People of a certain age remember the gas lines, the odd even rationing, and the calls for energy independence of the 1970s energy crises. But not many remember that the crisis ended almost as quickly as it started. It’s an excellent lesson in the pervasiveness of the laws of supply and demand.
In the 1960s, the oil exporting nations in the Middle East thought they were being cheated by Big Oil. At the time, the industry was dominated by “The 7 Sisters”: BP, Gulf, Texaco, Shell, and the Standard Oil Companies of New York, New Jersey, and California. They would sign agreements with the governments of the Middle East to drill at a fixed price. The countries decided to band together into a cartel called the Organization of Petroleum Exporting Countries (OPEC) to better negotiate with oil companies. By 1973, OPEC controlled over half of the world’s oil production and proceeded to flex its muscle. When Egypt and Syria went to war with Israel in the Yom Kippur War, OPEC announced it would reduce production 5% monthly until the war ended. More importantly, they raised the posted price of oil 2.5 fold.
This sent the world economy into a tailspin. It seemed like OPEC was an evil unstoppable force that could decide the fate of the world’s economy simply by turning the taps on and off. This was the first energy crisis. The second energy crisis started in 1979 when the Shah of Iran was overthrown in the Iranian revolution, the chaos knocked that country’s oil production offline. Prices soared once again. By mid-1980 they were 6 times higher, inflation adjusted, than in 1972. But OPEC, in its arrogance, did not appreciate how adaptable the world was to these shocks.
The doomsayers who claim we’re at risk of running out of oil ignore the fact that we have virtually unlimited reserves that can be tapped if the price goes high enough. One of them was Alaska. Drilling in the Arctic circle is risky and expensive, but with prices high, it was now profitable, particularly after the Alaska pipeline opened in 1977.
In the 60s, large oil resources were found under the North Sea between Britain and Scandanavia. With the energy crisis, both countries got to work on drilling and Scotland, in particular, soon had an oil boom.
But perhaps the biggest impact came from our good friends in the Soviet Union. During the 70s, they greatly expanded their production and overtook the United States to become the world’s largest oil producer. For the Russians, exporting oil to the West served as a lucrative source of foreign currency and as a way to further Detente. Even the communists could not pass up this type of business deal.
Before 1973, world oil consumption had been rising at a brisk 7% per year, but then in the latter part of the decade, it did the unthinkable, it fell. The US was under Nixon era price controls for most of the decade, which discouraged conservation, but the EPA began requiring appliances improve their energy efficiency. The mandates hit everything from light bulbs to automobiles. When the Carter administration began to lift the price controls in 1979, consumption fell enormously. By 1982, it was down by nearly 1/5 from 1979.
In the early 70s, utilities, urged by the newly created EPA and environmental groups like the Sierra Club, began switching their old coal fired power plants to cleaner residual fuel oil. This became untenable when the energy crisis hit. In 1978, fuel oil powered 15% of the nation’s electricity, it was down to just 5% by 1985. This saved 1 million barrels of daily oil consumption, the biggest source of reduction. Oil was replaced by coal and nuclear power.
In addition, people started heating their homes with electricity and natural gas instead of oil. Consumption of distillate fuel oil fell by 700,000 barrels per day between 1978 and 1981.
The most noticeable change was on the road. Detroit’s motto of “longer, lower, wider” came to an end. The first departure would be GM’s 1977 Full Sized cars. They were much smaller than their 1976 predecessors. They were about the same size as GM’s own intermediate cars and were lighter than them thanks to the use of high strength steel. Few other companies in history have taken such a big risk with their most popular product, New Coke being the exception. But the gamble paid off, sales surged, and everyone else followed suit. The average car in 1975 was a hulk, weighing 4036 pounds and getting just 13 mpg. By 1985, it weighed just 3000 pounds and got 23 mpg. In addition to making cars smaller, they switched to front wheel drive, and gained technology such as overdrive transmissions, lock-up torque converters, and electronic fuel injection. The drop in motor gasoline consumption saved 900,000 barrels per day between 1978 and 1980.
Back to that market share chart. OPEC found itself in an increasingly untenable position in the 1980s. The reason why cartels tend to collapse is that one member will tend to bolt from the agreement to keep production low so that they can make a windfall by producing more at the higher price. Then everyone else follows suit and prices drop. OPEC saw its market share drop from half to barely one quarter. And as they kept trying to cut production, more and more members starting producing above their quotas. Saudi Arabia, by far the biggest OPEC member, followed the quotas but by December 1985 was tired of everyone else screwing them over. They declared they would produce as much oil as they could, at whatever price the market could bear. Prices fell in half in the next 3 months.
Interestingly, prices wound up just above the level, in inflation adjusted terms, that they were in 1972. This meant, contrary to OPEC’s complaints, oil was being priced fairly all along. Today, OPEC is a declawed lion. Its members almost always violate their quotas and know that if they try artificially raising prices, it won’t end well. In fact, their strategy recently has been to try and keep prices low, to bankrupt American frackers. This is also a lesson to those who attack “speculators” who are blamed for supposedly driving up prices of gas, housing, and food, it is simply not possible to defy the laws of supply and demand forever, and eventually market forces will assert themselves. This is what OPEC, and the Hunt Brothers found out the hard way. Those who try to keep prices too high will get slapped hard by the upward sloping supply curve and the downward sloping demand curve.