Oil Crisis ME FINAL Group5

8/4/2019 Oil Crisis ME FINAL Group5

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Section B Group-5

AbhishekLahiri (PGP/14/62) Anshuma Mangtani (PGP/14/72)

Arpit Rastogi (PGP/14/77) Meemansa Vajpayee (PGP/14/95)Nidhi Pandey (PGP/14/97) Priyamvada Chouhan (PGP/14/106

1970s OIL CRISIS A CASE STUDY


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It is an event that produces a significantchange within an economy, despite occurringoutside of it

Economic shocks are unpredictable and

typically impact supply or demand throughout themarkets

An economic shock may come in a variety offorms:

Shock in the supply of staple commodities,such as oil, can cause prices to skyrocket

The rapid devaluation of a currency wouldproduce a shock for the import/exportindustry


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Demand Shock : A sudden surprise event that temporarily increases ordecreases demand for goods or services

A positive demand shock increases demand, while a negative demand shockdecreases demand effecting the prices of goods and services.

Supply Shock: If the shock is due to constrained supply it is called a supply shockand usually results in price increases for a particular product.

Technology Shock: A technology shock is the kind resulting from a technologicaldevelopment that affects productivity


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A supply shock is an event that suddenly changesthe price of a commodity or service

It may be caused by a sudden increase ordecrease in the supply of a particular good

This sudden change affects the equilibrium price

Negative supply shock (sudden supply decrease) : raises prices and shifts the aggregate supply curve to the left.

Causes stagflation due to a combination of raising prices and falling output

Positive supply shock (an increase in supply) : lowers the price of said good and shifts the aggregate supply curve to the right Could be an advance in technology ( a technology shock) which makes productionmore efficient, thus increasing output.


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Examples ofadverse supply shocks:Bad weather reduces crop yields, pushing upfood prices. Workers unionize, negotiate wage increases.

New environmental regulations require firms to reduceemissions. Firms charge higher prices to help cover the

costs of compliance.

AND THE MOST FAMOUS ILLUSTRATION WOULD BETHE OIL SHOCKS IN 1970s


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Oil is a resource which is :Only available in limited amounts and thus supply is limitedAvailability is confined to its particular geographical distribution.

Roughly 63 % of all worldwide oil reserves are concentrated in the Middle East.Therefore, this region is of essential strategic importance for the oil supply ofindustrialized western countries.


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Organization of the Petroleum Exporting Countries

OPEC's objective is to co-ordinate and unify petroleum policies among Member

Countries, in order to secure fair and stable prices for petroleum producers; anefficient, economic and regular supply of petroleum to consuming nations; and a fair

return on capital to those investing in the industry.


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Consisted of twelve countries, including Iran, seven Arab countries, plusVenezuela, Indonesia, Nigeria, and Ecuador, had been formed at a Baghdadconference on September 14, 1960.

OPEC was organized to resist pressure by the "Seven Sisters" (mostly owned byU.S., British, and Dutch nationals) to reduce oil prices and payments to producing

countries.

At first OPEC had operated as an informal bargaining unit for the sale of oil byresource-rich Third World nations.

OPEC confined its activities to gaining a larger share of the profits generated by

the Western oil companies and greater control over the members' levels ofproduction.

As a result of this and other events in the early 1970s, it began to exert itseconomic and political strength; the major Western oil conglomerates, as well asthe importing nations, suddenly faced a unified bloc of exporters.


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Two most important conditions for a cartelStable cartel organization i.e., members must

agree on price as well as production

Potential for monopoly power i.e., demand must be inelastic product should be rare

Payoff Matrix for Pricing Game (an example)

Firm 2

Charge $4 Charge $6

Firm 1 Charge $4 $12, $12 $20, $4


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QuantityQT

QOPEC

QC

PC

P*

Price

MROPEC

MCOPEC

DOPEC

TD SC

The pricing of Oil by OPEC


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The Yom Kippur War was the triggerfor the OPEC Oil Embargo in 1973.

Furious at the emergency re-supplyeffort that had enabled Israel towithstand Egyptian and Syrianforces, the Arab world imposed the1973 Oil Embargo against theUnited States and Western Europe

OPEC countries decided to cut off

the oil supply as long as the territoryoccupied by Israel was not freeand the rights of the Palestinianpeople were not re-established.


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The Gulf Six (Iran, Iraq, Abu Dhabi, Kuwait, SAU and Qatar) lifted the price forthe Saudi Light Blend by 17 % from $3.12 to $3.65 per barrel and alsoannounced cuts in production.

One day later, OPEC ministers agreed to use the dependency of industrializedWestern countries from oil supply as a weapon and to exert pressure against

unfriendly states by raising prices, cutting off exports and imposingembargoes.

The first country that was cut-off was the United States on October 19 because ofits political and military support for Israel.

The second country to be embargoed was the Netherlands for its support of theUS by providing facilities for the air force for supply flights to Israel.


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The cuts in overall oil production amounted to about 7 % during this first oilprice shock.

The cuts in Arab oil-exporting countries were much higher and reached upto 25 % The impact on the price was tremendous.

The price of oil (measured in US refinery acquisition costs) rose significantlyduring this first oil price shock from $2.59 in 1973 to $13.06 in June 1974.

This was an increase of more than 500 % within 7 months.

Such sharp oil price increases are supply shocks becausethey significantly impact production costs and prices


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Reasons Iranian Revolution

Started in 1968 but more prominent in 1978

Iraqi invasion of Iran

Started in September 1980, primarily due to border disputes

Effects on Oil PricesOil supply was less as Iran and Iraq both cut their production

Price increased to $39.5/barrel from $15.85/barrel


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Year Change in Oil Prices

(Percentage)

Inflation Rate (CPI)

(Percentage)

Unemployment Rate

(Percentage)

1973 11.0 6.2 4.9

1974 68.0 11.0 5.6

1975 16.0 9.1 8.5

1976 3.3 5.8 7.7

1977 8.1 6.5 7.1

1978 9.4 7.7 6.1

1979 25.4 11.3 5.8

1980 47.8 13.5 7.0

1981 44.4 10.3 7.5

1982 8.7 6.1 9.5

1983 7.1 3.2 9.5

1984 1.7 4.3 7.4

1985 7.5 3.6 7.1

1986 44.5 1.9 6.9

1987 l8.3 3.6 6.1


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The growth rate of the world economy fell to 2.1 % in 1974 and to 1.4 % in1975.

Worldwide trade also suffered significantly growth was negative in the twoyears at -5.4 % (1974) and -7.3 % (1975).

The annual FDI flow was negative compared to the previous year. While theannual FDI growth reached 40 % in 1973, the rate fell nearly by half in 1974.In 1976, there was a major slump of -21 % compared to the previous year.


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The impact on the US economy was tremendous.US GDP growth fell from more than 5.7 % in 1973 to -0.5 % and -0.19 % in1974 and 1975.

This development impacted upon the unemployment rate, which rose from4.9% in 1973, peaking at approx. 8.5 % in 1975. In terms of the number of

unemployed people, this was an increase of more than 80 %.

Inflation, more than tripled from 1972 to 1974 from 3.3 % to11.1 % (andactually nearly doubled from 1973 to 1974).


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An unfavorable supply-sideshock from higher oil prices

Input Scarcity (Higher Oil Prices)

GDP Growth Slows & Productivity Growth Slows

Wage Growth Slows

Unemployment Rate Rises

Price Level Rises

Interest Rate Rises


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1

SRAS1

Y

P

AD

LRAS

Y2

The oil price shockshifts SRASup,causing output andemployment to fall.

The oil price shockshifts SRASup,causing output andemployment to fall.

A

BIn absence of

further price shocks,

prices will fall over time

and economy moves

back toward fullemployment.

In absence of

further price shocks,

prices will fall over time

and economy moves

back toward fullemployment.

2SRAS2

A


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Predicted effectsof the oil shock: inflation

output

unemployment

and then agradual recovery.

0%

10%

20%

30%

40%

50%

60%

70%

1973 1974 1975 1976 1977

4%

6%

8%

10%

12%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)


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Late 1970s:

As economywas recovering,

oil prices shot upagain, causinganother hugesupply shock!!!

0%

10%

20%

30%

40%

50%

60%

1977 1978 1979 1980 1981

4%

6%

8%

10%

12%

14%





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1980s:

A favorablesupply shock--a significant fall

in oil prices.

As the modelpredicts,inflation and

unemploymentfell:

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1982 1983 1984 1985 1986 1987

0%

2%

4%

6%

8%

10%





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15

25

35

45

55

65

75

85

95

105

115

49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00

Oil price spikes tend to trigger U.S. recessionsIndex,Jan '82=100

Source: NBER

Oil price spikes tend to be followed by U.S. recessions


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Odd-even rationing of gasoline introduced

Fixed allocation of gasoline to states based on 1972 consumption levels

National speed limit of 55 miles per hour imposed to limit consumption

3 color flag system introduced at service stations: green unrationedgasoline, yellow restricted and rationed sales and red gasoline notavailable

Year round day light saving time implemented

Creation of United States Strategic Petroleum Reserve in 1975

Individuals and businesses encouraged to save energy: Campaign byAdvertising Council Dont be Fuelish


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Deregulation of oil prices This led to increase in domestic oil and gasproduction

The automobile majors Ford, GM and Chrysler were making smaller and bettereconomy cars

Huge R&D investments Lot of technology imports from other automobile makers like Toyota

U.S. refiners made short-term changes in oil purchasing and began importingcrude oil from any available source.

About 30 percent less of the more costly crude oil was imported during the embargo. Iran at the timeappeared to be a stable, long-term source.

Iran moved to expand sales to the United States, and these imports served to offset losses fromKuwait and Libya until Libyan crude oil imports resumed in early 1975.


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Imports from other Arab OPEC countries resumed shortly after the embargo endedin March 1974, and continued to climb through 1977.

Despite production buildups from the North Sea and Alaska, Arab OPEC's share ofU.S. crude oil imports increased from nearly 26 percent in 1973 to 36 percent in1977, when imports were than at historic high levels which were not again reacheduntil 1994.


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Oil price increase shifts purchasing power from oil-importing nations to oil-exporting nations

On net, demand for oil importers goods reduced

Lower consumption, lower GDP growth, higher savingand lower interest rates


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When a higher oil price raises a firms costs, the real consumption wage mustfall for firms to maintain profit share and employment in a competitive market.

However, if the workers resist the fall in real wages by asking for more nominalwages to compensate the loss in real income, the so-called second round effect

of oil price rise emerges.

When the monetary authorities put more weight on combating inflationarypressure they could respond to this with a contractionary monetary policy thatboosts interest rates, again leading to lower growth.


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When firms and households are uncertain about future oil prices, they find itincreasingly desirable to postpone investment decisions.

Where technology is embedded in capital and household items, such decisionsmake an irreversible commitment to the energy intensity of respectiveprocess/consumption items.

As uncertainty about future oil change increases, the value of postponinginvestment decisions increases.

In addition, uncertainty about how firms might fare in an environment of higher

energy prices is likely to reduce investor confidence and increase the interestrates that firms must pay for capital.

Together, these two effects work to reduce investment spending and weakeneconomic activity..


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The economy experiences some costly adjustment to both rising andfalling oil prices

When oil prices rise, slowing economic activity is further retarded byadjustment costs

When oil prices fall, stimulated economic activity is somewhat offset

by adjustment costs

We then have asymmetry: rising oil prices retard economic activity bymore than falling prices stimulate it


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Oil Prices and Inflation

0%

5%

10%

15%

1960

1970

1980

1990

2000

2010

0

50

100

150

Core US Inflation Real Blended Oil Price

Source: US BEA; UNDPSource: US BEA; UNDP


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www.recession.org

Microeconomics 7th Ed , Robert Pindyck

The 1979 Oil Shock: Legacy, Lessons, and Lasting Reverberations by The Middle EastInstitute Washington, DC

http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_1

http://en.wikipedia.org/wiki/1973_oil_crisis
http://www.recession.org/http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_11.htmlhttp://en.wikipedia.org/wiki/1973_oil_crisishttp://en.wikipedia.org/wiki/1973_oil_crisishttp://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_11.htmlhttp://www.recession.org/


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2000 2001 2002 2003 2004World GDPIndustrial CountriesReal GDPReal Domestic DemandTrade balance ($ billion)USReal GDPReal Domestic Demand

CPI InflationTrade Balance ($ billion)Euro AreaReal GDPReal Domestic DemandCPI InflationTrade Balance ($ billion)JapanReal GDPReal Domestic Demand

CPI InflationTrade Balance ($ billion)Developing CountriesReal GDPDomestic DemandTrade Balance ($ billion)

-0.2

-0.2-0.2-26.7

-0.3-0.3

0.8-12.2

-0.2-0.30.7-10.8

-0.1-0.2

0.3-10.5

-0.126.1

-0.3

-0.3-0.4-20.3

-0.4-0.5

0.5-9.1

-0.4-0.50.5-7.8

-0.2-0.3

0.2-8.5

-0.220.3

-0.3

-0.3-0.4-22.4

-0.4-0.4

0.3-10.5

-0.4-0.60.4-6.2

-0.3-0.4

0.1-6.5

-0.2-0.122.4

-0.2

-0.2-0.2-24.6

-0.2-0.3

0.2-12.5

-0.2-0.50.3-5.2

-0.2-0.3

0.1-5.3

-0.2-0.124.6

-0.1

-0.1-0.1-24.7

-0.1-0.2

0.1-7.3

-0.1-0.30.1-4.7

-0.1-0.2

-4.4

-0.2-0.124.7

Source:

Permanent $5 per barrel increase in the price of oil

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Oil Crisis ME FINAL Group5