Oil Crisis 1973

What would you do if oil prices went up from $3 to almost $12 in just a couple of months? This may look unrealistic but it actually happened in the United States during the 1973 Oil Crisis. The crisis quickly spread through the entire economy, bringing aggregate supply down and causing prices to skyrocket.

Oil crisis 1973: summary

It was early October 1973 when Egypt and Syria launched an attack against Israel. They managed to make some victories on the Golan Height and Suez Canal but they were quickly turned back by the Israeli forces. Israel’s army managed to reach Egyptian and Syrian territories which resulted in Arab nations of OPEC (Organization of the Petroleum Exporting Countries) ordering substantial oil production cutbacks. Additionally, they blocked the sale of oil to the United States and the Netherlands in an effort to compel Western countries to force Israel to withdraw from occupied territory.

Dislikes against the United States had grown among OPEC members well before the embargo because of Nixon's efforts to stimulate the American economy. Shortly after the Second World War had ended, President Nixon ordered the abolishment of the system where the dollar was tied to the gold standard. This caused a devaluation of the dollar. Due to the devaluation of the dollar, oil-producing countries suffered financial losses as a big portion of their revenues came from the US.

This was a time that coincided with a doubled oil consumption in Western countries, which only deepened the crisis after the embargo. The reason was that Western individuals had gotten used to cheap gasoline and steady prices.

The oil prices doubled when the embargo was imposed in 1974. This caused a fuel scarcity and a major spike in gasoline prices in the United States, which prompted the government to implement a number of policies aimed to address the issue. Fuel rationing was one of the measures. After many negotiations in Washington, D. C., the embargo was lifted in March 1974.

The 1973 and 1979 oil crises

There are two major oil crises that took place after the Second World War:

1. The oil crisis of 1973
2. The oil crisis of 1979

As previously mentioned, the oil crisis of 1973 occurred after Arab members of OPEC decided to quadruple the price of oil. They also prohibited oil exports to the United States and Western Europe, which caused the oil prices to increase to around $12 per barrel. There were many political and economic factors that lead the OPEC countries to make that decision. The main reason was because of a fall in export revenues. The devaluation of the US dollar undermined the export revenues of OPEC countries. Cutting oil production helped stabilise OPEC’s revenues.

The oil crisis of 1979 occurred 6 years after the first oil crisis. The Iranian Revolution of 1978–79 triggered a serious energy crisis in 1979. The Iranian oil sector was badly harmed by the country's high levels of civil unrest, which resulted in significant production losses and an increase in pricing. The war between Iran and Iraq increased to the degree of instability. The economic effects of this oil crisis were not as big. By 1983, most developed economies had embraced more efficient production models.

The effects of the 1973 oil crisis on the economy

The United States was the world’s leading oil producer before and during the Second World War. Thanks to oil resources in Texas, Oklahoma, and other states, the country could maintain cheap fuel throughout the 1950s and 1960s.

In 1973, the United States used a third of the world’s total oil production. The United States’ economy was dependent on oil imports to keep pace with the country's rapid industrial development and the construction of new roads and factories for the automotive industry. Due to environmental concerns and government regulations, domestic oil production and exploration had been limited by the early 1970s, when imports accounted for around 30% of US oil consumption.

Figure 1 below shows US oil prices throughout the 1970s. As the graph shows, oil prices in the US were climbing and peaked in 1980 at around $37 per barrel.

Fig 1. - US oil prices throughout the 1970s

Many Americans saw the OPEC embargo as evidence of their country’s downfall in the 1970s. The embargo also pointed out a significant increase in the OPEC cartel's influence in the global economy. As we mentioned at the beginning, oil prices rose from $3 to almost $12 per barrel when the embargo went into effect. Fuel costs rose by 40% in November 1973 alone, putting an enormous strain on the budgets of American consumers. Gas outlets hiked their rates multiple times daily while Americans waited in line out of fear of a gasoline scarcity. The long queues at the pump revealed the panic that arose as a result of the embargo. Many feared that they wouldn’t be able to afford petrol if they didn’t fill up immediately.

All of these translated into a huge increase in inflation throughout Western economies. The hike in the energy crisis quickly translated into other costs, especially in production processes that were reliant on oil prices. Other factors contributed to the increase in inflation as well. There was an increase in government expenditure on social programs.

Additionally, there was the Vietnamese War and the Federal Reserves Board had lowered interest rates. This led to price rises that surpassed pay increases for employees, which caused a significant decrease in purchasing power for many individuals. The US government’s response was to implement artificial price and wage restrictions. As soon as these restrictions were relaxed, the prices continued growing further.

Oil crisis of 1973 diagram

The economic scenario that emerged as a result of the oil crisis of 1973 can be simply illustrated in Figure 2 below.

Fig. 2 - Oil Crisis (1973) diagram

The oil embargo caused what is known as a negative supply shock.

The oil crisis is one of the most famous supply shocks known in economic history. As oil was a crucial input in production processes, but its availability was limited, firms had to cut down their production. As firms cut down their production due to the increase in oil price, the supply curve shifted to the left. People had to bid up the prices as there were fewer goods produced. Therefore, the new price equilibrium in the economy resulted in higher prices. Also, the growth of domestic products decreased as firms weren't producing as many goods as before. This caused an economic recession, also known as stagflation, one of the most challenging recessions to treat.

The US economy after the Oil Crisis 1973

A major economic and political shift occurred in the United States as a result of the 1973 oil crisis. Research on solar and wind energy was intensified to look for other alternative and renewable energy sources. The US government at the time started providing subsidies to corn-based ethanol production as another alternative to oil refining. The oil crisis also pushed automakers to produce smaller and more fuel-efficient cars as the demand for gas-guzzlers dropped significantly. All the efforts to tackle the oil crisis and to ensure that it didn’t repeat led to the US getting back on track. The inflation numbers quickly went down and the purchasing power was restored.