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Promoting the U.S. flag merchant marine.

*Gerald A. Pollack is Associate Professor of Finance at Pace University, New York, NY.

1 See footnotes at end of text.

For national security reasons, the United States has long had a policy of promoting the country's merchant marine. In general, U. S. flag ships in international commerce may be subsidized, but only unsubsidized U. S. flag ships may serve the domestic market. In the middle 1980s, however, the Administration admitted into domestic commerce three giant tankers from the international fleet. The results were lower freight rates and the displacement of a number of smaller but more modern tankers. The initial benefits accrued mainly to the owners of the three giant tankers and the oil companies chartering these ships. The direct costs were borne by the owners of the unsubsidized tankers, American seamen, and the U. S. shipbuilding industry. More generally, the overall economy was damaged, because investors cannot count on stability in important groundrules.

IN THE LATE 1970s, the United States began a far-reaching reversal of the preceding decades' trend toward ever more government regulation of business. By and large, deregulation has been a success. There have, however, been notable exceptions. This article concerns one of them, involving an industry that is little known but important for the national security. The article provides a case study of how, in pursuing deregulation, the Administration failed in its statutory responsibility of promoting the U.S. merchant marine. BACKGROUND

The nation's policy of promoting the U.S. flag merchant marine goes back to the early days of the Republic. The basic premise was and continues to be that, for national security reasons, the United States needs a merchant marine that is completely subject to national control in times of emergency.

The dual instruments of this promotional policy have been:

1. Absolute protection against foreign competition in domestic commerce (referred to within the industry as the domestic trades), consisting of the movement of cargoes from one U. S. port to another;(1)

2. Under the 1936 Act, subsidies in international commerce (the foreign trades), consisting of the movement of cargoes between ports in the United States and other nations.

These subsidies are intended to offset the higher costs of U. S. ships and thereby place them on a more even footing with their international competitors. In broad profile, these policies constitute a two-track system - unsubsidized ships for the domestic trades and subsidized ships for the foreign ones.(2) No law keeps unsubsidized ships from international commerce but their high costs usually do, except for government-impelled freight, where preferences apply. Such freight chiefly comprises agricultural cargoes under foreign assistance programs, items procured for or owned by the military, and cargoes underwritten by the Export-Import Bank. On the other hand, those receiving subsidies in international commerce are generally denied access to the domestic trades.


This compartmentalization of the domestic and foreign markets was never airtight, however, and it came under pressure after the oil shocks of the 1970s. These shocks, consisting of oil-supply disruptions and explosive price increases, created an enormous divergence in the fortunes of the domestic and international tanker markets.(3) Domestically, they created a boom; internationally, a bust. Skyrocketing oil prices caused a sharp decline in oil consumption around the world and a corresponding contraction in the demand for tankers. Indeed, the drop in tanker demand was even greater than the decline in oil consumption, because tanker demand is a function of distance as well as volume, and the long-haul Middle Eastern trades were particularly hard hit. The collapse of the international tanker market, moreover, was aggravated by overbuilding in the earlier period, when it seemed that the rapid growth of demand would continue forever. Freight rates had been highly lucrative just before the first oil shock, but afterward fell into a deep slump from which recovery is still incomplete.

The tanker boom in the domestic market had its foundations in the major Alaskan oil discoveries of 1968. Until the first oil shock, virtually none of this oil was being produced. Because the North Slope, where the discoveries were made, is inaccessible to tankers during much of the year, the oil companies involved wanted to build an 800-mile pipeline from the North Slope to the port of Valdez, from where the oil would be moved by tankers. Environmental objections, however, blocked construction of this pipeline and hence production of the oil. OPEC's gift to the domestic tanker fleet was that the oil-supply disruptions and price increases of 1973 so frightened the nation that Congress swept away the legal obstacles to pipeline construction. Thus, with the pipeline completed in 1977, the flow of North Slope oil began.

Because almost all Alaskan output has to be tankered once it reaches Valdez, this unblocking of the environmental gridlock paved the way for a surge in demand for shipping services. But this is not all that Congress did for the domestic tanker fleet; it also banned the export of North Slope crudes. In a world of uncertain supply, went the reasoning, we should hold on to our own resources. Support for the ban was reinforced by the argument that, if the cost of development was risk to the environment, then the people to get the oil in question should be Americans, not foreigners. U. S. flag tanker owners, mindful of their big stake in the outcome, lobbied hard for the ban. They knew that, without it, much of Alaska's production would find a market in the Far East where transportation would be provided by foreign flag tankers rather than by themselves. The export ban assured them of carrying almost every drop of the North Slope's bounty. They would carry Alaskan crude to the various refineries along the West Coast from Puget Sound down to Los Angeles; they also would carry the West Coast surplus (the excess of Alaskan production over West Coast requirements) on the long-haul voyage to the Texas Gulf via Panama.

Thus it was that the oil shocks devastated the international tanker market while being a godsend to the unsubsidized U.S. flag fleet, which enjoyed a near-monopoly on coastwide shipping. The subsidized ships of the U.S. flag fleet, confronting the shrunken international market, were quick to see that the grass was greener on the other side of the fence. Understandably, some of them wanted to cross over, and they found a channel, albeit a narrow one, to this end.


Under the Merchant Marine Act, the government may permit a vessel built with construction subsidies to operate in the domestic trades for up to six months per year, provided that the vessel repays a pro rata share of the subsidy. This possibility of temporarily increasing supply in the domestic trades serves as a safety valve in case increases in demand for tankers threaten to cause short-term surges in freight rates.

The completion of the Alaska pipeline and rapid buildup of tanker movements from Valdez created upward pressures on freight rates that brought this safety valve into operation. In 1978, one year after the Alaskan oil began to flow, the Transportation Secretary sought to relieve these pressures by issuing six-month waivers for subsidized tankers to ply the domestic trades. To guard against the possibility of allowing too much additional supply, the concept of "blocking" vessels was invoked. So long as even one unsubsidized tanker of not less than 100 thousand dwt (medium-size) remained unemployed, subsidized vessels were blocked from entering the domestic trades.

The six-month waiver program was not broad enough to satisfy the owners of subsidized tankers. In response to pressure and fearing defaults on federally guaranteed loans, the authorities began, on a case-by-ease basis, to grant permanent admission into the protected coastal trades to large tankers that repaid their construction subsidies. Two ships entered on this basis, and they succeeded in withstanding the court actions of the unsubsidized interests that sought to dislodge them.

In 1985, the Transportation Secretary, Mrs. Dole, went beyond the case-by-case approach. Specifically in the name of deregulation, she opened the door to all comers with a new rule that, for a one-year period, permitted any tanker built with construction subsidies to enter permanently into the domestic trades upon repayment of its unamortized subsidy with interest. Three Very Large Crude Carriers (VLCCs) availed themselves of this rule and jointly paid back more than $100 million in subsidies and interest.

Their entry set the stage for litigation that carried the argument from Federal District Court (which decided for the Administration's rule) to Circuit Court of Appeals (against), back to District Court (against), again to the Court of Appeals (for), and finally to the Supreme Court, which declined to hear the case. This case, however, was remanded to the District Court for judgment concerning one issue only: the question whether the Administration had adequately considered the environmental impact of the rule under which the three subsidy-repaying VLCCs entered into the domestic trades. As of August 1990, when this article was written, the lower court had not yet made its determination. The upshot of it all, at least up to that month, was that the subsidy-repaying VLCCs have been allowed to remain in the domestic trades. As one would expect, their presence, amounting to more than 10 percent of the total tonnage employed in the Alaskan trades, has significantly depressed freight rates.


For the unsubsidized fleet, the discovery of oil in Alaska and the ban on its export were the best things to happen in the postwar period. However, the permanent admission of the subsidy-repaying ships, particularly the three that entered in 1985 and 1986, was a great misfortune. By 1985, although Alaskan crude production was still rising, the demand for tankers to transport it was already past its peak. The reason is that consumption along the West Coast, which has first claim on Alaskan supply, has been rising faster than production in Alaska and California. Hence, the excess of production over West Coast consumption, the so-called West Coast surplus, was shrinking. The increase in short-haul deliveries to the West Coast could not fully compensate tanker demand for the decline in long-haul shipments via Panama. Accordingly, by 1985 and 1986, when the Administration was opening the door to the entry of additional ships, employment of vessels in the Alaskan trades had already declined some 10 to 15 percent from the peak level of 1982.

The outlook, moreover, was for further declines in demand. Predictably, depletion would begin to take its toll on production in Alaska, where the giant Prudhoe field accounts for three-quarters of total state production and no major new discoveries have been made since the late 1960s. By 1989, Alaska's crude production was on a downtrend. Demand for crude oil on the West Coast, on the other hand, could be expected to continue rising, thereby increasing the short-haul call on Alaskan supply at the expense of the long haul. To make matters worse for tanker operators, a new competitor - a large pipeline from California to Texas - was under construction and scheduled to begin operating around 1987. The crude it would carry across the continent to Texas would divert Alaskan crude from the long-haul Panama-Gulf route to the shorthaul West Coast runs.

To be sure, this overall picture was not in sharp focus back in 1985. But the focus was clear enough. West Coast demand was rising rapidly, the pipeline plans were known and, indeed, it seemed that Alaskan production would crest even sooner than 1989, and at a lower level. It was not difficult to estimate that the combination of these fundamentals would eliminate the West Coast surplus by the early to middle 1990s, bringing an end to long-haul tanker movements. By then, demand for tankers in the Alaskan trades would be down more than 50 percent from the level of 1984, the year that provided the point of departure for both the federal authorities who opened the repayment door and the subsidized shipping interests that had the opportunity to enter.


If this characterization of the situation is correct, it was surely irresponsible of the federal authorities to invite permanent entrants and ill-advised for anyone to accept. Yet three VLCCs did. Does this and the fact that they repaid more than $100 million for the privilege imply that the preceding analysis has been misleading? Not necessarily. First, the international tanker market, to which the subsidized VLCCs were confined, was depressed, as already explained. in the circumstances, it was not surprising that the Alaskan side of the fence should have looked attractive. Even so, it is noteworthy that the only subsidized ships that elected to repay their subsidies were VLCCs.

For these VLCCs, and evidently for them alone, there was a second reason for repaying the subsidy, a reason good enough to clinch the case. The three VLCCs in question were able to operate profitably at lower freight rates than could most, if not all, of the other ships that were already in the Alaskan trades. They were therefore certain of being able to compete their way into employment and, once there, had favorable prospects of making money. indeed, they made sure of this by lining up charterers before they took the plunge. Their cost advantage was not due to any special merit or efficiency; it was purely a function of size. The economies of scale involved were emphasized by the Administration, after the fact, when it had to justify itself in court. Without the three VLCCs, it declared, ". . . a significant portion of the domestic trade - the transport of crude oil from Valdez, Alaska to Panama - would face a shortage of vessels that can take advantage of inherent economies that larger ships (resulting from the length of haul) enjoy in the market."


These economies of scale, far from being a justification for admitting the three VLCCs, should have been sufficient cause to deny them entry. The reason for this counterintuitive and seemingly paradoxical conclusion is simply that, in normal circumstances, the markets afforded by the Alaskan trades could not support ships of the large VLCC class. Everyone recognized that the long-haul movement of Alaskan oil via Panama would last only about fifteen years, too short a period to justify the large investment required for a U. S.-built 250 thousand dwt VLCC. This would not have been a decisive consideration if such VLCCs had the flexibility to be used in shorter-haul coastal trades. But what VLCCs provide in economies of scale, they lack in flexibility. Their size and deep draft constrains their access to ports, and their cost advantages are vitiated when they operate light-loaded or require lightering (partial unloading into smaller ships) before discharge.

The permanent admission of subsidy-repaying VLCCs thus introduced a distortion into the restricted market system created by protection against foreign competition and the export ban. The initial investment in the three VLCCs did not have to be justified in terms of their prospects in the Alaskan trades; they were built for the international market. As it turned out, that was a mistake, but such mistakes are a normal part of decisionmaking in an unpredictable world. When the door to the coastal trades opened in 1985, one of the three entering VLCCs was already twelve years old and the other two were each eight. Their initial investments were sunk costs. All they had to justify was the subsidy repayment, minus scrap value at the time.

At this point it would seem that their second decision was not as advantageous as they may have thought at the time. One of them, after having repaid its subsidy, is now back where it started plying the international trades, where freight rates have improved. The company chartering the other two has given notice of its intention to return them to their owner by around the end of 1990. At that time, their only options will be the international trades or the scrap heap. Meanwhile, the entry of the three VLCCs has displaced around 750,000 deadweight tons of smaller tankers, more than 10 percent of the total tonnage working in the Alaskan trades, including a number of younger ships with more modern propulsion systems. Thus, modern, efficient tankers, which were highly competitive within the market system as originally constituted, were displaced by much larger ships, which were not commercially viable within that system, but which enjoy greater economies of scale.

Estimates by the Maritime Administration suggest that the entry of the three VLCCs depressed freight rates and reduced tanker revenues by $150 million to $200 million a year. Thus, their admission was a major, if not decisive, cause of defaults by numerous ships on federally guaranteed loans. Making good on these loans cost the government significantly more than it collected in subsidy repayments from the three VLCCs.

There were other adverse consequences. Several hundred seamen lost their jobs (from a total of around 10,000 jobs in the entire U.S. flag fleet), and numerous shipbuilding opportunities were lost to the U.S. industry.

To be sure, there were some positive effects. The owners of the three subsidy-repaying VLCCs benefited, although as things turned out probably less than they expected. In addition, Alaskan oil producers were able to enjoy transportation cost savings that enhanced their earnings. The increased profitability of their Alaskan operations may have led them to increase their exploration and development activities in Alaska or elsewhere, although the transportation cost savings, in the overall scheme of their operations, were modest. Consumers, on the other hand, realized little, if any, reduction in the prices of petroleum products; indeed, such prices may well have risen relative to levels that would otherwise have prevailed. This paradoxical conclusion comes from the reasoning that follows.

Because more Alaskan oil is produced than can be absorbed on the West Coast, competition tends to drive its delivered price down to the level prevailing in the nearest market large enough to absorb the surplus (Texas, in this case). Producers in Alaska are thus price-takers; they receive a netback price at the wellhead equal to the prevailing price in Texas less the transportation costs involved. In competitive equilibrium, the delivered price in Los Angeles is this netback price plus the transportation cost to Los Angeles; only when these price relationships hold is the Alaskan producer indifferent to selling an additional barrel in Texas or Los Angeles. When the three VLCCs entered the Alaska-Panama route, transportation costs to Texas fell, thus raising the wellhead price in Alaska. Competition from these VLCCs also caused a decline in freight rates from Alaska to West Coast destinations, but not as much as to Panama. Consequently, equilibrium prices on the West Coast tended to be somewhat higher. The delivered prices of imported petroleum products, however, set limits on what domestic refiners can charge. Because such imports occur from time to time (they have risen recently), the behavior of petroleum product prices on the West Coast may not have been very different from what it would have been in the absence of the three VLCCs. But the tendency of prices was to rise, not fall.

It is not apparent, therefore, that the three VLCCs brought economic benefits large enough to outweigh the harm they inflicted on the owners and seamen of the unsubsidized fleet and the U. S. shipbuilding industry. The negative effects would seem to predominate. In any event, most of the ongoing consequences of their presence in the Alaskan trades will disappear with their departure. They will probably all be gone by around year-end 1990, the shrinking West Coast crude surplus having greatly reduced shipments via Panama. In this perspective, their impact was only temporary; they only hastened an inevitable decline in the unsubsidized fleet.

In one sense, however, the decision to admit the VLCCs will have adverse consequences that outlive the direct effects of that decision. The government, in this instance, has provided yet another example of adverse changes in groundrules after investors have committed their capital. Doubts about the stability of groundrules, thus reinforced, cannot but discourage investment generally and distort the structure of capital spending toward quick-payback projects. The costs of what was done, therefore, go beyond the shipping and oil industries, and touch on economic performance in its broadest domestic and international dimensions.

The Administration could have found other ways to assist U.S. flag ships laboring in the depressed foreign trades than to open the domestic market to those willing to repay their subsidies. One obvious possibility would have been to liberalize the six-month waiver program for temporarily admitting subsidized tankers into the Alaskan trades. No doubt the concept of a blocking vessel could have been made less restrictive. Another possibility would have been to award operating-differential subsidies to U.S. flag tankers in international commerce to offset their competitive disadvantages. The Maritime Administration itself estimated that this would have required approximately $5 million per year per ship, or $15 million for the three VLCCs, an amount it termed "exorbitant." But it took in stride the $150 million to $200 million annual loss to the tanker operators in the Alaskan trades which, its own figures suggest, resulted from the entry of the three subsidy-repaying VLCCs.


Perhaps, at this point, something should be said about the validity of the national security argument that, in addition to the matter of equity, provides the main reason why a general audience should care about what happens to the U.S. flag fleet.

In the case at hand, the connection between a national flag merchant marine and possible emergency military requirements is more direct than is demonstrable in most cases. Even critics generally concede that this fleet proved itself to be of value in the wars of recent history. They argue, however, that the great changes in military technology since World War II have greatly reduced, if not altogether eliminated, the security need for such a fleet.

No doubt the nature of warfare has changed. Yet it would seem prudent to maintain a national fleet, at least at some level of capability, to help supply military and/or civilian needs in case of conventional warfare, involvement in regional conflicts, or participation in international efforts to contain aggression, for example, Iraq's invasion of Kuwait, with its threat to world oil supply. But if this is granted, a promotional policy must follow, for there would otherwise be no national fleet. The costs of building ships in the United States and crewing them with American seamen would be too high for survival in a free market.

To be sure, it does not follow from the need for a promotional policy that such a policy must take the particular form of absolute protection from foreign competition. But in the current budget climate, subsidies are simply not a realistic alternative. Even for U.S. flag ships in international commerce, there have been no new subsidy contracts for over a decade, and by 1995 all existing contracts will have expired. In the circumstances, a suboptimal solution is the best that is achievable. To put the matter more positively, absolute protection for coastwide shipping has been a feature of U.S. law since 1817.

The national security argument has been invoked not only as justification for the promotion of a U.S. flag merchant marine, but also as justification for the ban on exports of Alaskan North Slope crude. While the former argument has some merit, the latter has little, if any. Because oil is fungible, like money, it is difficult to conceive of an oil shock as other than a price phenomenon, i.e., a shortage that results in a higher market-clearing price, but not a denial of supply to those willing to pay. In the event of another oil shock, the United States, being the world's largest oil importer, would be subject to the same higher prices other importing nations would have to pay, with or without the export ban. We would be in essentially the same position, having kept the Alaskan oil for ourselves, as we would be if we sold it to Japan at prevailing market prices and used the proceeds to buy replacement oil on the world oil market. Moreover, the United States is signatory to an international emergency sharing agreement that commits it, in the event of a significant supply interruption, to limiting oil consumption and sharing supplies with other nations. Under the sharing formula, which is consumption-based, the quantities the United States would be called upon to share would be about the same with the export ban as without it.

The export ban is difficult to justify even as a means of promoting the merchant marine. It significantly distorted resource allocation relative to what would have been the outcome of free market forces. Crude oil prices along the West Coast were depressed by something in the range of $0.75 to $1.70 per barrel because of the ban (market imperfections on the West Coast preclude more exact estimates), and oil producers experienced revenue losses on the order of $1 billion to $1.5 billion a year. The lower prices discouraged production, stimulated consumption, and thus actually had the perverse effect of increasing the nation's net oil-import dependence. As a means of promoting the merchant marine, the export ban was very expensive.

Ill-advised as the export ban appears to be, it nevertheless represents a national policy on the basis of which investment decisions were made negative decisions in the case of the oil industry and positive ones in the case of the U.S. shipping industry. By increasing the attractiveness of the domestic tanker market, the ban helped to draw around $4 billion into the construction of new tankers to deliver Alaskan oil to the U.S. market. The irony is that, once they were built, a substantial number of these tankers were driven out of the Alaskan trades as a result of the Administration's decision to admit ships from the international wing of the U.S. flag fleet into the domestic trades.


As is typical when groundrules are changed, there were gainers and losers in this case. The subsidy-repaying VLCCs probably came out ahead, but perhaps by less than they had counted on. Because of oil pricing dynamics, however, consumers on the West Coast did not share directly in the lower costs of transporting Alaskan crude. The principal gainers were the oil producers of Alaska, whose earnings increased and who may therefore have expanded their operations (thus indirectly benefiting consumers). The main losers were the owners and seamen of the unsubsidized tanker fleet and the U. S. shipbuilding industry. The federal budget was also a loser. Having overtonnaged the domestic market, the government was obliged to pay out more on defaulted federally guaranteed shipping loans than it had collected in subsidy repayments from the three VLCCs. Finally, there was a loss to the overall U.S. economy through yet another reminder that investors cannot count on stability in groundrules; heightened perception of risk tends to discourage investment and skew capital spending toward quick-payback projects.

All in all, it would seem that the net economic effect of the change in groundrules was negative. Truly, U.S. policy toward the nation's merchant marine provides a fascinating case study of misguided decisionmaking.


1 This protection occurs pursuant to the Jones Act of 1920, which codifies previous acts going back to 1817, and several other laws. To qualify for the protection, a ship must be U.S.-citizen-owned (at least 75 percent U.S. ownership is required), built without subsidies in a U.S. shipyard, registered under the U.S. flag, and otherwise U.S.-documented for the domestic trades.

2 The protection granted for the domestic trades might be regarded as an indirect subsidy, paid for in higher transportation costs and ultimate prices by U.S. consumers rather than in cash by the U.S. Treasury.

3 The total privately owned U.S. flag bulk shipping fleet, more than 90 percent consists of tankers, and about 75 percent of these are unsubsidized.
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Title Annotation:negative effects of the decision to allow three giant tankers from the international fleet to enter domestic commerce
Author:Pollack, Gerald A.
Publication:Business Economics
Date:Apr 1, 1991
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