Price Uncertainty and Vertical Integration: An Empirical Examination of Petrochemical Firms

Abstract

Input transactions in the petrochemical industry are subject to temporal specificity. That is, non-performance in quantity, such as delaying delivery, is highly costly to producers and can be an effective holdup strategy. Buyers and sellers of petrochemical inputs have been averse to frequent price changes. The aversion to haggling over prices reflects the desire of maintaining stable input supplies critical to production efficiency. In the 1970s, two oil price shocks induced high price volatility in the industry. The price volatility created immense pressures for price adjustments in contracts. The traditional agreements of inflexible prices were destabilized, resulting in widespread disputes and renegotiation. The industry and the time period together create a natural opportunity for examining how governance structures of transactions adapt to price uncertainty. This paper examines in particular the effects of input price uncertainty on vertical integration. Based on plant-level data for U.S. producers of 49 petrochemical products, this study finds that the producers' extents of vertical integration, measured by their degrees of input self-sufficiency, were positively related to input price volatility during the period of the oil price shocks. The positive reaction of vertical integration to input price volatility is attributed to the producers who had the highest expecting costs of supply disruption.