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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" by 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" by 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 by 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 unantici- pated 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 hypoth- eses 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
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