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.
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