Oil Price Drivers: Now and in the 1980s

Posted Tuesday, Nov. 26, 2013  comments  Print Reprints
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It’s no secret that Texas is currently enjoying an oil boom, encouraged by high prices and technological advances. I’m in the middle of our annual Economic Outlook Conference Series (for the 30th year, by the way), and the Q&A always includes a query or two about oil prices. The industry is notoriously cyclical, and folks want to know it today’s prices are here to stay. The short answer to that is a definite “probably.”

As with any product or service, the price of oil is ultimately driven by supply and demand. Add to that the wrinkle of the OPEC (Organization of the Petroleum Exporting Countries) cartel, whereby a number of huge Middle Eastern and other oil producing nations try to hold down production (as a group) so they can keep global prices elevated. The actual process quite complex, but that’s the essential framework.

Back in the early 1970s, the price of oil was bouncing around at just under $20. (I’m using an inflation-adjusted series of annual costs of a barrel of imported oil maintained by the US Energy Information Administration; everything is expressed as of today’s dollars, accounting for inflation over the past few decades and allowing for comparisons of costs that make sense.) In October 1973, Egyptian and Syrian forces attacked Israel on Yom Kippur, the holiest day in the Jewish calendar, in an effort to regain territory lost to Israel during the third Arab-Israeli war several years prior. On October 17, OPEC declared that it would refuse to sell oil to any nation that had supported Israel in the Yom Kippur war, which included the United States.

Taking this huge block of the supply off the table (even though it still made its way into the market) and near simultaneous overall OPEC production cuts caused a dramatic spike in prices, which essentially tripled in a matter of months. Then, in 1979, the Iranian Revolution again caused a drop in supply, and prices pushed past the $95/barrel range and stayed there for a couple of years keep in mind that these are inflation-adjusted dollars). The oil price shocks of the 1970s caused major problems for the global economy, and the United States was one of many nations plagued by both a stagnant economy and inflation (the infamous “stagflation”).

Fortunately, the embargo didn’t last forever and the OPEC cartel was unable to hold together completely. Production quotas were regularly exceeded by some nations, bringing welcome relief as supplies rose and prices fell. By 1986, prices had dropped below $30 per barrel.

In Texas, we experienced these historical events in an upside-down way in terms of their economic effects. As a large oil producer back in the 1970s, the state benefitted enormously from the oil price shocks. The nation’s “shock” was, in fact, our “boom” here in the Lone Star State. The relief of the mid-1980s was our big “bust” and real estate crisis (with a little help from some tax law and financial regulation shenanigans). This one was helped along by a rift in the cartel in which Saudi Arabia no longer tolerated the “cheating” of its partners on their quotas.

In the early 2000s, with economic growth around the world, prices trended upward, peaking in 2008 at almost $101/barrel. Demand fell markedly during the recent recession, resulting in a fairly sharp drop in prices to $64 in 2009 (these are annual averages; the day-to-day peaks are even more volatile). However, prices jumped back up in a fairly short amount of time and were back over $100 in 2011. Even though many of the world’s economies are dealing with sluggish growth and fiscal problems, prices are staying at high levels.

The key question, then, is whether the current price picture has the potential to turn into a mid-1980s freefall (or, alternatively, an extreme escalation). Without a doubt, the energy industry is cyclical and we can expect price reactions in response to global events. However, the situation has changed in important ways since the 1970s. Today’s prices are stemming from a far more stable supply-demand relationship. The global economy (particularly the advanced segments) has developed many industries that aren’t quite as reliant on crude to generate value (such as technology). Also, after the era of cheap oil and gasoline ended in such dramatic fashion in the 1970s, concerted efforts (including energy conservation and development of domestic production capacity and sources of supply in nations whose interests more closely align with our own, such as Canada) were made to try to become less vulnerable to similar events.

At the moment, there is some upward pressure on price from unplanned supply disruptions in Libya and Iraq. The situation with Iran also has the potential to derail and cause some tension in the region (and, thus, some upward movement). On the other side of the equation, production in the United States is rising, thereby working to dampen these upward price pressures. Also, global demand has been somewhat weaker thanks to slower economic growth, further contributing to lower prices (a situation that is reversing itself as the less-developed countries become more industrialized). These counterbalancing effects are keeping prices at relatively elevated levels.

A perfect storm could lead to drastic changes. If demand drops off, things calm down in the Middle East, US production keeps rising, and we cement deals for supply from our allies (such as the Keystone Pipeline), prices could fall sharply. If OPEC decreases production or war breaks out in the region, look for a big jump. On balance, however, my best estimate is that there will continue to be forces working in opposition for a while, keeping prices fluctuating in a relatively narrow range.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.

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