Munich Personal RePEc Archive [608289]

Munich Personal RePEc Archive
Economic considerations regarding the
first oil shock, 1973 – 1974
Ilie, Livia
Lucian Blaga University of Sibiu
May 2006
Online at https://mpra.ub.uni-muenchen.de/6431/
MPRA Paper No. 6431, posted 22 Dec 2007 18:35 UTC

Economic considerations regarding the first oil shock, 1973 – 1974

dr. Lvia Ilie
Lucian Blaga University of Sibiu

Abstract

The oil shock of 1973-1974 was an economic and politic important event that produced
controversies in the years that followed. No event in the last decades of the 20th century was as
visible as the fourfold increase of the oil price in 1973-1974.

Due to different opinions and the topic itself there are many theories and point of views related to
the oil crisis. This paper aims to analyze the first oil shock and to brig to attention the existent
theories on the topic.

OPEC success showed at the beginning of the 70s, as the rising oil demand exceeded
production. Moreover, producing countries began to ask for ever more concessions. Muammar-al-
Qaddafi, taking over power after the military coup in Libya, obtained a 20% due increase and an
agreement to split profits 55-45%.1 This move led to new requests, which resulted in increased oil
price and exporting countries’ profit.
As oil market was ever straitened, the Arab world began to use oil as a weapon to reach
its economic and political goals. This was mainly achieved through the oil embargo during the
war between Egypt and Israel, in October 1973. Saudi Arabia refused to increase production in
order to stop the price from decreasing, unless the US supported the Arab case. Arab oil
Ministries decided to set an embargo in order to reach their political goals. Production was to be
reduced by 5% monthly, until the West gave up. The countries which adopted a “friendly”
attitude towards Arab states were not to be a ffected. When President Nixon suggested that a $2.2
billion military aid be given to Israel, Arab count ries set the embargo against the US (afterwards
extended to the Netherlands, Portugal, and South Africa).
The official oil price was set by OPEC memb ers at $11.65/barrel. The price increase was
without precedent in the oil history, from $3/ba rrel to 11.65/barrel. The embargo caused a deep
economic world recession.2
The Arab embargo was set at a time when Am erican oil production was decreasing, while
demand and import were increasing. OPEC produc tion decrease, together with minimal world
excess production capacities, created oil shortage on the market and, consequently, increased
price. At the end of the embargo, six months after it was set, the price was four fold and OPEC
controlled world oil market.
Immediately there were reactions in the market:

ƒ Refineries changed oil suppliers, starting to import from other available sources.3
ƒ Imports from Arab members of OPEC were begun again immediately after the embargo4 and
started to grow until 1977. Though exploitati ons in the North Sea and Alaska had become

1 Yergin, D, The Prize – the epic quest for oil, money and power , 1991, p.580
2 US GDP decreased by 6% in the ne xt two years; Japanese economy cont racted for the first time after the
Second World War.
3 Iran appeared to be a stable source, on the long run. Iran increased its sales towards the US, in order to
cover for the import losses from Kuwait and Libya.
4 The embargo ended in March 1974.

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important, OPEC quota in American imports ro se from 26% in 1973 to 36% in 1977 (when a
very important quota was recorded, afterwards reached only in 1994).
ƒ The refining industry began to develop oil pr ocessing technologies and methods to reduce oil
consumption and to enhanc e operational efficiency.

The embargo led to massive increases in the price of refined products. Between 1972 and
1975, period in which OPEC returned to the produc tion level before the embargo, consumers paid
on average 57% more on gas. The high increase in en ergy price recorded is considered to be the
cause for the 1974-1975 economic recession.
Considerable efforts were made, after the embargo, to preserve energy and to pass from
oil to alternative energy sources.
A result of this embargo was also the creation of the International Energy Agency in 1974
by the US and other 20 states. The purpose of this Agency was securing oil supply. Thus, member
countries developed plans with regard to creati ng strategic reserves nec essary in times of oil
supply interruptions. Law was also improved in the years following the embargo, in order to
stabilise oil market.
The 1973-1974 oil shock was an important ec onomic and political event, which led to
controversies and debates in the years and decades that followed. No other economic event in the
second half of the twentieth century has drawn a ttention worldwide in such a way in which the
four fold increase in oil price between 1973-1974 has.
Following the diversity of the issue and opinions, there are many points of view and
theories regarding the oil shock.

A. The traditionalist point of view regarding the oil crisis.

Economists’ analysis often comprises referr als to the oligopolistic structures of oil
companies, to the collective decisions of OPEC and to the demand-supply interaction on the
international oil market. Though there are diffe rences between these theoreticians, however the
approach of the 1973-1974 crisis is similar from the theoretical and methodological points of
view. Here are some examples:
Raymond Vernon5 argues that an energy crisis is the result of reduced oil cost, as
compared to other sources of energy. Consequent ly, he states that as the consumers’ incomes
increase, beginning the 50s, their demand for ener gy grew accordingly. Since oil was cheaper
than other sources, oil demand increased faster that that for other sources of energy, and this fact,
combined with the supply interruption, led to the 1973-74 crisis.
The need of rapid reconstruction of the West after the Second World War, on one hand,
and the existence of cheap oil sources in the Mi ddle East, on the other hand, resulted in the
substitution of coal industry in Europe. As Romano Prodi and Alberto Clô mentioned in an article
in 1975, this substitution determined:

ƒ coal market strict control
ƒ the lack of common energy policy and of separate ru les for the market of oil and that of coal
ƒ the lack of adequate legislation in order to limit the entry of multinational oil companies on
the European market.

Therefore, European market was invaded by ch eap Middle Eastern oil and the dependence of
European economies to imported oil was gradually set.
Vernon states, also, that market entrance of the so-called independent oil companies, in
the 50s and the 60s, was another cause of th e 1973-74 crisis. The vulnerability of the

5 Vernon Raymond, An Interpretation , DAEDALUS, 1975
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“independents” to OPEC led to the break of negotiati ons with regard to oil posted price and to the
production conditions6.
Edith Penrose7 outlines that an important role in developing the crisis had OPEC’s
negotiating power rise with regard to oil companies. Also, US rising dependence to Middle
Eastern oil, in general, and to Arab oil, in particular, added to a background of conflicts related to
the setting of the Israeli State.
A similar idea is presented by George Lenczowski8. He states that the oil companies’
dominant position with regard to oil producing c ountries can be related to three factors: the
existence of a buyer’s market, US self-sufficiency as oil producer and consumer and the dominant
position of the main oil companies. All these factors were turned upside-down at the beginning of
the 70s.
US position as importer at the beginning of the 70s is one of the often met explanations.
The high growth rate of American economy in the 60s led to a rise in oil consumption, which,
associated to the decrease of the real oil price, resulted in a higher oil demand. Price decline was
so important that in 1969 it was 10% bellow the figures recorded a decade earlier. Thus, the
dependence of US economy to sources of energy, especially of foreign ones, increased.
John Blair (in a book published in 1976: The Control of Oil ) places the 1973-74 oil crisis
in historic context, referring to the two Suez Ca nal crisis and comparing them to the Arab oil
embargo in 1973. At the time of the first crisis of Suez in 1957, oil reserves had been made.
Consequently, no increase in oil price was recorded. Also, during the Arab-Israeli war in 1967,
there was immense excess supply in the US which a nnihilated oil supply interruptions in Europe.
But, before 1973, US excess reserves and pr oduction capacity exhaus ted, and American
economy became dependent of imported oil. Therefore, the energy crisis was the logical
consequence, according to Blair, of US limited and declining reserves.
Other traditional points of view trying to explain the oil crisis wander from the demand-
supply ratio and focus on the expectations of those who act on this market.
In a paper from 1979 ( Economic Theory and Exhaustible Resources ), P.S. Dasgupta and
G.M. Heal take into consideration a series of f actors which, according to them, have led to the
change of attitude on the market9. Such a factor is the change in position of the US on
international oil market: from a country with su fficient energy resources, the US became an oil
importing country. This situation determined recognising OPEC states and their power to
negotiate on the international market. Another f actor, which contributed to the attitude change,
was the grown importance of neo-Malthusian ideol ogy and the idea of resource protection. This
led to a change in the financial position of oil producing countries and in their want to obtain
increased incomes, either through production or price growth. The second option was the one
used at the beginning of the 70s.
To synthesize the traditional points of view re garding the oil crisis, the following should
be remembered:
1. The law of supply and demand is the most important in this analysis.
2. OPEC ability to set the price is consider ed to have played a decisive role.
3. The dependence of the American economy of foreign oil and, especially, of OPEC oil,
which created severe scarcity and endangered oil supply secu rity, is considered an
important factor.

6 The pressure made by Libya over the Occidental Petroleum company during the 1970 negotiations related
to the degree on posted price increase and to the according profit quota, combined with oil production
restrictions due to the danger of nationalisation, were often considered to be the causes for the increase in
oil price.
7 Penrose, E. The Development of Crisis , DAEDALUS; 1975

8 Lenczowski, G., The Oil Producing Countries , DAEDALUS, 1975
9 Bina Cyrus, The Economics of the Oil Crisis , St. Martin’s Press, 1985, p. 3
3

4. The unexpected, sudden nature of price change a nd the adjustment issue is what led to the
crisis.
5. The crisis is considered to be the result of change in perceptions of those involved in the
oil market and not of change in the realities of that time.

A common error of those who second these traditionalist points of view is the lack of
separation between the causes and effects of the oil crisis.
From the point of view of the supply conditions, the scarcity extended on a short time
after the embargo. Temporary penury shouldn’t have had, according to economic theory, a long
run impact over price. However, reality infirmed that. Therefore, the factors which resulted in a
higher post-embargo price are a combination between price setting by OPEC and US dependence
to imported oil.
The question is why oil price didn’t drop after the embargo? Why the US weren’t able to
deal with the OPEC challenge?
Although that, after the embargo, the international market was “flooded” with oil, this
fact didn’t have as effect any price decr ease, which implies that the demand-supply
interdependence is in itself a consequence of f undamental changes occurring in the oil industry.
Dasgupta’s and Heal’s point of view, stating that all these are the result of perception
change, suggests that there were no objective r ealities involved, but only subjective perceptions.
Though the majority of these theories have made pertinent observations regarding event
description, they weren’t able to make theo ries about the 1973-74 crisis, only describing the
consequences of the cr isis and its conditions.

B. Dependence theories regarding the oil crisis

The oil crisis is considered by Norman Girvan10 to be a form of manifestation of
economic nationalism in Third World states, in order to gain an “equality position” in their
relationship with industrial powers. The 1973-74 crisis was a consequence of the fight for
economic independence of raw mate rials producing countries, in gene ral, and of OPEC countries
in particular. The situation created was a riot of oil exporting countries, a riot against inequitable
changes between the “centre” and the “suburbs”, a riot against the exchange of cheap raw
materials from Third World states and expensive imported goods from industrialised countries.
A more detailed perspective, which uses th e concept of Third World nationalism, is set
by Michael Tanzer11. He shifts light upon three interdepende nt events that have led to energy
crisis:
ƒ rising competition between oil companies, wh ich resulted in a price decrease, and,
therefore, a decrease of international oil industry profitability;
ƒ environmental concerns and the uncertainty regarding the dominant energy type of the
future;
ƒ the „rising” nationalism of OPEC countries, wh ich determined that large firms be less
dependant of OPEC countries as a source of oil (they turned towards other sources of
energy, which weren’t based on oil).

Tanzer argues that large oil companies, once having acquired significant quantities of
energy resources (not based on oil), intended to raise the price for every source of energy. A
tactics for attaining that goal was creating an „energy crisis”.

10 Norman Girvan, Economic Nationalism , DAEDALUS, 1975
11 Tanzer, M., The Energy Crisis: World Energy Struggle for Power and Wealth , 1974
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This theory combines OPEC economic nationa lism notion with the concentrated efforts
of large oil companies to increase the price as soon as they re-establish their monopoly in
international oil production.
Consequently, the crisis wasn’t caused by an oil scarcity on the market, but was started
with the only purpose of increasing the price.
Even though the idea of “inequitable trade” is explicitly or implicitly comprised in the
analysis of the 1973-74 crisis, economic nationali sm is the element of motivation behind the
sudden price growth, before and during the embargo.
The “OPEC offensive” against imperialist c ountries, in order to gain their economic
independence, is considered to be the reaction to the prolonged domination relations that have
existed between industrialised c ountries and Third World countries. The period of time after the
war in Vietnam created the politi cal conditions to allow Third World countries, especially OPEC
countries, to launch their offensive. The crisis is seen as a result of OPEC direct political action.
Supporters of such theories claim that among the causes of the crisis are: social and
political conditions in the period that followed afte r the war in Vietnam, the political decline of
the US, the rising involvement of OPEC, th e increase of OPEC countries’ incomes.

C. Conspiracy theories regarding the oil crisis

These theories are based on the idea according to which the American Government, in
collaboration with the oil companies and OPEC, inte ntionally started the crisis. The argument is
based on the effects the crisis had. These were ne gligible for the Americ an economy, as compared
to the effects on European and Japanese economies.
Thus, the 1973-74 crisis outlines the US domi nation, a domination that showed even
since the Second World War through undermining other economies.
This conspiracy theory is often encountered in European economic and political circles. It
is focused on the rivalry between the US, on one hand, and Europe and Japan, on the other, in
international exchanges.
The conspiracy theory offers a political fra grance to the mechanism of price setting,
which is no longer considered to be the objective result demand and supply, but of political will.
The conspiracy theory overbids the conf lict between American, European and Japanese
economies. This theory offers no economic expl anation of the price forming process during the
crisis. On the other hand, it is impossible to agree or deny a conspiracy. The evidence isn’t
evident.

All theories and points of view that have trie d to explain the energy crisis are, generally,
subjective in nature, and also, to great extent, speculative. These theories mostly referred to its
effects and not its causes. All theories consider th e crisis as being more the result of voluntary
action, rather than an objective social and political phenomenon.

Bibliografie:
1. Bina Cyrus, The Economics of the Oil Crisis , St. Martin’s Press, 1985
2. Lenczowski, G., The Oil Producing Countries , DAEDALUS, 1975
3. Norman Girvan, Economic Nationalism , DAEDALUS, 1975
4. Penrose, E. The Development of Crisis , DAEDALUS; 1975
5. Tanzer, M., The Energy Crisis: World Energy Struggle for Power and Wealth , 1974
6. Vernon Raymond, An Interpretation , DAEDALUS, 1975
7. Yergin, D, The Prize – the epic quest for oil, money and power , 1991
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