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40 years after the oil crisis: Could it happen again?

- October 16, 2013

This is a guest post by Jeff Colgan, assistant professor in the School of International Service at American University and author of  “Petro-Aggression: How Oil Makes War.”

— Erik Voeten

Forty years ago today, the Organization of the Petroleum Exporting Countries (OPEC) voted to raise the posted price of their oil by 70 percent.  The next day, several Arab oil producers decided to impose an embargo on oil sales to the United States to punish it for supporting Israel in the unfolding Yom Kippur War.  While the two decisions were not formally linked, policymakers have worried ever since that OPEC could again restrict the global supply of oil.

A lot has changed since 1973.  Oil embargoes used to happen fairly frequently: There was one in 1956, and another in 1967.  Until 1973, they didn’t attract much attention.  But due to structural changes in the oil market in the early 1970s, the one in 1973 had a huge impact.  Since that time, there hasn’t been a single international embargo. (The current sanctions against Iran are an importers’ boycott, not an exporters’ embargo.)  What happened?

In a way, the 1973 embargo was a victim of its own success.  As Eugene Gholz and Daryl Press point out, oil-importing countries reacted to ensure that they could not be threatened again.  They changed the nature of the oil market, moving away from long-term contracts and toward flexible spot-markets for oil trading.  The United States, Japan, Canada and several European countries created the International Energy Agency (IEA), designed to prevent and manage oil supply disruptions.  Perhaps most importantly, they each created strategic petroleum reserves that held a minimum of 90 days of oil imports, so they could ride out an embargo.  All of these changes made an embargo less likely, and less damaging if it did occur.

Still, new challenges exist.  In 1973, most of the world’s oil imports went to IEA members; today, emerging giants such as China and India import millions of barrels per day, a sizeable fraction of the world market. They do not maintain the same petroleum reserves, and are unlikely to join the IEA as full members. They should be encouraged to participate in collective efforts to manage supply disruptions, rather than free-riding on the IEA.

Even without an embargo, policymakers worry that OPEC manipulates the oil market. For example, James Woolsey, a former CIA director and self-proclaimed energy hawk, argues that OPEC has a grip on global oil and gasoline prices so tight that the U.S. will never be free of its influence.  Like most people, Woolsey wrongly believes that OPEC is a powerful cartel. Many economic studies cast doubt on that idea, but there are still some scholars who support the proposition.

OPEC rarely if ever influences its members’ oil production rates.  It has almost no impact on prices.  My research looked at OPEC’s behavior since 1982, when it first adopted formal production quotas for its members.  I found that joining OPEC has little influence on new members’ oil production rates; members cheat on their quotas a whopping 96 percent of the time; changes in OPEC quotas have little impact on changes in production; and members of OPEC produce oil at about the same rate as non-members of the group, all else equal.  Any of these findings would cast doubt on OPEC’s status as a cartel; collectively they are damning.  Of course, individual members are important: Saudi Arabia probably has some power to affect world oil prices by virtue of its spare production capacity, which it can turn on and off as it desires.  The key point, however, is that it has this power as an individual country: OPEC as an organization adds nothing.  Most OPEC members – from Venezuela to Nigeria to Iraq – are pumping their oil as fast as they can, with no spare capacity.

Instead, OPEC is a political club.  It perpetuates a “rational myth” about its cartel power to generate political benefits and prestige for its members, both at home and abroad.  As long as OPEC is viewed as powerful, its leaders can falsely claim credit at home for “managing the economy.”  For example, former Venezuelan president Hugo Chavez argued that he revitalized OPEC and thus almost single-handedly increased world oil prices after he was elected in 1998.  Internationally, the perceived power of OPEC allows its members to reap political rewards and diplomatic influence.  For instance, OPEC members receive more diplomatic recognition from other countries than comparable non-OPEC members.
All in all, the world would be better off if it stopped assuming that OPEC drives world energy markets.  It does not.  Most of the credit or blame for rising oil prices in recent years rests with the energy demands of Asian customers, not diabolic moves by OPEC.  With the price of oil set by market forces almost entirely outside of its control, OPEC is along for the ride like everyone else.