Saturday, November 7, 2009

Oil: Three Re-readings of History--the First Two

The study of oil is the study of a major market in “political economy”. Politics adds emotion, mis-step, and conflict to a reasonably straightforward set of supply and demand curves.

A. The 1967 Energy Crisis and the Arab Oil Embargo (1973)
Around 1967, U.S. domestic oil production left no surplus capacity: we were using everything we could pull out of the well. By 1973, the U.S. market status tipped. We were no longer an oil-producing nation but an oil-consuming nation. And we entered that buyer's floor with a heavy step.

The title “Arab Oil Embargo.” is partisan, and the way it's noted, at least in the West. But it’s equally justifiable to call it the year of “American Buyer Domination.” Certainly we crowded out a lot of little buyers. And we know which of these two conditions has proven more lasting.

1973 was also a year in the oil market’s economic cycle that coincided with “disinvestment.”  There was no surplus capacity world-wide, either. The oil market turned into a seller’s market, rather than a buyer’s market, for the first time in history.

Oil Market Cycle
The oil market cycle is historically a decade long. The high point: high demand creates a high price, but there's not enough infrastructure to bring in needed supply. The oil companies start investing in greater infrastructure so they can deliver. Supply increases, and price travels down to the low point. The oil companies slow their investment and cap wells—after all, there’s no sense in building, or keeping a staff around, if you can’t make money. Prices eventually travel back up to a new high.

In periods of high demand, when it looked like buyers might cooperate, OPEC (the Organization of Petroleum Exporting Countries) always talked about how to gain buyer concessions, or, more plainly, leverage something for themselves. This is a normal human behavior as well as normal cartel behavior. They certainly talked about it again in 1967, when the U.S. was running close to the wire. But in 1973, Arab members of OPEC (OAPEC) decided that they wanted to leverage politics. The embargo supported Egypt against U.S. intervention for Israel in the Yom Kippur War.

In sum, the price was bound to go up—a lot—according to every free enterprise/market model we have developed. The embargo added panic and further reduced supply: it sounded like an abrupt cutoff. It wasn’t, but it was still serious enough: OAPEC reduced its crude sales 5%, and said they would reduce supply a further 5% per month. So the price didn’t correct into sky-high, it went into orbit. Or, it felt like it.

Oil companies were already trying to meet contracts and adjust world distribution. But democracies have voters. States have national security considerations. So Panic added government interference (France needs it! Britain needs it! Ship it here first! We will nationalize our oil companies!). Adjusting distribution became complicated, quickly.

In the meantime, oil companies were also out locating new supply, consistent with a period of high prices/new investment in their cycle.

The Iranian Hostage Crisis (1979)
Jimmy Carter did not nationalize our oil companies, unlike many leaders of free market economies world-wide. He did institute price controls in an effort to reduce citizen panic (politics), which was a bad idea for getting supply in (economics). He also instituted the U.S. Department of Energy—long overdue.

Carter was smart, but not ruthless. We elected him because, after Nixon, somebody harmless sounded good (politics). He was a hairsplitter at a time when we had double-digit inflation but no gasoline. World-wide, people were afraid to take chances (market perception), so the economy tanked instead of adjusting.

In 1979, Iran fell, which raised the real price of oil to refiners higher than any other event before or since, including the Oil Embargo/American Buy-Up and the fall of the Twin Towers. We had hostages there. They had a theocracy, anarchy, an anti-American leader who was not a communist—but who could tell for sure?—Ayatollah Khomeini.

Our oil companies lost significant assets (the market for energy, the insurer’s market took the hit). The U.S. froze Iranian assets in its borders (the market for money) and went to the U.N.'s judicial system, protesting the violations of international law governing embassies and ambassadors (politics). Khomeini flipped off the courts, the U.N., and the U.S. one more time. Iran started to go to hell—participating in neither international politics nor international markets. Our hostage rescue failed.

So we elected Ronald Reagan, who was inspiring and yes, ruthless for American interests (politics). He also believed, absolutely, in market-based, rather than government-based, pricing. That worked for us on the energy front. Iran released our hostages but not oil company assets. We didn’t release their assets either. But people calmed down. States with government-run oil companies and no hostages also calmed down—and—why is this?

The supplies newly located since 1973 came on-line and were distributed (economics).

We have never forgiven Carter for being who we wanted him to be. We have never had gasoline under a dollar a gallon since 1973. That’s not Carter, OAPEC, or even Khomeini. This is all demand and supply.

(Note: I have over-simplified Daniel Yergin’s great history, The Prize; Susan Strange’s far-reaching ideas in The Retreat of the State and other texts. I recommend these books. None of them is a beach read. The oil cycle theory belongs to E.L Morse at HETCO. He is also brilliant. The opinions and any inaccuracies are of course my own.)

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