After a decade's bonanza, the Saudis found their cartel losing its power; its soaring prices had shrunk demand.

—William Safire, January 1986

OPEC meets two or three times a year to set the amount of oil each of its fourteen member countries will produce. The cartel’s market manipulations are not secret. You can find their “Crude Oil Production Allocations” here:

www.OPEC.org/home/Production/productionLevels.pdf

OPEC, the Organization of Petroleum Exporting Countries, controls the world price of oil by controlling its production. Were OPEC to cut production 10 percent, the resulting shortage would send the world price of oil far higher than it is. They don’t do this for two reasons. First, its members find it hard to agree on who will cut back and by how much. They also know that the world would take one look at such high prices and begin to cut oil use, just as it did once before. Let’s take a look back at this history to understand better the process of conserving oil and energy.

OPEC tripled the price of oil in 1974, then doubled that in 1979. By 1981, a worldwide reaction forced Saudi Arabia, OPEC’s leading supplier, to cut production in order to keep the price from falling below OPEC’s target level. By the end of 1985, Saudi Arabia had been forced to cut production 75 percent and could afford no more cuts. It abandoned the cartel rules, letting the price collapse. This ended a twelve-year price shock that is by far the largest experiment in energy policy ever conducted. The experiment did much harm and, quite by accident, much good as well. The experiment surprised people in three ways.

• High prices caused more conservation than was thought possible.

• This conservation brought down the price of oil.

• High energy prices reduced carbon dioxide emissions.

The importance of the carbon dioxide reduction was only recognized later, but the first two effects were noticed as they happened.

High Oil Prices Drive Conservation

William Safire, a newspaper columnist and a self-described “right winger,” proclaimed that “soaring prices had shrunk demand.” In the chapter’s opening quote, Safire demonstrates that in 1986 conservation was seen as more than an environmental strategy. Conservation had defeated the mighty OPEC cartel. Conservation was not then a partisan concept, and neither should it be today. Mainly, conservation is how consumers respond to high market prices. When price goes up, consumption comes down—but it takes a while for the full price effect to play out.

Market-driven conservation is a slow process—slow to get going and even slower to stop. Looking at recent high oil prices, people noticed that gasoline use was slightly higher in 2006 than in 2005 and concluded that higher prices were not working. People thought the same in 1974, when the price of oil tripled and world oil consumption fell only 1 percent.

Market-driven conservation starts slowly because the best way to conserve is to switch to better technology. People don’t buy cars and refrigerators until they need new ones, and companies take years to design new, more efficient models. As shown in Figure 1, by 1980, changes in technology were paying off, and world oil use took an unprecedented four-year nosedive. Figure 1 also shows that conservation largely kept going after the oil price collapse—and changes made in 1980 are still saving us oil. If they weren’t, we would have hit $100-a-barrel oil prices years earlier.

Figure 1. The brown line (labeled “if there had been no price shock”) shows a cautious projection of how oil use would have grown without the OPEC price shock. At a minimum, the amount saved over thirty years was eight years of world oil production at the 2006 rate. The projection includes the effects of economic activity, so the reduction in consumption caused by recession is not counted as conservation.

The size of the OPEC conservation effect was discovered years ago. The Department of Energy (DOE) documented it back in 1980, and William Nordhaus, a respected Yale economist, discussed it in the New York Times that same year. Dale W. Jorgenson, whom I cited in chapter 2, and Peter J. Wilcoxen are two of the country’s best applied economists. They intensively studied the impact of this shock on the United States and concluded that “over the period 1972–1987 US emissions of carbon dioxide were stabilized by price-induced energy conservation.” Although CO2 emissions worldwide did not stop increasing as they did in the United States, global emissions increased more slowly during the crisis.

The Power of Price

The power of price lies in its flexibility to act in a million different ways, many unexpected. Even when price directly affects people, they don’t always recognize it. For example, consumers upset with high gas prices back in 1975 lobbied for Corporate Average Fuel Economy mileage standards, federal regulations that require improved fuel efficiency in vehicles. Mileage standards continue to affect car buyers to the present day, but few recognize the role of OPEC’s high prices in bringing about these energy-saving standards. Many people also fail to notice that mileage standards were frozen from 1985 until 2007 because the price of oil went back down. Increases in mileage standards have only been revived because oil prices have again risen for several years running. Even the energy gurus who now push for stricter fuel-economy standards and subsidies and ignore energy prices owe their careers to OPEC’s high prices. I say this not to belittle their work, but to point out how fundamental and varied the price effect is. Price changes everything. and the whole world responded to OPEC’s high prices.

As Figure 2 shows, high prices also lead to increased supply. New oil supply generally requires new wells, and these also take time to develop. As you can see in the graph, it took about five years for supply to increase noticeably, and it took about five years, until 1993, after prices declined for the extra supply to evaporate. All told, the supply increase did not give us even one year of oil measured at the 2006 rate—compared to eight or more from conservation, as seen in Figure 1. Conservation gave us ten times more bang for the OPEC buck than increased supply. Even today, the leftover conservation measures from the 1974-1985 OPEC crisis are doing more for us than the extra supply did at its peak in 1985.

Figure 2. High oil prices cause more exploration for oil and eventually more production from non-OPEC countries. This helped defeat OPEC, but the effect was slower and weaker than the conservation effect.

Did an Oil Glut Cause Prices to Fall?

The most dramatic change shown in Figures 1 and 2 is not the enormous conservation effort or the rise in non-OPEC oil production, but the rise and fall of the oil price itself. The price increased to six times its 1973 level, then plunged to a third of that new high. What caused these changes?

The price increases were due to supply cutbacks and price fixing. In part, two events sparked these changes: the oil embargo in 1973 and the Iranian revolution in 1979. But they do not explain the bulk of what happened. The bottom line of this story is that the price increase was caused by OPEC raising the price, one way or another, to increase it profits. It really is that simple. But the price decrease is more puzzling.

Markets have a way of getting even. When some suppliers push the price up, the high price motivates consumers and other suppliers to take actions that push it back down. As we have just seen, OPEC’s massive price hikes caused the two standard reactions—increased supply and reduced demand. Both changes happened slowly, so OPEC was able to hang on to its profits for several years.

Both increased supply and decreased demand lead toward a glut of unsold oil, which frustrates suppliers trying to sell their oil. The most effective way to sell is to cut the price, which OPEC did. But was an oil glut really why OPEC cut the price? We want to be sure because our goal is to force such price cuts again. When OPEC cuts prices, it often gives a reason for the price reduction, such as a concern for the world economy. However, this is just part of the game. It’s better to check what was actually happening when OPEC cut the price. The Department of Energy keeps a history of events in the world oil market, and this is part of its record for that period:

• 1982. Indications of a world oil glut lead to a rapid decline in world oil prices early in the year. OPEC appears to lose control over world oil prices.

• 1983. Oil glut takes hold. Demand for oil falls as a result of conservation, use of other fuels, and recession.

• 1985. OPEC loses customers to cheaper North Sea oil. More OPEC price cuts.

History confirms that an oil glut is what put pressure on OPEC’s price. When demand decreases or supply increases, suppliers cannot sell a portion of their oil until the price falls.

Although most of the story is just this straightforward, one strange event occurred when the oil price first peaked:

• 1981. Saudi Arabia, a member of OPEC, floods the market with inexpensive oil, forcing unprecedented price cuts by other OPEC members. In October, all thirteen OPEC members align on a compromise $32-per-barrel benchmark (the figure is in 1981 dollars).

Why would a near monopolist flood the market? Saudi officials of the time would tell us it’s because they wanted a lower, more reasonable, price. Obviously they knew flooding the market would bring the price down, just as it did, but why did they want a lower price? Periodically, OPEC has lowered prices, and its members always make a fuss about how responsible they are being and how we all want a stable price. The reality is different. The Saudis—in particular Ahmed Zaki Yamani, Saudi Arabia’s oil minister from 1962 to 1986 (“Yamani the Enigmatic” of chapter 1)—wanted a lower price because they were afraid OPEC’s extremely high price would soon bring a market response strong enough to crush that price. Yamani was right. Unfortunately for him, he could not get the other members of OPEC to lower the price to a level that was sustainable. Six years later he was losing so much money from the oil glut caused by high prices that he started taking business away from other cartel members. This caused a complete price collapse, which disciplined the other cartel members. The cartel is stronger for it now, but Yamani lost his job in the process.

OPEC’s motives are simple. It wants to make as much money as possible over the long run. This means it wants the price of oil as high as it can be without causing a market response strong enough to force the price back down. When they overreach, consuming nations react with strong conservation measures that push the price down again. OPEC has learned the hard way that this destroys long-term profits. Notice in Figure 2 the eighteen years of low prices OPEC suffered the last time it overreached. This time it is being more cautious, but has it been cautious enough? In a world richer than it used to be, with demand booming in developing countries, OPEC is betting it can keep the price high indefinitely.

A Consumers’ Cartel—Do-it-Yourself Conservation

The market prompted consumers to act as if they had a cartel during the crisis. The consumers of the world all cooperated to some degree on reducing consumption to bring down OPEC’s prices. The trouble was that OPEC, Exxon and the other oil suppliers charged the high prices that kept consumers conserving. In effect they were charging the world’s consumers $4 billion per day or $1.44 trillion dollars per year to organize the consumers’ cartel.

A do-it-yourself cartel would be cheaper—about $1.44 trillion a year cheaper. We would charge ourselves the high prices and pocket the revenues. This is, of course, the untax concept discussed in the previous chapter. It will be discussed extensively in Part 3, but there is one point that can be cleared up now. Once OPEC raises the price high enough it’s not necessary for a consumer cartel to push prices even higher. If it wants to hasten the oil price collapse it can raise prices further, but it is sufficient just to lock in the already high price, or perhaps even a somewhat lower price.

At first the price-lock-in will be effective, and later when the world oil price falls, the higher consumer-cartel price will do its job. The price-lock-in has its effect by acting as a guarantee to those who wish to invest in alternative fuel technology or conservation technology—perhaps a fuel-efficient car. If they make an investment, the world price will not suddenly drop, ruining such investments, as it did in 1986. To be effective, the cartel must be put in effect permanently. It must keep the price of oil high and demand low. For example, we might keep the price to consumers at $90 to cause enough conservation to keep the world price at $50. The $40 difference would be recycled to consumers instead of going to OPEC and the oil companies.

This raises the question of just how much conservation it takes to bring the price of oil down. Unfortunately, there is no precise answer. Chapter 13 will review the evidence, but OPEC’s great energy experiment gives us one estimate.

Figure 1 shows that from 1979 through 1985, while prices remained high, oil use fell by at least 27 percent compared to the projected use in the without the price shock. Figure 2 shows that non-OPEC supply changed less during this period, increasing by about 8 percent over the expected level. The consequence of these two changes was a $60 drop in price from about $90 a barrel to about $30 (in 2007 dollars). Depending on how you figure it (60/90 or 60/30), that’s roughly a 100 percent price drop. And the cause of this price drop was a mere 35 percent drop in net demand relative to business as usual

That’s a powerful effect. For each 1 percent drop in net demand, on average, there was more than a 1 percent drop in price—perhaps as much as 3 percent. This is good news. For every 1 percent cut in world demand for oil, we should be rewarded, on average, with more than a 1 percent drop in the price of oil. As we will see later, this is consistent with estimates used by the International Energy Agency—the original attempt at a consumers’ cartel—and also by other economic models.

Conclusion

In the chapter’s opening quote, Safire explains that OPEC lost power because its soaring prices shrunk demand. He went on, in that 1986 column, to recommend that

What we should do to help oil prices continue moving down to the mid-teens, and stay there, is no secret: … impose a $12-a-barrel oil import fee.

Among other virtues, he points out that it would “encourage the continued conservation of fuel by the U.S. consumer.”

High energy prices have proved to be the most effective tool for achieving our twin goals of climate stability and energy security. Surprisingly, when a high price is applied, the demand side of the market responds more quickly and more vigorously than the supply side—and its response lasts far longer. Put simply, conservation is at least ten times more potent than supply increases.

Conservation and supply increases present OPEC with a net demand reduction, and a 1 percent reduction in world demand produced much more than an 1 percent reduction in the world price of oil during the first great energy experiment. Since that experiment cost us around a trillion dollars, we may as well learn what it had to teach us. It looks like we’ll be needing it.