Historical Background


In the beginning of the twentieth century carbohydrates became more and more important in the world because they were pure, easily manageable, and cheap, have huge energy capacity and were available in big amounts all over the world.

Petroleum is a very useful and important raw material; it is not only used as source of energy but it had a great significance in the manufacturing of plastics and fertilizers. It had an enormous importance strategically (motorization), as it provided speed and range advantages in wars. That is why it became the object of geopolitical confrontations. Many events were related to petroleum and oil and they had consequences on oil prices and supply worldwide.

In the beginning the United States of America did the 60% of the total exploitation, but later the undeveloped countries took over it, and the USA had to buy oil from foreign countries such as Venezuela, Iraq, Iran, etc.

Oil caused several conflicts within and also among countries and nations. The first oil crisis was only a local crisis; it had no significant effect on the world market. It took place in Iran, because Mohammad Mossadeq, the prime minister of Iran, nationalized the oil companies, so English professionals went home and the country went bankrupt in 3 years.

Then began the Suez crisis in 1956 when Nasser nationalized the canal, this time some outstanding problems were caused. In the 50es annually 210-220 thousands of tons of cargo went through the canal and the 2/3 of it was petroleum that had to be transported to Western Europe. But after the Arab-Israeli war blow-up, Nasser made the canal totally unusable. Provisional petroleum shortage evolved in Western Europe; consumption was decreased, higher taxes were levied on petrol, and petrol coupons were introduced. Simultaneously Syria closed the petroleum lines in the Iranian areas and Saudi Arabia introduced embargo towards Great Britain and France.

After the end of the crisis 90% of the petroleum export was compensated. At that time petroleum utilization was not so important, so there were no considerable changes in prices.

Seven Sisters of the petroleum industry

In World War I countries really needed oil because of motorization. At this time some huge companies wanted to take control over oil. These multinational were called the ‘Seven Sisters'. They established an oligopolistic commercial control on the price and the production of oil by the Achnacarry Agreements. Five of them were American - Exxon, Mobil and Socal - and the other two companies were British - Royal Dutch Shell (that was a joint venture with the Netherlands) and British Petroleum (BP). They dominated the mid 20th century oil production, refining and distribution and were so effectively in control of oil supply an demand of the world with a set of strategies just like fixing production, prices and quotas. They had a common goal: to gather a bigger share of the oil incomes by controlling supply.

World War II. was strategically dominated by oil because the key weapons were air and armored forces. The USA decided to establish an oil embargo on Japan, this was one event that triggered the war in the Pacific. The same year, Germany's invasion of the Soviet Union had the securing of the oil fields in the Caucasus region among its primal objectives, but both Germany and Japan failed to establish a secure source of oil, that contributed to their overthrow by strategically more mobile allied forces. About 86% of the world's oil supply was controlled by the allied nations.


The USA and Europe were importing more and more oil from the Middle-East, the geopolitical importance of this area increased after the World War II, plus in Saudi Arabia a new source of oil was discovered. They were trying many times to integrate countries like Iran, Iraq and Saudi Arabia in alliances with the Westerns, but some events just like the creation of the OPEC and Islamic nationalisms, made the access to oil resources more complicated.

In 1960 an organization called ‘Organization of Petroleum Exporting Countries' (OPEC) was founded that contained five founding members: Iraq, Iran, Kuwait, Saudi Arabia and Venezuela, but by the end of 1971, six other nations had joined the group. Their common goal was the maintenance the oil prices and in some years it achieved a glimpse of the extent of its power to influence prices.

During the period of the Six Day War (1967) OAPEC members announced an embargo towards countries aiding Israel; Iraqi and Saudi oil lines became shut down. Then 900 tons less were exported each day and also the Suez Canal was closed at that time, so the exploitation was raised in the United States, Venezuela, Iran and Indonesia.

In the end Iran and Saudi Arabia boycotted the embargo and they could manage to avoid a serious crisis. The only losers of this event were those Arab countries that were closing down the export.

The embargo

In the early 70es under the order of President Nixon, the USA began shipping arms to Israel to help and support them. In 1973 a war broke out called ‘Yom Kippur War' between Israel and Egypt, that gave the OPEC additional reasons to intervene. OPEC decided to impose export quotas, reduce production by 25% and nationalize production facilities. Not long after the start of the War, when the Arab countries decided to turn to the ‘oil weapon' again; the Organization of Arab Petroleum Exporting Countries announced the reduction of oil exploitation by 5% each month in those countries supporting Israel in the conflict during the war. They wanted to undermine Israel's support, mainly the USA, so they used oil as a geopolitical weapon.

The oil embargo affected the not only the United States of America, but its western European federates and also Japan. During this half year period the western world was facing with the strategic significance of oil and its shortage for the first time. This embargo damaged the U.S. economy so greatly that many were unsure if the country would escape such devastation.

Among the few countries that were affected, the United States suffered greatly, because after they gave aid to Israel the whole oil export ended toward them. Prices started to fall at the New York Stock Exchange, restrictions were introduced for car usage, and people were encouraged to use less energy. Petrol and oil prices increased because of the shortage and the forestalling of fuel started. This caused even higher prices in the market and it almost resulted in a shock.

The ability to control crude oil prices changed; it was passed from the United States to OPEC, and was removed during the Arab Oil Embargo. Prices increased 400% in 6 months, and the extreme sensitivity of prices to supply shortages became all too apparent at that time.

Prices were relatively flat from 1974 to 1978, ranging from 12.21 dollars per barrel to 13.55 per barrel, but when adjusted for inflation world oil prices were in a period of moderate decline.

With the start of the embargo, U.S. imports of oil from the Arab countries decreased from 1.2 million barrels a day to a mere 19,000 barrels. Daily consumption dropped by 6.1% from September to February, and by the summer of 1974, by 7 percent as the United States of America suffered its first fuel shortage since World War II.

The impact of the embargo was drastic and it had an immediate effect on the whole economy. In the United States of America the retail price of a gallon of gasoline rose from a national average of 38.5 cents in May of 1973 to 55.1 cents in June of 1974. Meanwhile, The New York Stock Exchange shares lost $ 97 billion dollars in value in 6 weeks.

Prices were rising since 1971 and by 1973 the price of petroleum reached the 11,68 USD/ton, this means that the prices became 10 times higher than they were originally. It could occur because of the disharmony of the consumer countries and so they could not make movements together against the embargo (for example anti-Americanism in France).

In times of shortage or oversupply crude oil prices behave much as any other commodity with wide price deflections. The crude oil price cycle may circulate over many years responding to changes in demand as well as OPEC and non-OPEC supply.

From 1974 to 1978 under the control of the OPEC, the price of oil still remained high but stable: around $12 per barrel. Many countries, mainly the developed ones, started to worry about the unreliable supply sources and the exhaustion of oil reserves, but they did almost nothing against it. The Iranian revolution caused another oil shock where the price of oil increased drastically, so oil consumption was reduced, they were trying to consume less energy in the different industries.

Framework for analysis

Monetary policy and internal balance

In order to better understand the short term effects and emerging problems of the oil crisis as in the early seventies, one must investigate the economic framework concerning the oil-importing countries at that time.

First of all, let us suppose that the OPEC countries reduce the amount of oil supplied, which leads to an increase in world oil prices as a new equilibrium is reached. The demand-elasticity of oil is relatively low, so expenditures on oil will go up. But as in the case of most commodities, it will also lead to a substitution effect against oil in the importing countries. For example natural rubber can be used instead of synthetic rubber, and other sources of energy will be used by a greater degree, say more coal will be imported or produced domestically. The consumption of relatively energy intensive products will be reduced and their price will significantly increase. The reducing demand for goods and services might create deflation, and in addition unemployment. The importing country can implement policies to stimulate the economic activity, but only after a certain delay, not to mention the cost of these countermeasures, the deadweight losses. (Rybczynski 1975)

For simplicity of the analysis treat all oil importing countries as a unit with zero balance of payments toward the OPEC countries. The rise in the price of oil will turn the importing countries ‘balance of payment into deficit, the oil producers' into surplus. An important issue is to know how the OPEC countries are paid, and how they will spend their extra income. Let us see what happens if they hold their extra amounts and do not invest in foreign markets capital m. The importer country will spend more on the imported oil, and thus it can spend less on domestic products. If we assume that nominal wages and profit margins are constant, then there will be unemployment and deflation. To resolve these problems, the government can use fiscal policy to reduce taxes but that will cause a budget deficit, which can be financed by the capital markets. But where can they borrow from? The answer seems obvious, from the OPEC owned balances. If we assume that OPEC balances do not stay idle, these extra deposits can bring down the structure of interest rates, they can make easier to obtain credit, and therefore lead to an increase in investments, which might make up for the reduction of income. This would cause the savings of non-opec citizens to fall, as well as their real incomes. (Rybczynski 1975)

As a conclusion of this part of the analysis, we can say that the impact of the high oil price would be deflationary, but appropriate countermeasures could maintain internal balance. In contrast, one can see that oil crisis actually caused stagflation; not just a slowdown in economic growth, but high inflation as well.

The price-wage spiral

Now let us see how the increase in oil price creates stagflation. It is clear from the previous section, that the reduction of oil price has lowered the real inome and expenditure in the oil importing country, a so called ‘absorption of goods and services”. It is true even if -as we assumed- full employment if maintained and all adjustments through substituion effects have taken place. As the economy has significantly less oil available, it has to use more expensive substitutes, the equlibrium real expenditure falls. We already noted, that the money expenditure needs to rise to maintain demand, and maintain full employment, but now we figured that the equlibrium real expendire falls. How can this happen? Let inital money income and expenditure be equal. Then, as the oil price rises, expenditure on oil rises against expenditure on domestic products and services. Then, to restore demand on domestic goods, the total expenditure has to rise by an amount which is fully spent on them. Then, we end up with the same total resources utilized in domestic production, and lower oil imoports. The oil price increase has more than offset the rise in money expenditure. (Rybczynski 1975)

With the total real expenditure having to fall, it is most likely that the real wage in the case of full employment has to fall as well. This real wage decrease can take a form of higher prices with constant money wages. It can also happen that money wages rise, but cannot keep up with the prices. If price rise brings forth a increase in money wages intending to maintain real wages, then it causes prices to rise further. This actually creates a deadly price-wage spiral which by large magnifies the direct effects of higher oil prices. Finally, to attempt to fight inflation, governments can use deflationary tools, but that will create unemployment. Using the Phillips-cruve concept, one could say that the oil price has shifted the curve to the right, an unfavorable direction, just the opposite as an effect of a succesful income policy would be. It leads to a fall in real output, and hence an additional fall in real income and expenditure. If one measures recession by the fall in output, and not by unemployment, then there are two reasons so far why reduced oil imports may cause recession. (Rybczynski 1975)

Effects and problems

Oil prices' effects on exporting countries' transfers

First of all we should know how are the oil-importing countries to pay the oil-exporting countries. To answer this question we can use an existing theory, the transfer problem based on study of conditions and policies of reparation payments after WW I. This theory is concerned with determining the importance of a real transfer that will follow any given financial transfer. This will depend on a few factors of which the most important is what is done with the financial transfer by the receiving country. There are three choices: to spend the amount on current imports to create real assets at home; to hold it in the form of monetary assets; to use it to attain assets abroad. The analysis is based on these three basic cases. (Tumlir, 1974)

At first assume that oil payments generate imports by oil producers. Assume further that the world comprises of only two countries, country A - an oil-exporting country, and country B - an oil-importing one. At start their accounts are in equilibrium. Then A increases the price of oil which hugely increases the payments B has to make because of the low price-elasticity of demand in the short run. The payment is made out of reserves and this represents the financial transfer. Now B has a great current account deficit, A a surplus. Now A - running a development program by its government - purchases goods and services from B to the full amount of its surplus. Now current accounts get in equilibrium again, the level of economic activity remains the same in B, however its real income decreased. As a consequence B now imports less oil for which it exchanges a larger part of its production than before. (Tumlir, 1974)

This time assume oil producers invest in monetary assets (assets, dollars, gold). First case is when the country determines to invest in financial assets. Now assume there are four countries: the oil-exporting A, and the oil-importing E, J and U. Assume further that A is willing to hold its additional proceeds to E's currency (euro), J's currency (jen) or U's currency (dollar). The financial transfer is made in the three currencies, but no real transfer follows, so the higher price of oil is paid in easily printable paper. The second case is investing in dollars. If there were a certainty that A would keep these reserves indefinitely, again nothing consequent happen, E and J could borrow and keep on borrowing. But if this certainty does not exist E and J do not want to maintain an increasing foreign debt, so they try to earn dollars to pay for the oil. The only way for them to do this is to run an export surplus with U. So this way the financial transfer would be seen going from E and J to U, and form U to A. Note that this case A can influence the direction of the real transfer by deciding which currency to choose. The third case is when the oil-exporting country A invests in gold. In a system based on gold it would seem logical for security-seeking A to wish to hold its reserves in gold - which is practically the same as setting oil prices in gold. With the low price-elasticity and high income-elasticity of demand for oil, the central banks of E, J and U would soon be emptied of gold, so would costs of gold mining and world price of gold drastically rise, and as a consequence price of oil would increase significantly too. This would mean the end of gold-based monetary system. As long as gold can be considered a financial instrument, the financial transfer would be taking place from E, J and U to A, and the real one from the formers to the gold producers. (Tumlir, 1974)

The third and last consideration of this question is when the oil producer invests in real assets either worldwide or in one foreign country. When deciding to invest worldwide - to avoid balance-of-payments difficulties of its customers - A agrees with E, J and U to invest the oil-trade proceeds with each country in real estate at each particular one. This way no real transfer occurs and each of the three oil-importers have a deficit on their current account offset by an increased inflow of long-term capital. When deciding to invest in real estate only in one of the three countries, channeling the full proceeds from worldwide sales to one single country, A would be more likely than the preceding variant to attain a growing share of the total real wealth of the country of its investment choice. (Tumlir, 1974)

Short term costs

It is also useful to list the various short-term costs to oil importing countries resulting from the rise in the price of oil:

First, there is a minimal real resource loss which is a direct consequence of reduced oil supply. It is a cost that would incur even if there was full employment. It causes the equlibrium real wage to fall, as described above. Then, there is also an output loss bacuse of micro-unemployment, the short term immobility of workforce employed in the energy intensive heavy-industy, and other industries which are closely related to petroleum. Up to this point we assumed that OPEC countries do not invest their extra incomes in oil-importing countries, nor do they import any products from them. Even if they did, there would be a so called tranfer affect, which would still reduce their equilibrium real expenditure. There can also be a loss or gain due to the changed terms of trade among various oil-importing countries, but these are more complex issues. It is also worth to take a look at costs incurring of the change in financial assets. There is a cost if OPEC countries hold foreign exchange and switch their portfolios, or if they choose to hold gold. There might be various problems and costs arising because of reduced liquidity and becuse of the measures taken to resolve them. (Corden 1975)

Difficulties for financial markets

Up till this point we have assumed that the extra OPEC funds would stay idle, but of course this assumption is not realistic. In fact, there are great problems arising from the huge amount of funds that have to go through financial channels to borrowers in just such a short time period. At that time four specific problems were apparent. (Oppenheimer 1975)

First of all, most of the Arab depositors were preferring short-term deposits to longer-term investments, these include properties and ordinary shares. The problem simply due to the huge amount of them, because the demand for short-term funds are nowhere near. Most of the banks find themselves lending long but borrowing short excessively, so they become reluctant to take on that much short term deposits. Continuing this sort of imbalance will eventually be reflected in the term structure of interest rates. When the rate of return on short term deposits is a lot less than the rate of return on long term ones a change in depositor requirement is inevitable. An initial problem arises because of the uncertainty of such a situation, concerning inflationary expectations, interest rates, and behavioral adjustment as well. (Oppenheimer 1975)

The second great problem is that banks are not prepared to handle business on such a great scale; they do not have enough capital, and also various official regulations require them to maintain at least a certain ratio of deposits to own resources. This is of course a technical issue, which can be solved over time, but nevertheless it meant a great technical difficulty for banks at that time. Furthermore government help was also expected to step in and help as financial intermediaries. Until this technical problem is solved, there is a great fear of interbank landing crash and bank failures. The seriousness of this situation largely depends on the central banks to act as the lender of last resort. Since the deposited fund must go somewhere, maintaining adequate recycling arrangements is also an issue, but not a huge problem. (Oppenheimer 1975)

The third difficulty arises if a substantial part of the funds is borrowed by only a small amount of governments. Then the risks that even well capitalized private banking intermediaries would have to face would be vast. It would rather make more sense to handle large scale borrowing directly or through international financial institutions. Finally, we have to return to the primary problem again, what will happen to demand of funds? Is it going to be sufficient or the banks will be loaded with funds that no one needs? If there is a negative real interest rate, then the banks will not end up holding excessive financial instruments. All together, these were short-term problems that the various financial markets had to face during the first oil crisis in the seventies. (Oppenheimer 1975)

Effects on the dollar

In response to this oil shock, the trade weighted US dollar index as measured against the major currencies first showed a strengthening together with oil and then as a sudden it sold off. To protect the dollar against the high inflationary pressure, the Federal Reserve, the central bank of the United States, was raising interest rates. The jump in oil price significantly increased the need for further rate hikes, so the Fed was forced to raise the Fed Funds target rate from 7.5 percent in early 1973 to a top high of 13 percent by the middle of 1974. (see next figure)

The focus on inflation initially rendered the dollar bullish but once the rate climb started to have a significant impact on US growth, the trend turned upside down causing the dollar to depreciate. In the period of two years after 1973 the growth of the GDP almost continuously showed a slowing tendency and in response the dollar lost all of its gains. (Lien 2008)

Impact of the oil shock on Western Europe

Energy shortages were not new to Europe. One of the first was in Athens at the time of Pericles in the fifth century B.C. when wood was the chief source of energy. This part is about the extent of the '73 oil crisis in Europe and the outlook for energy supplies in the short, medium and long run.

Western Europe - not having a significant reserve - depended on the worldwide situation regarding oil supplies. By this countries in Western Europe were way more affected by the oil crisis than any other highly industrialized countries. An average of 80% of Western Europe countries' petroleum supply came from the Middle-East, so it was quite an important issue to look for a great number of possible new energy suppliers. In the short term the replacement of oil was a difficult matter, however high prices caused by the shortage of petroleum were strong incentives for finding new substitutes. There were considerable difficulties to overcome on two grounds: technological feasibility and availability of other forms of fuel. It requires investment as well as adequate capacity to produce and install the new equipment. Coal was an obvious substitute especially in such countries where a coal industry was still present. Another one to consider was natural gas for some applications. In Western Europe suddenly coal became the more economical choice compared to the high price of oil products. There was a possibility to produce more in the already existing workings and to open up new ones. Apart from these possibilities the price-elasticity of demand for oil even at those prices was relatively low on the short term. However it was believed that the longer the period the higher the elasticity of demand becomes. It was assumed that these price differentials can generate technological advance. The sudden increase in oil prices had three major effects: it was a great incentive to economize the use of oil; it intensified the search for new forms of energy and new sources of traditional types of fuel; and it improved the economic viability of other sources and form of energy. (Ray, 1975)

Further impacts and Consequences of the Oil-Price Shock

During an oil-price shock an oil-importing country generally experiences a slowdown in the growth rate and on the other hand a significant increase in the price level, and may also experience an increasing rate of inflation. It acts like a tax on consumption, which - instead of going to the government - goes to the oil-exporter countries.

The oil crisis in 1973 was the first big oil shock in history which influenced the whole industrialized world, and demonstrated the dependence of the industrialized countries on fossil energy, particularly fossil fuels. Some of its many impacts can be felt even today.

The central banks of the Western nations fixed on to cut interest rates in order to encourage growth, saying that inflation was only a secondary problem. The result was stagflation which surprised central bankers and economists, and the policy is now reckoned by some to have worsened the case by deepening and lengthening the unfavorable effects of the embargo.

Public discussion of the implications of the rise in oil prices has mainly focused on the financial implications, with intergovernmental action being taken by the International Monetary Fund (IMF) and, as far as developed countries alone are concerned, by the Organization for Economic Cooperation and Development (OECD). It is in the OECD framework that the International Energy Agency has been established to carry out a comprehensive program of cooperation - both in the event of emergency and over the longer term - among sixteen oil-consuming countries belonging to the OECD. But the rise in oil prices implied structural changes, not only within oil-consuming countries, but also externally; and those changes had implications for the reform of the international trading system, which had been regulated under the General Agreement on Tariffs and Trade (GATT) since the end of WW II. (Ray, 1975)

In some Western states the result of the crisis in 1973 were considered military options. 30 years after the crisis a secret invasion plan was revealed saying an invasion of Saudi Arabia and Kuwait was planned by the British and U.S. governments. "It was thought that U.S. airborne troops would seize the oil installations in Saudi Arabia and Kuwait and might even ask the British to do the same in Abu Dhabi." To reduce the political blackmail in any state strategic oil reserves have been created or heavily reinforced.

Following the oil crisis also arose initiatives designed to reduce dependence on oil. Thus, advanced alternative fuels like biodiesel, vegetable oil and waste incineration came in to the public interest. Investments have increased in nuclear energy, renewable energy sources, thermal insulation of buildings and in the efficiency of motors and heating appliances. Even with the increased awareness of the oil crisis subsided, it was hard to get energy-saving behavior in the population. Moreover, the share of the money made from OPEC oil has been reduced by development of submarine oil fields in the North Sea and a diversification of trading partners. This trend has been reversed in favor of OPEC as the North Sea oil's peak production point has been reached and the production rates started to decline steadily.

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