THE COST MINIMIZING INDUSTRY STRUCTURE FOR PETROLEUM REFINING: AN APPLICATION OF CONTESTABLE MARKET THEORY AND MULTIPRODUCT COST FUNCTIONS

Since the elimination of crude oil price controls and the entitlements program in 1980, the U.S. petroleum refining industry has undergone significant changes in structure and technology. The number of refineries has declined from 303 in January 1981 to 191 in January 1985. Several mergers and acquisitions among major refiners have resulted in some reductions in capacity as plants have been retired or sold to independents. Meanwhile, capital investment in existing refineries has made the U.S. industry much more flexible in terms of handling various grades of crude oil. Given these changes, it is of increasing interest from a policy standpoint to determine the optimal (cost minimizing) industry structure for petroleum refining and whether or not the industry is moving in that direction. Policy implications concerning mergers and acquisitions are of particular interest.;From the estimated cost function, it is determined that the cost minimizing scale of overall company refining operations is approximately 425 thousand barrels per day (MBD) nameplate distillation capacity. Regarding the optimal company configuration, evidence is presented suggesting that combinations of smaller refineries is more efficient than one large refinery.;Applying the principles of contestable market theory to the estimated cost function, it is determined that the existing structure is not sustainable due to the discrepancy between the optimal and existing industry structures and the fact that firms are not producing where price equals marginal cost for each of the three products, motor gasoline, distillate fuels and other refined products. Examining market adjustments since 1980, however, it is determined that the industry is converging on both the optimal configuration and product mix. Therefore, it is concluded that the petroleum refining industry is sufficiently contestable that no policy measures are required to achieve the optimal industry structure.;The approach of this research is to first estimate econometrically the long run cost structure of petroleum refining operations using a translog multiproduct cost function and company refining data from the Financial Reporting System (FRS) maintained by the Energy Information Administration. The principles of contestable market theory are then applied to the estimated cost function to determine the cost minimizing number and size of overall company refining operations. Given that the existing configuration is significantly different from the cost minimizing structure, Stigler's survivor technique is used in part to determine if the industry is adjusting toward the optimal structure.