Question (11) of the Resolution requests the views of survey
participants on the following: 	
    
    (11)  The effects of prohibiting manufacturers of petroleum
          products not only from directly operating retail
          service stations, but also from franchising them or
          owning and leasing them to branded dealers
          (divestiture).


    State Government

	AG:  The Attorney General noted that, ultimately, divestiture would
make the gasoline retail market more competitive by "cleansing" that
market of inefficient retail dealers. Nevertheless, the price of
gasoline would not change significantly: 	
         
          Requiring the oil companies to divest themselves
     of their retail outlets would undo one level of the
     vertical integration of the gasoline markets in Hawaii.
     After divestiture, the oil companies would have to
     compete with one another for retail outlets.  Assuming
     the retail outlets were not organized horizontally by
     means of joint purchasing arrangements, the retail
     outlets would have to compete against one another for
     gasoline supplies.

          The procompetitive effect hoped-for, would be an
     increase in competition.  Because there are many retail
     dealers, divestiture should open up vigorous
     competition at the retail level for both gasoline
     consumers and for gasoline suppliers.

          That, however, won't change the retail price of
     gasoline much.  Increased competition will not bring
     gasoline prices down if the price is already at a
     competitive level.  The Department's ongoing
     investigation has failed to establish that the
     wholesale price of gasoline in recent years has ever
     risen substantially above competitive levels.

          Moreover, it is not clear that divestiture would
     help keep the price of gasoline from rising above a
     competitive level.

          The structure of the wholesale gasoline markets in
     Hawaii is not conducive to competition.  (1)  There are
     only two refiners in the market and only five
     significant wholesalers.  (2)  The market is dominated
     by the two refiners, Chevron and BHP.  (3)  The
     product, gasoline, is fungible.  Additives and brand
     names don't really make a difference.  (4)  The demand
     is inelastic.  A relatively small addition to the daily
     supply of gasoline would drive the retail price down
     substantially.  (5)  Entry and exit barriers are
     relatively high.  The principal barrier to entry is the
     high sunk cost of new storage relative to the storage
     capacity of the incumbent oil companies.  (6)  Price
     information is not freely available.  (7)  Production
     capacity generally exceeds demand.  And, (8) storage
     capacity generally falls short of the demand.

          The Department concluded both in its 1990 report
     and in its 1994 report that the incumbent oil companies
     possessed market power, that is, the power to increase
     the price of gasoline and to maintain it above a
     competitive level for a substantial period of time.

          Competition at the retail level would not
     necessarily force the oligopolistically organized
     wholesale level to become competitive.  One refiner
     would follow the price increase of the second since
     doing so would increase profits by increasing revenues
     without increasing costs.  The first refiner should
     maintain the existing price only if doing so would
     increase profits.  The only way the first refiner could
     increase profits by pricing below his competitor would
     be by taking enough business away from the competitor
     to increase revenues more than the cost to service the
     additional business.  But the second refiner surely
     would not tolerate the first refiner's effort and would
     promptly cancel its price increase.  Therefore, not
     following the price increase of the other refiner would
     only forego profits otherwise available.

          Since neither refiner currently can supply the
     entire consumer demand for gasoline in the Hawaii
     markets, about 25,000 barrels per day, one refiner
     would not likely mount an aggressive price war for
     market share against the other.

          Accordingly, divestiture might force a small
     decrease in the retail price of gasoline.  Ironically,
     the amount of that decrease would be less than the
     decrease that could be expected from the competition
     from company stations.  The competition from company
     stations theoretically would eliminate the wholesale
     profit from the retail price.  Divestiture, like
     divorcement would preserve the wholesale profit.
     Without substantial competition at the refiner-
     wholesale level, the decrease in the retail price that
     would flow from divestiture would have to come from
     decreases in the retail dealer's profits.  The effect
     would be to cleanse the retail market of inefficient
     retail dealers.  This increase in efficiency would be
     the primary procompetitive effect of divestiture.472 

	DBEDT:  The department reiterated its comments to questions (1) and
(7) of the Resolution that the prices of refined petroleum products are
largely determined by the market price of crude oil, while supply
arrangements and local market competition were only secondary
determinants of price.  Moreover, the department stated that "the
federal government (GAO) in its investigation found no evidence that
regulatory structures such as divestiture actually resulted in lower
gasoline prices or increased competition."473 	
	
	Gasoline Dealers
	
	HARGD:  The Association argued that divestiture would benefit
consumers, but would require additional measures to assist independents
in financing the purchase of their outlets: 	
     
     Divestiture would be the most effective method of
     providing the consumer with the best possible
     protection with respect to the petroleum marketing
     systems in operation.  It is however the most drastic
     of such methods of limiting control by petroleum
     giants, and would require some means of helping
     independents purchase their facility.  If small
     independents were not able to finance the purchase of
     their existing franchised location, divorcement would
     simply substitute multi-operation locations by firms
     large enough to meet the required financial
     requirement, yet not qualify as a petroleum jobber or
     refiner, if that is the way such a provision were
     established.

     Divestiture would allow a station owner to shop the
     market for the best price.  A problem that would arise
     is the chance of co-mingling of product from one
     delivery to another, if additives used for marketing
     under brand names were used by some and not by
     others.474 


     Jobbers
	
	HPMA:  HPMA stated its belief that consumers are best served "by
creating a competitive environment that motivates manufacturers,
jobbers, or individuals to build facilities to satisfy consumer
demand": 	
     
     A major oil company will not build a facility if there
     is a chance that their facility will be operated by an
     individual who will be motivated to buy product from
     someone else.  The franchise system, as it is set up,
     allows a manufacturer to build their proprietary
     facility, and a franchisee to operate it.  If the
     franchisee is successful, he will have the financial
     reward that is achieved with a high level of
     performance.  In most instances, the
     refiner/manufacturer has chosen to use the franchise
     system because they feel that the franchisee does a
     better job than the franchise as a director operator.
     However, it is their choice whether to franchise the
     facility or operate it directly themselves.  For
     example, the McDonald Corporation, the premier
     franchiser in the world, chooses to franchise certain
     facilities and to directly operate other facilities.
     They believe this is in the best interest of their
     company and the consumer.  The manufacturer should have
     that choice and government should not be allowed to
     take that choice away.475 
	
	Aloha Petroleum:  Aloha Petroleum argued that divestiture was
anticompetitive and would drive up the costs of the distribution
network, making it more difficult for undercapitalized dealers to start
or operate a business: 	
     
     Total divestiture as contemplated in this question is
     anti-competitive.  Prohibiting manufacturers of
     petroleum products from franchising, owning, or leasing
     gasoline stations to branded dealers would force the
     overall cost of the distribution network to increase
     and would make it more difficult for undercapitalized
     dealers to establish and operate their businesses.
     Branded dealers have benefited from the financial
     support of their suppliers.  In several other states,
     legislation has been enacted that prohibits
     manufacturers from directly operating retail gasoline
     stations.  If legislation of this sort is contemplated,
     jobbers should be excluded from its application since
     jobbers do not have the advantage of producing
     petroleum products and are dependent on refiners.476 


     Oil Companies

	Shell:  Shell stated that divestiture would be harmful to consumers
by resulting in less retail competition, increased prices, and fewer
consumer services: 	
          
          A prohibition on investment in retail operations
     by an entire class of competitors -- the suppliers who
     have the greatest interest in the efficient
     distribution of the products they manufacture -- would
     be virtually certain to lessen competition at the
     retail level, resulting in higher prices and less
     services for consumers....477 

          If ownership of retail service stations by persons
     other than suppliers were economically advantageous,
     one would expect such ownership to be a widespread
     phenomenon.  On the contrary, however, only a small
     percentage of retail service station dealers either own
     their stations or lease them from someone other than
     their supplier.  The reasons for this include the
     availability of relatively advantageous lease terms
     from gasoline suppliers and the difficulty and cost of
     environmental management.478 

	BHP:  BHP stated that divestiture raises issues relating to taking
property without just compensation and infringement of the contractual
relationship between station owner and dealer, and would lessen
competition, resulting in reduced consumer choice: 	
     
     In Hawaii's marketplace the majority of gas stations
     are owned by manufacturers of petroleum products.  A
     minority of these are operated by the manufacturers
     themselves while the rest are leased to branded dealers
     or owned by independent dealers.  Legislative
     divestiture would face some serious legal issues such
     as it amounts to a taking without just compensation in
     violation of the fifth and fourteenth amendments or
     that it infringes upon the established contractual
     relationship between the station owner and the dealer.

     Divestiture would reduce competition by eliminating an
     established competitive offering from the marketplace,
     leading to reduced consumer choice.  The decrease in
     competitive intensity would likely result in an
     increase in consumer prices and a decrease in the
     number of stations and station operating hours.  (This
     is consistent with the findings of numerous studies on
     the effects of divorcement in the Maryland market.)

     Divestiture and divorcement both serve to limit and
     restrict a select group of market participants from
     presenting their product/service offering to the
     consumer.  These discriminated against participants
     lose both their assets and consequently their ability
     to offer their product to the consumer.  Consumers lose
     in that they can expect higher prices coupled with
     fewer and diminished product/service offerings in the
     marketplace.  The winners are clearly those residual
     market participants who get to unfairly benefit from
     the diminished competitive environment.479 

	Chevron:  Chevron stated that divestiture would result in poorer
service and higher prices for Hawaii's consumers:

     A modern service station represents an investment of
     approximately $1.5 million, excluding land costs.  To
     provide such a station with the inviting appearance,
     cleanliness, convenience, and environmental safety
     demanded by consumers is a major undertaking.  Oil
     companies have the capital to make these investments
     and to provide consumers with the type of station they
     want.  If refiners are unable to make such investments,
     they will then by made by others.  But the public will
     be denied the benefits of vertical integration and of
     the oil companies' experience and  expertise.  Quality
     would deteriorate and prices would increase.480 


	Discussion
	
	Divestiture, i.e., forcing vertically integrated oil companies to
divest all or a portion of their major operations (also known as
"vertical divorcement"), has been viewed as a way to decrease market
concentration and interdependence and foster greater competition among
the oil companies.481  This section reviews some of the historical
antecedents of divestiture in the petroleum industry, and reviews
arguments for and against the vertical structure of that industry.
	
	Probably the "single greatest step" taken by the federal government
in this area was the divestiture suit brought against the Standard Oil
Company under the Sherman Antitrust Act, following the rise of that
company under the direction of John D. Rockefeller.482  Although
Standard Oil was only one of many economic empires arising in the
United States in the last half of the nineteenth century, it was
arguably the most successful and notorious.483  Through a syndicate of
thirty-three companies, Standard Oil had achieved a position of
dominance at the refining level which was subsequently protected by
integrating backwards into transportation; the company eventually was
able to effectively control the entire industry at all levels.484
	
	At the turn of the century, the Standard Oil monopoly had begun to
weaken when a combination of large new discoveries in Texas and growing
political hostility enabled new businesses to enter the market and
build themselves into integrated companies. The practices of the
Standard Oil Trust had already led many states to pass antitrust laws,
and the antitrust movement was gathering momentum at the national
level.485  Finally, in May 1911, in the landmark antitrust decision of
Standard Oil Co. v. United States, the United States Supreme Court
upheld a lower court decision finding Standard Oil in violation of the
Sherman Act and forcing it to divest itself of its constituent
companies, thereby destroying its vertically integrated structure.486
	
	In the aftermath of that decision, the larger of the companies
divested from Standard Oil proceeded to integrate by merger and
expansion.  Many of the severed companies themselves became fully
integrated and, by the 1930s, eight of them were among the twenty
largest oil companies in the country.487  Three of the divested
companies, namely, Exxon (formerly Standard of New Jersey), Mobil
(formerly Standard of New York), and Socal (formerly Standard of
California), eventually grew larger and wealthier than their parent
company.  In addition, because ownership of the new companies was
transferred to the same stockholders and because company officials had
long worked together, "the restructured companies began with a degree
of mutual cooperation and interdependence that has characterized the
relationships of the majors ever since."488  While some viewed the
vertical integration of the divested oil companies following the
break-up of Standard Oil as further evidence of the strategic (i.e.,
anticompetitive) advantages of vertical integration,489 others viewed
integration of the severed companies, as well as the reintegration of
the parent, as a way to minimize the risks inherent in the oil industry
and foster greater competition.490
	
	The attempt of the federal government to compel the vertical
divorcement of the major oil companies in the Standard Oil decision
marked a turning point in terms of legislative initiative:  "It was
from this precedent that future efforts to remold the vertical
structure of the oil industry through proposed divorcement legislation
would emerge."491  Divorcement legislation was first introduced during
the 1930s; interest in this legislation subsequently increased during
disruptions in the crude oil markets.492  Calls to dismantle the
integrated oil companies again arose out of the 1973-1974 energy
crisis.493
	
	Proponents of divestiture believe that it would encourage greater
competition in the oil industry by preventing the accumulation of
monopoly power: 	
	 
	 The basic arguments of the proponents of energy
     industry divestiture are couched in terms of enhancing
     competition.  For example, the preamble to one of the
     recent bills argues that "existing antitrust laws have
     been inadequate to maintain and restore effective
     competition in the petroleum industry."  So it is
     proposed that the laws be changed "to require the most
     expeditious and equitable separation and divestment of
     assets and interest of vertically integrated major
     petroleum companies."  Another bill is designed to
     "create competition in the petroleum industry, thereby,
     breaking the economic stranglehold of monopoly power"
     and "to prevent in advance the aggrandizement of
     monopoly power over alternative domestic sources of
     energy."494 

	On the other hand, it is argued that no oil company has the power to
establish a monopoly in gasoline retail marketing,495 and that
divestiture would inevitably lead to decreased competition within the
oil industry: 	
     
     [T]he structure of the oil industry in terms of number,
     size, and diversity of companies is a strongly pro-
     competitive factor.  Dismemberment legislation would
     create a larger total number of companies, but at each
     of the levels--producing, refining, transportation, and
     marketing--there would be the same number of companies
     as there are now, or possibly less.  Competition would
     not be increased since there is no inter-functional
     competition, only competition within like lines of
     business.  Moreover, there would be a tendency to
     eliminate the diversity of interest which together with
     low concentration ratios and ease of entry constitute
     the strongly competitive factors in the petroleum
     industry.

          Dismemberment legislation would complicate the
     ease of entry which has always characterized the
     petroleum industry.  Companies which have started in
     one function and wish to integrate into others where it
     appears more efficient to do so would be barred from
     competing in such fields. ...  If the companies
     themselves tried to create such a structure of limiting
     markets and erecting barriers to entry as is created by
     dismemberment legislation, they would be charged with a
     violation of antitrust laws.496 

	Moreover, it has been argued that divestiture would ultimately lead
to higher social costs in terms of increased costs to consumers, less
energy development, reduced technological innovation, and greater
dependence on foreign oil: 	
     
     Vertical divorcement could very well have the perverse
     effect of creating higher prices for petroleum products
     by virtue of the higher costs that would result from
     the increased production, investment, and inventory
     requirements following an adaptive response to vertical
     divorcement.  Moreover (and critically), by retarding
     technological innovation, vertical divorcement could
     stultify productivity improvements and jeopardize the
     development of new sources of energy.  In short,
     vertical divorcement offers nothing to benefit the
     American consumer or to reduce the dependence of the
     United States on the OPEC cartel.  It is more likely to
     increase product prices and increase the U.S.
     dependence on foreign oil.  If lower prices, efficient
     resource allocation, and less dependence on foreign
     supplies are the intended policy objectives, vertical
     divorcement should be abandoned as a serious policy
     alternative.497 

	Underlying question (11) of the Resolution is the assumption that such
a measure may be necessary to prevent vertically integrated oil
companies from driving independent dealers out of business.  The major
petroleum companies, it is argued, help to undercut small independent
service stations through such practices as predatory pricing and
downstream subsidization, i.e., that vertically integrated companies
are subsidizing their marketing operations to eliminate non-branded,
independent marketers from the marketplace.
	
	However, there is no evidence of predatory pricing in Hawaii's retail
gasoline markets,498 and, as noted in chapter 3, the decrease in the
number of lessee and open dealer stations and increased importance of
company-operated stations may be attributed to a number of alternative
explanations, including changes in gasoline consumption trends; the
trend toward large- volume, self-service outlets; the decline in demand
for repair and maintenance services; the growth of convenience stores;
the effects of governmental regulation; and changes in lease rents and
increasing land values.499
	
	Other factors may also contribute to a refiner's decision whether
to operate a company store or to use a lessee dealer, such as the
economics of gasoline marketing in rural areas as opposed to urban
areas.500  The United States Department of Energy (1984) noted that the
decision whether or not to operate a company store is made as part of a
broader marketing strategy.501 Vertical integration may be an important
factor where high volumes of gasoline are sold, as in self-service "gas
express" style outlets. In particular, the DOE noted that based on the
economics of vertical integration, owning and operating high- volume
outlets may in some cases be more efficient and yield greater economies
than traditional dealer outlets: 	
     
     [T]he managerial economies that affect the choice of
     using a dealer versus an employee to operate an outlet
     have been stressed.  There is an additional explanation
     based solely on the economics of vertical integration
     in the absence of such economies.  There is some
     irreducible minimum amount of labor and capital
     required to operate an outlet.  At relatively low
     volumes, the input factors are used effectively in
     fixed proportions.  When this is the case, there is no
     efficiency motive to integrate fully by both owning and
     operating the outlet.  At larger volumes, however, the
     ratio of factor inputs can be varied to achieve greater
     economies.  It appears that the cost-minimizing ratio
     of capital to labor input increases with volume.  This
     is particularly clear when the labor quality is held
     constant.  For example, the income necessary to retain
     a dealer-entrepreneur-mechanic at a location is
     substantially greater than the income required to
     retain a low-skill, part time, minimum wage employee.
     The dealer-entrepreneur tends to have greater
     difficulty in varying the quantity of quality-constant
     labor input because the dealer's high-quality labor
     input is difficult to subdivide.... [H]owever, if a
     dealer may operate more than one high-volume outlet,
     this difficulty can be reduced.  In summary, the
     traditional dealer-entrepreneur is less able to take
     advantage of efficiencies that can be obtained at
     higher volumes by varying the ratio of quality-constant
     input factors.  This stems from the relative fixity of
     the traditional dealer's own labor input.502 

	Therefore, it may be argued, divestiture legislation would result in
greater inefficiency and run counter to consumer preferences by
favoring traditional dealer outlets over more efficient high- volume
outlets.
	
	

		Endnotes	Chapter 13 Table of Contents