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Gas Shortage

Introduction

On October 17th, 1973, the industrialized world woke up to a sudden and unprecedented threat to its own growth and prosperity; never before had it faced such a constraint to its growth nor had it ever been so dependent on a resource it no longer had unlimited dominion over, overturning a system in place since 1860. Price shocks and crises of supply were nothing new within the oil market. However, it was the utter helplessness to alleviate the crisis given the dependence on and inelasticity of oil consumption. The US invited the 1973 oil shock through its complacency and revealed the rigidity of the oil supply-demand system. Although elements within the policymaking establishment sounded the alarm in the years prior to 1973, there was no action to prevent or mitigate the blow of a supply crisis. The direct event leading to the embargo was clear – US support for Israel during the 1973 war. The systemic issues were longstanding and pushed the oil supply-demand system in that direction for years. Despite the confluence of events that suggested a high probability of an effective and sustained oil embargo against the West, the US failed to understand the oil supply-demand system and its elements, misreading both the quantitative risk and immeasurable uncertainty, allowing itself to blunder into the crisis and forgo preventative measures.

1973 Crisis in Context

The oil crisis of 1973 presented the industrialized world with a radical departure from its collective experience in the previous oil crises of 1956 and 1967. An easy escape from consequences in the previous crises altered the calculus in the US, forming biases in the evaluation of risk and uncertainty. The outcome of these crises prevented an evaluation of the systemic changes had accrued between 1956 and 1973. Thus, a brief description of the 1956 and 1967 crises is necessary for understanding biases against action before October 1973.

In addition to the historical events, understanding the complex system that brought oil from well to consumer is crucial. In an economics system framework of Meadows, the stock of the system is the available supply of oil. The inflow into this stock comes from the producers, the supply-side, and the internal mechanisms that allowed this production. Up until 1973, the major producers of the world were the US and the countries of the Persian Gulf, North Africa, Indonesia, and Venezuela. The Eastern Bloc was generally autarkic and remained outside of this inflow. Within that, it was the Western oil companies that had the expertise and technology to extract oil effectively. Through this power, the companies were able to negotiate the terms of royalties agreements and dictate prices to the world markets through posted, rather than floating, prices. The entrance of smaller independent companies into the market gave host governments leverage to negotiate with them by the late 1960s. Within each producer, there was a different mixture of domestic politics that influenced production – regulatory bodies and environmental legislation in the US and authoritarian and popular politics that influenced production in the remainder. Of the US regulatory bodies, the Railroad Commission of Texas (RRC) was the most powerful, stewarding oil production to encourage conservation and maintain prices in a “situation of chronic potential oversupply,”[1] creating the easily employable spare production capacity in the US. Indeed, it controlled more oil production than all other major producers. The RRC served as both a buffer for the system and a regulatory feedback loop that regulated prices around a band to avoid the volatility that characterized the oil market in its early years. The main objective of the supply side of the oil market system was to provide abundant oil at relatively cheap prices; it was produced these exact results, much to its own detriment.

The demand side of the system, to which the stock outflowed, consisted of the major industrial economies, the US, Western Europe, and Japan and the subsystems that defined their level of oil consumption. Fueled by both economic expansion and preference against polluting coal, these economies expanded their use of oil for power generation, spurred on by seemingly endless cheap oil prices. As these countries became ever more reliant on oil for transportation and electricity, their demand increased and became more inelastic, making the system more rigid and precariously balanced on an oversupply of oil. This created an unsustainable reinforcing feedback loop that oversupply of oil kept prices low, which encouraged profligate oil use, which further tightened supply. Eventually, prices had to increase in accordance with supply and demand, or the rigid system would suffer a shock.

1956 – The American Oil Weapon

By the time Gamal Nasser finished excoriating erstwhile European colonial powers in his speech in Alexandria on July 26, 1956, the Egyptian army had already moved forward and seized the Suez Canal. The Canal was the crucial supply line to Middle East oil, and the British and French governments decided to bring it back under Western control. British Prime Minister Anthony Eden complained to Eisenhower that “Nasser can deny oil to Western Europe and we shall be at his mercy.”[2] Ironically, Eisenhower would be the one denying oil to Western Europe in short order.

US contingency plans for an oil shortage among the European allies centered on the Middle East Emergency Committee, which was tasked with coordinating the resources to draw on American spare oil capacity and reroute the tanker lines to supply the Europeans. The French and British, assuming they would have American support, coordinated with the Israelis to launch a joint intervention and seize the Suez Canal on October 24th, 1956. Eisenhower, fearing that military action could generate instability in the Middle East and open an opportunity for Soviet gains in the region, was furious with the Europeans. Nasser scuttled several ships in the Canal as a result of the war, shutting it down and forcing the oil supply lines to go around Africa and thus constricting supply to Europe.

With Britain and France in the middle of an oil supply crisis, Eisenhower refused to activate the emergency resupply committee and actually imposed oil sanctions on them until they accepted his demands for withdrawal. Meanwhile, Saudi Arabia also embargoed Britain and France to little effect. Under political and economic pressure, Britain and France fully withdrew from Egypt, at which point the US finally activated its emergency committee to make up the oil shortfall. The lesson was clear; the US was able to impose its will through its abundant oil resources. Although a European crisis, the 1956 oil shock confirmed US energy security.

1967 – The US Rescues Europe

By 1967, the global oil market was changing but was not a radical departure from 1956.  OPEC had come into existence in 1960, but it was still an ineffective coordinating body. The industrialized world consumed ever greater quantities of oil, averaging 35.5 million barrels each day in 1967, accounting for 45.7% of all domestic energy consumption.[3] On the eve of the Six-Day War, Europe imported 75% of its oil from the Arab exporters, leaving it vulnerable in the short term.

On June 5, 1967, Israel preempted an attack by the Arab states of Egypt, Syria, and Jordan, quickly overrunning their positions. For their support of Israel, the Arab exporters imposed an oil embargo against the US, UK, and West Germany on June 8, reducing production by 60% and precipitating an immediate oil crisis in Europe.[4] The US set into action, with the RRC allocating an additional million barrels of production to make up the shortfall, resupplying Europe and saving it from the crisis. By July, the oil weapon and the embargo had failed; the Arab exporters gave up revenues while continuously subsidizing the Arab belligerents. The Arab producers had to increase production to maintain their market share, thus Arab production was 8% higher after in August than just before the war.[5]  Once again, the US, as described by the National Security Council in 1960, was “Europe’s principal safety factor in the event of denial of Middle East oil.”[6] However, it took a mere six years for this margin of safety to erode.

The US Invites the Wolf

By 1973, the confluence of several factors eroded the energy security of the industrialized world, even if the perceptions of security remained. The US passed a significant milestone in March, 1971, when the RRC  allowed full production for the first time under normal circumstances; the spare capacity of 4 million barrels a day during the period of 1957 to 1963 had been whittled down to 500,000 barrels in 1973, only 1% of industrial world consumption.[7] As a result, the US was importing 36% of daily consumption by 1973. As early as 1968, the US State Department had informed the OECD countries, much to their surprise, that the US would soon be left with no spare capacity and unable to provide emergency relief. Contemporaneously, the industrialized nations were undergoing an economic boom, with 1973 GNP growing at 10.4% in Japan, 5.9% in the US, and 5.4% in Western Europe.[8] The oil glut of the previous 20 years kept prices low, incentivizing the switch from coal to oil electricity generation for economic and environmental reasons. Compounding the issue, the ordinary consumers became accustomed to boundless cheap energy; efficiency and conservation became an afterthought. Oil thus constituted 46% of all energy consumption in 1972, up from 28.9% in 1950.[9] These changes added not only demand but short-run inelasticity to the system of demand. On the supply-side, low oil prices made more expensive production uneconomical, an issue further compounded by increased environmental regulation. A victim of its own success, the cheapness of oil encouraged profligate use, which fed back into the system, making it even more rigid and vulnerable.

Just as the demand was becoming more inelastic, the major oil companies came under pressure from independent producers, which were offering host countries better royalties agreements. Nascent revolutionary regimes in Libya, Algeria, and Iraq seized upon the opportunity, isolating the companies and gaining concessions. Once Qaddafi wrested a 55% share of the profit from oil sales in 1970, the event changed the entire supply-side dynamic; 55% became the minimum acceptable to host governments. With profit sharing altered, the issue of price became the main negotiating point. The abandonment of the Bretton Woods System and relaxation of the gold standard devalued the US dollar in the early 1970s, bringing down the real posted price of oil. Suddenly, the oil companies came under further pressure to raise posted prices, which had remained nominally the same since 1961.[10] The US government was unconcerned with this development at the time, as the pressure to increase prices “did not immediately seem threating to a range of interests broader than those of the corporations immediately involved.”[11] These events significantly increased quantifiable risk in the system as a function of import dependence, tight supplies, and inelastic demand, suggesting a higher probability of a shock.

As the US ignored the risk, it also misread the uncertainty of the situation and gauge the probability of an impending disaster. Warnings did come from within the government. A 1970 State Department report recognized the changes in the oil market, warning that producing countries will be able to collude in raising prices and determining production, yet “no one in Washington paid any serious attention to the message.”[12] Contrarily in the same year, the president’s Task Force on Oil Imports predicted “only five million barrels per day would need to be imported, and most of this could come from the Western Hemisphere” by 1980.[13] The projection was already exceeded by 1971. Another alarming State Department report by James Akins, a senior Foreign Service Officer, encouraging “the development of alternative energy sources, and controlling [American] consumption”[14] to reduce dependence. Akins published his concerns publicly in his article “The Oil Crisis: This Time the Wolf is Here” in Foreign Affairs in 1973. Akins was able to separate the signal from the noise, recognizing the changing dynamics of US spare capacity, demand inelasticity, and changes in the Middle East that put OPEC in “[control of] a product which is irreplaceable in the short run, and is vitally necessary.”[15] The view of Akins and the State Department were controversial, particularly the projections of price increases seen as impossible, while opposing viewpoints, those of an impending oil glut, proliferated in Washington. In a sense, the “warning flags were up, but there was no particular response, nor…was there the requisite consensus either in the United States or among the industrial countries as a group that would have been needed for more concerted prophylactic action.”[16] Indeed, “before 1973, there was no policy at all envisaging a serious confrontation with OPEC.”[17] Understandably, in the 1960s, it was assumed that spare capacity of two million barrels would still prevail in 1975[18] and the US even rejected an offer from the Shah of Iran in 1969 to deliver “1,000,000 daily barrels of oil for ten years at $1.00 per barrel in order to establish a stockpile”[19] as a buffer in the system. The risk was in place; the uncertainty was made difficult by the multitude of opinions and misunderstanding of the supply and demand system.

The Arab Exporters

As the US entered the oil market as a major importer, market prices for oil began to exceed those of posted prices. In the tight market, some Arab leaders, particularly Sadat, were insisting that the oil weapon be used to realize political goals. King Faisal of Saudi Arabia, historically dovish, rejected this use of oil, preferring American favor as a counteracting force against instability and communist incursions into the region. However, Faisal was vulnerable to public perceptions; he had to maintain solidarity with Egypt and the Palestinians or risk suffering terrorist attacks on oil infrastructure. Faisal genuinely did not want conflict with the US, but continued support for the US would isolate Saudi Arabia from the other Arabs. In light of recent devaluations of the dollar, Faisal began to reconsider his position and warn that the Saudis would “not increase their oil production capacity to meet rising demand, and that the Arab oil weapon would be used in some fashion, unless the United States moved closer to the Arab viewpoint and away from Israel.”[20] This reality was impressed upon the oil executives at Aramco, the Western firm responsible for extracting Saudi oil, who conveyed the message to an unconcerned US government: there was “a large degree of disbelief that any drastic action as imminent or that any measures other than those already underway were needed to prevent such from happening.”[21] The Saudis continued to message that King Faisal is “one hundred percent determined to effect a change in US policy and to use oil for that purpose.”[22] Although such messaging was designed to convince the US of the seriousness of the threats, and even Nixon announced at a press conference that the use of the oil weapon to change US policy “was a subject of major concern,”[23] there was little “contingency planning relating to possible OPEC and producer country actions” or more overt messaging to assuage Arab concerns. Despite the use of the embargo in previous crises, the administration took no action.

As the Arabs prepared to launch the 1973 war against Israel, Western and Israeli intelligence indicated that the event was unlikely. As a result, the October 6 surprise attack on Israel worked as planned, with Egypt and Syria scoring several initial victories. Meanwhile, the negotiations over posted prices between exporting governments and the companies were at a standstill. The countries decided to unilaterally raise prices to those of the spot market, instantly increasing oil prices by 70% to $5.11 a barrel. This event changed the entire supply-demand radically from its structure in 1967. At this point, unaccustomed to high oil prices, the US was already facing an energy crisis.

The US only wanted to avoid involvement in the 1973 war. However, given Soviet supply shipments to Syria and Egypt, the US decided to resupply Israel and keep it in the war, thereby confirming its favor of Israel over the Arabs. Henry Kissinger tried to frame the actions as anti-Soviet rather than anti-Arab, erroneously still believing that the Arabs would not use the oil weapon. On October 17, the OPEC oil ministers agreed to cut overall production by 5% each month until their political objectives were realized and the US ended support for Israel. The cuts in absolute supply pushed prices to $11. The US then announced a $2.2 billion aid package to Israel. Thus everything was in place, a tight market, organization, a willingness to use oil for political ends and no emergency supply; the wolf was at the door and the US all but invited it into the house.  On October 20th, this final public action prompted the immediate embargo of oil exports to the US from the Arab states. Thus the US was caught almost totally by surprise by the imposition of the Arab oil embargo, which it had consistently assumed would not materialize. The effects were disastrous for the US economy, which had grown so reliant on cheap oil, and it went into recession, spending the better part of the 1970s dealing with stagflation and unemployment.

[1] Daniel Yergin, The Prize: The Epic Quest for Oil, Money, and Power. (New York: Free Press, 2008): p. 549

[2] Yergin, The Prize, p. 467.

[3] Data derived from British Petroleum. BP Statistical Review of World Energy June 2014. (London: BP, 2014).

[4] Yergin, The Prize, p. 537

[5] Ibid, p. 539.

[6] Ibid, p. 538.

[7] BP, Statistical Review.

[8] Darmstadter, Joel and Hans Landsberg. “The Economic Background.” The Oil Crisis. (New York: W.W. Norton & Company, 1976. 15-39): p. 18

[9] Ibid, 19

[10] BP, Statistical Review.

[11] Philip, George. The Political Economy of International Oil. (Edinburgh: Edinburgh University Press, 1994): p. 156.

[12] Yergin, The Prize, p. 569.

[13] Akins, James. “The Oil Crisis: This Time the Wolf is Here.” Foreign Affairs. April 1973.

[14] Akins, “The Oil Crisis.”

[15] Akins, “The Oil Crisis.”

[16] Yergin, The Prize, p. 573.

[17]  Parra, Francisco. Oil Politics: A Modern History of Petroleum. (New York: I.B. Tauris & Co., 2004): p. 168

[18] Lovejoy, Wallace and Paul Homan. Economics Aspects of Oil Conservation Regulation. (Baltimore: The Johns Hopkins University Press, 1967): p. 112.

[19] Ibid, 157.

[20] Yergin, The Prize, p. 577.

[21] Ibid, p. 578.

[22] Ibid, p. 579.

[23] Ibid, p. 580

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