Lessons 5&6: Oil1. Demand2. Supply3. Shifting market power – monopsony to monopoly4. Leadup to the 1973 Crisis5. The 1973 Crisis6. The 1980s7. The Gulf Wars

1. OIL DEMAND

IMF World Economic Outlook, Sept. 2003, Chapter 1

Why the world worries about oil prices

1. Demand• Short run elasticity

- holding investment constant• Long run elasticity

- allowing investment to adjust• Adjustment costs, stagflation and security

concerns• Environmental concern• Efficiency of taxation• Economic growth and expanding demand• What happens when oil runs out?

- alternative sources of oil vs. alternative energy- free rider problems with developing alternatives

Demand for oil

International Gasoline Prices, 2006

5.88France

6.36UK

2.73Mexico

3.51Canada

2.67U.S.

Price/Gallon (incl. Taxes; Premium)

Country

Source: International Energy Annual 2007, DOE

Sources: European Commission, Oil Bulletin, and EIA, Weekly Petroleum Status Report, Table 16

World Oil Use: 1970-2005

Source: EIA International Energy Annual 2005

World Total Oil Consumption

40000

50000

60000

70000

80000

90000

1970 1975 1980 1985 1990 1995 2000 2005

Year

2. Supply

• What are Reserves?- current reserves (profitable at current prices)- potential reserves (profitable at predicted prices)

• Concentration in Persian Gulf• Depletion

World Oil Reserves (billions of barrels)Country 2000 2007• Saudi Arabia 263.5 262.3 (x $25/barrel = $6.6T) • Iraq 112.5 115.0• Kuwait 96.5 101.5• UAR 97.8 97.8• Venezuela 72.6 80.0• Iran 89.7 136.3• Mexico 28.4 12.4• Libya 29.5 41.5• China 24.0 16.0• US 21.8 21.0• Nigeria 22.5 36.2

Source: EIA, DOE

(US GDP was about 14T$ in 2007, World GDP was 53T)

3. Shifting market power: from buyers’ cartel to sellers’ cartel

• Bilateral oligopoly: Few buyers and sellers of crude oil• Up to 1950: Buyers (Western oil companies) control crude

oil prices– Royalty system: Incentives to increase production.– Weak governments: Direct control by Western governments, lack of unity

among producers

• 1950-60: Countries increase control– Profit-sharing system: Incentives to affect prices (Demand for oil inelastic,

supply of close substitutes inelastic)– Increased competition in buyers: Oil companies had lower influence on crude

prices.

• 1960-73: Producers begin to control prices (OPEC)– Arab countries unified in cutting production: Development plans (Libya),

Arab-Israeli conflict (Saudi Arabia).– Renegotiation of profit shares, price setting mechanisms.

Monopsony•

Organization of Petroleum Exporting Countries

About 40% of world production, but 2/3 of reserves

Monopoly•

Oil Prices 1946-2007

U.S. cost of imported crude oil; Source DOE, IOGA

Price/Barrel in $, 2007 inflation-ad

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

1946 1956 1966 1976 1986 1996 2006

Year

OPEC revenues

http://www.eia.doe.gov/emeu/cabs/OPEC_Revenues/OPEC.html

Oil Crises“The meek shall inherit the earth, but not the property rights.”

- J. Paul Getty

– 1948-49: Israeli Independence (Iraq pipeline shut off)– 1951-53: Nationalization of oil Industry in Iran

(largest producer in the Middle east)– 1956: Sinai Campaign (Suez Canal blocked, Iraqi

pipelines shut down)– 1967: Six day war (Suez Canal blocked)

– 1973: Yom Kippur war (OPEC embargo for 4 months, price increases)

– 1980: Iranian Revolution (supply cut, price increases)– 1991: Expulsion of Iraq from Kuwait– 2003: Iraq War

Real Oil Prices 1980-05

• Source: Economist 8/27/05

4. Leadup to the 1973 crisis• Increasing demand.• Reduced political influence of importing countries.• Change in Arab relations: Unity of action.• OPEC: Rising share of world production and reserves.• Existence of a dominant producer: Saudi Arabia

– Can enforce cartel agreements

• Lack of contingency plans in importing countries– Small strategic reserves– Optimistic political assessments about OPEC unity.

5. The 1973 Oil crisis• OPEC’s Tools:

- oil embargo of US, Western Europe and Japan, - reduction of production by imposing quotas on members

• Results:– Hike in prices– Huge increase in revenues– Worldwide economic crisis– Change in energy policies of importing countries.

6. The 1980s1979: Iranian Revolution

- production falls from 5.2m bpd to 3.2- nationalization of oil industry- Saddam Hussein gains control of Iraqi Baath party

1980: Iran-Iraq war- before war Iraq exports 3.4m bpd, Iran 1.5m - targeting of oil production and refining reduces exports of both countries by about 75%.- Iraqi production recovers by using pipelines through Syria, Turkey and Saudi Arabia

By 1985 increased production by other countries, esp. Saudi Arabia, had reduced prices.

Effect on importing countries less severe than in 70s, because of shift to more efficient transport, demand control policies, incl. taxes.

7. Gulf Wars• 1st Gulf War: brief and decided quickly enough to

have small effect on supply- postwar sanctions reduce Iraqi oil exportsfrom 3.5mbd to .5mbd- increased to 2.5mbd by 1999 under “oil for food”- Iraqi production capacity declines

• 2nd Gulf War: long disruptions of Iraqi oil supply - slow reconstruction of Iraqi export capacity- current Iraqi production varies from 1 to 2.5 mbd

• Danger of future sanctions on Iran further reducing supply- how would that affect current price?