This year marks the 40th anniversary of the 1973 oil price shock. Rifling through an old Life magazine sparked memories of the Middle Eastern drama. Looking at some of the contrasting photos – a room full of jovial Arab leaders enjoying the 250-per-cent rise in the price of oil; a western freeway void of cars due to widespread gasoline shortages – the disco-era reminiscence gave pause for thought about vulnerable oil markets. Running some numbers on the flashback was thought-provoking, too: in real dollar terms a barrel of light oil (world price) is 40-per-cent more expensive today than it was during the second, 1979 price shock (see accompanying chart Real Price). Should oil producers be concerned about a price fall from today's lofty high?
At a time when global oil demand was growing by 9 per cent per year, the 1973 Arab-Israeli war and resulting embargo by the Organization of Arab Petroleum Exporting Countries (OAPEC) drove the price of a barrel of oil up nominally from $3.00 (U.S.) to $8.00. Figure 1 shows that the elevated prices lingered for seven years, until after 1979, when the second blow of the one-two punch was thrown. The vicious Iran-Iraq war took 7 million barrels per day (MMB/d) off the world market, resulting in a fourfold, average $32a barrel jump in oil prices. Adjusted to today's dollar terms, Figure 1 shows that prices in the late '70s climbed to $80 a barrel.
High oil prices in the 1970s had precedent. When oil emerged, in the latter half of the 1800s, it was priced around $80 a barrel (real dollars). Coveted for its application in lighting, lubrication and combustion engines, the demand for oil exceeded what the immature extraction technologies of the mid-19th century could deliver. In response to the lucrative pricing, productivity gains brought down unit costs and better drilling techniques delivered larger volumes. It wasn't long before oil barons were able to supply thirsty markets at greater cost efficiency. As a result, the price of oil fell to the consumer-friendly $20-a-barrel average in today's real terms.
In the early 1980s, the theme of high price as a catalyst for change recurred. In response to the two '70s price shocks, western nations implemented hard policies that encouraged substitution of oil with coal and nuclear power. Japan and Europe invested heavily in mass transportation, mostly rail. Governments also mandated higher fuel economy in vehicles. By the late '80s, these and other measures contributed to substantially reduced levels of oil consumption growth. On the supply side, the high price of oil was a big catalyst for putting new offshore technologies to work and bringing hitherto uneconomic oil to market from the North Sea and Gulf of Mexico. Like a rerun of the late 19th century, economies of scale and new drilling innovation brought the cost of expensive oil down. A hundred years later, by the 1990s, the price of oil came tumbling down to the long-term, real $20-a-barrel level.
Someone who knows nothing about oil may be inclined to look at Figure 1 and suggest that oil must once again revert to the long-term baseline of 20 bucks. Few will deny that similar themes to the 1970s are at work today: for example, government policies to push oil substitutes and higher vehicle fuel economy; substitutes for road transport; and once again, a massive roll-out of new drilling, completion and production technologies to bring large volumes of hitherto uneconomic oil to market.
Yet, a collapse back to $20 a barrel is not forthcoming. For one thing, over the past decade, in parallel with the rapidly rising price of oil, the real cost of oil field services has also hyper-inflated. Even a modest drop in the price of oil would crimp cash flow, cut investment and slow production. Yet while $20 a barrel may not be realistic, producers should not be in denial about recurring forces that are in play to bring costs down. Increasing productivity gains and proliferation of resource exploitation techniques to other regions of the world will be hard to stop at current price. Most trends in play today point to a decline in the marginal cost of bringing oil to the market.
At the moment, real oil prices remain stubbornly high. Market expectations of endless consumption in high-growth regions like China continue to buttress the price against the downward pressure of supply-side innovation. So for now, suggesting a sudden oil price drop – despite powerful supply side trends – is a riskier bet than the converse: a further run-up in price, potentially triggered by another disruptive Middle Eastern crisis. Forty years on, some traders are still taking the latter bet, which is another reason why oil prices will be stubborn to retreat.