We can use the supply and demand model to understand some of the major events that have determined the price of oil over the past half century. Figure 4.9 shows the real price of oil in 2005 dollars between 1960 and 2012. (The real price corrects prices for inflation.)

From the early twentieth century to the 1970s, the demand for oil increased steadily, but major discoveries and improved production techniques meant that the supply of oil increased at an even faster pace, leading to modest declines in price. Contrary to popular belief, slightly declining prices over time are common for minerals and other natural resources supplied under competitive conditions.

Although the streets of Baghdad were paved with tar as early as the eighth century, the discovery and development of the modern oil industry in the Middle East were made primarily by U.S., Dutch, and British firms much later. For many decades, these firms controlled oil in the Middle East, giving local governments just a small cut of their proceeds. It’s hard to take your oil well and leave the country, however, so the major firms were vulnerable to taxes and nationalization.

The Iranian government nationalized the British oil industry in Iran in 1951.* The Egyptians nationalized the Suez Canal, the main route through which oil flowed to the West, in 1956, leading to the Suez Crisis—a brief war that pitted Egypt against an alliance of the United Kingdom, France, and Israel. Further nationalizations and increased government control of the oil industry occurred throughout the 1960s and early 1970s.

OPEC, the Organization of the Petroleum Exporting Countries, was formed in 1960.† Initially, OPEC restricted itself to bargaining with the foreign nationals for a larger share of their oil revenues. By the early 1970s, however, further nationalizations in the OPEC countries made it possible for OPEC countries to act together to reduce supply and raise prices.

59

A triggering event for OPEC was the Yom Kippur War. Egypt and Syria attacked Israel in 1973 in an effort to regain the Sinai Peninsula and the Golan Heights, which Israel had captured in 1967. In an effort to punish Western countries that had supported Israel, a number of Arab exporting nations cut oil production. Supply had been increasing by about 7.5 percent per year in the previous decade, but between 1973 and 1974 production was dead flat. Prices tripled in just one year. The large increase in price from a small decline in supply (relative to what it would have been without the cut in production) demonstrated how much the world depended on oil.

Prices stabilized, albeit at a much higher level, after 1974, but political unrest in Iran in 1978, followed by revolution in 1979, cut Iranian oil production. This time the reduction in supply was accidental rather than deliberate, but the result was the same—sharply higher prices. When Iraq attacked Iran in 1980, production in both countries diminished yet again, pushing prices to their highest level in the twentieth century—$75.31 in 2005 dollars. Prices might have been driven even higher if demand had not been reduced by a recession in the United States.

60

Higher prices attract entry. In 1972, the United Kingdom produced 2,000 barrels of oil per day. By 1978, with the opening of the North Sea wells, the UK was producing 1 million barrels per day. In the same period, Norway increased production from 33,000 to 287,000 barrels per day and Mexico doubled its production from 506,000 barrels per day to just over 1 million barrels per day. By 1982, non-OPEC production exceeded OPEC production for the first time since OPEC was founded. Iranian production also began to recover, increasing by 1 million barrels per day in 1982. Prices began to fall during the 1980s and 1990s.

Prices can also fluctuate with shifts in demand. A sharp fall in the price of oil came in 2009 when the United States and many of the major economies in the world were in the trough of a deep recession. Incomes fell, reducing the demand for oil and reducing the price. As the United States slowly recovered, however, the demand for oil increased, driving up the price.

The economies of China and India have surged in the early twenty-first century to the point where millions of people are for the first time in the history of their country able to afford an automobile. In 1949, the Communists confiscated all the private cars in China. As late as 2000, there were just 6 million cars in all of China, but by 2010 more vehicles were bought in China than in the United States, almost 18 million in that one year alone. Total highway miles quadrupled between 2000 and 2010.2 This increased demand for oil has pushed prices up to levels not seen since the 1970s.*Moreover, unlike temporary events such as the Iranian Revolution and the Iran–Iraq War, the increase in demand in China and in other newly developing nations will not reverse soon. In the United States, there’s nearly one car for every two people. China has a population of 1.3 billion people, so there is plenty of room for growth in the number of cars and thus the demand for oil. What is your prediction for future oil prices?