifying key event dates may account for the generally negative findings which Binder (1985) reports for the use of stock returns to study the economic effects of regulation. He studied 20 major regulations which other economists have concluded, on the basis of data other than stock prices, had major effects on firms in the regulated industry.

Relying on the Wall Street Journal Index and supplemental industry and schol- arly sources to identify possible event dates, he found that the frequency of statistically significant effects of regulation on stock returns mimics that which would have been expected on the basis of type-I errors of statistical inference. The "state-of-the-art" methodology of event studies is not a powerful tool to study the economic effects of regulation.

Firm-specific models of abnormal returns, however, embody stronger hypotheses than the simpler ones of whether or not abnormal returns of individual firms are jointly equal to zero during a specified event period. An example from a hypothetical study of beer consumption can illustrate this

29 point. Suppose that individual beer consumption is log-normally distributed.

By definition, any draws from the population distribution would yield the conclusion that the difference between the logarithm of any individual's beer consumption and the population mean is statistically significant with the same frequency as Type-I errors--e.g. 57. of the individuals have (logarthim) consumption which exceeds the critical value given by the upper 57. tail of the population distribution. However, analysts would not be surprised to estimate a statistically significant relation between an individual's level of beer consumption and explanatory variables, such as income. The point, of course, is that distribution of beer consumption is dependent on the level of income.

The analogy for the study of firm-specific abnormal returns is that the hypotheses derived from economic theory predict that the distribution of abnormal returns during event periods is dependent on underlying firm-characteristics. Testing the proposition that the unconditional distribution of firm-specific abnormal returns is not statistically different from a normal distribution of mean zero is not equivalent to testing hypotheses about condi- tional distributions. It is conceivable that, on average, the proportionate effects of regulation on stock returns is small relative to the normal varia- bility in stock returns, but that firms with one set of characteristics gain while firms with another set of characteristics lose.

Pending major break-thoughs in the theory of public choice, perhaps economists must be content to study how regulation evolves in response to unanticipated changes in market forces. For example, a cost-saving innovation may be discovered that unleashes political forces which culminate in the passage of regulation within 18 months. How much of the initial stock market response to the innovation was due to the cost reductions experienced by firms, and how much was due to anticipated regulation? With the use of micro- economic theory, the economist can answer this question by devising testable

30 - hypotheses which relate the pattern of abnormal returns across firms to under-

lying characteristics of firms. To this end, firm-specific models of abnormal

returns promise to become useful tools for those researchers interested in

studying the economic effects of regulation with stock price data.

31 Footnotes

1. The text only discusses the market value of foreign oil reserves located in OPEC countries. The valuation formula for reserves located in Canada, for example, would not include the tax term, T, representing the payments due under the royalty and posted price systems levied in OPEC countries. As the vast majority of foreign oil production by the companies studied below was located in OPEC countries, concentration on the valuation of these properties seems warranted.

2. Expanding the model to include upfront exploration costs, which enable firms to increase their reserves, does not affect the results. Let Ef be the upfront exploration costs, which are a convex function of the level of foreign reserves. Then the wealth-maximizing level of reserves would be found by the following maximization problem:

max V = (P - C - T)R E (R ) f c c f f f f wrt R f By the envelope theorem, the total effect of higher taxes and world crude oil prices on the value of foreign reserves is still given by equation (1.2).

3. See Smith (1982, esp. appendix), where he shows that the second order approximation is obtained by integrating the following expression under the assumptions that a(Pc - Cf)/aT is a constant and Rf is a linear function of the market price net of extraction costs.

1' dV = SWF' - C )/aT)R dl f,c c f f To

4. See Smith and Phelps (1978) for a detailed description and analysis of the evolution of the alternative price ceilings placed on domestic crude oil production activity. The discussion in the text shall neglect the economic

F-1 incentives provided by the "released oil" provisions in price-control regulations.

5. The anticipated price path under the Hotelling model will hold as an equality for properties exempted from price controls--which also includes some non-U.S., non-OPEC oil properties. If marginal extractions costs were constant, however, price-controlled oil properties would produce no oil during the era of regulation. It would pay to "withhold" the reserves to market them in the future when deregulation is anticipated, because the rate of price increase enjoyed must exceed the price appreciation enjoyed by uncontrolled oil properties--by an amount proportional to the difference between uncontrolled and controlled oil prices multiplied by the probability of deregulation occurring in the future time period.

Suppose instead that marginal extraction costs were an increasing function of the rate of current output. Then as the price-controlled producer

"withheld" his production in anticipation of expanding his output in the future, the marginal costs of extracting oil today would fall relative to the marginal costs of extracting oil in the future. Eventually, the differences in marginal cost would exceed the gains from withholding production, implying that some oil would continue to be extracted from price-controlled properties during the era of regulation. In this circumstance, the statement advanced in the text would be true.

6. In November 1974, U.S. oil regulation supplemented the Crude Oil Alloca- tion Program with the Entitlement Program, which implemented a rationing ticket scheme for refiner access to price-controlled domestic crude oil. By concentrating on oil regulation in late 1973, the analysis in this paper shall not study how the Entitlement Program may or may not have affected the winners and losers from oil regulation. The methodology developed in this paper, of course, could be applied to study this question.

F-2 7. Equation (1.7) is derived by noting that the market value of common stock for a firm, V, equals the sum of the market value of the firm's domestic crude oil and refining operations (V and V ) and foreign crude oil and refining d,c d,r operations and V ) less the market value of outstanding debt, D. (Vf,c f,r (*) V=V +V +V +V -D f c d c f r d r The change in the firm's market vAlue fó m higher OPEC extraction taxes is obtained by differentiating equation (*) with respect to T.

** ) aV/aT = aV /aT + aVd,c/aT + aVf,r/aT + aV /aT f,c d,r

For simplicity, the financial risk of corporate debt is assumed to be unaffected by OPEC pricing and U.S. oil regulation, so guai = 0. Equity- holders would absorb any changes in the market valuation of the firm's assets.

Substituting from equation (1.2) for aVf,c/aT, equation (1.6) for

9V /aT writing the change in market value of refinery capital as the pro- dic duct of the effect of the tax on the market value of capital, aP iai, and the r quantity of capital, and letting S be the present value of rights to a barrel r of price-controlled crude oil under the Allocation Program, we have

aViaT = ( a(P - C )/aT - 1 ) R + ta(P - C )/aT1 R c f f d u,d + ((P -P ) - aC/aT 1 R + aP/aT t K + K ) + S R r c d d,c r f d r Dividing both sides by the original market value of the firm's common stock yields the specification in equation (1.7). Note that the division of equation (***) by the market value of common stock implicitly accounts for differences among oil firms in their financial leverage.

S. The market models of stock returns were estimated for monthly stock returns during 1967-71 for the 37 firms listed below in table 2. The estimated coefficients were then used to obtain predicted monthly returns during 1972-74 given the actual monthly return on the market portfolio. The deviation of actual from predicted values were then accumulated starting with January 1972.

F-3 See table 2 for the assignment of the 37 firms to the four portfolios.

9. The 37 firms in the sample produced 7090 TBD of domestic oil and refined

11,159 TBD of products in the United States in 1972--see Table 2. For the

United States in 1972, total oil production was 9441 TBD and oil refining was

• 11,696 TBD (Monthly Energy Review, Department of Energy, December 1974).

10. The Entitlement Program provided incentives for U.S. refiners to expand

their use of crude oil, and thereby expand their production relative to for-

eign refiners (see Phelps and Smith, 1977). This geographical substitution in

refinery utilization would increase the return to U.S. refining capital, and

reduce return earned on foreign refining capital. Given the economic circum-

stances in 1974, it is plausible that small changes in the absolute return to

foreign refinery capital could have large proportionate effects--see note 16.

11. Throughout the era of regulation, there was wide variation in the rates at

which oil producers reduced their production of price-controlled crude oil.

So the relative position of refiners' access to controlled oil would vary,

implying that the pattern of controlled oil received in 1975 would not be

identical to the pattern which prevailed in late 1973.

12. Let R. be the ratio of oil reserves to oil production for firm i. The 1 example in the text assumed that each firm had identical rates of production,

and the same other activities whose original market value is V o. Making

use of eq. (1.3), the proportionate change in firm i due to increased value of

its domestic oil operations would be: (dP - dC )R q/E(P -C )qR.+V ] c d i c d 1 o This expression is clearly an increasing function of Ri.

13. The data sources were:

1) Center for Research on Security Prices data tape for monthly returns

on firms and the market portfolio.

2) 10-K SEC reports for U.S. and foreign crude oil production and refining activity.

F-4 3) Federal Registrar for monthly reports of firm's access to price- controlled oil received during the administration of the entitlement program.

14. The reader is reminded that the abnormal return was measured in units of percent, so that specification implicitly multiplied by 100 the coefficients in equation (1.7).

15. In theory, the estimated coefficient for the domestic oil variable, 6, satisfies the following equation: 6 = RE2.45-dC 3, where R is the ratio of oil d reserves to oil production. If oil reserves were six times oil production, then an estimate of 6= $1.66 implies that dCd= $2.17.

16. If foreign refiners were near their shutdown position after the 4th of quarter 1973, then even small reductions in the absolute returns earned by foreign refiners from the Entitlement Program in 1974 would have had large proportionate effects on their market values.

17. In theory, the coefficient measures the present value of rights to price- controlled crude oil. In 1974 the difference between uncontrolled and controlled oil prices averaged about $7. The present value of rights, of course, would depend on expectations about the future price differential, the expected rate of decay in the quantity of controlled oil available, the duration of regulation, as well as the tax treatment of these gains. Perhaps all that can be said is that the estimated magnitude of the coefficient is reasonable.

18. The forecast error from using a biased estimate of beta to forecast the T E return earned on a firm's stock equals: (0 -6 )r + e. m t I E where (3 and 6 are the true and estimated values of beta, r is the return mt on the market portfolio in period t, and eit is the true abnormal return for firm i in period t.

19. The correlation between monthly abnormal returns, computed from forecasts of market models estimated for the 1967-1971 period, and the return on the market portfolio were: -.10 for domestic oil producers, .04 for U.S. integ-

F-5 rated refiners, .14 for U.S. integrated refiners with substantial foreign operations, and .09 for foreign integrated refiners. None of these correlations are significant at even the 207. level.

20. As a group, the 37 firms engaged in 11,159 TBD of refining activity and enjoyed rights to 3,505 TBD of price-controlled crude oil-see Table 2. The losses to refining and gains from price-controlled crude oil were estimated by multiplying these quantities--after converting them to quantities of million of barrels per year--by the relevant coefficient in Table 5.

21. The variance-covariance matrix for the estimated coefficients is:

U.S. Refining Old Oil

U.S. Refining .2357091 -.616977

Old Oil -.616977 2.222574

Letting 01 and 02 be the scale of U.S. Refining and Old Oil, respectively measured in millions of barrels, we have:

= .365 * 11,159 0 = .365 * 3,505 1 2 The standard error of the weighted sum of estimated coefficients is: 2 .5 a= ( .2357091 * + 2.222574 * - 2 * .616977 * 0 * 0 ) 1 1 2 22. A simple, admittedly extreme, example illustrates the point. Suppose that the decision of Congressmen to vote yea or nay on a bill or amendment could be represented by independent draws from a binominal distribution. Then the fraction of yea votes would be a consistent estimate of the underlying probability that any congressmen votes yea. So for close votes, the probability of a yea vote would be about 50 percent. Of course, the variance the number of yea votes actually received from N draws from the binominal distribution is maximized at p=.5, and close to zero at p=40 or 0-11.

F-6 References

Binder, John Measuring The Effects of Regulation with Stock Price Data: A New Methodoloqy Chicago: Unpublished Ph.D. dissertaf.ion, Graduate School of Business, University rr Chicago, 1983.

"A New Methodology for Measuring The Effects of Regulation with Stock Pr:ce Data" Unpublished manuscript, Washington University at St. Louis, 1985.

Blair, John M. The Control of Oil New York: Vintage Book, 1978.

Dann, Larry Y. and Christopher James "An Analysis of the Impact of Deposit Rate Ceilings onthe Market Values of Stock Savings and Loan Associa- tions" Washington D.C.: Officier of the Comptroller of the Currency Staff Paper, 1981.

Fama, Eugene F. Foundations of Finance N.Y.: Basic Books, 1976.

Fama, Eugene, Lawrence Fisher, Michael Jensen, and Richard Roll "The Adjust- ment of Stock Prices to New Information" International Economic Review 10 (February 1969): 1-21.

French, Kenneth R., Richard S. Ruback, and G. William Schwert "Effects of Nominal Contracting on Stock Returns" Journal of Political Economy 91 (February 1985): 70-96.

Gibbons, Michael Econometric Models for Testing A Class of Financial Models: An Application of the Non-Linear MultivariateRegression Model Chicago: Unpublished Ph.D. dissertation, Graduate Schoolof Business, University of Chicago, 1980.

Hughes, John S. and William E. Ricks "Accounting for Retail Land Sales: Analy- sis of A Mandated Change" Unpublished manuscript, 1983.

Izan, Haji Y. An Empirical Analysis of the Economic Effects of Mandated Government Auditing Requirements Chicago: Unpublished Ph. D. dissertation, Graduate Schoolof Business, University of Chicago, 1978.

Jaffe, Jeffrey "Special Information and Insider Trading" Journal of Business 47 (July 1974): 410-428.

Maloney, Michael T. and Robert E. McCormick "A Positive Theory of Environment- al Quality Regulation" Journal of Law and Economics 25 (April 1982): 99-123.

Mandelker, Gershen"Risk and Return: The Case of Merging Firms" Journal of Financial Economics 1 (December, 1974): 303-335.

R-1 Miller, Merton and Charles Upton "A Test of the Hotelling Valuation Principle" Journal of Political Economy 93 (February 1985): 1-25.

Phelps, Charles E. and Rodney T. Smith Petroleum Regulation: The False Dilem- ma of Decontrol Santa Monica, California: RAND Corporation, 1977.

Schipper, Katherine and Rex Thompson "The Impact,of Merger-Related Regulation on the Shareholders of Acquiring Firms" Unpublished manuscript, Au- gust 1982.

Schwert, William "Measuring the Effects of Regulation: Evidence from the Capital Markets" Journal of Law and Economics 25 (April 1981): 121-

Smith, Rodney T. "In Search of the 'Just' U.S. Oil Policy: A Review of Arrow and Kalt and More" Journal of Business 54 (January 1981): 87-116.

Smith, Rodney T. "An Economic Analysis of Income Growth by U.S. Oil Firms: The Roles of U.S. Oil Regulation and OPEC" Journal of Business 55 (October 1982): 427-478.

Smith, Rodney T. and Charles E. Phelps"The Subtle Impact of Price Controls on Domestic Oil Production" American Economic Review, Papers and Pro- ceedings 68 (May 1978): 428-433.

Spiller, Pablo "The Differential Impact of Airline Regulation on Individual Firms and Markets: An Empirical Analysis" Journal of Law and Econom- ics 26 (October 1983): 655-689

Sundar, Shyam Oil Industry Profits Washington, D.C.: American Enterprise Institute for Public Policy Research, 1977.

U.S. Senate Oil Price Decontrol Hearings--First session on the competitive and economic impacts of permitting decontrol of petroleum price and the termination of allocation authority Washington, D.C.: Senate Committee on Interior and Insular Affairs, 1975.

R-2