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KR. ALLARDICE

Economic Review
Federal Reserve Bank of Dallas
May 1982

Reducing U.s. Vulnerability
to World Oil Supply Disruptions

The economic cost of imported oil is greater than
its price because political events can lead to a
disruption of oil imports. Effective economic
policy for reducing vulnerability to unstable oil
imports takes this divergence into account.

Petrochemicals:
Changing Markets and Limits
to Growth Alter Outlook

Petrochemical manufacturing, a mainstay of the
southwestern economy, faces considerable changes
in the way it operates. Shifting demands appear
to be making the industry more cyclical, and
foreign producers are looking to capture a larger
share of the U S. market.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Reducing u.s. Vulnerability
to World Oil Supply Disruptions
By Stephen P. A. Brown*

Through 1978, Iran accounted for approximately 10
percent of the world's oil production, with output of
5 million to 6 million barrels per day. The overthrow
of the Shah in early 1979 led to a 10-week period in
which Iran produced almost no oil. The consequences of such a disruption in the world's oil
market are painfully familiar. Lines at gasoline stations have become the most widely recognized
symptom of stress in petroleum markets, but major
disruptions also lead to higher petroleum prices and
reduced production and consumption throughout
the economy.
The United States has reduced its consumption of
oil in the past few years, but the U.S. economy is
still vulnerable to disruptions in the world's oil
market. Past disruptions have resulted from political
disturbances that were largely independent of
market conditions. Much of today's production is in
countries with potentially unstable political systems
(Table 1), and an interruption of greater severity

* Stephen P. A. Brown is an economist at the
Federal Reserve Bank of Dallas. The author
gratefully acknowledges helpful discussions with
Michael }. Barron.
Economic Review/May 1982

than the disturbances of the past decade is certainly
possible.'
The unreliability of a significant share of the
world's oil production raises concern in industrial
nations such as the United States because energy
conservation and switching from oil to alternative
fuels require time and expensive adjustments in a
nation's capital stock. Thus, it is not possible to
maintain long-run consumption and production
levels when the supply of oil is abruptly curtailed.
In theory, vulnerability could be reduced by
negotiating long-term contracts with countries having stable political systems. These contracts might
specify prices and quantities to be delivered under
various contingencies. However, such international
contracts are not enforceable and, therefore, not
written.
The United States can employ foreign policy to
reduce the probability of supply disruptions, but
economic policy can only lessen the consequences.
Policies that would be effective in reducing
U S Department of Energy, Office of Oil Policy Analysis, "The
Energy Problem: Costs and Policy Options," Staff Working
Paper by Jerry Blankenship, Mike Barron, Joseph Eschbach,
lindsay Bower, and William lane (Washington, D.C., 1980).

Table 1
CRUDE OIL PRODUCTION IN MAJOR
PETROLEUM.pRODUCING COUNTRIES
1978

1979

1980

1981

Annual averages'
(Thousands of barrels per day)

Area

1,161
2,563
2,131
1,983
487
8,301
1,831

1,154
3,477
2,500
2,092
508
9,532
1,831

1,012
2,514
1,656
1,787
472
9,900
1,709

797
984
1,155
1,160
411
9,923
1,508

18,457

21,094

19,050

15,938

1,635
5,242
1,897
2,166

1,591
3,168
2,302
2,356

1,577
1,662
2,055
2,167

1,610
1,371
1,394
2,094

Total OPEC'

29,805

30,928

26,890

22,776

Canada
_
.
Mexico
_
.
United Kingdom
United States
China
USSR. ..
. ..•
Other ...•.....•...

1,313
1,209
1,082
8,707
2,082
11,185
4,782

1,496
1,461
1,568
8,552
2,122
11,460
5,111

1,424
1,937
1,622
8,597
2,114
11,770
5,098

1,222
2,320
1,798
8,556
2,018
11,827
5,275

World ... "

60,165

62,698

59,452

55,792

Algeria ..............••.
Iraq .........•..•..•..•.
Kuwait 2 • . • • • • • • • • • • • • • •
Libya. .. . .....••....•..
Qatar.
• ...•.•
Saudi Arabia 2 • . • • • • . . • • •
United Arab Emirates .....
Arab members of OPEC'
Indonesia ........••...
Iran
. .....•....••.
Nigeria
.
Venezuela ..

1. January-November averages for 1981.
2. Includes about one-half of the production in the former Kuwait-Saudi Arabia Neutral
Zone In November 1981. total production in this region amounted to approximately
279.()()() barrels per day
3 Arab members of the Organization of Petroleum Exporting Countries (OPEC) include
Algeria. Iraq, Kuwait, Libya, Qatar, Saudi Arabia, and the United Arab Emirates.
4 OPEC total includes production in Algeria, Iraq, Kuwait, Libya, Qatar, Saudi Arabia,
United Arab Emirates, Indonesia, Iran, Nigeria, Venezuela, Ecuador, and Gabon
SOURCES: US Department of Energy. Energv Information Administration
Federal Reserve Bank of Dallas

Federal Reserve Bank of Dallas

vulnerability fall into one of two categories: encouraging an accumulation of oil inventories
(stockpiling) and reducing imports in normal
periods. 2 The discussion in this article is limited to a
comparison of the methods for reducing imports.
Reduced oil imports are synonymous with higher
oil prices. In the past, U.S. energy policy has sought
to insulate consumers from higher oil prices-but at
the cost of increased vulnerability to world oil supply disruptions. Because imported oil is subject to
disruptions, the true economic cost of its use is
greater than its price. If energy policy resulted in
imported oil being accorded its true economic cost,
U.S. oil consumption and imports would fall while
domestic production would rise. An examination of
policies to reduce imports reveals that those most
effective in reducing vulnerability to import disruptions recognize higher prices in normal periods as
the solution, not the problem.

Analytics of the problem
Imported oil has an economic cost to the United
States that is in excess of its purchase price, for it is
subject to unexpected disruption. This nonprice cost
arises because the economic loss experienced during disruptions increases with the level of imports in
normal periods. As U.S. oil imports rise, the shortrun maintenance of national income becomes more
dependent on the maintenance of oil imports. Furthermore, increased US. imports will raise the share

2. It might seem that policy could insulate the United States from
disruptions without reducing imports by requiring oil importers
to purchase oil from stable suppliers only The intent of such
restrictions would be to reduce the share of world production
contributed by unstable suppliers and to establish a position
with those suppliers most likely to be producing during a
disruption In fact, neither objective would be accomplished
Oil is a fungible commodity, and a reduction in U S purchases from any particular country would not diminish that
country's share of the world market Another buyer would
replace the United States. In addition. the absence of contracts
makes the distribution of oil during a disruption independent
of any relationships that may exist during normal periods The
United States has joined 20 other countries as a member of the
International Energy Agency These countries, which account
for 56 percent of the world's petroleum consumption, have
established a set of rules for sharing oil during a disruption
These rules do not take into account historical relationships
between producing and consuming countries Furthermore, any
oil that is not allocated by such agreements will be sold in the
market to the highest bidder

Economic Review/May 1982

of world oil production contributed by potentially
unstable producers. It follows that the non price
costs of imported oil are an increasing function of
the quantity of imports.
From the U.S. perspective, the economic cost of
an additional barrel of imported oil is the sum of
the world oil price, the risk associated with greater
vulnerability to supply disruptions, and the impact
of higher U.S. imports on the world oil price. To the
extent that the nonprice economic costs of oil imports are ignored, U.S. oil consumplion and imports
will be too high while domestic production will be
too low.
The economic loss arising from an oil supply
disruption is the value of production lost as a result
of the disruption. The loss of production can be
severe because energy conservation and switching
from oil to alternative fuels are costly and timeconsuming Hence, the short-run response of oilusing firms to unexpectedly higher oil prices is
reduced production. These direct effects constitute
the primary loss during a disruption. In addition, a
general cooling-off of the economy may occur during the adjustment of relative prices necessitated
by the disruption. However, such secondary
macroeconomic losses occur during the adjustment
to the disruption only to the extent that monetary
and fiscal policies cannot be sufficiently fine-tuned.
The optimal import level is achieved at that quantity for which the contribution of an additional barrel of imported oil to current production just equals
its economic cost. At the optimal level of imports,
the nonprice cost of imported oil (P* less P' in
Figure 1) has been estimated by the U.S. Department of Energy at $4 to $8. 3

3 Michael J Barron of the Division of Energy Security, Office of
Policy, Planning and Analysis, US Department of Energy, provided the author with this updated estimate in a private com·
munication in March 1982. A model of the world oil market,
microeconomic and macroeconomic loss functions, subjective
estimates of the probabilities of various supply disruptions, and
an Energy Information Administration estimate of the elasticity
of import demand with respect to import prices were utilized
For a complete description of the methodology used, see
Department of Energy, "The Energy Problem"
A number of other estimates of the non price cost of imported oil have been made Most of them are higher than $4 to
$8 An advantage of the Department of Energy estimate is that
the nonprice cost is determined at the optimal level of imports,
not the current level of imports. Another advantage of the

FIGURE 1
Determining Optimal U.S. Consumption,
Production, and Imports of Oil
DOLLARS

DOLLARS

fOREIGN
SUPPLY

U.S. IMPORT
DEMAND

o
OIL
(BARRELS PER DAY)

OIL IMPORTS
(BARRELS PER DAY)

Net U.S. import demand for oil is the difference between domestic oil consumption and production at various world oil prices. At the equilibrium world oil price,
the quantity of oil imports demanded equals the quantity supplied by foreign producers. Assuming that the price of imported oil reflects its cost to the United States.
P is the equilibrium price. Qo is total U.S. consumption. Qs is domestic production.
and (Qo- Qs), or I, is imports.
The economic cost of oil imports is not limited to price, however. The additional
costs of increasing imports include greater exposure to economic loss resulting from
disruptions of foreign oil supply plus more expensive terms of trade for oil. If the
full economic costs of imports are considered. P' will be the import price. and P" its
economic cost and the price of domestic oil. Domestic consumption IS
domestic
production is
and imports are (Qo-Qsl, or {'.
As described in the article. an unleashed (ree market would lead to the desired
prices Otherwise. an import tariff of [P' - P') can be imposed

Qs.

A free market policy
The free market approach consists of encouraging
private sector preparation for the possibility of
disruptions by establishing a policy of not interfering in the free market pricing and allocation of oil

estimate is that the various components of the cost are
determined jointly-not independently-eliminating the
double-counting of costs that is implicit in the summing of
independently estimated components For a summary of
estimates of the nonprice costs of imported oil, see Harry G
Broadman, "Review and Analysis of Oil Import Premium
Estimates," RFF Discussion Papers. no D-82e (Washington,
D.C : Resources for the Future. December 1981).

Qo.

in the event of a disruption. The risk of temporarily
higher oil prices sometime in the future would induce oil consumers to hedge by stockpiling oil, signing long-term purchase agreements with domestic
suppliers, and undertaking oil conservation
measures,
Long-term supply agreements with domestic producers are an attractive investment, given the
possibility of oil supply disruptions. Recognizing
that they are forgoing the possibility of higher profits during a disruption, producers signing long-term
supply agreements will expect compensation in
higher prices during normal periods. Because purchasers expect to avoid the costs of uncertain oil
Federal Reserve Bank of Dallas

supplies, they will be willing to pay a premium to
obtain long-term contracts. Under long-term contracting, domestic oil prices will rise until the
domestic oil price just equals the economic cost
faced in utilizing its substitute, imported oil. As
domestic oil prices rise, domestic oil production will
increase, contributing to a decline in imports (Figure
1). Interestingly, vertical integration in the form of
domestic well ownership by oil-using firms appears
to be a good substitute for long-term contracts
Long-term contracts with stable foreign producers
would also be desirable but must be presumed
unenforceable.
Higher domestic oil prices and the economic
costs of imported oil encourage oil conservation
(Figure 1). Though the conservation investments
discussed here would raise the cost of production in
normal periods, they would result in lower expected
costs of production over the life of the investment.
Oil-conserving investments will be made until their
marginal cost just equals the value of the domestic
oil they save. Since oil consumption is greater and
has a greater price elasticity than domestic oil production, oil conservation measures can be expected
to contribute more than domestic production to
reducing oil imports. Investment intended to increase the short-run elasticity of demand for oil during disruptions is probably of an insignificant quantity, because the most attractive substitutes for oil
generally entail lower operating costs and higher
capital costs 4
One task at which the private market excels is the
continual reevaluation of the equilibrium non price
cost of imports. For example, natural gas deregulation, changed taxes on domestic oil production,
changed demand for imports, and the revised probabilities of disruptions will alter the profitability of
preparing for a disruption (Figure 2) The incentive
of profits will provide rapid and automatic adjustment to new market conditions. In contrast, the
political process will be rather slow and haphazard
in reacting to changes in the equilibrium divergence
between the economic cost and price of imports,
raising the continual possibility of inappropriately
weak or strong intervention measures.

FIGURE 2
Effect of Reduced Demand for Oil Imports
on Equilibrium Nonprice Costs
DOLLARS
ECONOMIC
COST

P;
P'o

10:

10
OIL IMPORTS
(BARRELS PER DAY)

The decontrol of natural gas prices decreases U 5
demand for oil by increasing the supply of gas Decreased
oil demand translates into decreased demand for oil
imports Similarly. elimination of the oil windfall profit tax
increases the domestic supply of oil and makes it more
elastic These changes In domestic oil supply translate into
a decreased and more elastic demand for oil imports
Decreased import demand reduces the optimal
economic cost of imports from Po to Pi. optimal imports
from '0 to Ii, the optimal import price from P'o to p',. and
the divergence between the economic cost and price of
imports from (Po-Po) to (P;- Pi) If the divergence
between the economic cost and price of oil imports is not
taken into consideration. the decrease in import demand
will reduce imports from /0 to /,

4. For a detailed discussion. see Douglas R. Bohi and W David
Montgomery. "Tariffs and the Economic Costs of an Oil
Disruption," RFF Discussion Papers, no D·82B (Washington,
DC: Resources for the Future, December 1981)

Economic Review/May 1982

FIGURE 3
Effects of a General Oil Tax on Domestic
Consumption and Production of Oil
DOLLARS
DOMESTIC
UPPLY

TOTAL
SUPPLY

P
P'

AFTER·TAX
DEMAND

Q2QO

Oil
(BARRElS PER DAY)
A general tax on crude oil consumption is shown as a
downward shift in demand by the amount of the tax, (P'-P') In
effect, the tax reduces the price of oil received by foreign and
domestic suppliers from P to P' while increasing the price paid by
consumers from P to P' U S consumption is reduced from Q, to
Q" with domestic production falling from Qo to Q2 Imports are
reduced from (Ql - Qo) to (Q, - Q 2)

The free market appears quite capable of preparing for world oil supply disruptions through stockpiling and an efficient reduction in imports. However,
some costs of imported oil would be ignored. The
most important of these arises from the absence of
an incentive for individual decisionmakers to consider the impact of their oil consumption on world
oil prices, And to the extent that it is impossible to
fine-tune monetary and fiscal policy accurately in
response to an oil supply disruption, indirect
macroeconomic losses will occur. Energy users have
no reason to take these costs into account either.
The exact magnitude of the resulting inefficiencies
is unknown but most likely is small.
Reluctance to rely on the market to prepare for
the possibility of disruptions has not centered on
reservations about the ability of the market to take
efficient measures, however. Objections have been
raised about the impact an unfettered market would
have on the distribution of income during a disruption, High oil prices are thought to have graver consequences for both the Northeast and lower-income
families than do Government allocation rules, As a
result, world oil supply disruptions in recent history
have been accompanied by domestic price controls
on petroleum and petroleum products and by
refinery output mix controls, These policies have
caused shortages, which have led to Government
allocation rules at both the industrial and the consumer level. In the past, these allocation rules have
undermined the effectiveness of oil-conserving investment in maintaining individual-firm production
during a disruption, Furthermore, a distaste for
"profiteering" has led to legislation limiting private
oil stockpiling. In the wake of this intervention, free
market preparation for oil supply disruptions has
been virtually eliminated because decisionmakers
have reason to believe that during a future supply
disruption, similar controls would prevent them
from benefiting from any such preparation,

Tariffs, taxes, and subsidies
Reluctance to rely on the free market to reduce imports leads to the consideration of interventionist
policies. The simplest methods for reducing imports
are an oil import tariff, an oil use tax, and a
domestic oil production subsidy, Of these three, the
most direct method for reducing oil imports to a
beneficial level is Government imposition of an oil
import tariff equal to the equilibrium divergence
6

Federal Reserve Bank of Dallas

between the price and economic cost of imports.
In many ways, implementation of an oil import
tariff is akin to the free market response to the
potential of a disruption. Under an oil import tariff
the reduction in oil imports will be achieved
through those consumption decreases and production increases that have the lowest opportunity cost.
Also, an oil import tariff equal to the non price
economic cost will reduce imports to the point
where the economic cost of their use equals the
benefit (Figure 1). An advantage an oil import tariff
has over reliance on the free market is that any
potential secondary macroeconomic losses arising
from world oil supply disruptions and any impact of
reduced U.S. imports on the world oil price can be
taken into account.
However, oil import tariffs might have a palling
effect on free international trade if some oilexporting nations retaliated against U.S. action by
imposing tariffs on their imports. While many oilexporting nations are not in a position to retaliate
with tariffs of their own (their governments are the
primary import purchasers) and many U.S. trading
partners would benefit from US imposition of an
oil import tariff, some of the oit-exporting nations,
notably the United Kingdom and Mexico, would suffer economic losses as a result of U.S. tariffs and
are in a position to retaliate with tariffs of their
own. U.S. imposition of a tariff on oil imports could
contribute to a worldwide movement away from
free trade. Because the United States has generally
favored free international trade and it is regarded
that this country and the rest of the free world have
benefited, the potential impact of a tariff on international trade cannot be taken lightly.
Public opposition to an oil import tariff has not
arisen from the issue of free trade, however.
Criticism has centered on the rise in oil prices that
would accompany a tariff. Under a tariff, U.s. consumers would pay higher prices for petroleum products, and domestic oil producers would receive
increased profits.
In view of the problems with an oil import tariff,
less efficient methods for reducing dependence on
imported oil must be considered. Oil use taxes and
oil production subsidies are possible alternatives.
Given that both the level and the elasticity of
U.S. demand for oil are greater than the level and
elasticity of the domestic supply of oil, oil use taxation is more efficient than production subsidies in
Economic Review/May 1982

FIGURE 4
A General Oil Tax Versus an Oil Import Tariff
DOLLARS
ECONOMIC
T

FOREIGN
SUPPLY

I
I

U.S. IMPORT
DEMAND

I
I
I IMPORT RESPONSE
: TO GENERAL OIL TAX

Ii
OIL IMPORTS
(BARRELS PER DAY)

Import response to a tariff-shown as U 5 import
demand - is more elastic than import response to a
general oil tax. This difference arises from the differing
impact of a tariff and a tax on domestic production A
tariff encourages domestic oil production while a tax
discourages it It follows that a tax is a more costly and
less effective measure for reducing imports
The optimal tariff is (Po-Po) because atlo the
marginal economic cost of imports equals its marginal
contribution to current production It is much more difficult to see that the optimal oil tax is (Pi - P\). When less
efficient means are used for reducing imports. the opportunity cost to current production of reducing imports is
greater Therefore, imports should be maintained at the
higher level. Ii, with which the tax (Pi - Pi) is consonant
Under the tax the consumer oil price is hig~er, Pi versus
Po; imports are higher. Ii versus 10; and the price of imported oil is higher. Pi versus Po, than with the tariff
However, under the tax the price received by domestic
producers is less than with the tariff, P\ versus Po; hence,
domestic production is less

FIGURE 5
Effects of an Investment Tax Credit
in the Market for Capital Equipment
DOLLARS

P,
Po
P,

CAPITAL EQUIPMENT
(QUANTITY PER YEAR)
An investment tax credit shifts the demand for qualified
equipment upward by the amount of the credit The effective
price paid by purchasers decreases from Po to P" while the
price received by producers increases from Po to P, The
Government makes up the difference between the effective
purchase price P, and the producer price P, The quantity of
equipment purchased increases from Q o to Q, However. the
loss in Government tax receipts is not restricted to the equipment purchases induced by the tax credit All purchasers of
qualified equipment receive the tax credit benefits Hence.
Government revenue losses are represented by the rectangle

P,P,BC
The economic cost of the investment tax credit program is
the difference between the opportunity cost of producing the
additional equipment-shown along the supply curve-and
the benefit of using the additional equi~nt-shown along
the demand curve Hence, the triangle ABC represents the
economic cost of the investment tax credit

reducing imports. An oil use tax decreases the demand for oil. However, unlike a tariff, which
stimulates domestic production, a tax discourages
domestic production (Figure 3). Compared with an
oil import tariff or the free market, the "optimal"
oil use tax leads to not only greater imports but also
higher domestic prices for petroleum products (as
can be seen in Figure 4).
Rebating the tax to the producers of domestic oil
would allow for an incentive structure that is identical to the import tariff. It is so transparently identical that most U.S. trading partners would view the
combination of an oil use tax and a domestic producer rebate as a de facto U.S. oil import tariff.
Interestingly, taxes on domestic oil production (including the windfall profit tax) reduce the portion of
any domestic price increase received by producers
and nongovernmental royalty owners to an average
of 26 percent at the margin. s Under current tax
laws, neither an oil import tariff nor an unleashed
free market provides much incentive to increase
domestic oil production. As a result of eroded production incentives, both policies will be more
similar in effect to an oil use tax than is suggested
by the preceding analysis.

Investment tax credits and oil use regulations
Free market preparation for oil disruptions, an oil
import tariff, and a general oil tax result in consumers facing higher oil prices in normal periods.
The desire to avoid higher oil prices while obtaining
some of the security benefits of reduced oil consumption has led to investment tax credits for oil
conservation and to regulations restricting oil use.
The Energy Tax Act of 1978 and the Crude Oil
Windfall Profit Tax Act of 1980 contain provisions
offering temporary tax credits for specified residential and business investments in energy conservation, the development of new energy sources, and
the substitution of other fuels for oil and gas. The
present analysis is limited to the business investment tax credit provisions of these acts. Business
energy use is considerably greater than residential
energy use, and the analysis and conclusions with
respect to residential tax incentives would be
similar. Qualifying business investments, the tax

Philip C Crouse. "U 5 Crude Prices: No Improvement in 1982,"
February 15. 1982. p 131

World Oil.
8

Federal Reserve Bank of Dallas

Table 2

SUMMARY OF TAX CREDITS
Energy property, equipment

Tax
credit
(Percent)

Effective
date

Expiration
date

October 1, 1978

December 31,1982'

October 1, 1978

December 31, 1979

january 1, 1980

December 31, 1985

january 1, 1980

December 31, 1985

'11

january 1, 1980

December 31,1985'

january 1,1980

December 31,1985

October 1, 1978

December 31, 1985

Alternative energy property (principally
combustors not using oil or gas).
Specially defined energy property (principally
equipment for the recovery of waste heat). ,

.........

Cogeneration equipment ....
Solid waste recycling equipment
Equipment for producing shale oil

............
..........

Equipment for producing natural gas
from geopressured brine
. , . . _ ............
Solar, wind, and geothermal energy equipment
(equipment for producing usable energy
from these sources) .......
..
. ...
Ocean thermal energy conversion equipment
(equipment for producing electricity
from differentials in ocean temperatures) .
Small hydroelectric facilities (hydroelectric
dams under 125-megawatt capacity)
Interc ity buses
Biomass equipment (equipment for producing
usable energy from agricultural products
or by-products)
... ..
~

1 In certain cases, expiration date is postponed until December 31. 1990
2 Actual tax credit rate varies inversely with size The rate is 11 percent for installations with capacities of 25 megawatts or less,
decreases from 11 percent to zero between 25 and 125 megawatts, and is zero for 125 megawatts or more.
3 For projects for which the application has been docketed by the Federal Energy Regulatory Commission prior to January 1,
1986, the expiration date is postponed to December 31,1988
SOURCE: Brown and Anandalingam, Economic Analysis of Tax Credit Incentives

Economic Review/May 1982

credit percentages, and the availabil ity dates for the
tax credits are summarized in Table 2.
Investment tax credits lower the effective price of
qualified equipment for the purchaser while raising
the price the manufacturer receives, with the
Government making up the difference. (See Figure
5.) The direct revenue loss to the Government is incurred on all units purchased-not just on units
whose purchase is induced by the tax credit.
Therefore, Federal revenue losses from a tax cred it
program are sizable compared with the other
economic consequences of the program. For the
most part, the revenue loss is not an economic cost.
The revenue loss is largely a transfer payment from
taxpayers to the manufacturers and purchasers of
equipment receiving the tax credit. However, the
reduction in Federal revenue requires increased
Government borrowing or taxation, both of which
generally have undesirable side effects.
More important, an investment tax credit causes
distortion costs that are the difference between the
full opportunity cost of producing the additional
equipment whose purchase has been induced by the
credit and the value of that additional equipment in
producing goods or saving other inputs (Figure 5).
The distortion costs result from not only substitution of capital equipment qualified for the credit for
other inputs but also increases in the output of
goods produced with the equipment.
To estimate the economic consequences of the
tax credits, a number of dynamic, partialequilibrium simulation models were constructed to
represent the markets in which the energy tax
credits would have an effect. 6 Construction of these
models involved economic theory, engineering data,
and econometric techniques.
Table 3 presents the results of exercising the
models. Estimates of the distortion cost and revenue
loss are biased downward because the models do
underestimate somewhat the substitution and output effects. However, the models do not significantly bias the oil savings estimates. It follows that
the estimates of average distortion cost per barrel

6 For a detailed description of the methodology, see S P. A
Brown and G Anandalingam, "Economic Analysis of Tax
Credit Incentives for Business Investment in Energy Conservation and Production," no. BNl-51526, Brookhaven National
laboratory (Upton, N.Y, December 1981).

reported in the table are biased downward
somewhat. Furthermore, since these investments
have diminishing marginal productivity in reducing
oil consumption, a small increase in the tax credit
rate would entail economic costs for each barrel of
oil saved that would be higher than the average cost
shown in the last column. Consonantly, the distortion costs avoided through a small decrease in the
rate would be larger per barrel consumed than the
average shown in the table,
The equilibrium non price economic costs of oil
imports (estimated at $4 to $8) and an Energy Information Administration estimate that a $5 increase in
the per-barrel price of imported oil would reduce
imports by 1 million barrels per day can be used as
standards of comparison in evaluating the investment tax credit program. 7 Examination of the
estimates in Table 3 reveals that it is nearly certain
(given the known biases in the estimates) that the investment tax credits for alternative energy property,
specially defined energy property, solid waste
recycling equipment, and intercity buses have a
higher marginal cost in saving oil than the
equilibrium non price economic cost of oil imports,
It is likely that the investment tax credit for
cogeneration equipment also has a higher marginal
cost than its marginal benefit.
Four tax credits were found to have no consequences, and as is evident in Table 3, the one tax
credit showing likely benefit has a great deal of
uncertainty surrounding its estimated effect. Furthermore, oil savings, at less than 120 million barrels
in the year with the greatest savings, are less than
one-third of the reduction in imports that would
result from a $5 increase in the oil import price.
The investment tax credit program relies too
heavily on a few oil-conserving activities. An efficient reduction in imports requires a more diverse
set of oil conservation and production activities (including increased production of oil from conventional sources) than those targeted by the current
incentives, with less reliance on each activity.8

7 Department of Energy, "The Energy Problem" A current
estimate of the import response to a $5 increase would probably be slightly lower
8 Similar results are obtained in a theoretical general-equilibrium
analysis See William) Baumol and Edward N Wolff, "Subsidies to New Energy Sources: Do They Add to Energy Stocks?"
Journal of Political Economy 89 (October 1981):891-913

Federal Reserve Bank of Dallas

Table 3

SUMMARY OF ESTIMATED CONSEQUENCES
OF BUSINESS ENERGY INVESTMENT TAX CREDITS
Presentvalue
distortion
cost
Tax credit

Present·
value
direct
revenue
loss

Millions of dollars

Maxlmum~

year
oil

Total
oil

savings

savings I

Millions of barrels

Average
distortion

cost 1
(Dollars
per barrel)

Alternative energy property
(combustors not using oil or gas)

$3,855.8

$5,122 9

111

973

$ 7.74

Specially defined energy property
(waste heat recovery equipment)

17678

712.51

1.75

7.11

315,13-3290

4596

156.27

2,07

7.36

33,25-7.08

1,13

.008

.033

11.03

29.35

3760

201

60,2

2.74

9.78

001

.007

1419

Cogeneration equipment
Solid waste recycling equipment
Equipment for producing shale oil
Equipment for producing natural gas
from geopressured brine
Solar and wind energy equipment
Ocean thermal energy conversion
(OlE C) equipment'
Small hydroelectric facilities
I ntercity buses

1, Figures represent savings over a 3D-year period in some cases
2 Values in this column cannot be determined from other columns in the table Rather, they are determined through the use of
a present-value formula that takes into account the time path of energy or oil savings
.3 The first value is for estimated oil and gas savings; the second, for estimated oil savmgs alone
4 These estimates represent the construction of one 200-megawatt OTEC facility The estimates are from the middle case of nine
cases examined In the other eight cases, no impact on energy use was found, either because oil was the choice With or without
the tax credit or because ocean thermal energy conversion was the choice with or Without the tax credit It should also be
understood that OTEC technology may not be sufficiently developed for any commercial lise during the period m question.
* No estimated consequence
SOURCES: Brown and Anandalmgam, Economic Analysis 01 Tax Cred,t Incentives.
Federal Reserve Bank of Dallas

Economic Review/May 1982

Regulations appear to have several advantages
over investment tax credits, although the two approaches produce similar undesirable side effects.
Direct losses of Federal revenues are avoided.
However, energy use regulations do not stimulate
domestic production. Moreover, the effects of
regulations already implemented bear little
resemblance to the least-cost means of reducing
imports.
The most significant legislation to regulate energy
use in recent years is the Powerplant and Industrial
Fuel Use Act of 1978 (P/FUA). The act mandates
that all baseload electric powerplants in the United
States that use oil or gas must be converted for use
of other fuels and that new baseload powerplants
must use fuels other than oil or gas. Furthermore,
all new major fuel-burning installations in industry
must use a fuel other than oil or gas unless the
estimated cost of doing so would substantially exceed the cost of imported oil. The Economic
Regulatory Administration of the Department of
Energy has ruled, for the purposes of PIFUA, that
substantial cost is to be defined in a manner
equivalent to placing a $1 tax on imported oil.
Other important regulatory legislation includes
the Energy Policy and Conservation Act (EPCA), the
Energy Conservation and Production Act (ECPA),
and the subsequent National Energy Conservation
Policy Act (NECPA). Under these acts, energy performance standards for buildings and appliances were
established, along with fuel economy standards for
automobiles. The EPCA also imposes Federal thermostat settings in nonresidential buildings.
Of these regulations, only the portion of PI FUA
directed at industrial combustors offers any explicit
recognition of the non price economic cost of imports. However, taken in isolation, PIFUA results in
an insufficient reduction of oil use in new industrial
combustors. Taken in conjunction with the investment tax credit for alternative energy properties,
PI FUA aggravates the excessive reduction of oil use
in new industrial combustors that is induced by the
tax credit Furthermore, unless exemptions are
granted, the marginal cost of banning baseload
generation of electricity with oil or gas under PIFUA
is undoubtedly greater than $8. The EPCA, ECPA,
and NECPA substitute Federal rule for individual
decisionmaking.
Because the costs of compliance cannot be considered on an individual basis in the administration
12

of Federal regulations, some users could be required
to cut oil consumption by more than is beneficial.
In addition, regulators may overlook beneficial
reductions in oil usage. The information required to
administer regulations makes impractical the
achievement of economic efficiency through finetuning. Besides, regulations that can achieve a leastcost reduction in oil consumption will impose costs
that seem inequitable.

Choosing among the policy alternatives
On balance, reliance on the free market to prepare
for the possibility of an oil supply disruption appears to be the most efficient policy for reducing oil
imports· It is followed by an oil import tariff and a
general oil tax. (See Table 4 for a summary of policy
consequences.) However, unleashing market forces
would require assurances that the Government will
not intervene in the energy market during oil supply
disruptions. Expiration of the Emergency Petroleum
Allocation Act (EPAA) in 1981 may be viewed as encouraging by those favoring a market solution. But
efforts to reinstate the EPAA are afoot, and many
decisionmakers in industry can recall the rapidity
with which the EPAA was adopted in 1973.
Though an oil import tariff is more effective than
an oil use tax in reducing oil imports, its use runs
the risk of decreased international trade. Given that
the tariff's supply incentives are seriously eroded by
the windfall profit tax, the oil use tax may prove the
most attractive method for reducing imports that is
currently available.
Although it is probably beneficial that the United
States is drifting toward elimination of energy investment tax credits and oil use regulations, no new
measures are being taken to reduce imports, and
that is risky. World oil prices are currently
languishing, but the world oil market was in a
similar situation during the summer of 1978, before
the shock of political upheaval in I ran led to a rapid

9 Most analysts recognize that least-cost preparation for the
possibility of world oil supply disruptions involves both
stockpiling and import reductions For instance, see Department of Energy. "The Energy Problem"; Broadman. "Oil Import
Premium Estimates"; and Thomas J Teisberg, "A Dynamic Programming Model of the U S Strategic Petroleum Reserve," Bell
Journal of Economics 12 (Autumn 1981):526-46. Current Government stockpiles do not appear sufficient to obViate either an
import reduction or further stockpiling.

Federal Reserve Bank of Dallas

Table 4

SUMMARY OF POLICY CONSEQUENCES
Tariff

Oil
use
taxation

Oil
production
subsidies

Investment
tax
credits

Oil
use
regulations

Yes

Some

Greatly
reduced'

No'

Provides automatic reevaluation

Yes

Has domestic production incentives and
increased profits for domestic oil producers ...

Yes'

No'

Yes'

No'

Has incentives to reduce U.S. oil consumption

Yes

In theory, has no extraneous distortion costs

Yes

Efficiency of policy not inhibited
by "fairness" considerations

Yes

In theory, all costs of oil imports
enter evaluation process

Yes

Avoids risk of palling effect on world trade

Yes

Avoids increases in oil prices

Yes'

Free
market

Provides decentralized evaluation

Effect of policy

Automatically provides stockpiling

.........

1 Has massive data requirements to achieve fine-tuning to effiCiency
2 Effectiveness eroded by windfall profit tax
3 Unless foreign oil supply to the United States is perfectly elastiC, will lead to decreased domestic oil production and dpcreased profits
for domestic oil producers
4 Unless foreign oil supply to the United States ,s perfectly elastIC, will lead to decreased oil prices

doubling of the world price of oil. This is not to suggest that an oil supply disruption will occur-only
that current oil market conditions do not greatly
reduce the possibility of an oil supply disruption.
Given the non price costs of oil imports, arising
from the possibility of disruptions in the supply, a
reduction in imports is beneficial. However, reduced U 5, oil imports must come at the expense of
decreased oil consumption or increased oil production. Effective policies for oil conservation involve
higher oil prices for consumers, and increased
domestic production is synonymous with higher producer prices and profits. Unfortunately, higher oil
prices and increased producer profits have proved
politically distasteful, and policy has reflected that
distaste.
Economic Review/May 1982

Petrochemicals:
Changing Markets and Limits
to Growth Alter Outlook
By Edward L. McClelland*

Sales of chemicals and allied products, which
include drugs, detergents, coatings, and agricultural
chemicals, total $200 billion a year in the United
States. A major segment of the industry is
petrochemicals. They are derived from natural gas
and crude oil and are used to manufacture plastics,
man-made fibers, and synthetic rubber.
The first stage in manufacturing petrochemicals
is the production of a few basic building-block
chemicals, from which other products are made.
The manufacture of building-block chemicals is a
major activity in the southwestern economy. For example, basic petrochemicals account for 59 percent
of all chemicals produced in Texas, which in turn
amount to 13 percent of total value added of the
state's manufacturing output. In Louisiana, basic
chemicals account for 50 percent of total chemical
production, which amounts to 17 percent of that
state's manufacturing output.
Petrochemical manufacturing has been a fast-

* Edward L. McClelland, formerly a senior economist

at the Federal Reserve Bank of Dallas, is vice
president and economist for the Republic of
Texas Corporation, Dallas, Texas.
14

growing industry. Since 1947, production of basic
chemicals has increased eightfold, compared with a
fourfold increase in the production of all manufactures. The development of the oil and gas industry
in the Southwest provided petrochemical manufacturers with abundant supplies of inexpensive
feedstocks. Chemicals and synthetic materials
increasingly displaced a wide range of natural
materials as technology advanced.
The current recession has substantially reduced
the demand for many products made from
petrochemicals. A quarter of the production capacity of basic chemicals is shut down, and those
plants still operating are running at about 70 percent of capacity. Several factors suggest demand for
petrochemicals will remain weak and that current
capacity will be more than adequate for some time.
Economic recovery may be slow in many domestic
petrochemical markets, and exports of chemical
products are down because of recessions abroad,
especially in Western Europe. There is concern that
in the long run, other major oil-producing countries
will build their own petrochemical industries and
permanently capture significant shares of the
export and domestic markets now served by U.S.
producers.
Federal Reserve Bank of Dallas

CONCENTRATION OF BUILDINGBLOCK CHEMICAL PLANTS
IN LOUISIANA AND TEXAS
(Dollar amounts in billions)
LOUIliiana

Chemical

Ethylene.
Propylene
Butadiene
Benzene
Para-xylene

rexa~

Percent of
U S capacity

25
22
20
16
2

Commerrlal

value of

1981

production

65
65
77

54
42

$7.0
3.2
1.1
2.4
1.1

SOURCES: Chemical & Engineering News
Chemical Marketing Reporter.
Pace Company Consultants &
Engineers
federal Rpserve Bank of Dallas

U.S. firms hold comparative advantage
The manufacture of petrochemicals began with
salvaging by-products of other industries and processing them into products of higher economic
value. Before the discovery and widespread production of crude oil, a few petrochemicals were made
from coal tars and from animal and vegetable
residues. But the biggest advances in petrochemicals arose from the expansion of the automobile industry and the accompanying demand for
more and better gasoline.
Distillation of crude oil yields gasoline and
heating oils but simultaneously produces other
coproducts or (in the terminology of economists)
joint products, such as gas oil and naphtha, which is
largely natural gasoline. These coproducts of
gasoline had no ready markets, but chemical
manufacturers were quick to see the potential for
processing those inexpensive materials into more
useful products. The growth of gasoline refining
made huge supplies of distillate feedstocks
available to the U.S. petrochemical industry.
Petrochemical plants were built and expanded
beside refineries. That close proximity allows the
free flow of primary and intermediate products between the two industries, minimizing transportation
cost:; and increasing economies of scale. As a result,
many of the refining and petrochemical industries
are clustered in heavy concentrations of plants and
Economic Review/May 1982

equipment. Today, some petrochemical manufacturers are operating subsidiaries of major oil companies, and others are chemical firms that buy their
feedstocks from refiners and gas processors.
Growing demand for gasoline stimulated production of crude oil, and increased crude output
resulted in a rise in the associated production of
natural gas, which initially had little value. It was
not until the 1940's, when the first major pipelines
were built to midwestern and eastern heating
markets, that natural gas gained significant value as
an inexpensive, clean-burning fuel. Natural gas consists of several component products. Natural gas
produced in association with crude oil is about 85
percent methane, and most of the remainder is
natural gas liquids-ethane, propane, and butane.
Methane is used largely for fuel, although it is an
important raw material in the production of
chemical fertilizers. Some natural gas liquids, such
as propane and butane, are also sold for fuel but, in
addition, they are used as petrochemical feedstocks.
In the early 1960's, in fact, natural gas liquids
displaced naphtha and gas oil as the largest source
of petrochemical inputs.
At the industry level and for firms with large
plants, there is often some flexibility to switch
between oil-based feedstocks and natural gas
liquids. Switching between feedstocks can be used
to minimize production costs. But it also depends
on the relative demands for petrochemicals that
compete with one another in end uses, the ability of
individual plants to use more than one feedstock,
the relative price differences among feedstocks, and
other capital and labor costs incurred by individual
producers. Each plant has its own matrix of production capabilities and its own cost structure, which
often make its product mix and level of output
unique.
The combination of abundant supplies of oil and
gas, a healthy refining industry, and expanding
markets for their products gave U.S. petrochemical
producers an advantage over foreign competitors.
They successfully exploited the low transportation
costs and economies of scale provided by this combination to keep prices low. After the sharp increases in oil prices shocked the industry in 1973,
Federal regulation of oil and gas prices helped U.s.
producers maintain their advantage of lower-cost
feedstocks.
Until recently, U.S. prices of crude oil and natural
15

Chemicals and allied products
in Texas have been outpacing
overall manufacturing output
(19&7 = 100)

230

r-----------------.....,

210
f

CHEMICALS AND
/
ALLIED PRODUCTS / '

190

/
•

••

170

,I
l

,•

,,.

•

110

"
90

.-.'

;"''vI '

t .. I

••

gas liquids were held below the world level by price
controls. In 1980, for example, U.S. refiners paid an
average composite price of $28.02 a barrel for crude
oil. The cost of domestic oil was held to $24.23,
compared with an average price of $33.89 for imported oil. Thus, for U.S. refiners and petrochemical
producers, the cost advantage over the world price
was nearly $6 a barrel. Crude oil prices were freed
in January 1981, and by the end of that year, the
price advantage had decreased to $2.33. Petrochemical producers using natural gas liquids,
however, faced another problem. Domestic reserves
of natural gas dwindled throughout the 1970's. As a
result, manufacturers began to build plants that
were geared to process naphtha and gas oil since
they believed that crude oil, which could be imported easily, would be more plentiful than natural
gas in the years ahead. That outlook proved incorrect because the rise in drilling that began in 1975
and was spurred by the lifting of price ceilings on
some categories of natural gas has led to increased
supplies of natural gas and natural gas liquids.
I n recent years, natural gas liquids have become
cheaper than naphtha, as the production of natural
gas has increased faster than was projected just a
few years ago. With soft markets for both gasoline
and petrochemicals, the major U.S. oil companies
are now rethinking their chemical operations.
Declining gasoline production yields less naphtha
and gas oil to feed their large-scale petrochemical
plants, resulting in a substantial rise in production
costs.

Petrochemical markets becoming more cyclical
Along with the changes in feedstock supplies and
production costs, significant changes are taking
place in major petrochemical markets. One example
is plastics. Sales of these materials are apparently
becoming more cyclical as more uses are found for
them. From 1974 to 1979-the year petrochemical
output peaked-sales of plastics rose from nearly
27 billion pounds to nearly 39 billion pounds. Most
of the rise was concentrated in the four major
markets in which the share of total sales increased:
packaging, building and construction, exports, and
"other." The volume of plastics sold during the 1980
recession fell in every major market except exports.
The biggest market for plastics is packaging,
where relatively inexpensive petrochemicals have
been substituted for such natural materials as
16

Federal Reserve Bank of Dallas

DISTRIBUTION OF U.S. SALES AND CAPTIVE USE OF PLASTICS
1974
Major market

Packaging
Bu ilding/construction
Exports
Consumer/institutional
Electrical/electronic
Adhesives, inks, etc
Furn itu re/furnishings
Transportation
Industrial/machinery
Other.
TOTAL

1979

180

1974

1979

1980

Percent of total

Millions of pounds

6,720
4,327
1,585
3,168
2,524
2,150
1,791
1,725
488
2,215

10,334
7,573
3,432
3,753
3,043
2,794
1,894
1,934
517
3,443

10,003
6,424
3,670
3,553
2,453
2,387
1,646
1,605
391
3,054

25.2
16.2
5.9
11 9
94
8.1
67
6.5
1.8
83

26.7
19.6
89
9.7
7.9
7.2
4.9
50
1.2
8.9

28.4
18.3
10.4
10.1
7.0
6.8
4.7
4.6
1.0
8.7

26,693

38,717

35,186

100.0

SOURCES: Societ~ of the Plastics Industry
Federal Reserve Bank of Dallas

metals, wood, paperboard, and paper. These
substitutions will likely continue at a slow pace.
Most of the future competition for existing plastics
will be with other plastic and synthetic materials, so
increasing this market share will be harder to
achieve. Demand for packaging materials is directly
related to factory shipments and inventory accumulations, which follow the business cycle
closely. Thus, increases in the share of petrochemicals sold for packaging will make the industry
more cyclical.
The second largest market for plastics is building
and construction materials. This market is also
cyclical. For example, new housing starts fell from
2.0 million units in 1978 to 1.1 million units in 1981,
and it is estimated they may recover to 1.2 million
units this year. But that is only half the level for the
banner year of 1973.
In addition, the housing market is undergoing
significant structural change as the size of dwelling
units declines. High land and mortgage costs are
forcing builders to reduce the size of new houses.
The median size of housing units reached a peak of
1,650 square feet in 1979 and declined to 1,570
square feet in 1980. That trend will likely continue,
given the current outlook for mortgage markets and
land prices. Smaller homes require smaller quantities of such petrochemical-based products as
plastic pipe, insulated wiring, exterior wall surface
Economic Review/May 1982

to insulate and side, resins used in the production of
plywood and particle board, paint and finishes, and
nylon for carpeting.
Motor vehicle production is looked upon as a
market of significant future growth for petrochemicals, even though total consumption of
plastics by that industry is declining. The current
outlook for domestic auto production is grim. The
6.2 million cars built during the 1981 model year
constituted the smallest level of output in six years.
And current auto sales have declined to the lowest
level in 22 years. As a result, auto assemblies have
been trimmed to an annual rate of about 5 million
units, compared with a typical boom year of 10
million units.
Low auto production reduces demand for plastics
and other synthetic materials. And in order to increase fuel economy, auto producers are making
future models smaller. In 1975, for example, the
average vehicle weighed 4,000 pounds. The average
is about 3,000 pounds now and will be reduced to
less than 2,500 pounds by 1990. While smaller cars
require less material, use of more lightweight
materials, such as aluminum and plastics, also helps
achieve weight reductions. Plastics, which are currently used for decorative and nonstructural parts,
account for about 200 pounds of total vehicle
weight. By 1990, that will rise to 275 to 300 pounds,
but engineering breakthroughs could increase the
17

Basic Building-Block Chemicals
Petrochemicals are chemical materials that are
manufactured from such hydrocarbon feedstocks as
natural gas liquids, naphtha, and gas oil. They are
subclassified as "primary" petrochemical materials,
petrochemical "intermediates," and petrochemical
"products." Primary petrochemicals are produced
directly from the raw material inputs and are the basic
building blocks of downstream intermediates and
products. More than 100 industrial chemicals constitute the most important primary and intermediate
materials, and further processing yields more than
5,000 petrochemical products of commercial
significance that are used to manufacture an even
wider range of finished consumer products.
Even though the petrochemical industry is widely
diversified, with the output of most materials used as
inputs for additional processing, an analysis of the
primary petrochemical markets at the head of the processing stream gives an indication of market conditions for all petrochemicals
Because primary
petrochemicals do not enter consumer markets directly, the demand for their production is derived from the
demand for products into which they are processed.
Broadly speaking, petrochemicals are any materials
derived from petroleum hydrocarbons But for this
study, primary petrochemicals consist of olefins and
aromatics, and most of the U.S production capacity is
in Texas and Louisiana Olefins-ethylene, propylene,
and butadiene-do not exist as such in nature and are
highly reactive materials having the chemical structures of paraffin Aromatics include any compounds
that contain a benzene ring in their chemical composition. They have a pungent odor, as the name implies
The principal aromatics are benzene, xylenes, and

total further if new plastic materials are developed
to build such structural components as body frames
and motor parts. It is only with such innovations
that the share of petrochemicals used by the motor
vehicle industry will increase.

Foreign competition looms as a limit to growth
Because domestic petrochemical manufacturers
have had a competitive advantage over foreign producers in the way of cheaper feedstocks, export
sales have grown at a rapid rate. From 1975 to 1980,
18

toluene. However, toluene is used primarily in the
manufacture of high-octane gasoline rather than
chemical materials, and when the economics is right,
it is dealkylated to make benzene.
Ethylene is the giant of petrochemicals. Production
capacity in the United States reached 42 billion
pounds last year, but the recession held output to 29
billion pounds. Two-thirds of all ethylene is made from
natural gas liquids While plastics are the biggest end
use, antifreeze, synthetic fibers, and solvents are other
major consumer products using ethylene.
Propylene is a coproduct of ethylene. However, the
production capacity of propylene is half that of
ethylene, and output last year totaled nearly 15 billion
pounds Half of all propylene production ends up in
fabricated plastic products, and synthetic fibers account for another major share of output
Four-fifths of all butadiene production is used by
the rubber industry, and with automobile sales off
sharply, output decreased to 2.8 billion pounds in 1981
from 3.1 billion pounds in 1980. Production capacity
totals 4.5 billion pounds. Aside from tires and other
fabricated rubber products, a significant share of butadiene is used to make synthetic fibers.
Benzene is the leading aromatic. Production last
year was 1.6 billion gallons, although production
capacity reached 2.6 billion gallons. Benzene is used
to make polystyrene and thermosetting plastics. Of
the other aromatics, several xylenes are produced in
commercial quantities, but para-xylene dominates.
Output of para-xylene totaled 3.8 billion pounds from
a production capacity of 5.5 billion pounds. Its major
end uses are polyester fibers, plastic films, and such
fabricated items as plastic bottles.

the value of exports increased 25 percent a year,
compared with a 21-percent rate of growth in total
factory shipments and a 22-percent rate of growth
in imports. A tenth of the production of basic
petrochemicals is sold in export markets. Growth in
export sales could help offset some of the slump in
the automobile and housing markets. Shipments of
exports slowed last year to a rate of increase of
about 2 percent, and there is little likelihood they
will rebound to the average rate of growth over the
prior five years.
Federal Reserve Bank of Dallas

Stages in the Production of Petrochemical Products
OIL REFINERY
OR GAS PLANT

CONSUMING
INDUSTRIES

INTERMEDIATE MATERIALS

Basic Products

Secondary Products

......-Naturill GilS - - . . Natural
Gas
Liquids

~ Ethylene ~OIYethYlenes ~

..._

Gas Oil
Naphtha

Calal tic

Propylene

'L:"

--..-4~

High-Oclan..
Gasolin~

Polypropylene

--.....j.~

Plastics

Acrylonitrile - - - _ Polyacrylonitrile Fibers
Oxo Alcohols --.....j.~ Plastic Coatings

Pyrolysis Gasoline

.~L--f
1.

Styrene ----.....j~ Plastics, Foams
CYclOhe:.::J--ane

- - Ortho-xylene

In the short run, two factors have a substantial
influence on export sales: foreign demand and the
strength of the U.S. dollar. The economies of most
of this country's major foreign trading partners will
likely begin weak recoveries this year and outperform the U.S. economy. That should boost U.S. exports slightly, but sales may be tempered somewhat
by the strength of the dollar. Continued high interest rates in this country relative to its trading
partners would hold up the value of the dollar and
make U.S. exports comparatively expensive.

Nylons

Phenol

. . . Para-xylene - - - - - - - - -

Economic Review/May 1982

Plastics, Films

~ Buladi~n~ - - - - - - - - - - - - -. . Synthetic Rubbers

R~lormer

;

Ethylene Oxide ~ Antifreeze, Detergents
Ethylene Glycol ......--- Polyester Fibers

~
Crude Oil -

Polyvinyl Chloride

....:

Plastic Coatings
Polyester Resins

~ Polyester Fibers

In the long run, domestic chemical producers
face stronger competition in international markets.
Foreign countries producing oil and gas are beginning to build their own petrochemical industries.
Countries in the Middle East have abundant supplies
of oil. This may lead them to become major
refiners, which would provide inexpensive
feedstocks they could use to capture a significant
share of the petrochemical market. However,
transportation costs to consumer markets would add
to the cost of their products, and major buyers
19

might not rely heavily on supplies from that
politically unstable part of the world.
More serious competitive challenges come from
closer to home. The Canadians are rapidly expanding their petrochemical industry to process inexpensive gas supplies developed in the western provinces. The price advantage stems from Canada's
price controls on oil and natural gas. The buildup in
petrochemical capacity will increase the chemical
trade surplus that country has with the United
States. Last year, for example, chemical exports to
the United States totaled $3.0 billion, compared
with imports of $2.5 billion. Ethylene capacity is being increased in Alberta to 7.2 billion pounds a year
by 1985 from 1.2 billion pounds currently. The increase will directly affect most U.S. manufacturers,
particularly those in Texas and Louisiana, since
three-quarters of Canada's ethylene output is sold in
the United States. Therefore, the Canadian expansion will likely limit the growth of U.S. capacity for
some time to come.
The Canadians will hold a strong competitive
edge because the price of their supplies of natural
gas liquids is held below the world price level. It is
estimated that ethane may cost about 12 cents a
pound in Alberta in 1986, compared with more than
20 cents in the United States, according to Chemical
Week. That advantage will be offset somewhat by
traditionally higher capital and transportation costs
in Canada. Construction costs, for example, are 30
to 40 percent higher in Alberta than on the Gulf
Coast. There are also some tariffs on Canadian
products, but producers north of the border will
still be able to deliver petrochemicals to users in
this country at well below U.S. prices.
The development of oil and gas fields in Mexico
also represents another source of substantial potential competition for U.S. petrochemical producers.
And located close to the heart of the Gulf Coast
petrochemical complex, the Mexican oil company,
Pemex, may eventually be able to deliver
petrochemicals very cheaply to U.S. users. Last year,
Mexico had 64 petrochemical projects proposed,
planned, or under construction, compared with 60
projects for the United States.
Despite the rise in foreign competition, domestic
producers still retain a strong market position. The
United States remains the largest integrated market
in the world for chemicals and synthetic materials.
The domestic industry has well-developed
20

downstream processing facilities, and the current
capacity of plants and equipment gives U.S.
manufacturers the highest economies of scale. And
the industry's strong technological base enables it to
develop new higher value-added products.
Therefore, even though domestic manufacturers
face growing competition, many will be able to adjust to the coming changes in market conditions.

Federal Reserve Bank of Dallas

Full text of Review (Federal Reserve Bank of Dallas) : May 1982

FRASER