What Earlier Oil Crises Teach Us About Recessions

The two biggest surges of inflation and two deepest and longest recessions of the postwar period were both associated with the oil price increases known as OPEC-1 and OPEC-2. Are we today looking at an OPEC-3 with similar economic consequences?

The current situation offers both important parallels with these earlier episodes--and important differences. Although we are unlikely to soar into the inflationary orbits of those earlier periods, we may not avoid recession.

On all three occasions, hostilities in the Middle East triggered surges in the price of oil. In 1973-74, it was the Arab-Israeli war, and in 1979-80, it was the overthrow of the Shah of Iran and the ascendancy of the Ayatollah Khomeini. This time, it is Saddam Hussein’s takeover of Kuwait and his threat to control, more tightly than ever before, all of the output of the Organization of Petroleum Exporting Countries.

With OPEC-1 and OPEC-2, the initial run-ups in oil prices--to $12 a barrel from $3 in the first case and to more than $30 from $12 in the second--were large and long enough to have a major impact on the world’s industrial economies. Eventually, oil prices fell as cooperation among OPEC members to restrict output eroded. By the time Hussein threatened the Arab oil producers this summer, the world oil price was back to about $15 a barrel, equivalent to about $5 a barrel in 1973 dollars.

In the first few weeks of the present crisis, the price rose to about $30 a barrel from $15. However, until the conflict with Iraq is resolved, it is impossible even to guess what price will be sustained this time. If Hussein were allowed to control the output of the Arab producers, he could maximize his own profits by getting oil prices much higher than they have ever been. Fortunately, he is not likely to achieve that kind of power. But there may still be some reductions in world oil supplies as a result of the present crisis.

Many seem to believe that we are better prepared for reduced oil supplies this time than we were either in 1973 or 1979, so that oil prices will not rise as much. One reason for this optimism is that efforts at conservation and at developing alternative fuels have made the industrial world less dependent on oil.

True, oil consumption per unit of output produced in industrial economies has declined by 30% over the past decade. But this economizing offers less comfort than one might think. What matters is not the oil savings that have been achieved in response to past crises, but how easily additional oil conservation can be achieved. Because so much has already been done, further conservation may be harder to come by.

In response to the oil shocks of OPEC-1 and OPEC-2, the easiest methods of saving have already been adopted. It has not been hard to turn thermostats down from a profligate 73 degrees to a still comfortable 68 to 70 degrees as many energy-conscious households have done. But it would make most people very uncomfortable to lower their thermostats another three to four degrees, and few would do it.

Major improvements in the design of engines and the downsizing of cars has greatly improved their fuel efficiency. The scope for further improvement is nowhere near what it was when oil prices first rose. Similarly, new construction has already incorporated many easy fuel-saving features, such as better insulation and windows. Additional improvements would require more drastic, and expensive, changes.

Furthermore, it takes a long time to change the stock of cars and other fuel-using capital, and even longer to redo the nation’s buildings and homes. For all these reasons, our current, more conservative use of oil offers no protection from a new constriction in oil supplies. If we had greatly enhanced our ability to substitute other fuels for oil, particularly fuels that are readily available at near-present prices, such substitution would provide an important buffer. But our ability to substitute in this way has not been tested and is no doubt quite limited.

A second reason that some observers are optimistic about our ability to sail smoothly through a new supply disruption is the existence of petroleum inventories, both in the hands of industry and in the official Strategic Petroleum Reserve run by the U.S. government. Inventories are indeed at generous levels. The Strategic Petroleum Reserve holds nearly 600 million barrels and refiners and oil dealers are estimated to hold between 150 million and 200 million barrels of excess inventory.

The trouble is, the incentives for holding inventories and the dynamics of oil prices may work the wrong way. If oil prices threaten to rise sharply, as they will in any supply disruption, producers and users both want to build inventories, not run them down. Indeed, the desire to build up oil inventories after prices started rising in 1979 added greatly to the total demand for oil and hence to the upward pressure on oil prices that occurred that year. In the same way, presently plentiful oil inventories will not offset reduced oil production if prices threaten to rise.

The government has no clear policy for how it will use the Strategic Petroleum Reserve and has avoided taking a position on what would trigger pumping more oil out of it. Although the 600-million-barrel reserve is equal to about what Kuwait and Iraq together were producing in half a year, the government is unlikely to draw from it merely in response to higher prices. In part this is because the effect on prices would be uncertain.

A modest rate of withdrawal might have no discernable effect and so appear to be wasted. A rate of withdrawal fast enough to matter would promise to deplete the reserve so quickly that industry would want to add to their own stocks against the time when government stocks were depleted, and so might defeat the aim of the government’s stock drawdown. Thus the government is likely to keep the reserves as a way to calm the market’s fears rather than actually bringing the oil to market to hold prices down. We will probably never know what effect such a policy has.

All this leads to the conclusion that oil prices are likely to rise as fast and as much as ever in response to a disruption of oil supplies. The combination of highly inelastic final demands for oil and precautionary inventory policies that are likely to motivate industry assures this. But even though we are as vulnerable as ever to a disruption of oil supplies, there are reasons to hope that the inflation-recession calamities of OPEC-1 and OPEC-2 will be avoided, at least in part.

One reason for optimism is that the present supply disruption may not last long. Another is that the economy is not as inflation-prone today as it was at the time of the two earlier episodes. We are in for several months of rapid increases in the consumer price index simply from the contribution of higher fuel prices.

But this time there may be little, if any, increase in the ongoing inflation rate once we are past these first months. As to recession, however, the U.S. economy was perilously near one even before this latest oil supply disruption. Unless the Federal Reserve moves aggressively to lower interest rates, this part of the story may be repeated.