Costs of Cargo Preference

Published by the Government Accountability Office on 1977-09-09.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                         DCCUMENT RESUME

03669 -   A2573714]

Costs of Cargo Preference. PAD-77-82;   B-95832. September 9,
1977. 43 pp.   appendix (1 pp.).

Deport to Rep. John M. Murphy,   Chairman, House Committee on
Merchant Marine and Fisheries;   by Elmer B. Stuats, Comptroller

  (3600);   ransportation Systems and Policies (2400).
Contact: Prcgram Analysis Div.
Budget Function: Commerce and    ransportation: Water
     Transportation (406).
Organizaticn Concerned: Department of Commerce.
Congressional Relevance: House Committee on Merchant Marine and
Authority:    .R. 1037 (95th Cong.). H.R. 8193 (93rd Cong.).

          The current version of cargo preference legislation
would require 9.5w of imported oil to be carried in U.S.-flag
ships.   itnesses before the House Committee on Merchant Marine
and Fisheries presented estimates of the difference in costs
between carrying imported oil on U.S. ships protected by
cargo-preference legislation and the cost of carrying oil on
 foreign-flag ships.  Findings/Conclusions: EstiIates of the
transportation cost differential ranged from 1.2 cents per
gallcn to 2.8 cents per gallon. The Maritime Administration
estimate was 1.6 cents per gallon. The differences in estimates
were due primarily to disagreement oer the capital cost
differential between building ships in the United States and
obtaining tem in wor2d markets. Estimates of costs to consumers
for all imported oil ranged from 0.1 cents per gallon to 1.0
cents per gallon- Because of the wide dispersion in estimates,
GAO made its own estimates using a   iwple average of operating
cost differentials which is about one-fourth of the total
differential. A range for capital cost differentials, the major
source of variation, was estimated on the basis of different
assumptions about world tanker prices. No firm conclusion was
reached on possible costs of retaliation by other countries,
since it could take forms other than adding to price. A
reasonable range cf cost estimates would be from about 0.15
cents to 0.23 cents per gallon of imported oil. (HTW)
''" '     REPORT OF THE

         Costs Of Cargo Preference

         GAO has assessed the Ltimates of the costs of
         cargo preference legislation that were sub-
         mitted to the House Committee on Merchant
         Marine and Fisheries. GAO's own estimates of
         these costs are preser.:ed.

        PAD-77-82                                        SEPTEMBER 9, 1977
                            WASHINGTON. D.C.   20541


The Honorable John M. Murphy
Chairman, Committee on Merchant
  Marine and Fisheries
House of Representatives

Dear Mr.   Chairman:

      Pursuant to your request of March 4, 1977, we have
prepared an independent assessment of thet cost estimates
presented to your office in connection with B.R. 1037,
a cargo preference bill.   On July 29, 1977, we sent you a
letter which presented our basic findings and our own cost
estimates.   Our final report presents these same cost
estimates and a more detailed review f the methodology
used by our staff end by the witnesses who presented
estimi tes to your office.

     Because of time constraints, we have not asked for
comments on this report by any of those whose estimates we

      As agreed with your office, this report is being re-
l2.-aed immediately.

                                      Sincerely yours,

                                      Comptroller General
                                      of the United States


               GAO has assessed the estimates of the costs
               of cargo preference legislation that were
               submitted to the House Committee n Merchant
               Marine and Fisheries. Because these estimates
               varied widely, GAO made its own estimates.

              The current version of the legislation would
              require 9.5 percent of imported oil to be
              carried in U.S.-flag ships. In this report,
              most figures in the text apply to 9.5 percent
              cargo preference. A preliminary report
              (PAD-77-74, July 29, 1977) stated figures
              for both 9.5 percent and the 30 percent
              cargo preference that had been proposed in
              an earlier version of the legislation. The
              two report are consistent, but the reader
              should be aware of that difference.

              All1 of the witnesses presented estimates of
              the transportation cost differential, which
              is the difference between the cost of carry-
              ing imported oil on U.S. ships protected
              by cargo-preference legislation and the cost
              of carrying oil on fcreign-flag ships. GAO
              put these estimates on a common footing by
              expressing them in a common unit of
              measurement--cents per gallon of oil in
              1977 rrices. This translation required re-
              moval of the various inflation factors
              that some witnesses had used in their
              estimates and the deflation of vessel values
              that had been stated in dollars of differ-
              ent years. GAO also presents the cost figures
              in dollars per year.

             The estimates of the transportation cost
             differential for ol car:ied in cargo-
             preference ships range from 1.2 cents per
             gallon (Marine Engineers' Beneficial Associa-
             tion) to 2.8 cents per gllon (Federation of
             American Controlled hipping)--a high-to-lo-

TsarLheet. Upon removal, he reporti
cover date should be nnied hereon.                      PAD-77-82
range of more than 2:1.  The Maritime
istration estimate given in testimony, Admin-
justed for comparability, is 1.6 cents per
gallon. The differences in there estimates
are due primarily to disagreement over the
capital cost differential--the cost of build-
ing new ship; in the United States and ob-
taining ships (new and existing) in world

The disagreement amcng witnesses was, how-
ever, far greater than this.   Costs to con-
sumers would eventually be reflected in the
price of oil, which is affected by oil trans-
port costs and other factors. When the cost
est:mates we.e expressed in cents per gallon
of aEli imported oil, they range from 0.1 cents
per gallon (Marine Engineers' Beneficial Asso-
ciation) to 1.0 cents per gallon (American
Petioleum Institute)--a high-to-low range of
10:'..  (These figures reflect adjustments by
GAO to 1977 prices.)

The ircreased dispersion in these estimates
is the result of the witnesses' varying
analyses t this point:

-- The witnesses who presented the hglest
   figures assert that the transport price
   would increase by considerably more than
   transport cost. That is, because of cargo
   preference, U.S. ships would be much in
   demand and, it is assumed, they could
   receive returns far in excess f normal
   profit levels.

-- These witnesses also assert that there
   would be costs due to retaliation by
   foreigners whose economic interests are
   harmed by the legislation. These witnesses
   expect the retaliation to result in sub-
   stantially higher prices of foreign-flag
   petroleum carriage.


Because of the wide dispersion in the wit-
nesses' estimates, GAO estimated the cost
of cargo perference.  The method of analysis
is summarized below.

            Operating cost differential

            Because there.was substantial agreement
            among the witne, ses on operating cost dif',er-
            enltial, GAO used a simple average of these
            estimates. The perating cost differential
            is roughly one-fuurth of the total differen-
            tial, the capital cost differential   cccunting
            for the balance.

            Capital cost-differential

            This was the major source of variation in
            the estimates of the cost differential.   It
            is understandable that the estimates should
            vary, because it is difficult to predict
            capital costs due to the present tanker glut
            and the uncertain prospects of recovery by
            any given date. GAO therefore estimated a
            range for the capital cost differentials,
            on the  1sis of different assumptions about
            world tanker prices and, thus, foreign-flag
            capital cost. GAO believes that it has
            improved upon the techniques of capital cost
            estimation provided by the witnesses.


            GAO assumed that regulation of some form would
            prevent excess pr'fits on cargo preference
            shipping.   H.R. 037 would give the Secretary
            of Commerce authority to wive the reqlirerent
            of shipment on U.S.-flag tankers if the rates
            are not "fair and reasonable.") GAO believes
            that regulatory efforts to reduce excess pro-
            fits will encounter substantial difficulties.
            GAO assumed, however, a 10-percent markup on
            U.S.-flag transport costs as virtually un-


            GAO reached no frm conclusion on the pos-
            sible costs of retaliation by other coun-
            tries. Although retaliation might occur, it
            could take different forms other than adding
            to the price of oil. GAO therefore did not
            include such a cost in its estimates of the
            cost of cargo preference to oil consumers.

IUL.~flU.                       iii
Based upon these nd other assumptions, GAO
concluded that a reasonable range oI cost
estimates would be from about 0.15 cents
to 0.23 cents per gallon of imported oil.

To estimate annual costs, it is necessary
to estimate how much oil will be imported
in 1985. Eight million barrels per day was
a figure used in some of the testimony, and
this figure is probably on the low side.
A recent GAO report entitled "An Evaluation
of the National Energy Plan" (EMD-77-48,
July 25, 1977) conc'udes that, even with the
National Energy Plan, imports of 10.3 mil-
lion barrels a day in 1988 is a more plaus-
ible estimate.  If the level of imports
is higher, more oil would have to be carried
in cargo-preference vessels, and the total
costs would be hgher.

For imports of 8 million barrels per day,
each 1-cent increase in price per gallon
means $1.23 billion annually. Therefore,
GAO's midrange estimate of 0.2 cents per
gallon translates into about $240 million
annually. For imports of 10.3 million
barrels per day, GAO's midrange cost figure
would be about $300 million annually.

Besides these additional transport fees, the
American consumer probably faces an increase
in the price of domestically produced oil,
as the price of this oil adjusts to the change
in the world market prico. A full adjust-
ment of domestic prices would cost consumers
an additional $310 million, in our midrange
estimate, if rJ.S. oil production reaches 10.5
million barrels per day as estimated for the
National Energy Plan by the GAO report re-
ferred to earlier. Some of this increase
could be suppressed by price control, at
least in the shortrun, or recovered by well-
head taxes.

Because of time constraints, we did not obtain
comments on this report from any of those
whose estimates we reviewed.

                        C o n t en t s

DIGEST                                                     i

   1      INTRODUCTION                                  1
              Scope of review                           1
              Comparability of estimates               3
              Cost and price differential concepts
                and the importance of market
                factors                                7
              Estimates of cost and prics differen-
                tials                                  7
              Transport cost differential             11
              Transport. price differential: market
                conditions in the U.S.- and
                foreig.-flag tanker markets           18
              Import price differential
            DIFFERENTIAL                              25
              Operating cost differential             25
              Capital cost concept                    25
              Tanker price estimates                  27
              Transport cost, transport price,
                and import price estimates            30
              The cost of possible retaliation        32
            PEREFERENCE                               36
             Impact on the price of domestic
               tanker services                        36
             Impact on the price of alternative
               energy sources                         37
             Impact on employment
             Impact on inflation
             Impact on the balance of payments        39
             Effects on the price of oil produced
               domestically                           40
             Higher price of domestic oil             41
             Price controls on the domestic
               petroleum price                        41
             Wellhead taxes                           42

      I    Letter dated March 4, 1977, rom the
             Chairman of the House Committee on
             Merchant Marine and Fisheries              44

             ADJUSTED FOR COMPARABILITY                     5
             OF 9.5 AND 30 PERCENT                      9
             COMPARABILITY                             10
             WITNESSES                                 13
             CONSTRUCTION COSTS, IN 1977 DOLLARS       29
             OF CAPTIAL AND ECONOMIC LIFE              31

           PRICE DIFFERENTIALS                        33
           ERENCE LEVELS, 1985                        34
          EMPLOYMENT LEVELS                           38


AMA      American Maritime Associaticn

API      American Petroleum Institute
CDS      construction differential subsidy

DWT      dead weight tons

FACS     Federation of American-Controlled Shipping
MarAd    U.S. Maritime Administration

MEBA     Marine Engineers Beneficial Association

MDWT     thousand dead weight tons
MMB/D    million barrels a day

SCA      Shipbuilders Council on America

ULCC     ultra large crude carriers

VLCC     very large crude carriers
                          CHAPTER 1


     Legislation which would reserve a portion of U.S. petro-
leum imports for carriage by tankships under U.S. registry
(cargo preference or cargo reservation) has been reported
out of the House Committee on Merchant Marine and Fisheries
as H.R. 1037. Witnesses that have testified before the Com-
mittee on H.R. 1037 agreed that U.S. shipping has substan-
tially higher operating and capital costs than its foreign

     Proponents of cargo preference do not dispute this.
Thei contention is that (1) the extra cost of cargo prefer-
ence to the consumer is small and (2) the national security,
environmental, employment, and distressed industry benefits
of fostering the U.S. tanker industry by Government interven-
tion are worth the extra cosL.  Opponents of the legislation'
dispute these two points.


     The Chairman of the House Committee on Merchant Marine and
Fisheries requested us to make an independent assessment of
the cost estimate f cargo preference to the consumer which
was presented in testimony to the Committee during May-August
1977. Our assessment is based partly on data (1) provided
by the witnesses and (2) from other sources. Also provided
dre our estimates of the cost of cargo preferences to the

     This report does not address the potential national
security or environmental impacts of the legislation.  Thus,
no recommendation is made as to ultimate cost effectiveness
of the proposed legislation.

     According to the original version of H.R. 1037, the
level of cargo preference wa3 to reach 30 percent in 1980.
Virtually all of the testimony received during hearings and
in statements prepared for the record consequently referred
to cargo preference at the 30-percent level.  Subsequently
an amendmert was adopted that changed the maximum percentage
of cargo preference from 30 percent to 9.5 percent.

     In chapter 2 the testimony on the cost of cargo prefer-
ence at both the 9.5 and 30 percent levels is analyzed. In
chapter 3 our estimates of the cost of cargo preference are
presented for both the 9.5-percent and the 30-percent levels.

Chapter 4 addresses some of the other economic effects
cargo preference.                                      of

     The witnesses who testified concerning the cost of cargo
preference and whose estimates are analyzed ill this report
are the following:

     -- American Maritime Association (AMA).

     -- American Petroleum Institute (API).

     -- Federation of American-Controlled Shipping (FACS).

     -- Marine Engineers Beneficial Association (MEBA).

     -- Mobil Oil Corporation.

     -- Shipbuilders Council on America (SCA).

     -- U.S. Maritime Administration (MarAM).

     This report was requested and prepared within a short
period o time.   Thus, it does not include comments from
MarAd or from the other  itnesses.

                             CHAPTER 2
     There is substantial agreement on the size of the operat-
ing cost differential between U.S.- and foreign-flag tankers,
when these are considered for each vessel size. 1/ There are,
hcwever, substantial differences in capital cost estimates
even when individual vssel sizes are taken into account.
These differences in capital cost estimates result in esti-
mates of the cost of cargo preference that lso differ widely.
At the 30-percent level of cargo preference, which most of
the testimony was directed to, the estimates of the import
price differential in 1985 differ by $3.1 and $4.6 billion
at oil import levels of 8 and 12 million barrels per day,
respectively. (These figures are presented in constant 1977
     At the 9.5-percent level of cargo preference specified
in the amended version of H.R. 1037, the difference between
the low- and high-co.t estimates is $1.1 and $1.7 billion at
the two import levels. Given differences of this magnitude,
we constructed a set of our estimates of the costs of cargo
preference. These will be presented in chapter 3.

     The original cost estimates are not comparable with each
other, since transport costs, or its operating-and capital
cost components, are often expressed in monetary values for
different base years. We have adjusted the estimates and
expressed them in 1977 dollars to make the cost estimates

1/It wasn't quite unanimous, however.  One argument presented
  at the Hearings before the Subcommittee on Merchant Marine
  during the 93d Congress on H.R. 8193 by Stanley Ritterburg
  did suggest that American-flag cargo preference tanker rates
  would be below foreign-flag tanker rates existing prior to
  cargo preference, because the regulations accompanying cargo
  preference would force the large petroleum companies to
  disclose what they charge for ocean petroleum carriage.
  Furthermore, a test of "fair and reasonable," if applied
  to the shipping charges would, according to his argument,
  result in a reduction f the charges, however, this argument
  is not considered germane to the subject of this report,
  since both disclosure of oil company shipping charges and
  the imposition of price con'rols to force these charges to
  conform more closely to costs could be done without refer-
  ence to cargo preference. Cargo preference, for its part,
  could also be carried out without price controls.

comparable. We have also recalculated all of the original
estimates that asrume a cargo preference rate of 30 percent
and converted them .o a 9.5-percent rate of cargo preference.
In each case, the methodology of the witness was follc--oed.
(See table 1.)

     Different assumptions have been made by the various
witnesses as to the years in which new purchases are to be
valued.  This is particularly important in the case of newly
purchased VLCCs, which in all analyses are assumed to carry
the'bulk of preference oil.   In this case, new ship purchases
have been valued in the dollars of a wide isparity of base
years (see table 1, column 3).   Of the six witnesses covered
in table 2 only two (Mobil and MEBA) value 1985 capital costs
in the same year's dollars as operating costs,   Two others use
book values for new VLCCs (API and FACS), but because differ-
ent amounts of ship construction are projected by the two wit-
nesses to take place in the various years before 1985, even
these values are not completely comparable.   Fc, .MA, 1985
operating costs are expressed in 1985 dollars a&- the 1985
capital costs of new VLCCs are expressed in 1978 dollars.
For MarAd, however, 1985 operating costs are expressed in 1976
dollars and 1985 capital costs of new VLCCs are expressed in
1981 dollars.  (VLCCs are expected by MarAd and all other
witnesses to carry the vast bulk of preference oil in 1985.) 1/

     The use of different base years for capital costs impedes
comparability. Since subsequent analysis will show that capi-
tal cost is the crucial elemient in determining the cost of
cargo preference, we have therefore chosen to deflate all
capital costs consistently so that, to the extent possible,
they are all expressed in the same 1977 dollars as operating
costs. This procedure results in the adjusted estimates of
table 1, column 5.

     It should be noted that, after adjustment to produce
consistent capital valuation, the estimates of transport cost
for the 30-percent and the 9.5-percent preference levels are
the same. Thus, the adjusted estimates of table 1, column 5
are valid, given the witnesses methodology and the adjustment
technique, for all levels of cargo preference.  This occurs
because the only factor that caused a difference in the
original estimates for the different preference levels was
the inconsistent valuation of ships purchased in different

1/MEBA does not independently determine a vessel mix.  For
  its calculations of transport cost, it uses 100 percent
  90 MDWT vessels, but elsewhere in its statement, it regaros
  a mix of vessel sizes as likely.


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     The focus of the remainder of this chapter will be on
the testimony received on three cost or price differentials
due to cargo preference:

     1.   The additional cost of carrying oil on American-flag
          rather than foreign-flag tankers ("the transport cost
          differential per gallon of preference oil.")

     2.   The additional price charged by American-flag tankers
          over that charged by foreign-flag tankers ("the
          transport price differential per gallon of preference

     3.   The additional price  f imported oil due to the ship-
          ment of a fraction of imports on American-flag tankers
          at a given level of cargo preference ("the import
          price differential per gallon of imported oil.")

     Chapter 4 below discusses another type of cost.

     1.   The additional price of oil consumed in the United
           States ("the consumption price differential" or the
          A'cost of cargo preference to the consumer.")

     Since market factors are involved in each of these con-
cepts, no simple change f base can translate the transport
cost differential into an estimate of the cost to the con-
sumer.   Except under specific circumstances, costs do not
completely determine prices, the latter being determined by
the interplay of the forces of supply and demand in markets.
Important market factors that will be evaluated in the course
of this chapter and the next are (1) the depression of foreign
tnaker rates below cost, (2) the possible excess profits of
U.S.-flag operators that could result from various regulatory
scenarios, (3) a possible change in foreign-flag rates due to
retaliation or emulation, and (4) the reaction of the price
of donmestically produced oil to a change in the price of im-
ported oil.


     Tables 2 and 3 present the adjusted cost and price esti-
mates given by witnesses at the hearings or in backup docu-
ments. All estimates have been adjusted to achieve compara-
bility.  The estimates of the 1985 transport cost differen-
tial varied widely, with the highest (2.8 cents per gallon)

being more than double the lowest
For 9.5 percent cargo preference,  (1.2 cents per gallon).
                                  this range translates into
a $190 million range in estimated
of 8 million barrels of oil       annual costs for imports
                            per day, and a $280 million
if imports are 12 million barrels                        range
                                  of oil per day.
      The divergence between the
 nesses as to the transport price estimates of the various wit-
 than the divergence between        differential is even wider
                              their estimates of the transport
 cost differential (see table
                               2, column 2).   Of the six wit-
 nesses, three, API, FACS, and
                                MEBA, attempted to account for
market factors.   The others ignored them and
 cost and transport price differentials.        equated transport
tion of market factors, the                 After the incorpora-
                             range of transport price differen-
tial estimates widens with the
                                 highest, 5.2 cents per gallon
of preference oil, being more
                                than five times the lowest,
1.0 cents per gallon.   In total 1977 dollar value,
rate of cargo preference is                           if the
the rate of 8 million barrels9.5 percent and imports are at
1985 transport bill estimates per day, the difference in the
                                is on the order of $490 million.
If imports are at the rate of
                                12 million barrels per day, the
difference in the estimates
                             is on the order of $730 million.
                                        TABL    2
        Summar of Testimonv on Transport
             bv Cro                      Cost and Price Differentials
                      Preference-in 985,     osted forComparabi.,l    (note a:
                             Transport cost      Transport price
                              differential         differential
                witness         (note b)             (notec)
                                   (1977 dollars; cents per gallon)
               PACS                     2.8
               API                                             5.2
                 oAPi                   2.5                    4.7
                  (note d)             2.0
               AMA                                             2.0
                                       1 6                     1.6
               MarAd I                 1.6
               :arAd I                                         1.6
                                       1.3                     1.3
               MEBA                    1.2                     1.0
        I/Estimates presented in this
           testimony presented 1985 estimates are adjusted estimates. Original
           years.    For comparability, the originalthe values of various base
           table , column 1) were adjusted                estimates (presented in
                                                 so that the values are expressed
           in the dollars of a common
                                         base year (1977), according
          preferred deflation technique                                   to the
          costs are expressed in 1977       described in the text in which
          ential estimates in column dollars. The transport cost differ-
                                         1 are taken from table 1, column
        O/Basic transport cost differential,
                                                    i:,cluding, in the case of the
          API and FACS rnalyses, estimated
          premium') due to scheduling            cost increments ("inflexibility
                                          and other inefficiencies expected
          these analyses to result from                                            by
                                            the implementation of cargo
          ence.    The transport cost differential                           prefer-
          are taken from table i. column                estimates  in this  column
       c/Includes market factors,
                                      where these are considered by
         analyses, in the market for                                     the
                                         U.S.-fl&g tanker services.
       d/The estimates of Mobil are
         methodology, it is unlikely formally for 1981 but, given the
                                         that they would differ materially
         for 1985 once inflation is
                                        taken into account,
       Source:    Unadjusted baser data token
                  Subcommittee on Merchant Marine, testimony before the
                  sentatives, 1977 (exception            U.S. House of Repre-
                                                  noted in footnote on
                  P. 4.)

                            TABLE- 3

           Summary-of Testimony-on-the-ImportPrice
           Differential at Cargo-Preference Rates-of
                      9;5 and-30-Percent

               (1)           (2)           (3)             (4)

               9.5 percent cargo               30 percent cargo
            -- reference- (note-a) -     ---      preference   ------
            Allocated                   Allocated
            transport                   transport
            price dif-   Import price   price dif- Import price
            ferential    differential   ferential differential
Witness     (note-b)       (note-c)     (note-b)     (note-c)

                     (1977 dollars; cents per gallon)-

FACS           .?9            .94         1.6              2.4
API            .45           1.00         1.4              2.9
Mobil          .19            .19        d/.60            d/.60
AMA            .15            .15          .48              .48
MarAd II       .15            .15         N/A              N/A
MarAd I        .12            .12           .39             .39
MEBA           .10            .10         N/A              N/A

a/Except for MarAd II and MEBA, all other analyses were for
  30-percent cargo preference. The original unadjusted testi-
  mony on transport cost in a number of the analyses did
  depend on the'level of cargo preference because lower book-
  valued ships make up a larger proportion of the U.S. Fleet
  at 9.5 percent than at 30 percent (see table 1, note a).
  However, when capital is consistently valued in 1977 dol-
  lars, the resulting adjusted estimates of transport cost and
  transport price are scalable. This is not true for the im-
  port price differential, however, for those analyses (FACS
  and API) that see a change in foreign-flag prices. Here we
  have the import price differential for 9.5-percent cargo
  preference using he witnesses' methodology.

b/Columns 1 and 3 are obtained by multiplying the numbers from
  table 2, column 2 by 9.5 and 30 percent respectively.

c/Where columns 2 and 4 diffeL from columns 1 and 3, they in-
  corporate the impact of pricing reactions of foreign-flag
  operators that certain witnesses assert will be caused by
  cargo preference.

d/Mobil's original testimony referred to a cargo preference
  rate of 15 percent, but backup papers provided to us give
  the following equivalence, "15% Cargo Preference Proforma
  Basis = Approximately 30% Ton Mile Basis," which is the
  approach of all other witnesses.

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                                                                                                                       I0                        0                                 "-.
      Some witnesses indicated that the transport
 by foreign-flag tankers would change in response price charged
                                                     to a U.S.
 imposition of cargo preference.   Their analyses took into
 account the effect of retaliatory and emulative
                                                   behavior of
 foreign-flag tanker fleets servicing the U.S. market.
 example of such behavior, oil-exporting countries          As an
 U.S. cargo preference by imposing their own unilateral match
 preference arrangements specifying that a certain          cargo
 of their exports to the United States be carried
 of their own national registry. Such emulative on tankers
                                                   behavior might
 extend to price as well, with the exporting country
charging rates equal to U.S. rates. For 9.5-percent
preference, the increased rates of foreign-flag          cargo
included in the import price diffe' ntial, further tankers,   when
spread between the highest estimate                    widens  the
                                       e.g., 1.0 cent per gallon
of total imports, and the lowest 0.10 cent per gallon
                                                          of total
imports.   The highest estimate is ncw ten times the lowest.
The figures for each witness and the corresponding
for 3 0-percent cargo preference are given in table
total 1977 dollar value, with imports at the rate 3. In
                                                      Df 8 million
barrels per day and cargo preference at 9.5 percent,
ference in the estimates of increased import cost        the dif-
                                                     is about
$1.1 billion; at the import rate of 12
day, the difference in the estimates of million  barrels per
                                          increased import
cost is $1.7 billion.


     The reasons for the divergence in the various witnesses'
estimates of the transport cost differential become apparent
when their estimates are disaggregated by cost
                                               component and
by ship size (see table 4). 1/

     The operating cost differential (mainly wages) is
tant, relative to the capital cost differential,        impor-
                                                  only for the
smallest tonnage category f the projected fleets.
larger ship sizes, the capital cost differential     For the
nant. All parties agree that the small-tonnage    becomes  domi-
                                                 segment of the
fleet will be quantitatively unimportant in moving
into this country in 1985, and that the primary     oil imports
crude oil imports will be the                    source or
                              Persian Gulf and West Africa. 2/

1/In all analyses, the witnesses assumed that
  for the foreign flagships and U.S. flagships the fleet mixes
                                                would be the
2/The prospects of the new Mexican find in the Yucatan
  unfortunately, unevaluated in all analyses.

 For transport from these distant sources,
 tankers (very large crude carriers of 200 cnly  the larger
 weight tons and ultra large carriers above to 300 thousand dead-
                                             300 thousand dead-
 weight tons (ULCC)) are economic. Therefore,
 projected in all analyses 1/ (table 5) are     the vessel mixes
 weighted toward VLCCs, and the average transport
 marily a reflection of the VLCC transport-cost    cost is pri-
      Just how dominant the capital-cost differential
 transport cost differential can be calculated         is in the
 table 4. This calculation shows that the average    the data in
 differential as a percentage of the average        capital-cost
                                             total transport-
 cost differential ranges frDm 4 percent to
                                             87 percent for the
 different analyses (not including MERA's 2/).

     Besides being the dominant element in the cost
tial, capital cost is also the major source          differen-
                                            of disagreement
in the estimates. The range of the capital-cost
estimates, which are averages over the             ifferential
                                       projected fleet in
each case, is from $9.33 per DWT of fleet capacity
per ton (table 4).                                  to $55.41

     Since the witnesses basically agree on the
will carry petroleum imports in 1985, as is      fleet mix that
larity of the fleet mixes used (table 5) 3/, shown by the simi-
                                              estimated capital
cost differentials of the magnitude indicated
from two sources:                              arise primarily
                    (1) different valuation of U.S.-flag and
foreign-flag vessels, especially VLCCs, and
                                             (2) different

I/Except for MEBA, which for an Luexi:lained
                                             reason uses only
  90 MDWT in its comparative cost analysis.
                                              Elsewhere in its
  statement uses a vessel mix of 21 percent
  cent (90 MWDT) and 27 percent (225 MDWT).  (30 MDWT), 52 per-
                                              These percentages
  refer to numbers of ships.  When converted to percentages
  of tonnage in each tonnage class, the percentages
  5.5 percent (30 MDWT), 41.4 percent (90 MDWT),      are:
  cent (225 MDWT).                                and  53.3 per-

2/Except again for MEBA, which derives its
                                           low capital cost
  differential using questionable methodology.
                                                 This involves
  using the period of amortization for tax purposes
  measure of the economic life of the vessel.         as a
                                                In the case
  of U.S.-flag vessels it uses a period of 20
                                               years.   In the
  case of foreign-t1ag vessels, the period used
  This results in a higher capital consumption   is 7  years.
  flag vessels than for U.S.-flag ones.         for foreign-

3/See footnote   above.

                                              TABLE 5
                    Vessel Mix; Import Level, Average Vessel Size,
                    Average Num er o Voyages   anc Averaqe Lav own
                               Assomptions of Witnesses
Vessel mix          FACS      API     Mobil        AMA       MarAd I   MarAd I   MEBA         SCA
Tonnage class

                                 (Percent of tonnage in each tonnage class)--
  0-75                8.0      4.5      -          10.9        4.6       12.5      -           3.9
 75-200             21.0      21.9      -          24.7        9.8       25.9    100.0       a/9.3
200+                71.0      73.6    100.0        64.4       85.6       61.6               b86.8
    Total           100.0     100.0   100.0       100.0      100.0      100.0    1o0.0       100
 import level

(MMB/D) (note c)     11.0       9.7     8.6         9.5      d/7.55     d/7.53     8.0        10.0
 Average vessel

(MDWT) (note e)       143       139         275        140      170        113         90      194
 Average no. of
vovaoes per annum     6.7       7.4     10.3           8.1      8.9        8.0     5.5         7.0
Average laydown
  per annum
  (note f)

    (MT)             958      1,029    2,833       1,134      1,513        904     492       1,358
I/See footnote f.

b/We have included SCA's 188 WDT vessel category, an unusual ship size in our 200+
  MDWT category as well as its 265 MDWT and 390 MDw vessel categories. Actually,
  none of the other witnesses except SCA specify vessel sizes between 120 MDWT and
  200 MDWT. Since SCA   s not included in table 4, we have avoided altering our
  vessel size categc ies just to accomodate SCA's 188,000 tonner, which in any
  case, would seem to fit naturally in the topmost vessel category.

c/Million barrels per day.
d/7.55 and 7.53 MMB/D scenarios. MarAd used a 8 MMB/D total imports figure which
  included .45 anu .47 MMB/D, respectively, overland from Canada for the two

 /Thousand deadweight tons.

f/Average amount of petroleum delivezed in a year, long tons per annum.

translations of these valuations into annial capical cost.
Tables 6 and 7 give data on the VLCC valuations by the dif-
ferent witnesses and on the annual capital cost factors they
use, respectively.

     Some of the wide disparities in the valuation of VLCCs,
particularly foreign ones, which are shown in table 6, arise
from divergent price data. For example, MarAd expects ew
VLCCs constructed in U.S. shipyards (1981 delivery) to cost
$119.6 million in 1981 dollars, while Mobil expects them to
cost $139 million. Most of the disagreement, however, comes
from the use of an inappropriate methodology in valuing

      In the economic heory of capital valuation, the value
of an asset is the present expected value of its future earn-
ing stream (including its ult 4 mate return as scrap), dis-
counted at the opportunity cost of capital available to the
firm. Economic depreciation in a given year is the
betweer. the expected present value at the beginning difference
                                                      and at the
end of the year. Annual capital cost is the sum of deprecia-
tion and te return that would have been earned at the oppor-
tunity rate if an alternative investment at that rate had been
     The analyses presented at the Subcommittee hearings were
not always based on this definition. Manywitnesses presented
capital cost estimates based on accounting book value, that
is, on the purchase price of vessels expressed in dollars of
the year in which the purchase took place. This practice is
inconsistent with an economic analysis of capital cost for
'wo main reasons:  first, the   ok value does not reflect the
cecrease in the value of money due to inflation. Thus, when
book va:ue is used o calculate capital cost, virtually iden-
tical vessels purchased a few years apart in an era of rapid
inflation will have substantially differing capital costs in
any given year, independent of physical depreciation.

     Second, the use of book value to calculate capital cost
has the defect that changed future earnings patterns of
vessels are not taken into account, except y accident. If
a vessel remains with the ownf.r who purchased it new, the
book value will have a rela 4 ;,r
                                1 to the economic expectations
at the time of purchase, however long ago that may have been,
since an economic decision was then maat as to its profit-
ability.  If a drastically changed charter market occurs,
however, book value and economic expectations can be sub-
stantially unequal in a relatively short time, even if an
adjustment for inflation has been made.

                              TABLE 6

          Valuation-of-VLCCs in-1985 bytheVa rious
    Witnesses, -Deflated-to 1977-Dollar         for Comparability

                   U.S.-flag         Foreign-flag
                     VLCCs              VLCCs           Differential

                                (1977 dollars per DWT)-

FACS                   $502             $116               $38E
API                     480              189                291
Mobil (note a)          386              122                264
AMA                     463              111                352
MarAd                   391              185                206
MEBA (note b)           N/A              N/A                N/A
SCA (note c)            470              235                235
a/Mobil's analysis i   for 1981.

b/MEBA's did not use VLCCs in its cost analysis.

c/SCA's analysis is for 1983.


                 Annual-Capital Cost-Factors
                 Used by-Witnesses for VLCCs R(vote a)

                                          U.S.-             Foreign
                       Year             flagship            flagshir

FACS                   1985               .10                 .12
API                    1985               .12                 .14
Mobil                  1981               .18                 .11
AMA                    1985               .08                 .11
MarAd                  1985               .11                 .11
MEBA (note b)          1977               .09                 .17
SCA                    1983               .10                 .10
Average                                   .11                 .12

a/Calculated by dividing the annual capital cost estimate for
  VLCCs by the VLCC's average valuation for the indicated yeaL.

b/For 90 MDWT vessels; MEBA did not use VLCCs in its cost

      The relation of book value to current asset value can be
even more widely diverqent. If the vessel has changed hands
during, for example, a tanker glut or durihg a tanker boom
such, as existed after the 1967 Middle East War, the purchase
price of a used tanker, which is set up as the book value,
will relate to the economic expectations at the time of the
sale but, may be unrelated to the conditions that existed
when it was constructed. Thus, the combined book value of
a number of vessels, which have been purchased both new and
used, even if an inflation correction has been made, is likely
to be an unmanageable aggregation of obsolete economic estima-

     In chapter 3, high and low estimates of capital cost will
be presented that conform to the economic theory of capital
valuation. Alternative estimates are required, since substan-
tial uncertainties exist as to the economic values of foreign-
flag vessels in 1985, dependent as they are on expected tanker
profits in the world market from 1985 on.  The future of tanker
profits, in turn, for owner3 operating in the unprotected world
market, is decidedly uncertain. It depends on demand factors,
such as world economic growth, the implementation of conserva-
tion measures, and the relative prices of oil and other energy
sources and on supply factors, such as the rtes of scrappage
and new construction and the ability of the Suez Canal to take
large tankers on backhaul. Each of these factors has a large
degree of uncertainty attached to it.  Consequently, it is
highly uncertain when the world tanker market will recover
from the depressed prices of the present tanker glut to prices
closer to longrun equilibrium.

     It might also be no.ed that when most commentators refer
to the "recovery" of the world tanker market, they mean the
situation where the demand for tanker tonnage has increased
to the point where it equals the supply of it, the point
where all laid-up tonnage is back in service. A fuller
definition of recovery would be where demand equals supply
at tanker rates equal to longrun average cost plus normal
profits. Recovery, according to this fuller defirtion,
need not take place until sometime after recovery i.
announced in the shipping press.

     Two alternative futures are projected as the basis for
estimates of foreign-flag tanker values, one in which tanker
resale prices continue at their currently depressed levels
and another in which they recover to the point where they
differ from construction cost only because of physical

      Once the values of U.S.- and foreign-flag vessels were
determilned, the witnesses faced the problem of determining the
annual capital cost of using these vessels. The general tech-
nique used by all wtnesses 1/ was to use an annual capital'
recovery factor, which incorporates the witnesses' assumptions
about the cost of investment capital, the length of life of
the vessel, and the value of any special financing or tax pro-
visions. The latter include the Merchant Matine Act Title XI
Loan Guarvnte: Program, the Capital Construction Fund provi-
sion, 2/ and the investment tax credit. The capital recovery
factors used by the various witnesses are presented in table 7.

     These annual capital recovery factors vary considerably
and, when used by the witnesses to compute annual capital
costs, in some cases account for more of the difference in
capital cost estimates than do the difference in vessel valua-
tion. For instance, although AMA asserts that the value of
U.S.-flag VLCCs is $352 per deadweight ton greater than that
of foreign-flag ones, compared to Mobil's estimate of $264 per
deadweight ton, a comparison of their annal capital cost dif-
ferentials goes the other way. In this latter comparison,
AMA's annual capital cost differential ($25.93, table 4) is
less than Mobil's ($55.41) and considerably so. The apparent
inconsistency is resolved by noting that Mobil  sed a capital
recovery factor of .18 for U.S.-flag vessels, wnereas AMA
used .08.

     Capital recovery factor- are a convenient way of deter-
mining an annual capital-cost estimate that is cnstant for
every year.  It would be somewhat coincidental if the esti-
mate of economic depreciation that is implied in the method is
realistic. According to the economic definition of deprecia-
tion (the change in the present expected value o the stream
of future earnings), this can vary from year to year, depend-
ing on the vintage of the vessel and the :market conditions in
which it operates. The use of capital recovery factors to
produce constant capital cost, by contrast, results in an
implied estimate of annual depreciation (capital cost less

1/Except MEBA's estimate of foreign-flag capital ccst.

2/Capital Construction Fund:    S.ip-owners under construction
  differential subsidy agreements   are, or in some instances,
  required to make deposits  in  a CCF sufficient to purchase a
  similar vessel at the end of the vessel's economic life.
  Earnings deposited in a CCF are tax deferred while in the
  CCF.  Funds withdrawn from CCF's, ecept for the purchase of
  a new vessel in U.S. shipyards,    re taxed upon withdrawal.

 the return on invested capital) that starts
 house mortgage, and increases exponentially low, just as in a
                                             until the final
 year of the assumed economic life.  This may be a rather good
 approximation of the time path of depreciation
 years in stable market conditions, but t is    in the early
                                              surely a poor
 approximation in the later years of a vessel's
      Nevertheless, the analytical convenience
 estimate of capital cost that is constant from of having an
 is so great that we will accept the depreciationyear to year
 it implies as a useful approximation.


     The analysis of the transport
difference n the rates charged for price differential, the
                                    oil transport by U.S.-
and foreign-flag tankers, is generally inadequate
appropriate in the analyses presented in testimony.or in-
of the witnesses approach the issue, but they         Three
                                               did not ade-
quately analyze the market factors and the
Involved.                                   regulatory issues
           The other three witnesses simply equate transport
price with transport cost. The transport
                                          price differential
estimates of the witnesses are presented in
                                             table 2, column 2.
      Full costs may not, in fact, determine prices,
on market conditions.                                 depending
                        Prospective market conditions in both
the world market and the prospective U.S.-flag
market suggest the probability of prices diverging
tially from full costs. Current conditions
                                              in the market for
foreign-flag tanker services show a severe
                                            excess supply of
tanker capacity even at charter prices that
                                             cover only vari-
able costs. As a consequence, a vast amount
tonnage is idle for lack of busingss.          of new tanker
                                        Sixty-nine tankers
above 100,000 DWT, averaging
delivered new between 1972 and213,J00 DWT each, which had been
                                1976, a total tonnage of
15 million DWT, were laid up as of January
tonnage of somewhat older or smaller tankers1977. An equal
up, to add to the serious situation of the     was also laid
                                            world tnker glut.
Such depressed conditions are likely to persist
future.                                           fr into the

     Market conditions in the prospective U.S.-flag
market are also' liable to cause price to diverge     preference
                                                  from costs
but in the opposite direction. H.R. 1037
after October 1, 1982, 9.5 percent of U.S.-petroleum that
shall be carried in U.S.-flag ships "to the            imports
                                             extent that such
vessels are available at fair and reasonable
                                              rates."   Since,

at present, only about 2 percent of U.S -petroleuln imports
are carried in U.S.-flag tankers, at the 30-percent level of
cargo preference there would clearly have been a situation of
severe excess demand for U.S.--flag tonnage during the lengthy
period before the vessels necessary to relieve the excess
demand would have been ordered and built in U.S. shipyards.

     At the 9.5-percent level of cargo preference, the situa-
tion is less clear. There will be demands for U.S. flagships
in other preference trades--the coastal and oer traditional
Jones Act trades, the Alaska trade, the Strategic Petroleum
Reserve trade and the Virgin Islands trade. Not including any
demands from the possible Virgin Islands preference trade,
MarAd estimates that U.S. tonnage available for the cargo
preference trade will grow from about 1 million DWT in 1977
to about 5 million in 1981, and remain there until 1985.
MarAd also estimates that, at 9.5-percent argo preference,
the tonnage requirements will be the following at various
import levels:

               6 MMB/D           2.6 million DT
               8 MMB/D           4.4 million DWT
              10 MMB/D           6.2 million DWT
During the transition period from 1978 to 1982, lesser tonnage
requirements will prevail under the different import-level

      It is apparent that MarAd expects an excess demand in
1985 at 10 million barrels per day and an excess supply at
8 million barrels per day in the absence of new construction.
Over the 1978 to 1985 period, MarAd epects a situation of
excess demand to persist until 1985, t an import level of
10 million barrels per day.    (At higher import levels, pre-
sumably, MarAd would expect an intensified situation of excess
demand.)   At an import level of 8 million barrels per day,
however, MarAd expects a situation of excess demands for
existing U.S.-flag tonnage and for ships now under construc-
tion to persist only until 1980.

     We did not attempt to evaluate the adequacy of these
forecasts; however, we do note that the supply and demand of
tanker tonnage is forecast without any explicit tanker-rate
and regulatory assumptions.  MarAd's forecasts do indicate
a situation of excess demand in the U.S.-flag tanker market
in the absence of new construction until 1980 under all
scenarios and a continuation of that excess demand to at
least 1985 if imports are at the rate of 10 million barrels
per day or more.

      Under such a situation of excess demand,
 absence of regulatory action, the shortrun     and in the
 port price at which supply and demand       equilibrium trans-
 very high due to both inelastic supply will be equal could be
                                         and inelastic demand
 for tanker services.  In chart 1, which is an expositional
 diagram for the shortrun U.S.-flag tanker
                                            market, price P4
 illustrates this outcome.  Lower prices, however, can be
 obtained by regulatory action of the
                                       Secretary of Commerce,
 who is empowered by H.R. 1037 to grant
 ference if charter rates for U.S.-flag waivers of cargo pre-
                                         vessels are not "fair
 and reasonable."

       One regulatory possibility is that waivers
 if charters are offered above some waiver        will be issued
                                            rate, such as P,
 P2 , and P3 . One point to note is that,
                                          even if the waiver
 rate is raised a substantial amount (e.g.,
                                             from P2 to P3 in
 chart 1), only a negligible amount of
                                        extra cargo preference
 tanker capacity may be called forth (Q
                                        3  versus Q 2 ).
      Whether or not excess profits will be earned
situation of excess demand in the U.S.-flag          in the
depends on the waiver policy pursued by      tanker   market
Commerce. Since no specification of waiver   Secretary   of
in H.R. 1037, the various witnesses were     policy is made
implicitly, to assume any waiver policy free, explicitly or
                                         they liked. API and
FACS assumed that the transport price would
                                             rise to 50 percent
above nonfuel cost, their so-called "captive-market
The other witnesses assumed that transport             premium."
transport cost, implicitly or explicitly    price  would  equal
waiver policy.                            assuming  a  perfect

      Surely a waiver policy would be
 profits well below a 50-percent margindesigned
                                                  to keep excess
 hand, the regulatory problem will be one    costs.    On the other
 Should waiver prices be set for each ship of great complexity.
                                             and route or only
 for each route? The transport cost calculations
nesses assume that appropriately sized vessels       of the wit-
on the various routes. If waiver prices            will  be used
                                           are  set  for
ship on each route, what would prevent inappropriatelyeach
and thus inefficient, vessels from being                    sized,
Persian Gulf route? This would result in   used  on,  say,  the
prices (and costs). If the waiver prices higher transport
route, however, would they be set low enoughare set for each
route from the Persian Gulf to keep efficient on the longhaul
charter rates equal to cost plus normal          VLCCs down to
would price much of the U.S.-flag fleet  profit?     If so, they
                                          out of these trades.
Our guess is that a compromise will be made,
route waiver policy that will result in         in any route--by-
                                         some excess profits
to U.S.-flag tanker owners. We believe
                                         that it would be

                                             CHART 1
                                                 TANKER MARKET

                                                                    ,Demand For U.S.-Flag lemon
                                                                       At 9.5% Crgo ftrerwaJ

                P41          WYOfUS_

                          Flag Tonnage

               P3 1


                                                 l1 C2C304                  QUANTITY OF U.S..
                                                                            FLAG TONNAGE

The dlot In the elind wvenrrfe.t       the dcin in pelm      aofummgfon due to ghW transl       ri.
Ae rnti     to seen trnspeart of etroIum which would a*so
                                                            Ut in · lop.  rieaby wHI h    nelilie     Se.

 extremely difficult to pursue a regulatory policy to keep
 excess profits below a 10-percent markup on cost plus normal

     If higher levels of cargo preference should be enacted
in the future and if they are accompanied by a substantial
requirement for new tonnage, a new regulatory problem arises:
This is, what should the waiver price be to induce tanker
owners to invest in enough tonnage to meet the cargo prefer-
ence percentage mandated? Since there are many uncertainties
involved in tanker operation, the waiver price may have to
set so as to include some excess current profits in order be
induce tanker owners to invest.

     Tanker owners are likely to be uncertain about a number
of key factors that will affect tanker profitability. The
first area of uncertainty that is likely to affect tanker
investment is uncertainty about the demand for U.S.-flag
tankers.  Under percentage cargo preference, U.S.-flag tanker
demand will, of course, depend on the level of imports. Un-
certainty as to energy policy and the rate of economic growth
and, therefore, the import level may leave owners uncertain
about whether there will be a situation of excess demand or
excess supply in the U.S.-tanker market.

     A second area of uncertainty that tanker investors
confront is with respect to the characteristics and constancy
of regulatory policy. For instance, if 10 years from now,
regulation were issued that foreign-flag tankers could easily
be re-flagged under U.S. registration, U.S.-flag tankers just
put into service could be rendered unprofitable. Uncertainly
also affects investor appraisal of a number of other crucial
regulatory decisions in this much regulated industry.

     A third area of uncertainty for tanker investors concerns
the profitability of given vessel sizes. There is a question
about whether sufficient deepwater ports will be available
service the vLCC and ULCC tankers that are the most appropri-
ately sized vessels to carry crude oil from the Persian Gulf.
Changes in deepwater-port or lightering policy, for environ-
mental or other reasons, could leave investors with vessels
unprofitable sizes. The same would be true if the import
should shift substantially from the Persian Gulf to Mexico,
since medium-size tankers would then be more in demand.

     In summary, any number of factors could, if they occurred,
create a situation of excess supply in the cargo preference
segment of the market or in some vessel-size submarket. Fear
about these factors may inhibit tanker investment in U.S.-flag
vessels unless there are high enough short term pofits to


      Knowing the transport price differential
how muchl more one would have to pay to ship on tells us only
                                                 a U.S.-flag
tanker then on a foreign-flag one.    In order to calculate
the import price differential, the fact that under
                                                     H.R. 1037,
90.5 percent of imported oil will probably be carried
costly foreign tankers must also be taken into account.in less
the imposition of cargo preference did not Lesult            If
changes in the rates for foreign-flag oil transport,in  any
                                                        we could
calculate the import price differential by allocating
transport price differential over the total volume       the
                                                     of  imports.
This is how column 1 in table 3 is calculated.
                                                  All of the
witnesses in favor of H.R. 1037 have implicitly
                                                  or explicitly
taken this position.   Witnesses opposed to the legislation,
however, have directed attention to another set
                                                  of potentially
important market factors that could raise the foreign-flag
transport price if the U.S. imposes cargo preference.

     These factors represent the reaction of two sets
eign governments:                                      of for-
                   first, the governments of countries with
large nationally controlled tanker fleets, such
the United Kingdom and, secondly, governments of as Norway and
                                                  the oil-
producing countries. Oil-producing countries and
with large tanker fleets might retaliate against countries
                                                  what they
perceive to be economic loss caused by the cargo
     We have not analyzed the likelihood of retaliation
therefore take no position on what its cost might        and
                                                   be.  It is
doubtful that any firm evidence could be presented,
or the ther.                                         one way
               In addition, if some kind of retaliation did
occur, it would not necessarily affect the price
                                                  of imported
oil. Therefore, we have not added an estimate of
costs to the cost of cargo preference.

     With the exception of
witnesses presented analysesMarAd in one of its studies, all
                              to answer the following question,
which we agree is the relevant one: What is the
preference as a maritime support program? The     cost of cargo
                                                first analysis
of MarAd (referred to as MarAd I in this report),
used as a basis for the discussion of cargo preference was
executive branch, also addressed this question.           in the
analysis (referred to as MarAd II in this report),In  its  second
MarAd implicitly posed a different question, which
                                                     might be
phrased as:  What is the cost of cargo preference minus the
recoverable part of past maritime support programs?
is to be estimated, the recoverable amounts of the     If this
tion differential subsidy would have to be subtractedconstruc-

the import price differential. This is what was done in
MarAd II.  MarAd subtracted "DS Payback Allowances" of $64
and $71 million from the MarAd I estimates of the import
price differential of $]75 ane $245 million, respectively,
at import levels of 8 and 10 million barrels per day. For
the urpose of maintaining comparability with the estimates
of the other witnesses, with ours, and even with those of
MarAd I, we added back the CDS Paybac- Allowance to obtain
the adjusted MarAd II estimates presented in this report.
(See table 1, footnote k, for a description of the adjust-

                          CHAPTER 3


     In the previous chapter, the major differences in
estimates of the transport price differential due to cargo
preference were discussed.  The witnesses' estimates of
capital cost differed substantially, even after all cols
had been expressed in 1977 dollars.  The capital cost appear
to explain a large portion of the differences of costs of
cargo preference. This chapter presents our estimates, which
we believe improve upon those of the witnesses.


     In estimating the operating cost differential, we have
made use of the estimates presented by the witnesses. First
of all, the operating cost diferential is a minor fraction
of the total transport cost differential for all analyses but
MEBA's. Second, there is relatively little disagreement
among the witnesses as to what the operating cost differential
is.  Thus, we regard a simple average o the testimony as an
adequate estimate of the operating cost differential and have
used it as such. 1/


      According to the theory nf capital valuation presented
in chapter 2, "economic" depreciation (to distinguish it
from accounting depreciation concepts that are used for fi-
nancial reporting) is the difference between the present
expected value at the beginning and end of the year in ques-
tion.   Annual capital cost is the sum of economic depreciation

l/The danger of using simple averages of operating cost
  estimates produced by different witnesses using different
  assumptions has been pointed out in an undated MarAd memo
  provided to the Merchant Marine Subcommittee commenting on
  our preliminary estimates reported in a letter report to
  Chairman Murphy dated July 29, 1977. We take nD exception
  to the general caution but would note that the averaging
  of estimates produced by different assumptions has the
  advantage of reducing the effect of the eccentric assump-
  tions of the individual analyses.  In the present case
  of operating costs per deadweight ton, any one of the
  witnesses' estimates could be used without affecting the
  GAO low and high transport cost estimates by more than
  7 or 4 precent respectively.

and the expected return that could have been earned in the
alternative investment under consideration. For purposes
of this analysis, the alternative investment is any invest-
ment that would be undertakenr, at the going cost of invest-
ment capital for investments of similar risk.

     This efinition of capital cost, the opportunity capital
cost, is the appropriate concept for allocating society's re-
sources to alternative uses.  It attempts to measure the value
of the capital resources used in implementing cargo preference
that could have been used elsewhere. Conventional accounting
measures, like book value, measure economic trade-off only
when they approximate market value.

     The use of the oortunity capital-cost concept necess-
arily requires knowledge of the future earnings prospects of
foreign-flag and U.S.-flag tankers.  If this information were
available, the present expected value of a tanker in each
year would be determined.  The annual change in this valua-
tion could then be calculated, leading to a determination
of annual depreciation. The opportunity cost of capital would
then be the sum of the cost of investment capital in the gen-
eral economy for investments o equal risk, plus this
earnings-based estimate of depreciation.

      If markets work freely, estimation of future earnings
is the basis of the caluculations of tanker value on the
part of both buyers and sellers. Thus, market values in
both the new and used tanker markets are estimates of the
present expected value of future tanker earnings prospects
by those who are closest to the technical and economic con-
ditions of the industry. For instance, the depressed used
tanker prices of 1977 are the best available indicators of
depressed earnings prospects of tankers over their future

      To determine foreign-flag capital cost as of 1977, the
prices at which tanker tonnage changed hands in the world
tanker market would permit a single estimate, since these
prices incorporate the forecdsts of tanker earnings by per-
sons close to the economic and technical conditions of the
tanker industry.   Tanker earnings prospects after 1985,
and hence tanker prices in 1985, are highly uncertain, how-
ever.   As we discussed in chapter 2, there are substantial
uncertainties on both the demand and supply sides of the
market for tanker services. A number of forecasters have
tentatively projected an end to tanker lay-ups in the early
to late 1980's, given certain assumptions, but none of the
available forecasts have attempted to predict when tanker pices

would return to normal levels. 1/ Because of this uncer-
tainty, two world tanker market-scenarios have been chosen
to produce high and low estimates of tanker prices in 1985.
The low estimate constitutes a projection of current glut
condition prices to 1985 (in 177 dollars).   The high estimate
constitutes a projection of market recovery to the point
where earnings prospects justify the purchase of new tankers
for the world tanker trade at prices that reflect the full
construction costs in foreign shipyards.

      For the determination of the capital cost of U.S.-flag
tankers, we consider it unlikely that conditions of glut will
occur ir the protected U.S. crgo preference market before
1985.   A more likely prospect is conditions of shortage but,
as described in chapter 2, it is assumed that regulatory
policy designed to keep U.S.-flag tanker rates "fair and
reasonable," will eliminate this possibility.    Thus, projected
construction cost for U.S. tankers is considered to be an
adequate estimate of U.S.-flag tanker value in 1985.


     To summarize the discussion of the preceding section,
three price projections for 1985 (expressed in 1977 dollars)
are needed as the basis of our estimates of the capital cost

     (1) The glut price of tankers on the world market.

     (2) The price of new tankers in foreign shipyards
         (estimated to cover full costs).
     (3) The price of new tankers in U.S. shipyards (also
         estimated to cover full costs).

The first and third of these will be discussed first, fol-
lowed by the second.

     The glut price in 1985 (in 1977 dollars) can be estimated
by the average price of tanker tonnage sold to the world market
in each tonnage class since the beginning of 1975 when the tanker
glut became fully established.  Since no reliable trend can be as-
certained in the data since that date, the simple average is

1/E. g., Drewry (Shipping Consultants), Inc., 1976; and
  Organization for Economic Cooperation and Development,

used rather than the most recent data.   (See chart 2 for a
presentation of data on sales of VLCCs, the most important
segment of the market for present purposes).   The aerage
price for relatively new tonnage, calculated by using the
average weights of the witnesses, 1/ is $100 per DWT. The
data for the individual tonnage categories appear in table
      Th- full-cost price of new U.S. tankers in 1985 is
estLmated from MarAd-provided data and from data in its annual
repoL Ls on recently constructed vessels that have received
the construction differential subsidy. This data, when con-
verted to 1977 dollars, can be used to directly estimate the
cost in 1985 (expressed in 1977 dollars).   The weighted
average estimate per DWT calculated in this way is $470 per
DWT, using the average weights of the witnesses. 2/ (See
table 8 for data on individual tonnage categories.)

     The full-cost price of ships built
is derived from the price of ships built in foreign shipyards
                                          in U.S. shipyards
by using the subsidy rates established by MarAd. According
to its 1976 annual report, the typical subsidy rates for
tankers delivered in 1976, 1977, and 1978 is about 40 percent.
This represents MarAd's determination of the relative prices
charged for equivalent tankships in foreign yards and is,
therefore, the subsidy necessary to induce the purchaser to
buy in the United States.

      Given the three vessel valiations discussed, the next
step is to convert them into annual capital cost estimates.
Based on a decision to determine a constant annual capital
cost, we need to make assumptions on the average economic
life of tankers and an assumption on the cost of capital in
1985 so that the capital recovery factor can be determined.
Capital recovery factors, depending on different assumptions
about economic life and cost of capital, are given in table
As shown in table 6, the various witnesses made assumptions
that result in a diversity of capital recovery factors.
of the assumptions made by them is easily defensible over None
the others, since they incorporate estimates abc.!t technical
progress and capital market events that are uncertain in
most cases. As can be seen i table 9, the capital-recovery
factor is not highly sensitive to small changes in either

1/See footnote 1 on p. 12.

2/See footnote 1 on p. 12.

economic life or cost of capital assumptions. Neither is
the capital-cost differential if the same capital-recovery
factor is used for both U.S.- and foreign--built ships.

                                    Table 8

       Resale Prices for Tankers in the World Market and Foreign
         and U.S. Tanker Construction Costs, in 977 Dollars

                         (li                   (2)              (3)
                    Average world
                    market resale            Average          Average
                     prices for            U.S. tanker     foreign tanker
                    tankers up to         construction      construction
    Tonnage          5 years old,            costs              costs
    category           1975-77              (note a)           (note b)

  {thousand DWT)     ------- (1977 dollars per DWT)      note c))-----

    0-75                $309                  $697              $418
   75-200                108                   477               286
   200 +                  85                   429               257
     (note d)             100                  450               270

 a/Estimates constructed by us from MarAd data. MarAd include an
   allowance for engineering and legal fees and for interest during
   vessel construction.

 b/Foreign construction cost is estimated on the basis of MarAd con-
   struction differential subsidy rates of approximately 40 percent in
   effect in 1975 and 1976. The higher rates of 1977 were not used, due
   to the presence by that ear of an undetermined amount of underpricing
   in foreign shipyards.

 c/1977 dollar prices obtained by using an annual 7-percent inflation

 d/Tonnage-category weights are the average weights assumed by the
   witnesses.  (See table 4.)  Also see note (a), table 10.

  Source:  Drewry Ltd., Shippina Statistics and Economics, Shipping
  World and Shipbuilders and MarAd.

      The capital cost differential is sensitive, however, to
the use of different capital recovery factors for U.S.- and
foreign-built ships. Although an arcuement can be made for
different cst of capital assumptions in the two cases,
based on the existence of different capital market situations,
it is not clear that such differences which exist at present
will persist into the future.   A conservative assumption
in this case is that the cost of capital will be roughly the
same for foreign- and U.S.-built vessels, as the operation
of the international economy works to equalize rates of re-
turn in different countries. As to economic life, there
seems to be no reason to expect that physical depreciation
or technical obsolescence will affect foreign-built vessels
any differently then their U.S.-built counterparts.   We
have aso, therefore, used the conservative assumption that
the two vssel classes have roughly the same economic life.
In combination, the same assumptions on cost of capital and
economic life, of course, result in the use of the same
capital recovery factor for U.S.-built and foreign-built
vessels. The question then becomes, what should be the
common cost of capital and economic life assumptions? For
lack of any prefered alternative, we have accepted the assump-
tions of MarAd of a 25-year vessel life and a 10-percent pre-
tax return.


     We now use the vessel prices presented and discussed
in the previous section to clculate high and low estimates
of 1985 transport cost. The low estimate, based on the
differential between U.S.- and foreign-shipyard construction
cost is 1.4 cents per gallon of preference oil.  The high
estimate, based on the differential of U.S.- construction
cost of tanker tonnage over the world market price for used
tanker tonnage, is 2 cents per gallon of preference oil.
Both figures are for 1985 and are in 1977 dollars. The
calculation of these figures is given in table i0.

     The transport price estimate differs from the transport
cost estimate by the inclusion of an estimate of the effect
of market factors in the cargo preference market.  In chapter 2
we gave our judgment that, given the difficulties of regulatory
policy, it would be optimistic to expect U.S.-flag tanker rates
to rise no more than 10 percent above cost. Using this 10-
percent markup as a measure of exce-s profit in situations of
excess demand for U.S.-tanker tonnage, we estimate the trans-
port price differential as 1.8 cents per gallon of preference
oil (low estimate) and 2.3 cents per gallon (high estimate).
(Calculation in table 10.)

                                 Table 9

      Capital Recovery Factors Resulting From Various
Assumptions About Cost of Capital and Economic Life (note a)

                                      Economic life
Cost of capital      15 yrs.         20 yrs.   25 yrs.       30 yrs.


     8.0                 .1169          .1019     .0937       .0889
     9.0                 .1241          .1096     .1019       .0974
     9.5                 .1278          .1135     .1060       .1017
    10.0                 .1315          .1175     .1102       .1061
    10.5                 .1353          .1215     .1145       .1106
    11.0                 .1391          .1256     .1188       .1151

a/Calculated using the follc zing formual, where r - cost
  of capital and t = economic life:

           CPF =             r
                   r -    (i +     )t

Source:  David Thorndike (ed.), The Thorndike Enclyclopedia
of Banking and Financial Tables, Boston Warren, Gorham and
Lamount, 1973. Table b. p. 6-2.

     Finally, we calculate estimates of the import price
differential.  For reasons that we discussed in chapter 2,
we do not expect any change in the transport price of oil
in foreign-flag tankers due to the imposition of cargo pre-
ference. Consequently, the import price differential can be
calculated by simply allocating the transport price differen-
tial over the total of oil imports, both preference and non-
preference. At the two levels of cargo preference we have
analyzed, our import price differential estimate per gallon
of oil imports is the following:

                                        Low estimate      High estimate


9.5 pecent-cargo preference                 .15                 .23
30 percent-cargo preference                 .48                 .72

(Calculation in table 10.)

      When we apply these cents-per-gallon estimates to various
 import levels, we get different total dollar estimates. For
 instance, at 9.5-percent cargo pre.erence and an import level
of 8 million barrels per day, our estimates are $190 million
 (low estimate) to $280 million (high estimate), with $240 mil-
lion being at the midpoint of the range. With the range
depending on the state of the world tanker market, this last
estimate assumes that the market is partially, but not com-
pletely, recovered. At an import level of 10.3 million bar-
rels per day (our estimate of 1985 imports), our estimates
range from 240 million to 360 million, with 300 being the
midpoint estimate.   These estimates and also estimates for
cargo preference at the 30-percent level, are given in
table 11.


     No provision was made in the estimates of the import
price differential for an increase in the transport price
of foreign-flag tanker services, not because we believe
that retaliation by the petroleum and maritime nations
would not occur, but simply because we believe that any
retaliation is unlikely to affect the import price of oil
itself. As was discussed in chapter 2, estimates of retalia-
tion costs cannot be mad- with any precision.

                                                Table 10
                             Calculation of our Estimate of Transport Cost,
                             Transport Price and Import Price Differentials

                                                                    Low estimate    High estimate
  1.    Operating cost differential (per DWT/ year) (note a)           S10.46           So0.48
  2.    Capital cost differential      (per DWT/ year)   (note b)       18.73            38.57
  3. Total transport cost differential (per DWT/year)                  29.21             49.05
  4.    Aterage number of voyages per year (note c)                     8.07             8.07
  5.    Transport cost differential      (per unit of petroleum
             $ per long ton (note d)                                   $3.62            $6.08
             $ per barrel (note e)                                     S .50            $ .84

             cent per gallon (note f)                                   1.2              2.0
 6.     10 percent U.S.-flag transport cost (note g) (cons
              per gallon)                                               0.4              0.4
 7.     Transport price differential     (note h) (cent per
          gallon)                                                       1.6              2.4
 8.     Import price differential at 30-percent cargo prefer-
          ence (note i) (cent per gallon)                                .48              .72
 9.     Import price differential at 9.5-percent cargo pre-
          ference (note j) (cent per gallon)                     .15              .23
 a/Derived from tables 4 and 5, average of figures for the various analyses,
   MESA and arAd II.   These are not included since their fleet mixes, which except
   mined their estimates of both the weighted average operating cost
                                                                      and the average
   number of voyages, were problematic:   (1) EBA's 100 percent reliance on 90 MDWT
   veisels is not realistic.   (2) For MarAd, MarAd I was used rather than HarAd II,
   since MarAd II assume   (as did arAd I) that the fleet mix for U.S. flagships
   would be the same as for foreign flagships. In the case of MarAd II,
                                                                         but not
   MarAd I, this assumption rebulted in a distorted mix for foreign flagships,
   would, of course, carry 90.5 percent of imports. The U.S. flag mix            which
                                                                        is constrained
   (at 9.5 percent cargo preference) by the fleet in existence, to be sure.
   foreign-flag fleet, however, is not so constrained, and would be likely    The
   VLCCs wherever they are economic.                                        to use

 b/See text.

c/See footnote a.
d/T-ansport cost differential divided by average number of voyages:
                                                                                line 3 divided by
  line 4.

e/Using one long ton            7.2 barrels.
f/At 42 gallons/barre.
a/The percent applies :o the .S.-flig cost figure including voyage costs rather than
  to th? cost differential. we estimated U.S.-flag cost to be $96.61 per
  ton per annum.                                                         deadweight

h/Total of (5) and (6).

i/30 percent of (7).

i/9.5     percent cf   (7)

                               lable 11

       Our Estimates of Import Pr ice Differential at Two
Import Levels and Two Cargo Preferences Levels, 1985 (note a)

                      (1)           (2)             (3)
                                    High          Midrange
                      Low         estimate        estimate
                    estimate      (note b)        (note c)

                       (millions of 1977 dollars)

9.5 percent cargo
       8 MMB/D        $190            $     280    $     240
    10.3 MMB/D         240                  360          300
      12 MMB/D         280                  420          370

30 percert cargo
       8 MMB/D         590                  880          740
    10.3 MMB/D         760                1,100          930
      12 MMB/D         880                1,300        1,100

a/Derived from table 10o

b/High and low estimates are ends of a range that depends
  on the state of the world tanker market in 1985.  See
  text for explanation.

c/Average of columns (1) and (2) rounded to 2 digits.

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                          CHAPTER 4


     The increase in the consumption price of petroleum is
the major cost of cargo preference. There are, however,
otner effects that are not negligible, although difficult
to measure. These effects include effects on:

     -- The price of domestic tanker services, including
        those in the Alaska trade.

     -- The price of alternative energy sources.

     -- Employment.

     -- Inflation.

     -- The balance of payments.

     -- The price of oil produced domestically.

Some estimates of these effects were given by the witnesses,
but tley were presented mainly in general terms. We make
no attempt to quantify these effects, except the last
since either data are not available or an analysis beyond
the scope of our present report would be required.


     If the transport price of U._.  lag  ankers serving the
international trades is above transport cost by more than
that of U.S.-flag tankers serving the domestic (coastal,
Alaska, Puerto Rico, etc.) trades, this price effect is
likely to be at least partially transmitted to the do-
mestic transport price. If.the excess of the transport
price above transport cost should be of the magnitude as-
serted by FACS and API (50 percent of nonvoyage cost)
rather than of the magnitude assumed for our estimate (10
percent of transport cost), this impact might be uite large.
For instance, FACS, the only witness to make a quantitative
est.mate, estimated total increase in domestic tanker prices
of $1.6 billion (1977 dollars) per year in 1985.

     Quantitative estimation of the price impact on the do-
mestic tanker trades is difficult. However, given our as-
sumptions on regulatory policy under the "fair and reason-
able" waiver authority of the Secretary of Commerce, this
effect is unlikely to be very large.


     Insofar as other energy sources are competitive with
petroleum, an increase in the price of petroleum will pro-
duce some increase in their price.   For .instance, natural
gas is competitive in a range of industrial uses with fuel
oil.  A large number of electric utility boilers are also
usable for either oil or coal, either immediately or after
conversion.  It would, however, require knowledge of the
appropriate demand and supply elasticities to make numeri-
cal estimates of the impact of an increase in the price of
petroleum on the price of coal and natural gas. No esti-
mates will be nmade in this report of these additional costs
to the consumer.


     Employment is a third area of economic impact. There
would be an increase in employment of Amrrican seagoing
workers and in the employment in U.S. shipyards. Estimates
by a number of the witnesses on the direct employment ef-
fects are given in table 12.  They vary by the level of
cargo preference assumed, with roughly 30,000 jobs (sea-
going and shipyard) estimated for 30 percent cargo preference
and 2,500 jobs (all seagoing) for the 9.5 percent cargo

     The direct employment effects are probably exceeded by
the indirect effects, however.   (Some of the indirect em-
ployment effect estimates, given by the witnesses, also ap-
pear in tabl- 12.)  There are two prominent indirect dis-
employment effects:   (1) the international trade effect and
(2) the macroeconomic effect.

     The international trade effect tends to offset the
direct effect of creating maritime jobs.  It would come
about over a period of adjustment in the following way:
the decrease in the purchase of foreign-flag shipping serv-
ices would cause the exchange rate of the dollar to rise,
since the demand for foreign exchange to pay for the ship-
ping services would decline. The increase in the dollar
rate, in turn, would decrease the competitive advantage
of U.S. exports and of domestic goods competing against im-
ported substitutes. Those industries under mo.t competi-
tive pressure from foreign goods in either U.S. or foreign
markets would lose sales and suffer a decline in employment.
The number of jobs lost depends on how labor intensive these
industries are. The first approximation, lacking a detailed
analysis, is that the indirect international trade disemploy-
ment effect would approximately offset the positive maritime

                             TABLE 12
        Witnesses' Estimates-of-the-Impact-of Cargo
        Preference Legislation on Employment Levels

                   IMPACT ON EMPLOYMENT

                                     Increase        Reduction
FACS                                a/35,322
API                                                 b/284,000
Mobil                              No estimate      No estimate
AMA                                No estimate      No estimate
MarAd                           /2,500 to 3,600           -
SCA                               d/120,000               -
Transportation Institute          e/539,000
Labor Management Committee     f/106,000 to 248,000       -
MEBA                               2/39,400               -
a/However, FACS estimated that each job would cost $2.2 mil-
  lion (at 30-percent cargo preference).

b/Based on 30-percent level.

c/Based on a 9.5-percent level of cargo preference, with im-
  port levels of 8 and 10 MMB/D, respectively.

d/Inrludes a "multiplier effect" of 90,000 new jobs and is
  estimated at the 30-percent level.

e/Estimated at the 30-percent level as follows:  134,000
  construction jobs, 400,000 allied industry jobs, and
  5,000 shipboard jobs (statement of March 1, 1977). A
  separate figure of 230,000 jobs was given in direct
  testimony on the same date.

f/Increase in jobs estimated as follows (at the 20-peLcent

            104,000 to 2.000--production and support
              2,000-to---5,000--seagoing-       --
            106,000 to 248,000--total increase

j/Inciudes 4,400 seagoing jobs, at the 9.5-percent level.

employment effect. Since the maritime industry is heavily
capital intensive, the net effect would probably be dis-

     The second indirect employment effect, the macroeconomic
effect, is negative.  Purchasing power, which previously was
spent on a range of goods and services, would under cargo
preference be spent on the transport-cost differential.
Thus, the gross national product and the employment engaged
in the production of these other goods and services would
both decline. If we purchase goods and services, in this
case oil transport services, from costly producers, we have
less to spend on the other goods and services.

     Considering the direct employment increase in the mari-
time industries and the indirect employment effects together,
our judgment is that cargo preference will cause a net loss
of employment. Of course, macroeconomic stimulation of
the appropriate magnitude, could attempt to reverse the
net disemployment effect, depending on the state of economy
at the time, but with possible inflationary effects.


     Cargo preference legislation would tend to increase the
general price level.  The increased price of petroleum--our
estimate, 0.19 cents per gallon at 9.5 percent cargo
preference--would add a small amount to the general price
level as it works its way through the economy.


     There will be an immediate balance of payments increase
due to cargo preference, because the United States would be
purchasing less from foreigners.  Under the present inter-
national monetary system of floating exchange rates, the
balance of payments effect has two characteristics. First,
it is temporary, as a surplus or deficit in the balance
of payments is translated into a change in the exchange rate,
rather than into a long-lasting change in the level of in-
ternational reserves. Secondly, the economic or political
advantages of a foreign exchange surplus over a deficit
have significantly declined, if not disappeared.  Thus, the
favorable temporary balance of payments effect of cargo
preference should not be considered to be an advantage of
any great significance.


     The direct cost of cargo preference is the higher cost
of transporting oil to this country. Whatever the magnitude
of this cost, it represents a real loss of resources.  It is
an amount which could have been spent on other goods and
services.  Under cargo preference this amount would be spent
upon higher cost transportation.

      When the price of imported oil increases, the price of
domestically produced oil will have a tendency to increase by
a similar amount. Such an increase would represent a cost
to consumers, but at the same time it would increase the in-
comes of oil producers. As such, it is a transfer of money
from one group to another, rather than a direct resource
     There are various possibilities of how the potential
transfers of income might be dealt with:
     i. The price of domestic oil could be allowed to rise
in response to the increase in imported oil prices, in which
case the transfer would be from oil consumers to producers.

     2. There could be price controls on domestically pro-
duced oil to prevent a price increase.  In this case, there
would be no transfer of income. Such control may be diffi-
cult to achieve in practice, and it may not correspond
with the Nation's energy policy.

     3. There ould be a wellhead tax on oil.    In this
case the income would be transferred from oil consumers to
the Treasury. This might also be viewed as a transfer of
income from oil consumers as a group to taxpayers as a group.

     How large would the cost to consumers be in cases (1)
and (3)? This depends upon the quantity of domestically
produced oil.  If the quanti-y of domestically produced oil
is equal to the quantity of imported oil, and the increase
in the price of do.nestic oil matches the price increase due
to cargo preference, then the cost to consumers would be
about the same as the direct costs of cargo preference.

     Our report entitled "An Evaluation of the National
Energy Plan," (EMD-77-48, July 25, 1977) estimated that
under the 1985 plan the following would occur:

     Production                               10.5 MMB/D
     Imports                                  10;3 MMB/D
     Consumption                              20.8 MMB/D
     We now consider the three cases in more detail.


     In the first case, the price of domestically produced
oil would have a tendency to rise to the price level of im-
ported oil.  As a first approximation, this is simply the
import price differential times the entire U.S. consumption.
Without price controls, since domestic crude is substitut-
able for imported crude, domestic producers will be able to
sell their crude at the import price. An increase in the
import price will, therefore, cause an equal increase in
the price of domestically produced crude.  This essential
conclusion was largely missed by all witnesses whose testi-
mony is analyzed in this report.


     The second case, that of price controls, is more complex.
If price controls on domestically produced oil are perfect,
and if the controlled price never responds to changes in the
import price, then it follows that a increase in the import
price will not cause an increase in the price of domestically
produced crude oil. One deviation from perfect price control
that has been applied in the oil market is to distinguish
certain classes of domestic crude for differential price con-
trol treatment.  For instance, oil from older oil wells may
be dubbed "old oil" and its price controlled. Other classes
of oil, "new oil," may, however, be free to espond to the
force of the international market.  In such a situation,
there will be a partial response in the shortrun, to a change
in the import price.

     A further complication in the case of price controls is
how the controlled prices re set. If the differential be-
tween the controlled domestic price and the import price is
a basis for revising the controlled price, then over a period
of time, the price of domestic oil would at least partially
respond to increases the import price. This response could
vary from nothing to a hiigher price of domestic oil that is
the same as the higher price of imported oil, depending on
the characteristics of the control system and its behavior

over time.  If there was a control system at the time of
the imposition of cargo preference but one that was sub-
sequently eliminated, then the price increase on domestic
oil, held back for a time by a control system, would take

     Although the present system of price controls on the
sale of domestic crude oil, together with the entitlements
system designed to equalize prices for refiners who use
differing proportions for domestic and imported crude, is
due to expire, a more likely replacement than simple de-
control is probably something like  resident Carter's energy
proposals that allow for a price ceiling that, depending on
the Organization of etroleum Exporting Countries' actions,
could be either abo.e or below the import price. If the
ceiling is above the import price, the administration's
proposed system would have the domestic crude oil price re-
spond to a change in the landed import price of petroleum.
If the ceiling is elow the import price, the domestic price
will not be free to respond to an increase in the landed
import price except through induced changes in the ceiling

      Because of the complexity of the price-control case,
no precise estimate is possible of the cost of cargo
preference to consumers under the case of price control.    It
can be asserted, however, that price controls could sup-
press part of the distributional component of the cost,
at least in the shortrun. Insofar as the controlled price
responds to the import price, however, the change in the
import price would b transmitted to the domestic price
even though the controlled domestic price moves no closer
to the import price.   In this case, the transfer from con-
sumers to domestic oil producers would nut take place.
Thus,   he cost to the consumer would only be the direct
cost described in the previous section on the free market


     The third regulatory case is that in which wellhead
taxes are imposed on oil at the wellhead. Wellhead taxes
can be imposed in the context of a free market n domes-
tically produced oil or of a price control system. The aim
of wellhead taxes is to recover some or all of the excess
profits earned by the holders of existing oil wells when
the price of oil exceeds the cost of developing and operat-
ing the wells plus normal profits. The increase in domes-
tic producer profits can be recaptured, at least partially,
by the Government in the form of a wellhead tax.

      The wellhead tax may differ for different classes of oil.
For example President Carter's National Energy Plan proposal
has three classes of oil--"old oil," "new oil," and "new new
oil."   The two lower classes will have wellhead equalization
taxes, designed to bring them into price parity with new new
oil which, as was described above, may or may not be allowed
to rise to the import price.   In the case of wellhead taxes,
some or all of the price increase in domestically produced
oil is recaptured in Government revenues. If a tax on oil
should increase by exactly the amount of any increase in the
landed price of petroleum due to cargo preference, (a "per-
fect" wellhead tax) then extra cost of cargo preference to
the consumer would be offset by an equal increase in Treasury
revenues. All or part of this could be rebated to consumers.
If the rebates were in roportion to purchases, the net effect
would differ from the perfect price control case only in that
the levels of consumption, production, and imports would be
the same as the free-market case.
     In summary, it is not certain how much of the transfer
from consumers to producers of domestic crude oil can be
suppressed by a possible price control system or recovered
by wellhead taxes. If the full impact is passed on to con-
sumers, however, the total increase in the consumers' oil
bill from this transfer would be approximately $310 million
(1977 dollars), using the GAO estimate of domestic production
under the National Energy Plan of 10.5 million barrels per
day previously cited and our mid-range import price differen-
tial of 0.19 cents per gallon. The transfer from consumers
to domestic crude oil producers is in additior-to the higher
amount paid for imported oil that results from cargo pref-
erence.   t does not, however, constitute a resource cost
to society, as does the higher import bill.

 APPENDIX I                                                                                                                                                                      APPENDIX I

                                   NIlmTY.FiTN CONrGl
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                 IflD. I                     .
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                                                                            o.              J.
     A   -. W          M eelst.
                             a                    rIS.

                                General Accounting Office
                                441 Mr.    on
                                        G Stree,
                                           Staats: Not.s
                                          Street,  Northwest
                                Washington, D.
                                undoubtdly     . C. 20548                                                                                       o                          m.2

                                The Merchant Marine Subcommittee is currently con-
                                sidering H.R.1037,                                                a Cargo Preference                                  Bill, which
                                would require that twenty to thirty percent of U.S.
                                oil imports be carried on U.S.-lag ships.
                                One of the most complex and controversial issues
                                whicGnwill be addressed at these hearings i the
                                potential of increased cost to consumers which might
                                result from the bill's passage.

                                Several witnesses either have or will present economic
                                analyses on this point.   Since the cost estimates will
                                undoubtedly vary significantlv,  it should be extremely
                                helpful to the Committee to have a secondary analysis
                                of this information.  My request then is to have the
                                General Accounting Office staff monitor our hearings
                                and then do an aneylsis of the economic information
                                that is presented there.  Len Sutter, Counsel to he
                                Committee, may be reached at 225-6786 if you hve
                                further questions about this.


                                                                                                                                 John M. Murphy