Oil Prices, OPEC, and the Impact on Competing Economies

Introduction: The Global Crude Oil Market

Crude oil is an important commodity in today's world, providing the major source of energy that keeps economies running. This centrality has produced very large price swings whenever shortages or excess supply occur. These price cycles can last several years, as demand is spread across both OPEC and non-OPEC supply sources (Oil Price History and Analysis). The entire petroleum market is highly controlled in terms of marketing, and the seven companies that dominate the international market — either directly or in collaboration with others — sell petroleum products through subsidiaries and affiliates in all major markets of the world (The International Petroleum Cartel).

As far as the United States is concerned, prices have been directly controlled through production and price regulations for most of the twentieth century. During the entire period after World War II, the price of oil averaged approximately $19.61 per barrel, measured in year-2000 dollars. During the same period, the price paid for domestic American crude was about $15.25 in 2000 dollars. This means that crude prices from 1947 to 2003 exceeded $15.25 only about half the time (Oil Price History and Analysis).

In terms of market dominance, seven companies control the oil market throughout the world. Five are American: Standard Oil Co. of New Jersey, Standard Oil Co. of California, Socony-Vacuum Oil Co., Gulf Oil Corp., and The Texas Co. Two are British-Dutch: Anglo-Iranian Oil Co., Ltd., and the Royal Dutch-Shell group (The International Petroleum Cartel). Prices rose slowly in the early postwar years, standing at only about $3.00 per barrel in 1957, up from a low of $2.50 in 1948. By the end of the century, prices were between $14 and $16 per barrel — figures that do not represent a real increase but rather reflect the inflation occurring over that period (Oil Price History and Analysis). The oil companies maintain strong control over their operations, in part through directors serving on the boards of more than one affiliated company (The International Petroleum Cartel).

When considering the international situation, control over the petroleum industry is divided between two major forces: state monopolies and the seven large international petroleum companies noted above. This control encompasses reserves, production, refining, transportation, and marketing (The International Petroleum Cartel). Despite such controls, oil prices have reached very high levels in recent times — the price of U.S. light crude exceeded $56 per barrel before retreating to lower levels (Higher oil prices hit US growth).

The interconnections among the major oil companies are extensive. The Iraq Petroleum Co. and its subsidiaries are owned by Jersey Standard, Socony, Royal Dutch Shell, and Anglo-Iranian. Kuwait Oil is owned jointly by Gulf and Anglo-Iranian. Standard of California and The Texas Co. are linked through the Caltex group of companies, and are also tied to Jersey Standard and Socony through the Arabian American Oil Co. and the Trans-Arabian Pipe Line Co. (The International Petroleum Cartel). The importance of the United States in the global oil market stems in part from the fact that oil sales worldwide are denominated in U.S. dollars.

International Oil Regime and Major Producers

As a result, increases or decreases in the value of other currencies against the dollar directly affect OPEC's pricing decisions and production levels. When the international value of the dollar falls, OPEC members receive less revenue in their own currencies, reducing their buying power. This dynamic led Iraq at one point to demand payment in euros shortly after that currency was introduced. It was widely believed that if other OPEC members had followed this precedent, the consequences for the American economy could have been severe (OPEC: Wikipedia, the free encyclopedia). At current price levels — nearly double those of the prior year at the time of writing — oil has become a critical factor in the world economy and commands the attention of most national leaders (Oil and Stagflation).

OPEC currently consists of Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela, with its headquarters in Vienna, Austria. The organization exists to negotiate with oil companies regarding petroleum production, prices, and future concession rights (OPEC: Wikipedia, the free encyclopedia). It is therefore essentially a pricing agency for crude oil, without direct control over downstream processing. The seven major international petroleum companies own 65 percent of the world's estimated crude oil reserves, giving them effective control over future global oil supply — assuming alternative fuels do not become widely adopted.

Outside the United States, these "seven sisters" hold 82 percent of reserves after accounting for their 34 percent share of U.S. reserves (The International Petroleum Cartel). OPEC's agreements are intended to help its members maximize returns from the roughly two-thirds of reserves they collectively own. Today, OPEC members supply about 40 percent of world production and half the world's oil exports. Their position generated over $338 billion in oil export revenues for the eleven member countries — an increase of 42 percent over 2003 figures, according to the Energy Information Administration. By comparison, oil exporters collected only $23 billion in 1972, and even in 1977 — when prices were at their highest following the 1973 oil crisis — the total was only $140 billion (OPEC: Wikipedia, the free encyclopedia).

It is important to note, however, that raw dollar figures do not tell the complete story, as the impact of inflation must be taken into account. Consumer spending has not been dramatically affected by high oil prices, although there has been some softening as prices gradually increased. The effect became more pronounced when prices climbed above $50 per barrel. The inflationary pressure from higher oil prices has remained modest (Prospects for US Economy). Most analysts at the time believed that a prolonged increase in the second quarter of 2005 could seriously harm U.S. economic growth (Higher oil prices hit US growth).

OPEC's ability to control prices has historically been limited, which is one reason it is difficult to classify it as a true cartel. The organization has never been able to enforce member production quotas. This was evident even during the 1979–1980 period of rapidly rising prices, when Saudi Arabia's oil minister, Ahmed Yamani, warned other OPEC members that rapid price increases would lead to a corresponding fall in demand — advice that went unheeded (Oil Price History and Analysis).

The concept of an oil embargo did not originate in 1973. One of the earliest attempts was the embargo imposed by the United States and the Netherlands on Japan before World War II. The use of oil as a strategic weapon by Arab countries in 1956 came 17 years before the famous 1973 embargo. During the 1960s, the United States and Western Europe also restricted oil imports from the Soviet Union, fearing that dependence on Soviet energy supplies could be exploited for political leverage — they even banned the export of wide-diameter steel pipes used in Soviet pipeline construction (The Failure of the Oil Weapon: Consumer Nationalism vs. Producer Symbolism). At that time, Western countries were not as critically dependent on foreign oil as they would later become. The situation changed fundamentally with the October War, which began shortly after midday on Saturday, October 6, 1973, with a coordinated attack by Egypt and Syria on Israel (Oil Price History and Analysis).

Wars, Embargoes, and Inflation

Three important contextual points must be kept in mind regarding the 1973 embargo. First, the escalation to an embargo was not a surprise to Western nations — the United States and its allies had been receiving warnings from Arab countries months in advance, and the embargo was politically rather than economically motivated. Second, the United States was already experiencing an energy crisis well before the embargo; President Richard Nixon had addressed the nation on energy shortages six months prior. Third, Saudi Arabia — the largest supplier to the United States — did not support the imposition of the 1973 embargo (The Failure of the Oil Weapon: Consumer Nationalism vs. Producer Symbolism).

Even within the Arab world, the use of oil as a political weapon had precedents. Producing countries had wielded it against Western nations in 1956, 1967, and 1973, with those earlier efforts led by Saudi Arabia and Kuwait — countries that maintained friendly relations with the United States. The objective was to pressure nations supporting Israel into changing their positions and compelling Israel to withdraw from territory occupied during the 1967 war (The Failure of the Oil Weapon: Consumer Nationalism vs. Producer Symbolism).

The 1973 war began on the holiest day of the Jewish calendar, Yom Kippur, when Jews observe synagogue prayers and fasting. The element of surprise gave Egypt initial success: Egyptian forces crossed the Suez Canal while Syrian forces seized the Golan Heights. The tide began to turn after October 10, when Israeli forces pushed beyond the 1967 ceasefire line. On the Egyptian front, Israel's counteroffensive was even more dramatic — on October 14, Israeli forces crossed the Suez Canal and surrounded the Egyptian Third Army. The fighting drew in the superpowers, bringing the United States and the Soviet Union dangerously close to direct confrontation. A ceasefire agreement approved on October 22 did not immediately end the fighting, but a joint U.S.-Soviet resolution calling for a ceasefire was ultimately approved by all parties on October 26 (Israel and Zionism: October War: 1973). While it had been assumed that a combination of consumer nationalism and producer symbolism could allow the "oil weapon" to achieve short-term economic goals, the episode demonstrated that it could not achieve lasting political objectives. In the days just before the embargo and the war, OPEC members had already raised prices by 70 percent (The Failure of the Oil Weapon: Consumer Nationalism vs. Producer Symbolism).

The relationship between petroleum prices and inflation is not as straightforward as often assumed. In 1970, before the oil shocks, gas shortages, the popularization of the term "stagflation," and OPEC's rise to prominence, the price of oil was $1.80 per barrel. It rose to $2.25 within two years, reflecting a presidential election cycle and Libya's decision under Col. Muammar Gaddafi to withhold oil from the market. The October War and subsequent Arab oil embargo sent prices to $11.58 per barrel — equivalent to approximately $43.40 in today's currency. Alarmed central banks responded with tight monetary policies, but these measures proved ineffective in restraining oil-driven price increases. In the 1980s, the Iran-Iraq War restricted supply further, pushing prices to about $35 per barrel — roughly $80 in today's dollars (Oil and Stagflation). The current round of price increases is being partially offset by GDP growth of approximately 3.1 percent, as consumers and businesses tighten their spending (Higher oil prices hit US growth).

OPEC has acknowledged since August 2004 that its members have little remaining spare pumping capacity, signaling a diminishing ability to influence prices. One member, Indonesia, has been considering withdrawing from the organization, having become a net oil importer unable to meet its production quota (OPEC: Wikipedia, the free encyclopedia). Arab oil-producing countries generated significant revenues from oil exports for only a limited number of years following the embargo. Even those gains did not deliver large strategic advantages, as the "petrodollars" earned were largely recycled back into Western economies through investment. This outcome improved the U.S. trade balance while hurting Western Europe and Japan, making the embargo exercise a poor long-term decision for the Arab countries involved (The Failure of the Oil Weapon: Consumer Nationalism vs. Producer Symbolism).

For China, labor-intensive manufactured goods have captured a large share of the international market, but this sector's role as an engine of growth is expected to slow, potentially generating significant urban unemployment (Higher oil prices hit US growth). In terms of petroleum demand, China has led growth with an additional 840,000 barrels per day consumed in the most recent year, driven partly by a doubling of car sales — though this rate of increase is expected to moderate. In India, vehicle sales rose 18 percent in the same period (China, India's oil demand unlikely to decline). India's situation is further complicated by the fact that it remains one of the most heavily regulated economies in the world (India Economy Growth).

The Indian government has been working to reduce prices of oil-based goods in the near term in order to bring inflation — which has been running above 8 percent annually — under control. A truckers' strike, while disruptive, was not expected to reduce underlying oil demand (China, India's oil demand unlikely to decline). India has recently seen a significant expansion in its consuming class: approximately 10 million Indians are now considered upper class, and an estimated 300 million fall into the middle class. This has attracted foreign businesses seeking to serve a large pool of potential customers, and demand has surged for televisions, refrigerators, motorcycles, and automobiles (India Economy Growth). The Chinese government, for its part, has attempted to cap domestic energy prices for average consumers despite rapid global price increases, in an effort to prevent economic overheating (China, India's oil demand unlikely to decline).