Economical Effects of OPEC Oil Crisis

One of the most important commodities worldwide is crude oil. It is a main chief source of energy, contributing to a staggering 56% of total energy consumption.[1] Oil is a major source of energy because, unlike other sources, it is much cheaper. Much of the oil that a country consumes is imported from OPEC countries, whereas only three and a half percent of the oil that is consumed is produced domestically.[2] Hence, oil accounts for a large percentage of import bills. When OPEC begins to change oil prices in the 1970s, an oil crisis occurs, and oil-importing countries began to take notice as their import bills begin to rise dramatically. [1: Rybczynski (1976, p. 3)] [2: Rybczynski (1976, p. 3)]

OPEC is an intergovernmental organization. Most of the nations that were a part of this organization formed after the breakup of the colonies after World War II. Thus, they were experiencing a rise in nationalism that enhanced their takeover of international oil production companies.[3] This takeover allowed OPEC and OPAEC (Organization of Arab Petroleum Exporting Countries) to coordinate crude oil pricing, production decisions, and basic policies. OPEC used its newfound power to place an oil embargo on several countries and increase the price of oil from $0.91 per barrel in 1970 to $10 per barrel in 1974.[4] Economists believe there are two major causes of the oil crisis that involve both economics and political factors. [3: Jacoby (1974, p. 261)] [4: Rybczynski (1976, pp. 3-4)]

The political argument or the crisis revolves around the Arab-Israeli war. In this argument, Arab countries used oil as a weapon against countries that were supporting Israel. Israel’s allies, such as the United States, were boycotted. This boycott included an embargo that was accompanied by gradual monthly production cuts; whereas those friendly with the Arab countries experienced preferential treatment[5]. Along with the political factors, there are also economic factors that involve the floating of gold, which was a direct result of the ending of Bretton-Woods in 1971. [5: Rybczynski (1976, p. 4)]

Bretton-Woods, formed in July 1944, created “international monetary agencies and rules governing the exchange rates and international monetary cooperation, and those arrangements governed the conduct of world and payments.”[6] Each country fixed its currency value to the US dollar. When countries started to redeem the reserve dollars for gold, which was fixed at $35 dollars per ounce, it became clear the U.S. could not support this gold price.[7] The US closing the gold window, in August 1991, suspending the United States’ obligation to buy these dollars from the foreign central banks. The world moved to a flexible exchange-rate system as the price of gold began to float. The currency market began to experience turmoil and inflation began to rise, causing the price of the dollars to fall. “Given that oil contracts were stipulated in US dollars, this decline meant that oil revenues per unit from these countries fell to OPEC while prices of all commodities,, including gold, rose.”[8] Therefore, the rise in the price of oil was due to the price of oil being in terms of a fixed amount of gold instead of US dollars. In 1972, the 8.49% increase in oil price corresponded to the 8.57% rise in the price of gold.[9] [6: Hammes and Wills (2005, p. 503)] [7: Hammes and Wills (2005, p. 504)] [8: Hammes and Wills (2005, p. 504)] [9: Reference Figure 1 in Hammes and Wills (2005, p. 504)]

Despite how you interpret the cause of this crisis, there were many profound effects that occurred due to this price change and embargo, ranging from inflation to balance of payments to trade disturbances. Ben Bernanke focused on the increased inflation that the oil crisis caused and whether monetary policy could fight this increased inflation. Bernanke believed that “an increase in oil prices slowed economic growth in the short run, primarily through its effects on spending, or aggregate demand.”[10] Bernanke concluded that this increase in oil prices is analogous to an imposition of a tax on a US resident. However, the revenue of this supposed tax will be going to the oil producers and leads to a duel inflation effect, etc.[11] [10: Bernanke (2004)] [11: Bernanke (2004)]

The first-round inflation effect focuses on the fact that an increase in oil prices leads to a higher demand for alternative energy sources, which leads to a higher price on those substitute energy sources. These higher energy prices drive an increase on the cost of living. The second-round interest effect focuses on the indirect effects of the price increase of oil. “Firms pass on the increased cost of production in the form of higher consumer prices for non-energy goods or services. Consumers respond the increased cost of living by demanding higher wages”.[12] If the Federal Reserve decided to fight this inflation by increasing interest rates, then it would lead to a slow growth and rising unemployment which leads to recessions that occurred in 1973. Therefore, a country experiences stagflation, meaning they have high inflation combined with high unemployment.

Unfortunately, monetary policy cannot offset both at the same time. The central bank can lower interest rates in hopes of stimulating growth in the economy, but this action could risk adding inflationary pressure and make the economic slowdown worse. Whether monetary policy eases or tightens “depends on how the policymakers balance the risks they perceive to their employment and price-stability objectives, most choose a policymaking approach between the two extremes.”[13] However, Bernanke believes that the best option is to “follow a policy rule based on target values of unemployment and some appropriate measure of inflation, much like the Taylor rule where monetary policy makers would move the short-term target interest rate--the federal funds rate in the United States--up or down to respond to deviations in core inflation and unemployment from their target values”. [14]The United States, however, was not the only nation that was affected by this oil crisis. [12: Bernanke (2004)] [13: Bernanke (2004)] [14: Bernanke (2004)]

The oil crisis had a worldwide effect. David S Painter focused on three areas that were affected: non-oil producing countries, western European oil-producing countries, and the Soviet Union. Western industrial countries that could produce some oil domestically experienced inflation, and the higher import bills disrupted the imbalance of payments, resulting in higher prices of commodities. These higher prices on exports resulted in a harder hit for the non-oil producing countries because, not only did they have to pay higher prices for energy sources, but they also had to pay higher prices for products in developed and developing countries.[15] With demand for exports low and prices continually increasing, these under-developed countries had to borrow money from western banks. Unfortunately, they borrowed more than they could afford and were unable to pay back, resulting in the third world debt crisis in the 1980s. [15: Painter (2014, p. 194)]

The Soviet Union, in the late 1960s, was an exception to the high import prices for oil. This exception is due to the Soviets finding rich fields that could triple their oil production. The oil exports for the Soviet Union covered half the Soviet’s hard currency earnings. An indirect benefit of the crisis was that the Soviets could use this hard currency to increase weapon production which strengthened their military. These enhanced weapons were also exported to the Arab countries who had a newfound surplus of wealth. Although, there were many benefits in the short run, issues began to occur in the long run.

As oil prices continued to rise, many programs went into effect around the world that decreased the demand for oil. These programs made an emphasis on reducing the use of imported oil by increasing domestic oil, substituting for alternative energy sources, and increasing nuclear power. This reduction in demand, along with the Saudi leadership increasing production of oil and putting a premium on volume rather than price led to the collapse of oil prices, decimated the Soviet’s hard currency. The Russians also used their wealth and advanced technology to provide both foreign and military aid to Afghanistan. Unfortunately, when they invaded Afghanistan, their relationship took a turn for the worst. The Soviets were met with opposition. This opposition and the hard currency decimation played a hand in the collapse of the Soviet Union at the end of the Cold War. [16] [16: Painter (2014, pp. 194-196)]

Demand and supply economics of the oil crisis was also a focus for Chistopher Knittel. Knittel emphasized the two-tiered pricing system that Nixon signed which stated that “wells drilled before 1973 had a price ceiling of $5.23 a barrel while oil from wells which began to operate after 1972 could be as high as $11 per barrel.”[17] This system extended price controls for refined products and created large rent transfers. Later, when Ford came into office, he urged for the decontrol of oil prices, but was denied by congress until the EPCA (The Energy Policy and Conservation Act). This act, created in 1975, was a compromise of sorts that reduced the price for domestic oil. The EPCA “created a maximum average price for domestic oil and removed the $2 tariff on oil imports.”[18] [17: Knittel (2014, p. 105)] [18: Knittel (2014, p. 106)]

On the demand side, the government focused on programs and policies that reduced the consumption of oil, which led to the decrease in demand of oil. The government created an odds-evens rationing program, the Emergency Highway Energy Conservation Act, and implemented gas guzzler taxes that are still in effect today. The rationing program limited when people could get gas, and the conservation act gave states a limited amount of time to reduce speed limits. If the states failed to do so, then they lost all federal highway funds.[19] [19: Emergency Highway Conservation Act (Public Law 93-239) also contributed $1.5 billion to finance a new rail system.]

Although consumption decreased, there was a lag, so demand remained constant for awhile. Hence, there was an imbalance of payments created. Painter believed that the increase in oil prices had a harmful effect on the balance of payments. Other economists, such as Gerald A. Pollack found that, although there will be an imbalance of payments, the payment problems will only primarily involve financial relations within the importing countries, not between the importing and exporting countries.[20] Gerald A. Pollack established three advancements, or conclusions. He established that a quantum jump in import bills leads to OPEC holding an investible surplus. Thus, foreign investment is inevitable. “The only disturbances in the capital market will be if OPEC’s preferences differed slightly from pre-existing patterns.”[21]

With the knowledge of these three advancements, Pollack concludes that the imbalance of payments can be worked out through each country. “The essential problem of consuming countries, once equilibrium is disturbed, is to move to a new structure of trade compatible with the altered flow of international investments funds.”[22] This new equilibrium will be obtained with exchange rate movements. Countries receiving a rise in capital inflows that exceed their oil import bills will experience a rise in exchange rates, making them less competitive internationally. This rate will continue to rise until “the deterioration of their trade balances become large enough to offset the extra capital inflows.[23]” The reverse process will occur for countries that do not have sufficient capital for their import bills. This process will allow trade and capital for each nation to come to a new equilibrium. [20: Pollack (1974, pp. 456-457)] [21: Pollack (1974, p. 457)] [22: Pollack (1974, p. 457)] [23: Pollack (1974, p. 457)]

There are many different economist’s views on the implications of the OPEC oil crisis. Each economist’s perspective revolves around the long-term and short-term economic impacts. I believe that the oil price shocks and embargo do ultimately result in more negative impacts than positive impacts. Many large countries, such as the US could afford this increase in oil prices by increasing exports to balance off their payments while other countries dependent on oil had to borrow funds to cover the increased cost. These funds could be obtained in the international money market or the International Monetary Fund.[24] The countries with the largest strain would be those less-developed countries with very little money and a no ready access to the international money market. [24: Jacoby (1974, p. 265)]

Countries do not only worry about the higher oil prices, but the increase in prices of commodities. Firms will notice a rise in the cost of producing products due to the oil price change, and they will transfer that cost to the consumers as higher prices on commodities and services. These higher prices leads to an increase in inflation, which was already escalating before the crisis. The rise of oil prices means businesses that use oil will change or adapt. For example, car companies may begin to cut back employment as demand for cars is low due to the prices. Companies that focus on fuel-efficient cars will see an increase in demand. Therefore, the cutback of oil supply follows the basic Keynesian economics. Aggregate supply decreases, resulting in and an increase in price and decrease in demand as other energy sources will begin to be used as a substitute. This change in the market results in adverse supply side shocks such as inflation, higher unemployment, and a decrease in GDP. All these changes involve economics. However, the oil crisis also affected politics.

OPEC countries begin experiencing nationalism as they grow in power. They use oil as a weapon to see whether the US will choose its civilians over the aid of foreign nations such as Israel. This action increases tensions between the US and the Arab countries, and it also increases tensions between the US and its allies. These tensions occur because the allies place the blame on the US for supporting Israel, which fueled the fire and resulted in embargos and enhanced oil cutbacks. Tensions occurred between the US and the OPEC countries because these oil-producing Arab countries begin to amass power and control, and they show this newfound power in the form of controlling oil prices. They begin to threaten the international system by taking control of the world oil market. This monopoly makes it seem like the OPEC countries have an upper hand and receive all the benefits from this crisis, but, in the long run, these countries will not reap all these benefits.

OPEC’s decision to place an embargo and raise oil prices woke the United States up. The United States placed a majority of their eggs into one basket. They neglected other energy sources because coal production fell sharply due to environmental concerns, nuclear power was costly, and the development of natural gas was held up by the very low price fixed by government regulations.[25]

Oil was a cheap reliable source that was available, and the Western world believed that no problems would occur. Particularly, they “behaved like spoilt children in thinking they could have unlimited amounts of energy at no cost.”[26] This shock to the system made the Western world realize that they could not rely solely on one source, and this realization potentially changed the trends in the oil market. Not only did oil-importing countries increase their total production of domestic oil, but there are many new emerging non-OPEC oil sources that increased as a result. OPEC joined to take control of oil prices and policies, but these decisions resulted in OPEC’s share of world oil output lowering. [25: Issawi (1978, p. 11)] [26: Issawi (1978, p. 11)]

The economics of the oil crisis is still talked about today. The world experienced oil shocks even after the oil crisis in the 1970s, and these shocks continue to this day. Therefore, it is important that the Western world broadens their energy sources to ensure that price shocks do not slow the international global economy or an individual nation’s economy. It is also important to notice the downfalls that potentially caused these crises. The failure of the Bretton-Woods resulted in gold floating which brought the foreign currency market into turmoil and further increased inflation rates. This collapse of an international system had rippled effects throughout the world economy. It is important to maintain these systems and to use the failures and successes that occurred during this crisis in the future to make sure that oil price shocks do not have such a profound effect on the economy.