OPEC Oil Embargo: Causes and Effects of the Crisis

OPEC Oil Embargo: Causes and Effects of the Crisis explained by professional Forex trading experts the “ForexSQ” FX trading team.

OPEC Oil Embargo: Causes and Effects of the Crisis

Definition: The OPEC oil embargo was a decision to stop exporting oil to the United States. The twelve members of the Organization of Petroleum Exporting Countries agreed to the embargo on October 19, 1973. Over the next six months, oil prices quadrupled. Prices remained at higher levels even after the embargo ended in March 1974. For more, see Oil Price History.

Ever since the embargo, OPEC has used its influence to manage oil prices and supply.

Today, OPEC controls 42 percent of the world’s oil supply. It also controls 61 percent of its exports and 80 percent of proven oil reserves.

Causes

President Nixon prompted the embargo when he decided to take the United States off of the gold standard in 1971. That meant that countries could no longer redeem the U.S. dollars in their foreign exchange reserves for gold, as established by the Bretton Woods Agreement in 1944. While it sent the price of gold skyrocketing, it also sent the value of the dollar down. For more, see History of the Gold Standard.

The plummeting value of the dollar hurt OPEC countries. Their oil contracts were priced in U.S. dollars. That meant their revenue fell along with the dollar. The cost of imports that were denominated in other currencies stayed the same or rose. OPEC even considered pricing oil in gold, instead of dollars, to keep revenue from disappearing. (Source: “1973-1974 Oil Crisis,” University of California, Berkeley.)

For OPEC, the last straw came when the U.S. supported Israel against Egypt in the Yom Kippur War. On October 19, 1973, Nixon requested $2.2 billion from Congress in emergency military aid for Israel. The Arab members of OPEC responded swiftly, halting oil exports to the United States and other Israeli allies.

Egypt, Syria, and Israel declared a truce on October 25, 1973. But OPEC continued the embargo until March 1974. By then, oil prices had skyrocketed from $2.90/barrel to $11.65/barrel. (Source: “Yom Kippur War,” History.com.)

Effects

The oil embargo is widely blamed for causing the 1973-1975 recession. But the recession and the stagflation that accompanied it were caused by U.S. government policies. They included Nixon’s wage-price controls and the Federal Reserve’s stop-go monetary policy. Wage-price controls forced companies to keep wages high, which meant businesses laid off workers to reduce costs. At the same time, they couldn’t lower prices to stimulate demand, which also fell.

To make matters worse, the Fed raised and lowered interest rates so many times that businesses were unable to plan for the future. As a result, they kept prices high which worsened inflation. They were afraid to hire new workers. That exacerbated the recession. For more see History of U.S. Recessions.

The oil embargo aggravated inflation, already at 10 percent for some commodities, by raising oil prices. It came at a vulnerable time for the U.S. economy. Domestic oil producers were running at full tilt. They were unable to produce more oil to make up the slack.

Furthermore, U.S. oil production was declining as a percent of world output. (Source: Michael Corbett, “Oil Shock of 1973-1974,” Federal Reserve Bank of Boston.)

It also worsened the recession by shaking consumer confidence. People were forced to change habits, making it feel like a crisis that the government tried unsuccessfully to resolve. This lack of confidence made people spend less.

For example, drivers were forced to wait in lines that often snaked around the block for gas. Drivers woke up before dawn or waited until dusk to avoid the lines. Gas stations posted color-coded signs: green when gas was available, yellow when it was rationed, and red when it was gone. States introduced odd-even rationing: drivers with license plates ending with odd numbers could get gas on odd-numbered days.

The national speed limit was reduced to 55 miles per hour to conserve gas. In 1974, daylight savings time was instituted year round. (Source: Greg Myre, “Gas Lines Evoke Memories of Oil Crises in the 1970s,” NPR, November 10, 2012.)

Also, higher gas prices meant consumers had less money to spend on other goods and services. This lowered demand, worsening the recession.

The oil embargo gave OPEC new power to achieve its goal of managing the world’s oil supply and keeping prices stable. By raising and lowering supply, OPEC tries to maintain the price between $70-$80 per barrel. Lower than that, and they are selling their finite commodity to cheap. Higher than that, and development of shale oil looks attractive.

The United States created the Strategic Petroleum Reserve, to supply at least 90 days of oil in case of another embargo.