Energy Production & Transmission Committee

Energy Production Committee

Understanding the Petroleum Industry

Price Overview

Oil prices: The Backdrop

In 1973, 25 years ago, the Arab oil embargo triggered the first significant, sustained increase in oil prices of the 20^th century. This event shattered the long-standing complacency about supply security and low prices and brought about a sea change in perceptions about oil’s future. Consequently, this price increase became known as the first oil price shock.
Since then, there have been two other price upheavals that have gained similar labels. The sharp increase in prices in 1979 that occurred on the back of the Iranian Revolution became the second oil price shock. The sharp drop that occurred in 1985/86 -- triggered by Saudi Arabia’s rebellion against its role as the world's swing producer and implementation of a new and ultimately successful pricing strategy to regain its market share -- became the third.
Prices did jump up again in 1990, in response to Iraq’s invasion of Kuwait, but since this run-up was not sustained it is not generally classified as a fourth oil price shock. So far, the drop in prices in 1998 is not being classified as a price shock either, although the final judgment on that will only be made in retrospect.

Chart: Graph of annual oil prices, 1972-1997(nominal and real).

These price shocks divide the last 25 years into two distinct periods -- high prices and a seller's market in the early period, and low prices and a buyer's market during the later period. During the period from 1973-1985, which includes the first two oil price shocks, prices on average were 7 to 8 times higher, in nominal dollars, and 3 to 4 times higher, in real dollars (adjusted for inflation), than at any time in living memory. The widely held consensus view was that they would get even stronger, with projections of $100/bbl (nominal $) oil by 2000 commonplace.
In fact, the opposite happened. In the period from 1986-1997, which starts with the third oil price shock, prices were significantly weaker than in the first period, although they did not return to the pre-1973 level. Prices were also significantly more volatile after the third shock than after either of the first two.
As we shall see later, these changes in price levels are both a product of and a key contributor to fundamental changes in the structure of the oil market. These include a much more efficient use of oil and a revolution in the economics of its supply. There is therefore now less demand and much more supply at any given price than was expected to be the case, everything else being equal – which it is not.
There has been a shift away from oil market controls in both consuming and producing countries toward a much greater reliance on market forces. There has also been a dramatic erosion in the financial health, and therefore in the flexibility and in the power of the members of OPEC (see Box). Consequently, oil has become increasingly a commodity. In other words, oil prices are much more directly a function of normal supply and demand, and the role of the cartel has faded to a shadow of what it was in the 1970’s and early 1980’s.

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