1970s OIL CRISIS A CASE STUDY

Section B Group-5 AbhishekLahiri (PGP/14/62) Arpit Rastogi (PGP/14/77) Nidhi Pandey (PGP/14/97) Anshuma Mangtani (PGP/14/72) Meemansa Vajpayee (PGP/14/95) Priyamvada Chouhan (PGP/14/106

 It is an event that produces a significant change within an economy, despite occurring outside of it Economic shocks are unpredictable and typically impact supply or demand throughout the markets An economic shock may come in a variety of forms:

Shock in the supply of staple commodities, such as oil, can cause prices to skyrocket The rapid devaluation of a currency would produce a shock for the import/export industry

 Demand Shock : A sudden surprise event that temporarily increases or decreases demand for goods or services A positive demand shock increases demand, while a negative demand shock decreases demand effecting the prices of goods and services. Supply Shock: If the shock is due to constrained supply it is called a supply shock and usually results in price increases for a particular product. Technology Shock: A technology shock is the kind resulting from a technological development that affects productivity

A supply shock is an event that suddenly changes the price of a commodity or service It may be caused by a sudden increase or decrease in the supply of a particular good This sudden change affects the equilibrium price

Negative supply shock (sudden supply decrease) : raises prices and shifts the aggregate supply curve to the left. Causes stagflation due to a combination of raising prices and falling output

Positive supply shock (an increase in supply) : lowers the price of said good and shifts the aggregate supply curve to the right Could be an advance in technology ( a technology shock) which makes production

more efficient, thus increasing output.

 Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

AND THE MOST FAMOUS ILLUSTRATION WOULD BE THE OIL SHOCKS IN 1970s

Oil is a resource which is : Only available in limited amounts and thus supply is limited Availability is confined to its particular geographical distribution.

Roughly 63 % of all worldwide oil reserves are concentrated in the Middle East. Therefore, this region is of essential strategic importance for the oil supply of industrialized western countries.

Organization of the Petroleum Exporting Countries

OPEC's objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.

 Consisted of twelve countries, including Iran, seven Arab countries, plus Venezuela, Indonesia, Nigeria, and Ecuador, had been formed at a Baghdad conference on September 14, 1960. OPEC was organized to resist pressure by the "Seven Sisters" (mostly owned by U.S., British, and Dutch nationals) to reduce oil prices and payments to producing countries. At first OPEC had operated as an informal bargaining unit for the sale of oil by resource-rich Third World nations. OPEC confined its activities to gaining a larger share of the profits generated by the Western oil companies and greater control over the members' levels of production. As a result of this and other events in the early 1970s, it began to exert its economic and political strength; the major Western oil conglomerates, as well as the importing nations, suddenly faced a unified bloc of exporters.

 Two

most important conditions for a cartel

Stable cartel organization i.e., members must

agree on price as well as production Potential for monopoly power i.e.,

demand must be inelastic product should be rare
Payoff Matrix for Pricing Game (an example) Firm 2 Charge $4 Charge $6

Firm 1

Charge $4

$12, $12

$20, $4

The pricing of Oil by OPEC

TD Price SC

P*

DOPEC PC MROPEC QC QOPE

C

MCOPEC

Q
T

Quantity

The Yom Kippur War was the trigger for the OPEC Oil Embargo in 1973. Furious at the emergency re-supply effort that had enabled Israel to withstand Egyptian and Syrian forces, the Arab world imposed the 1973 Oil Embargo against the United States and Western Europe OPEC countries decided to cut off the oil supply as long as the territory occupied by Israel was not free and the rights of the Palestinian people were not re-established.

 The Gulf Six (Iran, Iraq, Abu Dhabi, Kuwait, SAU and Qatar) lifted the price for the Saudi Light Blend by 17 % from $3.12 to $3.65 per barrel and also announced cuts in production. One day later, OPEC ministers agreed to use the dependency of industrialized Western countries from oil supply as a weapon and to exert pressure against unfriendly states by raising prices, cutting off exports and imposing embargoes.

The first country that was cut-off was the United States on October 19 because of its political and military support for Israel. The second country to be embargoed was the Netherlands for its support of the US by providing facilities for the air force for supply flights to Israel.

 The cuts in overall oil production amounted to about 7 % during this first oil price shock. The cuts in Arab oil-exporting countries were much higher and reached up to 25 % The impact on the price was tremendous. The price of oil (measured in US refinery acquisition costs) rose significantly during this first oil price shock from $2.59 in 1973 to $13.06 in June 1974. This was an increase of more than 500 % within 7 months.

Such sharp oil price increases are supply shocks because they significantly impact production costs and prices

Reasons
Iranian Revolution Started in 1968 but more prominent in 1978 Iraqi invasion of Iran
Started in September 1980, primarily due to border disputes

Effects on Oil Prices

Oil supply was less as Iran and Iraq both cut their production Price increased to $39.5/barrel from $15.85/barrel

Year 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

Change in Oil Prices (Percentage) 11.0 68.0 16.0 3.3 8.1 9.4 25.4 47.8 44.4 8.7 7.1 1.7 7.5 44.5 l8.3

Inflation Rate (CPI) (Percentage) 6.2 11.0 9.1 5.8 6.5 7.7 11.3 13.5 10.3 6.1 3.2 4.3 3.6 1.9 3.6

Unemployment Rate (Percentage) 4.9 5.6 8.5 7.7 7.1 6.1 5.8 7.0 7.5 9.5 9.5 7.4 7.1 6.9 6.1

 The growth rate of the world economy fell to 2.1 % in 1974 and to 1.4 % in 1975. Worldwide trade also suffered significantly growth was negative in the two years at -5.4 % (1974) and -7.3 % (1975). The annual FDI flow was negative compared to the previous year. While the annual FDI growth reached 40 % in 1973, the rate fell nearly by half in 1974. In 1976, there was a major slump of -21 % compared to the previous year.

The impact on the US economy was tremendous. US GDP growth fell from more than 5.7 % in 1973 to -0.5 % and -0.19 % in 1974 and 1975. This development impacted upon the unemployment rate, which rose from 4.9% in 1973, peaking at approx. 8.5 % in 1975. In terms of the number of unemployed people, this was an increase of more than 80 %. Inflation, more than tripled from 1972 to 1974 from 3.3 % to11.1 % (and actually nearly doubled from 1973 to 1974).

An unfavorable supply-side shock from higher oil prices

Input Scarcity (Higher Oil Prices)
GDP Growth Slows & Productivity Growth Slows

Price Level Rises

Wage Growth Slows

Interest Rate Rises

Unemployment Rate Rises

The oil price shock The oil price shock shifts SRAS up, shifts SRAS up, causing output and causing output and employment to fall. employment to fall.
In absence of In absence of further price shocks, further price shocks, prices will fall over time prices will fall over time and economy moves and economy moves back toward full back toward full employment. employment.

LRAS

P2

B A

SRAS2 SRAS1 AD

P1

Y2

70% 60% 50% 40% 30% 20% 10% 0% 1973 1974 1975 1976

12% 10% 8% 6% 4% 1977

Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)

Predicted effects of the oil shock: inflation output unemployment and then a gradual recovery.

60%

14% 12% 10% 8% 6% 4% 1978 1979 1980 1981

Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

50% 40% 30% 20% 10% 0% 1977

Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)

40%

10% 8% 6% 4% 2% 0% 1983 1984 1985 1986 1987

1980s: A favorable supply shock-a significant fall in oil prices. As the model predicts, inflation and unemployment fell:

30% 20% 10% 0% -10% -20% -30% -40% -50% 1982

Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)

Index, Ja '82=100 n 115 105 95 85 75 65 55 45 35 25 15

49

Oil prices pike tond to trig e U.S re s iorecessions gr . ce s Oil price spikes tends te be followed by U.S. ns

Source: NBER
52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00

Odd-even rationing of gasoline introduced Fixed allocation of gasoline to states based on 1972 consumption levels National speed limit of 55 miles per hour imposed to limit consumption 3 color flag system introduced at service stations: green unrationed gasoline, yellow restricted and rationed sales and red gasoline not available Year round day light saving time implemented Creation of United States Strategic Petroleum Reserve in 1975 Individuals and businesses encouraged to save energy: Campaign by Advertising Council Dont be Fuelish

Deregulation of oil prices This led to increase in domestic oil and gas production The automobile majors Ford, GM and Chrysler were making smaller and better economy cars Huge R&D investments Lot of technology imports from other automobile makers like Toyota U.S. refiners made short-term changes in oil purchasing and began importing crude oil from any available source.
About 30 percent less of the more costly crude oil was imported during the embargo. Iran at the time

appeared to be a stable, long-term source. Iran moved to expand sales to the United States, and these imports served to offset losses from Kuwait and Libya until Libyan crude oil imports resumed in early 1975.

Imports from other Arab OPEC countries resumed shortly after the embargo ended in March 1974, and continued to climb through 1977. Despite production buildups from the North Sea and Alaska, Arab OPEC's share of U.S. crude oil imports increased from nearly 26 percent in 1973 to 36 percent in 1977, when imports were than at historic high levels which were not again reached until 1994.

Oil price increase shifts purchasing power from oilimporting nations to oil-exporting nations On net, demand for oil importers goods reduced Lower consumption, lower GDP growth, higher saving and lower interest rates

When a higher oil price raises a firms costs, the real consumption wage must fall for firms to maintain profit share and employment in a competitive market. However, if the workers resist the fall in real wages by asking for more nominal wages to compensate the loss in real income, the so-called second round effect of oil price rise emerges. When the monetary authorities put more weight on combating inflationary pressure they could respond to this with a contractionary monetary policy that boosts interest rates, again leading to lower growth.

When firms and households are uncertain about future oil prices, they find it increasingly desirable to postpone investment decisions. Where technology is embedded in capital and household items, such decisions make an irreversible commitment to the energy intensity of respective process/consumption items. As uncertainty about future oil change increases, the value of postponing investment decisions increases. In addition, uncertainty about how firms might fare in an environment of higher energy prices is likely to reduce investor confidence and increase the interest rates that firms must pay for capital. Together, these two effects work to reduce investment spending and weaken economic activity..

The economy experiences some costly adjustment to both rising and falling oil prices When oil prices rise, slowing economic activity is further retarded by adjustment costs When oil prices fall, stimulated economic activity is somewhat offset by adjustment costs We then have asymmetry: rising oil prices retard economic activity by more than falling prices stimulate it

Oil Prices and Inflation

15% 150

10%

100

5%

50

0%
19 60 19 70 19 80 19 90 20 00 20 10

Core US Inflation
Source: US BEA; UNDP

Real Blended Oil Price

www.recession.org Microeconomics 7th Ed , Robert Pindyck The 1979 Oil Shock: Legacy, Lessons, and Lasting Reverberations by The Middle East Institute Washington, DC http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_1 http://en.wikipedia.org/wiki/1973_oil_crisis

Permanent $5 per barrel increase in the price of oil

World GDP Industrial Countries Real GDP Real Domestic Demand Trade balance ($ billion) US Real GDP Real Domestic Demand CPI Inflation Trade Balance ($ billion) Euro Area Real GDP Real Domestic Demand CPI Inflation Trade Balance ($ billion) Japan Real GDP Real Domestic Demand CPI Inflation Trade Balance ($ billion) Developing Countries Real GDP Domestic Demand Trade Balance ($ billion) 2000 -0.2 -0.2 -0.2 -26.7 -0.3 -0.3 0.8 -12.2 -0.2 -0.3 0.7 -10.8 -0.1 -0.2 0.3 -10.5 -0.1 26.1 2001 -0.3 -0.3 -0.4 -20.3 -0.4 -0.5 0.5 -9.1 -0.4 -0.5 0.5 -7.8 -0.2 -0.3 0.2 -8.5 -0.2 20.3 2002 -0.3 -0.3 -0.4 -22.4 -0.4 -0.4 0.3 -10.5 -0.4 -0.6 0.4 -6.2 -0.3 -0.4 0.1 -6.5 -0.2 -0.1 22.4 2003 -0.2 -0.2 -0.2 -24.6 -0.2 -0.3 0.2 -12.5 -0.2 -0.5 0.3 -5.2 -0.2 -0.3 0.1 -5.3 -0.2 -0.1 24.6 2004 -0.1 -0.1 -0.1 -24.7 -0.1 -0.2 0.1 -7.3 -0.1 -0.3 0.1 -4.7 -0.1 -0.2 -4.4 -0.2 -0.1 24.7

Source: IMF.