The Secret History of Oil and Money - Part 2

The Balance Tips

Last time we saw how all during the 1950's and 1960's, there was a glut of oil, and it was very cheap. This profoundly affected American post-war society, which grew up around the idea of cars, highways, suburbs, and personal mobility. White flight caused the suburbs to metastasize, and air conditioning caused the Sunbelt to be settled. Wages were rising and inflation was nonexistent. The next major expansion of the welfare state was proceeding, and there was plenty of money for space exploration. Widespread prosperity brought a questioning of social authority.Oil surpassed coal as the predominant energy source.

Oil stayed cheap through the 1960's , and everyone believed the glut would last forever. Then a series of events conspired to drive it off the rails. Even though OPEC was formed in 1960, it had little effect. There was too much oil out there, and always someone willing to sell it for what the oil companies wanted to pay.

After the 1967 war between Egypt and Israel, the Suez Canal was closed and would remain closed until after the 1975 Yom Kippur War.

On 5 June 1967, at the beginning of the Six Day War, Egypt closed the Suez Canal. The closure was sudden and unexpected – fifteen cargo ships known as "The Yellow Fleet"' were trapped inside during the closure. At the end of the war, the Egyptian and Israeli armies were stationed on either side of the canal and the prospects for reopening were very uncertain. The canal remained closed until the end of a second conflict – the Yom Kippur War – and subsequent peace negotiations, eight years later.

http://www.voxeu.org/article/1967-75-suez-canal-closure-lessons-trade

The Suez Canal was closed, but there was a pipeline from the great Saudi fields to the Lebanese town of Sidon as well as the supertankers lifting oil in the Persian Gulf. And there was Libya, right across the Mediterranean from Europe—no canal necessary, no supertankers necessary. Libya was supplying a quarter of Europe's oil. (p. 164)

In 1970 came a Black Swan - the unexpected closure of a vital pipeline to the Mediterranean:

In May 1970 a French bulldozer on a job in Syria accidentally broke the "Tapline," the Trans-Arabian Pipeline running to the Mediterranean. The Syrians refused to repair it until they got higher transmission fees. The Nigerians were in a civil war, with their own oil province of Biafra the chief battleground, and Nigerian production was off. Suddenly—or what seemed suddenly—the cushion was gone. There was still no shortage of oil in the world, but political events had interrupted the delivery of oil. (p. 165)

On September 1, 1969 Colonel Muammar el-Qaddafi seized power from King Idris in Libya. The dependence of Europe upon Libyan oil and the closures of the Suez canal and the Trans-arabian pipeline emboldened him to take on the oil companies to get a higher price. He demanded 40 cents more per barrel. The oil companies offered five.

Most of the concessions in Libya were awarded to Occidental Petroleum, and most of that oil went to Europe. The Libyans decided to pursue a strategy of divide and conquer against the oil companies. In the name of "conservation," they cut back Occidental's oil production. Occidental went to Exxon and asked if they would supply the missing oil at cost so that they could could resist the Libyan demands. Exxon turned them down. With no other recourse, Occidental capitulated. It was a minor move that would have major implications. The floodgates were now open.

"The Libyan success was an embarrassment to other OPEC countries," wrote Abdul Amir Kubbah. OPEC, said Kubbah, had been too moderate. "We wasted ten years not following what our Venezuelan friends had told us," said Kubbah. "Now Colonel Qaddafi had shocked us into action."  (p. 166)

The Shah of Iran was not happy, either. Here he was, the King of Kings, and he had been shown up by some tin-pot military dictator from a minor Arab country. He could do better! He wanted the oil companies to negotiate with him. Countries like Iraq and Algeria were already trying to leapfrog Libya's demands.

The Shah of Iran was miffed at the Libyan initiative. Among his own self-given titles were Shahanshah, King of Kings, Shadow of God on Earth; and here was an upstart colonel leading the Club. His power in the area, he said, was ten times, no, twenty times as great as that of the British had ever been. He warned the consuming countries not to get together behind their oil companies; he warned the oil companies not to get together to defeat the legitimate demands of the producers. The companies, he said, would now negotiate with the Persian Gulf states. That way he, the Shahanshah, could restrain the "wild men" of OPEC. The "wild men," Iraq and Algeria among them, were already leapfrogging their prices to match those of the Libyans. When OPEC met in Caracas in December, though, there was little difference between the "wild men" and the "moderates." A month later the oil companies met the Persian Gulf states in Tehran.

The Shah could see that the British and American governments had left the oil companies without diplomatic support, and he was a grimly determined host. The Libyans had found the way to transfer the wealth of the world; they had used a temporary market condition to kick up the prices. Theoretically, the Tapline break was temporary, the Nigerian civil war was temporary, the Suez Canal closing was temporary, and even the European demand in the summer of 1970 seemed temporarily above normal. ...The Libyans had also shown that a "negotiation" between strong producers and divided consumers scarcely had to be a negotiation at all; it was the exact reverse of the oil situation Perez Alfonso had found when he first got elected to Congress in Venezuela, when the oil cartel dictated the prices. The Shah said that the proper price for oil was perhaps ten times the current price, which would bring it to the level of the price of alternative fuels. (pp. 166-167)

The oil companies started to worry. Rather than play this game of leapfrog with individual nations, it was the oil companies themselves who advised that the oil producing nations unite and fall in behind OPEC. They reasoned that negotiating with one entity would be a lot easier than with each country individually, and they could come out ahead. "The text sent to OPEC by the oil companies had, considering the old history of the oil cartel, an ironic twist: it said that the oil consumers and producers both needed stability, and this business of Leapfrog was very unstable; OPEC should act together and bind its members! The companies did not want to have two sets of negotiations as the Shah suggested; they feared another round of Leapfrog." (p168)

The picture the oil companies had of OPEC was straight out of the scene in Lawrence of Arabia (released 1962) where the Arab tribes, having united behind Lawrence, have taken Damascus and are squabbling among themselves leading to chaos. Economists like Milton Friedman had advised that OPEC would break up after a year. As with so many things, he was wrong. Smith quotes a British observer: "We were used to these chaps always quarreling among themselves, the Iraqui hotheads and the conservative Saudis. The Western countries were not prepared at all for economic blackmail. We know the Iranians were spending twenty percent more than their income, so they had to get a raise, but we were surprised at how very tough all of them had become." (p169)

Rather than quarrelsome towelheads, the people sitting across the negotiating table from the oil companies were highly educated PhD.'s, trained, by and large, at American universities such as Harvard, Stanford, Cornell, and the Universities of Texas and Wisconsin. Many had worked for Western oil companies at one time or another. They were no pushovers. This time the Arab nations were united while the oil companies were divided: "The oil companies were not used to acting in concert, even though they had once been a powerful cartel. They had to obtain a Department of Justice antitrust waiver just to be able to talk to one another." (p 168) After 33 days of tense negotiations in London, OPEC got a raise of 50 cents per barrel, higher than the demand they had gone in with. The agreement was signed on February 14, 1971, which Smith refers to as "the St. Valentine's Day Massacre."

The price rise of the St. Valentine's Day Massacre did not dampen demand; indeed, that demand went up and up, all over the world. Behind the "invisible dike" the price of Texas oil was $3.45 a barrel, frozen by the price and wage controls imposed by the Nixon administration. The United States was now importing 23 percent of its oil, but most of that still came from Canada and Venezuela. The Middle Eastern oil was $2.20 a barrel at Ras Tanura in Saudi Arabia, still cheaper than the Texas oil.  

All through the 1960s the oil companies had worried about the Endless Glut. Michael Haider, chairman of Exxon, said at its annual meeting in Houston, in May 1967, "I wish I could say I will be around when there is a shortage of crude oil outside the United States." A memo from Standard of California in December of 1968 warned Arctic oil would keep the Glut going...Richard Nixon was reelected by forty-nine of fifty states. His energy task force, headed by George Schultz, had reported there was little danger of an Arab boycott and that import restrictions should be liberalized...A whole generation of oil men had grown up with the Glut. 

By 1972 the Glut was gone. The Texas Railroad Commission did not have to worry about how many days a month the wells could pump; they were going flat out, every day. The demand was right across the board: gasoline for automobiles, kerosene for jets, chemicals, weed sprays, fertilizers, plastics...James Akins, the career State Department official who had counseled the companies to make their peace with Libya, defended the State Department position...World oil consumption, he said, in April 1973, would be as great in the next twelve years as world oil consumption through all of previous history. The loss of production from any two Middle Eastern countries would cause a panic, and the price of oil could go to $5 a barrel.

The "invisible dike" around the American oil began to shudder and shake. It had been built to keep the cheap foreign oil from coming in. Now it blew away, not from the supply pressure outside, but from the demand inside. The import restrictions were lifted, and what went roaring out, of course, was dollars. Those dollars went out and competed for oil supplies that were already tight. The administration in Washington did nothing to control the scramble. It had other problems on its mind. It was about to go on trial.

The demand for oil was running ahead of the most extreme predictions. Independent oil companies tried to beat the seven great oil companies to the wellheads. Japanese trading companies tried to beat the independent oil companies. Only Aramco, in Saudi Arabia, had spare capacity, and it had little. By September 1973 the market price had for the first time overtaken the official "posted" price. OPEC could easily read what this meant politically. Its former secretary-general, Nadim al-Pachaci, told a conference, "The Arabs now hold the keys to the energy and monetary crisis. They will know how to use both as a political weapon." (pp. 171-173)

And they did use it as a political weapon. In October 1973, the Egyptians crossed the Bar-Lev line into Sinai intending to reopen the Suez Canal. The United States resupplied Israel despite threats of a boycott. The OPEC countries met, with no oil companies across the table (because they were not invited) and declared the price to be $5.12 a barrel "By ukase, by fiat, by order of the high command. The press release was prepared only in Arabic." (p. 174) The Arabs doubled the price again a few weeks later and added an oil embargo on top of it in addition to the cutbacks to nations which had resupplied Israel in the war (The United States and the Netherlands).

The Arab countries expected bombs to start raining down on them any day for defying the almighty West. The bombs never came. The United States had been humiliated in Vietnam, withdrawing that same year: "Vietnam," said my British friend later, "took the edge off, the great giant brought down by an army in sneakers." (p175). OPEC met again in Tehran in December of 1973. The whole world, not just oil specialists and insiders, were watching. Emboldened by their success at cowing the West, there was debate as to how high the price should go. Too high, and you might cripple Western economies. Sidestepping the negotiations, the Shah called a press conference and unilaterally declared the new price to be $11.65 a barrel.

The Shah, said Jamshid Amouzegar, had ordered a study of alternative fuels. "We were struck," said the eminent Cornell alumnus, "by the fact that in 1951 coal was fifty-one percent of the fuel in the United States, and now it is nineteen percent. Because of cheap oil, alternative sources are being neglected. No one in the West is worrying about what happens when the oil runs out. The embargo had showed the weakness of the West. OPEC's economic commission had determined that the price should be $17 a barrel. 

Sheikh Yamani was apprehensive at so large a boost. "I was afraid the effects would be even more harmful than they were, that they would create a major depression in the West. I knew that if you went down, we would go down," he said. Yamani tried to get in touch with King Faisal, but was unable to. If he kept the price down, it might break OPEC but leave the Saudis isolated. Yamani remained within OPEC, insisting on a smaller price increase, and was later reprimanded by Faisal. But Yamani was stunned when, while the OPEC ministers were still meeting, the Shah called a press conference.

The price of oil, the Shah said, would be $11.65 a barrel. That was even more than Yamani had agreed to. The Shah's arrogance astounded the assembled diplomats and reporters. The new price of oil, he said, was very low and "was reached on the basis of generosity and kindness." As for the Western consumers, it would do them good to economize: "All those children of well-to-do families who have plenty to eat at every meal, who have their own cars, who act almost as terrorists and throw bombs here and there, will have to rethink all these privileges . . . they will have to work harder."

pp.175-176

There were stunned reactions around the world. Smith relates the director of the National Bank of Hungary, Janos Fekete, finding that all his budgets were in deficit. The Hungarians bought oil from the Russians, but the Russians used the OPEC price. "And then somebody—maybe the financial people, like Fekete—would say, 'But now we have to pay four times as much for the oil, and we have no oil. Where do we get the money?'"

Where indeed? As we shall see, this price increase was, in the words of Smith, "The greatest transfer of wealth in world history" After the twin humiliations of Vietnam and Watergate, America was now slammed with a quadrupling of oil prices and an embargo overnight. Lines were forming at gas stations. Suddenly, Happy Motoring didn't look like such a good anymore. Why did we rip up all the streetcars, again?

We'll see what the implications were for the global economy next time.

UP NEXT: The Fallout