The Hindu Business Line : The wrong lessons of the 1970s

The relatively low-impact oil crises of the 1970s may have lulled the world into believing that the problems of high oil prices will somehow get solved. But, SHANMUGANATHAN. N says, it should be remembered that the world was relatively under-explored then. No longer, and the falling rate of discoveries since the 1960s indicates that the probability of discovering another giant field is remote.

There have been two oil crises in the past — in 1973 and 1979. Both were short-lived and provided an opportunity to understand what would happen to oil prices in the event of a supply disruption. In some sense, these were blessings in disguise as otherwise we would have no real experiences of how oil prices would move if a crisis were to occur.

However, for all practical purposes when we look at those events today, we draw all the wrong conclusions — that oil shocks would be short-lived and that higher prices would force new supplies to come online that would help stabilise the prices. That is what the "Law of Supply" in economics states and that's what happened exactly in the past and hence that's what would happen in the future.

To understand why such conclusions are misplaced, we need to go back in time and study what really happened during the 1973 and 1979 crises.

The 1973 Yom Kippur War

The Yom Kippur War started with an attack on Israel by Syria and Egypt in 1973. The United States and many countries in the Western world showed strong support for Israel and, as a result, Arab oil-exporting nations imposed an embargo on the countries supporting Israel. Arab nations curtailed production by 5 million barrels per day (mbpd) andthe extreme sensitivity of prices to supply shortages became all too apparent when prices increased by $3 to $12 a barrel by 1974.

From 1974 to 1978 world crude oil prices were relatively flat, ranging from $12.2 a barrel to $13.5. When adjusted for inflation the price over that period of time exhibited a moderate decline.

The 1979 Iran Crisis

Events in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980. The Iranian revolution resulted in the loss of 2.5 mbpd between November 1978 and June 1979.

Iraq invaded Iran in September 1980 and the combined production of both countries dropped to 1mbpd (from 7.5mbpd a year earlier). The combination of the Iranian revolution and the Iraq/Iran war resulted in crude oil prices nearly tripling from $13 in 1978 to $35 in 1981 (with spot prices touching almost $50) and forecast for $100 were in the air.

But what happened was that two giant oilfields were brought into production after the 1973 crisis. Alaska, the largest field in North America, and North Sea, the biggest outside of OPEC, ramped up output that helped to cool down prices. This is consistent with what the Law of Supply predicts, that higher prices will bring new sources. So why are we saying that this is wrong conclusion? To answer that we need to go back further in time, to the 1950s.

The 1951 Crisis

For several years before 1950, the Iranians were in dispute with BP as they thought the distribution of profits from BP's Iranian subsidiary as inequitable (Iran received royalties of £90 million while BP registered profits in excess of £250 million) and so in 1951, the Iranian government nationalised BP's assets. This crisis was not well recognised simply because there was no supply disruption, but just a change of ownership.

The Second World War weary Britain could do nothing more other than register feeble protests. BP, which until then had been assured of long-term supply sources, found itself in a situation where it was not in a position to make long-term plans. It then took up a massive exploration campaign that culminated in the discovery of North Sea and Prudhoe Bay in the 1960s.

The Alaskan pipeline was commissioned in 1971 and the Alaska coming online in 1974 had little to do with the 1973 crisis and was just coincidental. Similar is the case of North Sea ramping up production by the late 1970s. Both these giant fields were responses to the 1951 crisis and not to the 1973 and 1979 crisis as would prima facie appear. Thus there could be a considerable lag, running into decades, between facing oil shortages and getting new sources online. A more important point to remember is that the world was relatively under-explored during the 1950s and the 1960s, and elephant fields were discovered.

The falling rate of discoveries since the 1960s (the peak decade of discovery) indicates that the probability of discovering another elephant field is remote.

The 1973 and 1979 oil crises provided the world with a window of opportunity to truly understand the dependence on the fragile oil industry. Yet, we choose to draw all the wrong lessons and conclusions. In that sense, the previous two crises has lulled into complacency as it is believed that "somehow" the problems of high oil prices will get solved.

(The author, a Director at Benchmark Advisory Services, can be reached at shanmuganathan.sundaram@gmail.com. The previous articles of the Hubbert Speak series can be viewed at http://kinghubbert.blogspot.com)