Streetwise Professor

February 26, 2014

The Division of Labor is Limited by the Extent of the Market: Oil Industry Edition

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 11:49 am

The world petroleum market is undergoing substantial organizational changes, with private oil companies become progressively less vertically integrated and increasingly focused on the upstream.  The latest indicator of this trend is that Chevron is investigating the possibility of divesting its midstream operation.  This follows hard on the heels of the sale of Shell’s midstream and downstream operations in Australia to Vitol (bonus SWP quotes in the linked Reuters article).

This represents an interesting case study in transactions cost/Coasian economics.  In particular, the development of vibrant spot and forward markets for crude oil and petroleum products, and the growth and development of specialized trading firms (like Vitol, Trafigura, and Glencore) have reduced the costs of transacting on the market via the price system relative to the costs of conducting transactions within integrated firms.  Given the existence of thick, liquid, and active spot markets, and the development of logistical expertise by trading firms, assets at a particular stage of the value chain are less subject to holdup by owners of assets at adjacent links of the chain.  For instance, the existence of highly competitive spot markets for crude means that a refinery is  not locked into a small number of upstream suppliers, and thus need not be integrated with a source of crude supply to avoid contractual hazards.  The existence of active product markets has a similar effect.

It is interesting to note that much of the recent disintegration is occurring in smaller markets, and emerging markets, where contracting hazards have historically been particularly acute.  But this is precisely where the trading firms (notably Trafigura and Vitol) have stepped in and acquired assets from oil majors.

This evolution allows the majors to free up capital that they can employ in higher returning-and massively expensive-upstream exploration, development, and production activities.

I said that this was an illustration of transactions cost/Coasian economics in action.  As in most things economic, Adam Smith should really get the credit.  He noted that the division of labor (i.e., specialization) is limited by the extent of the market: Stigler used this insight to explain vertical integration.  The past thirty years have seen the development of a very extensive and vibrant market for oil and refined products (with Marc Rich deserving much of the credit for starting the process).  This spot market facilitates specialization, with the petroleum markets being increasingly characterized by firms that specialize in upstream, midstream, or downstream activities.

Interestingly, this development creates political and regulatory battles, as specialized firms at different segments of the value chain use political and regulatory means to capture a bigger share of the value of a barrel (pace the new battle over US crude oil exports).

Markets in action are a beautiful thing to behold.  Politics not so much.



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  1. BINGO! It is competition and open markets which bring about prosperity. There might be some “waste” in competition, but it is much smaller than the waste in bureaucracy and monopoly.

    Just how do you think China (& the tigers before it) got prosperous? Certainly no trace of democracy, but they had opened markets and encouraged competition. Even on the heavy industrial scale, China has both CNOOC and Sinopec as competing NOCs.

    The question for us becomes, how do we keep competition alive when it is threatened by regulation, captured politicians and oligopolies? Some might decry current AntiTrust as toothless and highly selective. True. But the Internet as we know it could not have happened without the 1982 AT&T breakup.

    Comment by Robert in Houston — February 26, 2014 @ 1:55 pm

  2. Hey, Marc Rich and Pincus Green are/were great americans but giving them credit for broadening the crude market is just wrong. Credit goes to Jummy Carter who price controlled domestic crude prodiction. Rich/Green only relabelled it.

    Comment by t c phillips — February 26, 2014 @ 2:37 pm

  3. That’s a serious mischaracterization of Rich’s role. You are focusing on the US market. Rich and Pincus definitely broadened the international spot crude market.

    The ProfessorComment by The Professor — February 26, 2014 @ 10:29 pm

  4. Marc and Pinky broadened the international market for crude by trading domestic crude until it was effectively relabelled int’l crude. Every large participant in intl spot trading was busy relabelling in similar fashion. I remember many players ( think ARCO ) were convicted but only Marc got sentenced to jail.

    Comment by t c phillips — February 27, 2014 @ 7:56 am

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