Crude Volatility

In the 1870s, the oil market was transformed by Rockefeller from chaos to stability. The 1970s were equally transformative but in the other direction: from stability to chaos. In the early 1970s, OPEC destroyed the old order, just as the U.S. Supreme Court had terminated the Rockefeller era in 1911. The result was much higher and more volatile prices than seen during the Texas Era.

For the first one hundred years in the oil market’s history, with a few exceptions and a few “peak oil” scares, the main problem for the oil industry was managing excess supply. To prevent gluts from crashing prices, regulators and cartelized oil companies were obligated to hold back or “shut in” production from flowing wells. But starting in the 1960s trends in global oil supply and demand began shifting the other way. World oil demand rose sharply in the late 1960s, growing by 8 percent per year on average in the second half of the decade and by nearly 9 percent in 1969 alone.¹ Many analysts expected demand to keep booming. In 1971 the U.S. National Petroleum Council estimated demand outside the communist world would increase from 37 mb/d in 1970 to 92 mb/d by 1985.² And while the amount of new oil being produced continued to outpace the amount consumed, the gap between the two began to close. U.S. foreign policy officials grew concerned that most of the oil needed to meet the massive projected oil demand would come from OPEC producers, and the bulk of that from the Middle East.

As domestic demand raced ahead of supply, the United States increasingly turned to crude imports. The United States’ spare capacity as a percentage of global demand fell from over 15 percent at the beginning of the 1960s to around 5 percent at the decade’s end, making the United States vulnerable to an oil supply disruption. Washington’s anxiety about a supply cutoff was well-founded, given the disruptions they had seen already from Middle East conflicts in 1956 and 1967. The ongoing Arab-Israeli acrimony posed a constant threat of another.

During the Cold War, Washington’s top foreign policy concern with regard to oil was to prevent Soviet encroachment on the Gulf’s huge oil reserves, as well as its processing and export facilities—hence the CIA’s help in overthrowing Mossadegh in 1953 to prevent Iran from entering the Soviet orbit. Looking to backstop U.S. Cold War interests and support allies in the Gulf, the State Department shielded majors from harsh anti-competition probes and Washington also granted majors fiscal incentives to operate in the region, so as to keep large producers friendly to the United States and ensure access to the regions mammoth reserves.³ Although its interest also fluctuated, in general, Congress was responsive to the interests of domestic oil companies, especially, which had a bigger political footprint in states than their international counterparts. Congress often pushed on behalf of domestic production for protection from cheap foreign imports.

But with soaring demand and rising dependence on the Middle East, OPEC countries became increasingly assertive in their long running battle to claw more rent and reassert control (if not at first ownership) from western majors, and U.S. officials found themselves in the unpleasant position of having to choose between their own oil companies—both majors like Exxon and Chevron but also many independent oil companies that had entered foreign concessions, particularly in Libya—and the governments of OPEC producing countries. While it may be going too far to say western officials sided with OPEC, the reality was that the majors received little to no support from their capitals in the late 1960s and early 1970s. While Washington kept an eye on oil for Cold War considerations, it was not a top priority in the United States. Inflation, civil rights, the Vietnam War, and Watergate dominated the news. The United States and Great Britain relied on Iran and Saudi Arabia to step up and play the regional policeman role, and were selling them lots of weapons.⁴ Leaders were unwilling to challenge Gulf producers.

To the extent that federal officials thought about international oil markets and policy, they tended to lean toward OPEC because they regarded higher U.S. import dependence as inevitable and feared a supply cut off above all. U.S. officials were resigned to OPEC’s increased leverage; some officials even welcomed higher oil prices, which would slow galloping demand growth (one of the causes of rising import dependence).⁵ Former OPEC Secretary General Parra related that U.S. State Department officials quietly urged OPEC countries to raise taxes on production, knowing they would feed through to higher prices.⁶ On the supply side, industry officials welcomed higher oil prices, partly to underpin investment in large but costly oil discoveries in Alaska (Prudhoe Bay, discovered in 1968) and North Sea (giant Ekofisk and Forties discoveries in 1969 and 1970, respectively).

With the market tightening, exports growing, and Washington distracted and sympathetic to OPEC, power was shifting fast to OPEC producers, who promptly used it against foreign operators, majors and independents alike.

Unlike other producing countries, Libya did not restrict oil concessions to one producer or consortium. Libya came late to the game, but was open to all. It had invited many majors and independent firms like Amerada Hess and Occidental to operate as well as the Seven Sisters. About half of Libya’s production was in the hands of independent oil companies that were not integrated with refineries and had no reason to restrain supply to support prices. Blocked by import quotas from selling to the United States and unconstrained by Seven Sisters’ cartelized production, transportation, and marketing rules, independent operators producing in Libya dumped their oil in nearby Europe.

As production expanded, Libya’s monarch King Idris I pressured producing companies for fiscal concessions. King Idris’ strategy involved targeting one company intensely and, when it complied, demanding the same from others. On September 1, 1969, a military coup overthrew King Idris I and installed 27-year-old Muammar Qaddafi as leader. Qaddafi followed King Idris’ strategy of singling out the weakest first to then squeeze all oil companies much harder.⁹ Targeting Occidental because it had little production outside the country, by September 1970 Libya extracted an increase of $0.30 per barrel in administered prices and higher income taxes.¹⁰ Qaddafi then turned on the other twenty independent and majors, demanding the same concessions won from Occidental.

As small independent operators in Libya buckled and conceded, pressure grew on the majors—Exxon, Texaco, and Chevron—to meet Qaddafi’s terms. Exxon resisted, so Libya turned the screws by ordering production cuts from the company’s fields. The majors discussed approaching Qaddafi en bloc and turned to Washington and London for support. London did not bite, and a top State Department oil official in Washington told Congress that he thought Libya’s initial demand for a $0.40 per barrel hike was fair enough. By mid-October 1970, all producers in Libya had agreed to higher administered prices and income tax rates.¹¹

The defeat of foreign companies in Libya marked a turning point in the balance of power between international oil companies and host governments. A game of follow the leader started. Other producers, marveling at Qaddafi’ s unheard of victory at wringing a substantive increase in both taxes and administered prices, now clamored for the same. Jealous that Qaddafi had in a few months achieved more than OPEC had in five years, Gulf producers—particularly the Shah of Iran—insisted on a 55 percent income tax rate. Then OPEC governments started leapfrogging each other, demanding bigger concessions from operators. For example, after Iran won a 55 percent income tax from majors, Venezuela demanded 60 percent.¹²

Fearful of being picked off one by one, the seven majors, Total, and eight independents banded together in a united front to bargain with OPEC. Companies obtained clearance from the U.S. Justice Department to avoid antitrust risk, and prepared to compensate any producer forced to cut production as a pressure tactic, as Libya had done to Occidental. But OPEC rejected the oil companies’ proposal for one all—encompassing negotiation and insisted on two separate tracks, one with producers on the Mediterranean such as Libya and another with Persian Gulf producers. The Shah played on western officials and companies’ fears, warning the former that if oil companies resisted, “the entire Gulf would be shutdown and no oil would flow,”¹³ and admonishing that the “all-powerful Six or Seven Sisters have got to open their eyes, and see they they’re living in 1971, and not in 1948 or 1949.”¹⁴ Washington—terrified above all of a supply cut off it no longer had ample spare capacity to offset—sided with the Shah and against oil companies, supporting OPEC’s demand for two regional negotiations. Talks began in Tehran to cover the Gulf and in Tripoli to address the Mediterranean market.¹⁵

Their bargaining power extremely low, western oil companies capitulated on February 14, 1971, to Gulf producers, signing a Tehran agreement that buried for good the two-decade-old 50–50 profit-sharing deal Venezuela first won in 1948 and raised the minimum host country take to 55 percent (which the Gulf countries, spurred by Qaddafi, had already won). The Tehran agreement also raised concession-administered prices by $0.30 immediately and to $0.35 in 1975. When the Mediterranean producers concluded the Tripoli Agreement in April 1971 the oil companies had agreed to even bigger price increases—enraging the Shah of Iran, who felt he had been leapfrogged.¹⁶

The OPEC producers’ efforts to wrest money from foreign operators was greatly aided by supply and demand dynamics that continued to work in their favor. In the early 1970s, oil demand was raging and large new discoveries outside OPEC had yet to come online. The U.S. production peaked in 1971 and then started to decline. Huge new oil discoveries in Alaska, Mexico, and the North Sea were still in their early development phases and would not result in new barrels on the market for another 5 years or so. Any incremental barrels had to come mainly from OPEC, which was now raising prices consumers had no choice but to accept. The sudden shattering of decades-old relationships between oil companies and host governments disrupted relationships between buyers and sellers, adding to buyer’s panic, confusion, and willingness to pay a fear premium for any barrels they could find. Security of supply was the watchword; price was no option.

Frantic inventory building also helped drive oil prices higher. During the Texas Era, private crude oil inventories tended to vary within a small range. When refiners are confident about supply availability and stable future prices, they have no reason to hoard. But OPEC’s price hikes created perceptions of future price hikes, which made oil companies want to store. The rush to buy was fueled when President Nixon abolished import quotas in April 1973, unleashing a new wave of Middle Eastern oil sales to U.S. traders and refiners.⁷³ Refined product prices followed crude upward. Between 1970 and 1974 U.S. gasoline prices increased by nearly 50 percent, from $0.36 per gallon to $0.53 per gallon—sharp, but not sharp enough to significantly reverse demand.¹⁸

With prices rising and demand strong, OPEC producers held leverage and knew it.¹⁹ The majors were disunited and weakly supported by their governments, encouraging further forays by OPEC countries. The Tehran and Tripoli Agreements were supposed to last for five years, until 1976, but by 1973 they were already starting to fall apart. Dependence on OPEC for additional supplies was growing. But most significant in pushing OPEC countries to demand new terms was the fallout from President Nixon’s decision on August 15, 1971, to devalue the U.S. dollar.

Many OPEC producers, including Saudi Arabia, had U.S. dollar-based oil contracts, which lost significant value when the greenback was delinked from gold. An oil exporter receiving dollars saw the number of barrels needed to purchase one ounce of gold rise by 200 percent between 1971 and 1973, from 12 to 34 barrels of oil per ounce of gold.²⁰ Producers insisted that, to compensate for the weaker dollar, it was necessary to set higher prices than they had originally agreed on in Tehran and in Tripoli.

In January 1972, OPEC met with majors in Geneva and obtained agreement to link administered prices to a basket of currencies instead of the dollar, resulting in an immediate 8.5 percent price increase.²¹ In June 1973, OPEC met in Geneva and decided to press for another hike in administered prices. In early August Saudi Oil Minister Yamani “warned Aramco that the Tehran Agreement would have to be renegotiated” altogether.²²

A new development in global oil price history fueled OPEC’s assertiveness toward the fall of 1973. The price of oil set in small, “spot” markets started to rise above administered prices.²³ “Spot transactions” refers to arms—length, often one-off or single cargo deals between two autonomous parties, usually between an independent producer and a seller (private or state—owned oil producer) and unconnected to a long-term contract. Relatively rare in the post–World War II decade when intra-company transfers between subsidiaries of the Seven Sisters dominated most internationally traded oil, spot transactions proliferated after the late 1950s as smaller independent countries began to produce and sell oil. Even though such spot market transactions amounted to only about 3 percent of internationally traded oil, they had a psychologically important effect as they soared above administered prices. Rising spot prices convinced OPEC, Maugeri wrote, “that consumers were so oil crazy that they were ready to pay well above official [administered] prices, which they consequently raised in a rush to catch up with spot values.”²⁴ While spot transactions and their prices were not widely reported in the press, they would come to be seen as the most authentic indicator of the real market price of crude oil—and they were on the move.

Emboldened, OPEC summoned oil companies to a meeting in Vienna on October 8, 1973, to reopen the 1971 Tehran and Tripoli Agreements. Beleaguered U.S. oil companies again sought and were grudgingly granted an antitrust waiver from the Justice Department to negotiate.²⁵ The majors offered OPEC a 15 percent increase in administered prices; OPEC demanded a 100 percent hike, a doubling from $3 to $6 per barrel. Western companies sought guidance from their capitals and were told to resist as such a price shock would harm economic growth. Talks ended inconclusively on October 14, with participants distracted by the outbreak of another war between Israel and its Arab neighbors two days before the conference began. Unlike the prior conflicts, this one would mark an epochal change in the history of the oil market.

Since refounding in 1948, Israel had been at odds with its neighbors—to put it mildly. War erupted immediately after Israel declared independence and again in 1956 and 1967, the latter resulting in a humiliating loss of territory by Egypt, Jordan, and Syria. Eager to reclaim it, Egypt and Syria mounted a surprise attack on Israel on October 6, 1973, while Israelis were observing Yom Kippur (Day of Atonement). Soon supported by Iraq and Jordan, Arab armies made large territorial gains. After absorbing initial blows, Israeli planes struck Syrian exports terminals at Banias and Tartus. That damage, combined with Saudi cutbacks through the Tapline²⁶ to the Mediterranean Sea, immediately took 1 mb/d off the eastern Mediterranean crude market. Arab producers had long seethed at western support for Israel and decided to use its newfound oil weapon to intimidate Israel’s supporters by cutting supply and raising administered prices.

Administered price hikes came first. On October 16, 1973, a group of five Arab OPEC representatives and Iran met in Kuwait City and announced a unilateral price increase of the benchmark Arabian Light from $3.01 to $5.11 per barrel, a 70 percent bump that lifted administered prices higher than prevailing market ones (see figure 6.1).²⁷ From then on, OPEC would no longer go through the pretense of negotiating with foreign oil companies: Thereafter administered price changes would be imposed unilaterally by OPEC members.

Arab oil producers believed production cuts were necessary to make enforcement of higher administered oil prices credible. On October 17, after Iran’s representative had departed the Kuwait meeting,²⁸ remaining Arab producers agreed to cut production by 5 percent per month relative to September’s level until Israeli forces left territory seized after the 1967 war. The next day Saudi Arabia announced a 10 percent production cut. After the US announcement of a major aid program for Israel on October 19, Riyadh retaliated by announcing a total ban on exports to the US, and other Arab producers soon followed suit. A ceasefire between Israel and its Arab enemies was implemented on October 25, but Arab producers kept up the pressure; meeting again on November 4, they decided to reduce supply to 25 percent below September’s level.²⁹

The Arab oil embargo failed to pressure Israel or the United States to change policy. But its impact on oil prices and psychology were significant. The war, embargo, and production cutbacks triggered widespread confusion in markets already preoccupied with fears of supply shortages. In December, OPEC raised the administered price of the informal benchmark crude, Arabian Light, to $11.65 per barrel (around $60 in 2016 prices), four times what it had been four months prior and six times 1970 levels. Iran had encouraged the $11.65 per barrel price, justifying it with a study the Shah had commissioned that set that as the cost of alternative fuel to oil.³⁰ Market—based prices raced ahead of administered ones; Iran was reportedly able to sell oil at auction for $17.40 per barrel.³¹ “It is hard to find in history,” Maugeri wrote, “a comparable revolution in the price of a strategic resource.”³²

Israel and Arab countries held disengagement talks that lasted until May 1974, during which time the oil supply situation gradually returned to normal. The Arab oil embargo failed to achieve its aim of forcing an Israeli withdrawal and was formally ended in March, 1974.³³ The embargo had only caused a small and short physical supply disruption; traders diverted non—embargoed crude to embargoed countries,³⁴ and inventory draws and increased supply from outside OPEC offset the temporary loss of OPEC crude. So while the OPEC embargo was purely a symbolic move—as Saudi Oil Minister Yamani would admit³⁵—it was an incredibly effective one. It amped up feelings of insecurity in the U.S. and other consuming countries while goading OPEC members to further accelerate price increases and nationalize foreign–owned oil assets.³⁶

It is difficult to overstate the depth of the gloom that descended on western officials and business people in the 1970s at the prospect of massive future dependence on Middle Eastern oil imports. Over the four preceding decades, the US and its allies had enjoyed stable oil prices and felt secure about supply security, though the 1967 and especially 1956 disruptions did cause a fright, particularly in Europe. But shifts that began after World War II and gathered force in the 1960s—soaring oil demand and replacement of the U.S. with the Middle East as key supply region—triggered a convulsion and reshaped the global oil market, shattering prior complacency about energy security and energy policy. Western governments and majors had ignored OPEC after it was created in 1960. “But now, in the middle 1970s, all that had changed,” Daniel Yergin wrote. “The international order had been turned upside down. OPEC’s members were courted, flattered, railed against, and denounced. There was good reason. Oil prices were at the heart of world commerce, and those who seemed to control oil prices were regarded as the new masters of the global economy.”³⁷

Western shock and dismay was compounded by lack of unity between the U.S. and Europe, which struggled to formulate a common policy. France sought to appease Saudi Arabia; the United States tried to rally Europe against OPEC; other European countries and Japan fell somewhere in the middle. Every country tried to get the best deal it could from Arab producers—chacun pour soi.³⁸

Unable to agree on a unified way forward, Western countries were left to their own national responses—and in the United States, that response was “energy independence.” In a major speech on November 7, 1973, devoted to reassuring and mobilizing an American public traumatized over energy crisis, President Nixon alluded to the “Manhattan Project” and the spirit of the “Apollo Project,” and called for making the U.S. energy self-sufficient by 1980 through conservation, increased domestic production, and alternative fuels. He called his plan Project Independence. His top energy advisor told him seven years was impractical (and indeed oil import dependence rose from 34 to 44 percent by 1979)³⁹and Nixon’s pledge soon became a joke as energy dependence continued rising.⁴⁰

If President Nixon’s promises about energy independence did little to alleviate the energy crisis, wage and price controls he imposed made it worse. Economy–wide wage and price controls first went into effect in August, 1971 with a 90-day price freeze, including on refined products. They were followed in November 1971 by a second phase, which allowed non-oil firms to pass along higher import costs but kept prices frozen for crude oil or products like gasoline, heating oil, and heavy fuel oil. With oil import prices rising, domestic importers were starting to lose money. Problems developed particularly in the heating oil market, and shortages appeared during the winter of 1972–1973. In January 1973 price controls were made voluntary for smaller oil importers and refiners amounting to about 5 percent of the market, but heavy public pressure was placed on them to restrain increases, including the threat of reimposition of mandatory price controls. Meanwhile, prices on crude and refined products remained frozen for the big oil producers and importers accounting for 95 percent of the market, constrained in their ability to expand production.⁴¹

Customers of the big companies—independent marketers, fuel oil distributors, and other large fuel purchasers—found themselves unable to get the supply they needed at controlled prices. This is not surprising, since basic economics tells us when prices are held below market–clearing level, producers suffer losses if they produce or expand. Physical shortages result. Rising prices and shortages thrust the oil industry into the public’s crosshairs. Claims that the big firms were “holding back” supplies began to surface. Political pressure rose for the federal government to expand regulation beyond prices onto supply via the direct allocation (in other words, rationing) of supplies of crude and refined products. In response, Congress passed the Emergency Petroleum Allocation Act of 1973, spawning what oil historian Daniel Yergin described as an “awesome Rube Goldberg system of price controls, entitlements, and allocations” that made Eisenhower’s oil import quotas (also complex but which Nixon ended in 1973) appear by comparison “to have the simplicity of haiku.”⁴²

Under the byzantine system,⁴³ the Federal Energy Administration (the precursor to the Energy Department established under President Carter in 1977) decreed that “old oil” produced from domestic wells and not exceeding the rate of output in 1972 could sell for no more than $5.25 per barrel. “New oil”—oil from domestic wells in excess of 1972’s production rate, or from wells drilled after 1972—sold for $11.47 per barrel. Imported crude sold for $13.28. The policy was intended to spur domestic production while holding domestic prices below those being imposed by OPEC. In March 1975 U.S. refiners processed approximately 41 percent “old” oil, 27 percent “new” oil, and 32 percent imported oil, and the effective blended price was $9.49.⁴⁴

Price controls succeeded in their aim of insulating the U.S. from rising global oil prices. But they created at least two unintended, negative consequences. First, producers were effectively encouraged to stop producing “old” oil because they expected price controls to end eventually. Rather than produce for $5.25, they preferred to keep the oil in the ground and sell later at a higher price. Domestic production fell, which increased dependence on imports.⁴⁵

Second, the price controls increased incentives to import oil which in turn emboldened OPEC and made the U.S. more likely to see higher prices.⁴⁶

The famous gas lines and shortages of the mid-1970s originated partly from price controls ⁴⁷ (to the extent controls held prices below market—clearing levels, they stimulated consumption), but mainly from allocation programs, state regulations, and consumer panic. Allocation programs, which stipulated the geographic allotment of fuel and were based on historical consumption patterns, denied oil companies the flexibility to move supplies from ample to lacking parts of the country. State regulations limited how long stations could remain open (previously they were open around the clock) and allocated purchases based on an odd or even license plate. Finally, consumers used to stable pump prices got socked with a 40 percent increase after the Arab oil embargo and watch pump prices rise during the day. In the past drivers would let the fuel gauge go down to near empty before filling up, but now—fearing higher prices or worse, not being able to get gas at all—they topped up frequently, even by small amounts, and got in lines to do so. Gas lines themselves resulted in higher fuel consumption due to idling.⁴⁸

Price controls lasted until 1979 and allocations until 1981. Most public and private sector experts concluded that price and allocation systems made dislocations in the 1970s worse and that relying on market forces would have been less disruptive.⁴⁹ The cost of these price controls, as estimated by Harvard economist Joseph Kalt in 1981, included 0.3 to 1.4 mb/d of forgone domestic production and a $1–6 billion annual “deadweight loss” to the economy. This didn’t include costs of regulatory administration, enforcement, compliance, and lobbying, nor does it include difficult to quantify economic distortions or the environmental costs extra oil consumed.⁵⁰

While the United States had been able to impose unified restrictions (if of questionable efficacy), European countries had different national interests and were unable to form a united response to the oil crisis.⁵¹ Opportunities for quick savings in oil consumption were also more limited in Europe than in the United States because European oil use was concentrated in the industrial sector whereas, in the United States oil was primarily used in transportation.⁵² It is cheaper and easier to drive less than shutdown a factory. Nonetheless, concerned with the impact of fuel oil shortages in the industrial sectors, European countries pursued a policy of restricting oil use in transportation through a combination of fuel taxes, rationing of gasoline, restrictions on heating and lightening, limited driving bans, speed limits, and fuel price increases⁵³ Similar conservation policies were also adopted in Japan during the crisis.⁵⁴

By the end of 1974 shaken oil importing countries began to realize their go-it-alone policies were counterproductive and started to appreciate the potential benefits of collective action. That year U.S. Secretary of State Henry Kissinger convinced thirteen western European countries (France joined in 1992), Japan and Canada to form the International Energy Agency, whose main mission would be to prepare for another disruption by encouraging the building of strategic stocks (oil inventories held or controlled by governments for use in a major disruption) and sharing oil among each other in an emergency. Members initially agreed to hold strategic stocks equal to 60 days of imports, but in 1976 IEA members decided to gradually raise the import cover commitment to 90 days by 1980.⁵⁵ Strategic stock releases following a severe supply interruption were “expected to help calm markets, mitigate sharp price spikes, and reduce the economic damage that had accompanied the 1973 disruption.” Strategic Petroleum Reserve releases would also “buy time” for a geopolitical crisis “to sort itself out” or for diplomacy to resolve before the oil disruption itself caused it to metastasize beyond ability of diplomacy to resolve.⁵⁶

The establishment of the U.S. Strategic Petroleum Reserve became the centerpiece a comprehensive national energy law signed in December 1975 by Nixon’s successor President Ford to address the ongoing “energy crisis.” Called the Energy Policy and Conservation Act, the law also included a ban on crude oil and refined product exports, conservation standards for appliances, and vehicle fuel limits called Corporate Average Fuel Economy (CAFE) regulations. While initially intended to promote energy security by lowering oil imports and save consumers money at the pump, in recent years the federal government has added reducing greenhouse gas emissions to CAFE’s objectives. Oil began pouring into underground salt caverns chiseled under the Texas and Louisiana coasts in July 1977, and the SPR came to life.

Other IEA countries also established crude and in some cases petroleum product reserves. But persistent divisions between the allies limited the IEA’s effectiveness. Whereas the United States saw the IEA as a weapon against OPEC, more docile EU and Asian members preferred to keep it a low-key forum to collect data and share technical perspectives.

Meanwhile OPEC confronted another tricky problem: How to market oil as they nationalized foreign concessions. Under traditional concessions, foreign oil companies were obligated to pay host governments taxes and royalties, but majors owned the oil and sold or refined it as they saw fit. However, starting in the early 1970s OPEC countries demanded and received partial and eventually full ownership of the oil. As OPEC members came to own more of their crude, they had to figure out how and where to sell it. At first OPEC countries just forced majors to buy back their equity crude at inflated prices. But rising prices in small spot markets started to look more attractive to OPEC governments which began to sidestep their concession companies and sell their equity crude in spot transactions directly with third-party brokers or other intermediaries.⁵⁷

During most of the 1970s, except in a brief spell during economic weakness in 1974, OPEC did not need to grapple with the tough work of imposing quotas and production cutbacks, as cartels usually do and the TRC and Seven Sisters did. There was no need for OPEC to play the TRC role its founder Pérez Alfonzo had hoped for it. Amid widespread fears of shortages, prices stayed high without the need for OPEC to consider formally restricting supply.

However, individual OPEC members did decide to cut back oil supply for their own reasons. Many producers held production back out of fear of premature depletion of reserves—that old concern about “physical waste” from the earlier days in Oklahoma and Texas. Anxiety about endless voracious demand and shortages did not just swirl in western consuming countries, but also in producing ones. OPEC countries feared consuming countries would pressure them—even force them—to produce all out and to the point of exhaustion, then discard them. When Kuwait decided to limit its oil production to 3 mb/d to preserve resources in 1972, it exacerbated fears of a shortage.⁵⁸

Moreover, western oil companies were no longer setting prices after 1973, they did retain—until nationalizations were completed later that decade—some leeway in terms of how much to produce. While host governments would badger, punish, or reward majors for keeping production below desire levels, western companies preferred to keep substantial amounts in excess capacity seasonal fluctuations and contingencies.⁵⁹

In addition, some OPEC countries refused to discount their oil at times of demand weakness, such as during 1974 and 1975, instead holding oil back until prices went up. While OPEC members squabbled about large spare capacity and the need to “share losses” during this period, they shied away from attempting to set formal market share agreements. Producers were on their own and lived with the consequences of their own actions. The unwillingness of producers to discount caused Libya’s spare capacity to rise to over half of its production capacity, 1.6 mb/d of 3 mb/d by August 1974.⁶⁰

When supply surpluses appeared in mid-1974 and oil prices weakened toward the end of the year, OPEC staff recommended production cutbacks. OPEC rejected formal quotas, although the question of sharing losses began to dominate their discussions. Saudi Arabia informally agreed to act as the shock absorber, cutting production from 8.8 mb/d in October 1974 to 5.7 mb/d in March 1975.⁶¹ This was the first instance of Saudi Arabia acting as a swing producer.

The period from 1974 through 1978 was relatively calm. OPEC kept administered benchmark prices generally stable, implementing only two increases. In inflation adjusted terms, crude oil prices actually fell about 10 percent in value from immediately after the Arab oil embargo of 1973.⁶² It appeared the world had reached a new, higher, but stable, normal level for oil prices. But that normality was about to be dashed by a revolution in Iran.

In 1977 widespread public dissatisfaction by Islamist and secular Iranians at the authoritarian monarchy of Mohammad Reza Shah Pahlavi resulted in regime-rattling demonstrations that intensified in early 1978. Oil worker strikes the next year reduced Iran’s oil exports from 4.5 mb/d to less than 1.0 mb/d. A military government installed by the Shah restored production, but by the end of 1978 violence and strikes had intensified, expatriate oil workers had begun evacuating, and oil exports had come to a complete halt. In 1979 protests snowballed into a full-blown revolution. The Shah fled Iran in January 1979 and an Islamic Republic was proclaimed that year, headed by returned exile and now Supreme Leader Ruhollah Khomeini.

The Iranian revolution caused a severe disruption in oil supplies—much more so than had been seen during the Arab oil embargo of 1973 (see figure 6.2). Iran was then the world’s second-largest oil exporter after Saudi Arabia. While Saudi Arabia and other OPEC producers were able to partially offset Iran’s loss and global oil production actually increased in 1978, the swiftness of Iran’s decline startled the market.⁶³ Actual world production rose in 1979, but the loss of Iran’s 2 mb/d (about 3 percent of the prior year’s supply) triggered a 126 percent price increase for oil⁶⁴—even though inventories and spare capacity were still ample. One explanation of the outsized price spike was a desire by importers to build even higher inventories as a precaution.⁶⁵

Japan was particularly hurt by the sudden loss in supply. Tokyo had prioritized making Iran a niche supplier and received 20 percent of its supplies from the country. After two decades of astounding growth, Japan’s leaders suddenly confronted their country’s core vulnerability—the near total absence of oil resources. Shocked by the sudden cancellation of their long-term contracts, Japanese refiners embarked on a frantic spree in the spot market, buying all the crude they could, wherever they could, becoming increasingly resourceful along the way.⁶⁶ Spot markets—which had been growing but were still largely used as a balancing mechanism, enabling buyers to obtain an extra cargo here and there if due to logistical or other factors they found themselves short–started to see even more trading. The Japanese were joined by independent oil companies and a host of new buyers scrambling to procure crude in the increasingly liquid spot market, including “Wall Street refiners, state oil companies, trading houses and oil traders.”⁶⁷ Havoc ensued, as buyers scurried into the spot markets looking for immediately available cargoes to replace lost Iranian volumes. Spot prices were increasingly monitored closely by OPEC as an indicator of the “real” market price of oil—and this real price was rising.

Under long-term contracts, OPEC producers were obliged to sell oil to customers based on administered prices. But by February 1979, spot market prices were twice as high as administered ones.⁶⁸ Thus, traders who could buy OPEC oil at lower administered prices and sell them on the higher spot market made large profits. This had two consequences. First, some OPEC producers began selling more oil directly to third parties at higher spot prices. Second, OPEC raised administered prices toward higher spot levels, which in turn fueled more panic and hoarding that translated into higher spot prices. The self-reinforcing cycle continued.

Saudi Arabia fueled the panic by cutting production by around 600 kb/d in January, 1979.⁶⁹ Spot oil prices rose from $12.80 per barrel before the first Iranian oil worker’s strike in October 1978 to $21.80 in February 1979 just after the Shah left, and hit a high of nearly $40 in November of that year.⁷⁰ One oil executive recoiled at the “ratchet” strategy that appeared to be similar to the TRC’s strategy following disruptions in Iran and Suez and the Middle East in the 1950s of holding back supply to ensure price increases stuck. “When Iranian oil went off the market,” he said, “OPEC tacitly agreed to limit production. It is much simpler to limit production so that price increases are automatic. The OPEC nations are acting the same way the TRC did for 30 years.”⁷¹ If not yet a functioning cartel, OPEC producers were starting to experiment with exercising supply cutbacks to make oil price increases stick.

In March 1979 Iranian oil began trickling back onto the market, but fear and panic enabled the OPEC producers to demand large surcharges on their oil sales. Saudi Oil Minister Yamani called it a “free-for-all.” Publicly Saudi Arabia continued to maintain an opposition to exorbitant oil prices. Yamani insisted Saudi Arabia wanted to avoid recessions and incentives to invest in substitutes for oil.

In Washington, the sudden loss of a top Middle East ally and attendant oil price spikes whipped smoldering expectations of an imminent oil shortage into a full-blown panic. Gasoline lines reappeared in 1979 after Iran’s exports were cut off. Iran tended to produce a type of crude oil that yielded a lot of gasoline; refiners were forced to replace Iranian barrels with heavier crudes that did not yield as much. Once again, rising prices, federal allocation rules, and local regulations created local shortages and fueled panic buying. Gasoline stocks in California ran low and as rumors of shortages circulated “all 12 million vehicles in the state seemed to show up at once at gasoline stations to fill up.” Some states limited purchases to a small dollar amount, which had the perverse consequence of forcing motorists to tank up more than once, worsening gasoline lines.⁷²

The new energy disaster sent Washington into crisis mode. In 1979 the CIA warned that gas lines and oil price increases signaled an “underlying oil supply problem … the world can no longer count on increases in oil production to meet its energy needs.”⁷³ In June 1979 Energy Secretary James Schlesinger reminded people that he had been warning of an inevitable supply shortfall since 1977 and, upon leaving office in August of that year, warned that oil was tapped out and “unless we achieve the greater use of coal and nuclear power over the next decade, this society may just not make it.”⁷⁴ In 1980 the CIA warned “[w]e believe that world oil production is probably at or near its peak … [p]olitically, the cardinal issue is how vicious the struggle for energy supplies will become.”⁷⁵

The public erupted in anger at oil companies and at President Jimmy Carter, whose approval ratings nosedived to about Nixon’s during the worst of Watergate. Carter excoriated oil companies but, recognizing (in what had become consensus view) that 1970s price controls failed, began decontrolling oil prices.⁷⁶

Congress also banned construction of fuel–oil-fired power plants, promoted switching from oil to coal for industrial fuel, and enacted subsidies for renewable energy sources like solar, wind, and ethanol, and tax credits for home insulation. A 55-mile-per-hour speed limit was introduced.⁷⁷ (Many of these policies, such as fuel economy regulations and renewable subsidies, remain in effect today, although in changed form.)

Carter also famously launched the federal Synthetic Fuels Corporation (SFC)—synfuels—to use chemical engineering to produce liquid fuels, mainly from coal—coming full circle, as 110 years before, petroleum was first commercialized to replace oil refined from coal. The SFC also intended to develop liquid fuels from oil shale (not today’s famous “shale oil” but instead kerogen-laden rocks), oil sands, and heavy oils. (The SFC failed to commercialize alternatives to oil, and was terminated in 1986.⁷⁸)

None of Carter’s measures brought immediate relief and the country spiraled deeper into crisis. During the first weekend of summer—June 23 and 24, 1979—58 percent of the nation’s gasoline stations were closed on Saturday and 70 percent were closed on Sunday.⁷⁹

To address the immediate problem of soaring oil prices, President Carter also quietly implored Saudi Arabia to increase production. With the overthrow of the Shah, Tehran was no longer the linchpin U.S. ally in the region, and that included on oil matters. From now on, when an American president needed more oil, he would call Riyadh. And Saudi Arabia’s substantial production and excess capacity enhanced the kingdom’s role in stabilizing price. Riyadh obliged, increasing supply from 8.8 mb/d in June 1979 to 9.8 mb/d by November of that year.⁸⁰ Prices eased a bit but other OPEC countries reduced output, causing prices to resume their climb—particularly after Iran seized U.S. hostages in November.

As the Iran revolution and the oil disruption and price shock brought the United States and Saudi Arabia closer together, it also intensified ancient Saudi-Iranian ethnic, religious, and geopolitical rivalries, making them a permanent feature of geopolitics—and as we shall see, OPEC oil policy—in the decades since. Saudi Arabia is the center of Islam’s Sunni sect and home to its two most revered sites, Mecca and Medina. The majority of Iran’s citizens adhere to the Shiite sect of Islam; while Shiites also dominate Iraq and Bahrain, they comprise only 15 percent of the world’s 1.6 billion Muslims.⁸¹ Tehran and Riyadh compete for leadership within Islam, although before the nineteenth century, their rivalry had been suppressed by distance, lack of direct economic and political linkages, and intervention by foreign powers. In the 1950s, when both became major oil powerhouses, their vital interests became closely intertwined. Until 1979 both monarchies kept tensions low. But the 1979 Iranian revolution established a revolutionary Islamic state scathingly critical of both Sunni sect and especially the Saudi monarchy and unleashed a succession of mostly indirect conflict and proxy wars.⁸²

Just when circumstances in the oil market seemed impossibly dire, they got worse. In September 1980 Iraq attacked Iran, severing oil exports from both. World oil production slumped by 5 percent from 1979 to 1980.⁸⁵ Crude oil prices briefly exceeded $40 per barrel and averaged another 17 percent higher than 1979. Combined, world crude prices had risen by $23 per barrel—163 percent—between 1978 and 1980.⁸⁶

The United States had already formally declared its commitment to stability in the region, and deepened its links to the region. After the Soviet Union’s invasion of Afghanistan in late December, 1979, President Carter—reflecting increased worries inform U.S. defense planners about a threat to the Gulf’s energy resources—stated the United States would not allow the Persian Gulf to be dominated by a hostile outside power, and established a new military command (the Rapid Deployment Joint Task Force, forerunner to CENTCOM) to back it up. It quickly was dubbed the “Carter Doctrine.” President Reagan added a corollary to the Carter Doctrine with a policy that would “guarantee the territorial integrity and internal stability of Saudi Arabia.” Under the Reagan Corollary, the United States supported Iraq against Saudi Arabia’s chief regional rival Iran while ordering reflagging and escorts of oil tankers in the 1980s.

The traumatic price spikes in 1973 and 1979–1980 are often twinned, but are very different. In 1973, OPEC deliberately imposed price increases while taking control of pricing from majors. The process was hardly elegant, but it was deliberate. There was no significant disruption of crude oil, and shortages in consuming countries were largely due to domestic price controls and rationing. In the case of the 1979 Iranian revolution and the 1980 Iran-Iraq war, there was a major supply disruption, especially the latter, although commercial inventories were quite ample. The disruption and panic sent market prices up, and OPEC simply followed along by raising prices. By 1981 OPEC’s administered prices reached $34 per barrel, roughly three times their level three years before.