Vertical Integration and Vertical Divestiture in the U.S. Petroleum Industry

By David J. Teece
1976| Working Paper No. 300

This paper demonstrates that vertical integration in the U.S. petroleum industry represents a competitive response to the disabilities associated with market contracting. If intermediate product markets could operate, according to the frictionless textbook ideal, then vertical integration between the various operations in the industry would not be necessary since contractual purchases and sales would eliminate the need for internalizing transactions within a vertically integrated firm structure. Very often, however, the requisite contracts for crude oil, R&D services, product supply and so forth cannot be written, executed, or enforced. This paper demonstrates that supply and demand uncertainty, the capital intensive character of many industry investments, and the opportunistic proclivities of human decision makers renders it prudent for firms to integrate across particular stages of industry activity. The resultant vertically integrated firm is able to adapt to changing economic circumstances more efficiently, to attenuate opportunism more effectively, to coordinate complementary investments in the different stages of the industry more exactly, and to schedule production and inventories more efficiently. Nevertheless, as firms grow larger and more complex,various inefficiencies can emerge. Reorganization and improved decision making procedures can limit if not eliminate these inefficiencies. However, the growth of any organization inevitably involves some costs and there are limits to the performance improvements which vertical integration can provide. Otherwise, intermediate product markets would be pre-empted quite generally. These considerations explain why the majors are not fully integrated; integration into exploration and production, refining, marketing, transportation, and R&D is carried only to the appropriate degree while integration into some industry related activities such as well drilling and refinery and pipeline construction is generally completely avoided. There is thus an optimal degree of vertical integration for each firm, which theoretically occurs when the incremental costs and benefits associated with internalizing transactions are equalized. The affirmative rationale for vertical integration needs to be juxtaposed against its potential anticompetitive characteristics. Vertical integration can extend monopoly power throughout an industry, but only if there is monopoly power in at least one intermediate product market. Otherwise vertical integration has a neutral effect on competition. The various intermediate product markets - including crude oil production, refined products, and pipeline transportation - are therefore examined. They are found to be competitive. A11 of the standard objective tests of monopoly power affirm that the industry is highly competitive throughout. Furthermore, there is no evidence available to support fanciful assertions that the industry is effectively and systemmatically collusive. Even if attempted, it would seem that comprehensive collusion would be quite impossible. The evidence shows that entry barriers are not formidable, concentration in the relevant markets is low, long run profits have been very modest, and technological innovation - commonly regarded as a characteristic of competitive industries - has been impressive. Accordingly, vertical divorcement would impose efficiency losses on the industry and could not enhance competition. Investment and production costs in all stages of the industry would increase and technological innovation would decline. The later factor is especially critical: basic research projects, R&D projects of large size and long gestation, projects having complex objectives, and projects pooling technology from many parts of the industry, for example shale oil and geothermal power research, would be the most seriously affected. In short, vertical divestiture would result in higher prices for the American consumer, both immediately and in the long run. In addition, technological innovation and the development of new sources of energy would be retarded, thus increasing the strategic dependence of the U.S. on the OPEC cartel.