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A C I L A L L E N C O N S U L T I N G

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28 JUNE 2014

OIL MARKET RESPONSES TO CRISES:

AN HISTORICAL SURVEY

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D R A F T A C I L A L L E N C O N S U L T I N G

OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY ii

C o n t e n t s Executive Summary i

1 Introduction 1

2 The Global Oil Market 2

2.1 Global Oil Production and Sources 2

2.2 History of Oil Shocks, Prices and Evolution of Oil Market 4

2.2.1 References to Crude Oil Prices 4

2.2.2 Pre-1973 4

2.2.3 Oil Shocks and Prices since 1973 5

2.3 Institutions 8

2.3.1 Organisation of Petroleum Exporting Countries (OPEC) 8

2.3.2 International Energy Agency 8

2.3.3 International Energy Forum 8

3 Australian Economy, Policy and Oil 9

3.1 General Economic Context 9

3.2 Oil and the Australian economy 13

3.3 Petroleum market arrangements 15

3.3.1 General background 15

3.3.2 Regulation and taxation of petroleum 16

3.3.3 1970 to 1980 17

3.3.4 1980 to 1990 18

3.3.5 1990 to present day 19

4 Markets and Oil Shocks, 1964-2014 20

4.1 Types of Oil Shocks 20

4.1.1 Crude Oil Shocks 21

4.1.2 Refined Oil Product Shocks 22

4.2 Oil Market Responses to Shocks 23

4.2.1 Roles of Oil Markets and Prices 23

4.2.2 Price Elasticity of Demand and Supply 24

4.2.3 Estimates of Price Elasticity of Demand and Supply 27

4.2.4 Effects of Highly Price Inelastic Demand and Supply 34

4.3 Physical Oil Markets, Derivatives Markets, and Inventories 35


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY iii

5 Repudiation of agreements and Yom Kippur Arab-Israeli War,

1973-74 36

5.1 Preceding Circumstances 37

5.2 Political Conflict Trigger 38

5.3 Policy Tactics and Market Responses 39

5.4 Causes of the 1973-74 Price Shock 41

5.5 United States Price Control 43

5.6 Impacts on the Australian economy 44

5.7 Policy Issues and Policy Responses 49

6 Iranian Revolution and Iran-Iraq War, 1978-80 51


6.2 Iranian Revolution 53

6.2.1 Unfolding of Events 53

6.2.2 Market and Policy Responses 54

6.2.3 Petrol Queuing Returned in the United States 55

6.2.4 Causes of the Oil Shock 56

6.3 Iran-Iraq War 58

6.3.1 The Conflict and Its Origins 58

6.3.2 Market and Policy Responses 58

6.3.3 Causes of the Oil Shock 59

6.4 Impacts on the Australian Economy 59

6.5 Australian policy issues and responses 65

7 Responses to high oil prices and withdrawal of Saudi Arabian

support for the oil price, 1985-86 66

7.1 Oil Market Circumstances, 1981-1985 67

7.2 Saudi Arabia’s Abandonment of Price Support 68

7.3 Market Responses to Positive Oil Supply Shock 69

7.4 Causes of Oil Shock 69

7.5 Impacts in Australia 69

7.6 Australian Policy Issues and Responses 74

8 Iraq’s invasion of Kuwait, 1990-91 76


8.2 Invasion 77

8.3 Market and Policy Responses 78

8.4 Causes of the Price Shock 78

8.5 Impact on Australia 79

8.6 Australian Policy Issues and Responses 84


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY iv

9 Venezuelan oil supply crisis and Iraq War, 2002-03 86


9.2 Closely-Spaced Supply Shocks 88

9.3 Market Responses 88

9.4 Causes of the Small, Short-Lived Price Spike 89

9.5 Impact on Australia 89

9.6 Policy Responses and Issues 94

10 Multiple Shocks, 2003-14 95


10.2 Multiple Interacting Shocks 96

10.3 Strong Global Economic Expansion, 2003-2008 97

10.4 OPEC Production and Capacity Constraints 98

10.5 Conventional Supply Shocks, 2003-2008 100

10.5.1 Hurricanes Katrina and Rita, 2005 101

10.5.2 Plethora of Small Supply Shocks, 2008 103

10.6 Speculative Demand, 2003-2008 104

10.7 Global Financial Crisis and Recovery, 2008-2014 106

10.7.1 Global Financial Crisis 106

10.7.2 Libyan Revolution 107

10.7.3 Iran Tension 107

10.8 Impacts in Australia 108

10.9 Policy responses and issues 113

11 Economic Effects of Oil Shocks 115

11.1 Economic Effects Depend on Shock Type and Nett Energy

Exports/Imports Position 116

11.1.1 Oil Supply Shock 117

11.1.2 Aggregate Demand Shock 118

11.1.3 Speculative Oil-Specific Demand Shock 119

11.1.4 Refined Products Supply Shocks 119

11.1.5 Compound Shocks 120

11.2 Changes Across Time and Countries 120

11.2.1 Nett Energy Export/Import Balances 120

11.2.2 Energy Intensity 121

11.2.3 Price Elasticity of Supply and Demand 121

11.2.4 Magnitudes of Oil Shocks 122

11.2.5 OPEC’s Changed Price Control Policy 122

11.2.6 Productivity Shocks 123

11.2.7 Monetary Policy and Real Wage Flexibility 123


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY v

11.2.8 Exchange Rate Flexibility 124

11.3 Implications for Australia 125

12 Conclusions 126

Appendix A Fuel taxation A-1

Appendix B References B-1

List of boxes

Box 1 Import parity pricing (IPP) 18

Box 2 Speculative Demand and Taxes in “First Oil Crisis” 40

Box 3 Yergin on Petrol Queuing in United States 56

Box 4 Daniel Yergin on Panic, Speculative Demand and Inventories 57

Box 5 Mined-Commodity-Intensive Growth 98

Box 6 OPEC Capacity Constraint 100

Box 7 Katrina and Rita Supply Shocks and Market Forces 103

List of figures

Figure 1 Global oil supplies (million tonnes) 3

Figure 2 Share of production (million tonnes) 3

Figure 3 Production by country grouping 4

Figure 4 Crude oil prices from 1918 to 2012 5

Figure 5 Crude oil prices quarterly from 1970 to 2014 (US$ per bbl) 6

Figure 6 Growth in GDP 10

Figure 7 Australian/US Dollar Exchange Rate 11

Figure 8 Unemployment rate – Australia (seasonally adjusted) 12

Figure 9 Change in Consumer Price Index 12

Figure 10 Percentage change in automotive fuels price index 13

Figure 11 Primary energy consumption in Australia by fuel source (energy units) 13

Figure 12 Consumption of petroleum by end use 14

Figure 13 Consumption and domestic production of petroleum fuels in Australia 14

Figure 14 Oil intensity of the Australian economy (PJ/$billion GDP) 15

Figure 15 1973-74 Oil Price Surge 39

Figure 16 Crude oil price, US$ and $A 45

Figure 17 Crude oil prices and petrol prices 45

Figure 18 Capital city petrol prices 46

Figure 19 Consumption of petroleum products 46

Figure 20 Production and imports of crude oil and refinery feedstock 47

Figure 21 Refinery production 47

Figure 22 Net imports of petroleum products 48

Figure 23 Billions of km travelled 48


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY vi

Figure 24 Percentage change in CPI from previous quarter 49

Figure 25 Annual GDP growth rate 49

Figure 26 Crude oil price 54

Figure 27 Crude oil price A$ and US$ 60

Figure 28 Crude oil prices and petrol prices - A$ terms “second oil crisis” 60

Figure 29 Capital cities petrol prices (nominal) 61







Figure 36 GDP growth rate 64

Figure 37 Crude oil price in A$ and US$ 70








Figure 45 Percentage change in quarterly CPI from previous year 74






Figure 51 Production of crude oil and net imports of refinery feedstock 82










Figure 61 Production and of crude oil and net imports of refinery feedstock 91






Figure 67 Singapore Export Petrol Price and Crude Oil Price Movements Compared, 2005-06 101


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY vii

Figure 68 Crude oil price in Australian and US dollars 109










List of tables

Table A1 History of fuel taxation in Australia A-1


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY i

Executive Summary

Australia’s vulnerability to a major interruption to global oil supply has been addressed in

previous ACIL Allen reports to government for National Energy Security Assessments, and

considered by the House of Representatives Standing Committee on Economics in its 2012

Inquiry into Australia’s Refining Industry.

These recent reviews found that Australia’s supply security was high – with a watch point

concerning increasing net imports – underpinned by the ability of international markets to

supply crude oil and refined oil products to Australia, and to respond to international and

regional perturbations in supply and demand. This position has been reinforced by the

availability of surplus refining capacity in Asia.

This report builds on previous work by ACIL Allen. It examines historical oil market

responses to global oil market crises. The examination is based on a wide-ranging literature

review, and consultations with people with experience in the oil market over the period. It

discusses in detail how Australian and international oil markets responded to selected oil

shocks of different types. It also discusses the economic consequences of different types of

shocks in the context of changing economic and policy circumstances over time, particularly

in the Australian case. It aims to answer five key questions.

How has the international oil market changed since the 1970’s?

Does the oil continue to flow?

How does the oil price respond during shock episodes and what role does it play?

How have Australia’s oil and refined products markets performed historically?

What conclusions can be drawn?

Six oil market events are considered:

“first oil crisis”: Arab-Israeli War and repudiation of agreements, 1973-74

“second oil crisis”: Iranian revolution and Iran-Iraq war, 1979-80

withdrawal of Saudi Arabian support for oil price, 1985-86

first Gulf war: Iraq’s invasion of Kuwait, 1990-91

Venezuelan oil supply disruption and invasion of Iraq (second Gulf war), 2002-03

multiple oil shocks, 2003-14.

The six case studies serve to illustrate the changes in both the global market over time and the way in which the responses of the market and economies to oil shocks have changed. The case studies also consider the effects on Australia as distinct from global impacts.

Developments in the Global Oil Market since 1973

The report sets out how the global market has developed over the period from the “first oil

crisis” in 1973-74 to the present. Some key developments identified within the report and

the case studies include:

change in the structure of the international crude oil market

the move from long term contracts to spot transactions

the emergence of oil futures and other financial oil derivatives markets


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY ii

decline in short-term responsiveness of quantities demanded and supplied to changes in

price (declining short-term price elasticity of demand and supply)

OPEC capacity restraint

changing mixes of different types of oil shock.

Prior to the “first oil crisis”, global oil markets were broadly competitive, dominated by seven

major oil companies, and oil trading was dominated by long-term contracts. This changed

during the period from 1973 to 1980, when OPEC producers found ways of exercising their

potential market power.

However, their approach to exercising market power was undermined by progressive

nationalisation of oil companies in the Middle East and North Africa. Nationalisation meant

that governments had to sell oil, agree on production quotas, and rely on other members to

comply with their quota obligations.

Saudi Arabia has played a critical role in preserving OPEC influence on oil prices. It bore

most of the burden of OPEC’s desire to maintain high oil prices after the “first and second oil

crises” by cutting production substantially while losing considerable market share to other

OPEC countries. When Saudi Arabia abandoned its efforts in the second half of 1985 and

increased production substantially over several months, the crude oil price collapsed. This

helped restore some discipline within OPEC.

Saudi Arabia typically has maintained substantial excess capacity, because of production

constraints. Since the 1980s, Saudi Arabia has tended to increase production to take

advantage of rising prices following oil shocks, but not enough to eliminate price spikes, and

tended to reduce production as prices declined. However, in the 2003-2008 oil shock, Saudi

Arabia departed from this pattern by cutting production after 2005, with prices already rising

strongly.

Another development of great importance is that OPEC members have not increased

aggregate capacity since 1973. Saudi Arabia has deliberately constrained investment in

more capacity. Some other OPEC members’ capacity has been constrained by wars,

internal strife, and government budget issues. OPEC capacity constraint has resulted in a

persistent negative oil shock that has often been overlooked. It maintains upward pressure

on oil prices.

Until a decade ago, the conventional view was that major price spikes were caused by major

exogenous supply shocks. This view not only overlooked the existence of the persistent

supply shock, but also ignored the importance of aggregate demand shocks and speculative

demand shocks, as well as oil producers restraining production to take advantage of higher

prices later (forms of speculative supply or demand shocks).

It is now widely recognised in the relevant economics literature that various types of shocks

have often occurred in close proximity in time, and that the mix of shocks has varied

between major oil price events.

In contrast to the pre-1973 situation, therefore, the market is now characterised by

increased diversity, hedging to address price volatility, declining short-term price elasticity of

demand and supply, OPEC production quotas and capacity constraints, the swing producer

role of Saudi Arabia, and participation of a wide range of entities including commodities and

financial derivatives traders.

More recently, persistent high oil prices have brought forward a supply response from

unconventional oil particularly in the United States. This has the potential to change the oil

supply balance between OPEC and non OPEC production.


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY iii

Developments in the Australian Economy and Oil

Market

In addition to identifying the way the global market has changed, the report also sets out key

changes to the Australian oil market and structure of the economy, as these are important

for understanding how global disruptions have affected Australia differently to other

countries.

The structure and regulation of the Australian economy changed significantly over the

review period. Significant changes included:

the move to import parity pricing for crude oil in 1978

the floating of the Australian dollar in December 1983

the progressive introduction of the Petroleum Resource Rent Tax from 1986

deregulation of the petroleum market during the1980s

microeconomic reform during the 1980s and beyond

more credible monetary policy

greater real wage flexibility

Australia’s increasing nett energy export position

declining oil- and energy-use intensity of the economy.

In 1973-74, the price of crude oil was regulated by the Commonwealth Government. When

the US$ oil price increased by 255 per cent in 1973-74, petrol prices only rose 22 per cent.

As a result the full price impact of the rise in oil prices was not felt by Australian consumers.

Consumption that had been rising at about 6 per cent per annum on average over the

previous four years flattened off. No shortages were experienced.

In 1978-80, when the Iran Iraq war pushed the price of crude oil from around US$15 per

barrel to US$35 per barrel, the Australian petrol price was more responsive rising from 20

cents per litre to around 30 cents per litre because of the move to import parity pricing for

Australian crude oil into refineries.

There was no interruption to oil supplies to Australia from international events.

During the period from 1981 to 1985, OPEC attempted to support the oil price through

production quotas, but some members did not comply with their quotas. Saudi Arabia bore

most of the burden of supporting the price via production cuts. In mid-1985, Saudi Arabia

abandoned this approach and increased production. The fall in oil prices was not fully

transmitted to Australian petrol prices, partly because of depreciation in the exchange rate

following the floating of the Australian dollar in December 1983. Consumption of refined oil

products fell significantly with the recession in 1982-83 and lagged responses to high prices.

Consumption recovered from 1984-85, but by 1986-87, still had not re-attained the 1980-81

level of about, 37,900 ML per annum.

In 1990-91, Iraq’s invasion of Kuwait removed nearly 4.6 million barrels per day of oil from

the market, causing oil prices to rise from US$18 per barrel to US$30 per barrel. The price

of crude oil in Australian dollars moved proportionately, and petrol prices rose from 62 cents

per litre to 80 cents per litre. Growth in consumption of petroleum products that had been

2.5 per cent per annum in the two previous years fell to zero in 1990-91 as a result of the

price rise and transmission of a global recession to Australia before the Iraq-Kuwait war.

There was no government intervention in the market and no interruption to oil supplies.

In 2002-03, the Venezuelan oil supply crisis and another Iraq war reduced global oil supplies

by around 4 million barrels per day. However, the combined Venezuelan and Iraqi supply


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY iv

shocks were more than offset by an unexpected increase in global oil production early in

2003 – a countervailing positive supply shock. This reversed the speculative demand

shock. The price spike was minor and short-lived. Consumption of petroleum products fell

about 4 per cent in 2000-01, again influenced by a global recession, but by 2002-03

consumption had recovered. There was no interruption in oil supplies in Australia.

The period from 2003 to 2008 was characterised by large global aggregate demand shocks,

and ongoing OPEC capacity constraint. In addition there were several exogenous supply

shocks. For example, crude oil production was reduced by about 1.4 million barrels per day

and refinery production reduced by about 2 million barrels per day following Hurricane

Katrina in the Gulf of Mexico in the third quarter of 2005. However, prices spiked to ration

anad reallocate supply, and oil and refined products were released from stockpiles. So,

when Hurricane Rita arrived a month later the price impact was minimal.

The 2003 to 2008 surge in oil prices was reversed rapidly in 2008. The global financial

crisis caused large negative aggregate demand and speculative oil-specific demand shocks.

Prices had recovered strongly in late 2009, because of the influence of rapid growth of

demand from major developing economies. Petrol prices in Australia reflected the change

in global oil prices. However, consumption continued to rise at around 2 per cent per year

over the 2003-2008 period. The global financial crisis caused consumption to fall by 2 per

cent in 2008-09, before recovering the longer term growth trend by 2010-11.

At no time over the past 50 years were supplies disrupted as a result of international

perturbations in the market. The only occasions in which supplies were disrupted in

Australia involved industrial action. This occurred in the late-1970s in South Australia, in

late-1988 in New South Wales, and again in 2001 in South Australia. In these cases, State

Governments introduced measures to manage demand through odds and evens days or

minimum fill requirements.

Key Messages

Drawing on the discussion of the development of the market and the literature about types

of oil shocks along with the lessons gained from the case studies, the report arrived at the

following key conclusions. Some are general and others are particular to Australia.

Oil continues to flow though prices may be affected

The history of oil shocks over the past 40 years has not provided any evidence to

suggest that, in response to unexpected interruptions to supply or surges in demand,

crude oil and refined product markets would not swiftly ration and reallocate supply

efficiently through price movements to avoid shortages.

The evidence collected for this report indicates that there were no interruptions in supply

caused by global market perturbations, with the notable exception of the United States,

which experienced shortages during the “first and second oil crises” because of self-

imposed price controls and administrative allocation arrangements.

Over time, the oil market has become more globalised, diverse, and transparent, and

therefore, more adept at responding to shocks and restoring market balance, with

shocks quickly reflected in price movements globally.

While oil price spikes understandably create concerns in the community, they are

essential to clear the market and avoid shortages to consumers and business. Short

term price spikes encourage consumers to reduce consumption and encourage

producers and traders to increase supplies. Consumers and businesses benefit in the

longer-term from this important role of prices.


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY v

These price movements have also encouraged oil producers and users to adopt

hedging, stock management, and capacity management strategies .

Intervention in the market is generally unhelpful

The global oil market worked well during the various oil shocks. In Australia, spikes in

international prices translated appropriately into rises in the Australian price of fuel after

Import Parity Pricing for crude oil was introduced in 1978. This ensured that Australia

became well integrated into the global market.

Price spikes were typically felt uniformly around the nation, as they were globally.

Reductions in quantity demanded and some increases in quantity supplied, helped

rebalance the market, and avoided shortages.

Market-determined prices are far superior at rationing supply and allocating resources

efficiently, than queuing and administrative allocation. In the 1970s, when price controls

and administrative allocation were applied to oil and refined oil products in the United

States, shortages and administrative allocation anomalies that misallocated resources

occurred in the wake of major oil shocks.

The challenge for policy makers in Australia as well as globally is to ensure that the

markets are not impeded by poorly thought out policies involving governments interfering

with the efficient allocation of resources during oil shocks. If market or policy failures

impede the efficient operation of markets, intervention is warranted, provided that the

benefits of intervention exceed the cost. In addition, the chosen form of intervention

should be the one that would yield the greatest surplus of benefits over costs.

Otherwise, the operation of markets should be left alone.

Each oil shock is different and several types of shock may occur in

tandem

The economic consequences of an oil shock depend crucially on its cause or causes.

There are important differences between the economic effects of aggregate demand

shocks, oil and refined product supply shocks, and speculative demand shocks.

Until a decade ago, the conventional view was that major price spikes were caused by

major exogenous supply shocks. It is now widely recognised in the relevant economics

literature that various types of shocks have often occurred in close proximity in time and

that the mix of shocks has varied between major oil price events.

The emergence of a spot market from the early-1980s and increased volatility led to

development of financial oil derivatives and markets in which to trade them. This meant

that traders were more able to manage volatility of spot prices. This, along with other

factors, contributed to reductions in short-term price elasticities of supply and demand

that tended to accentuate price spikes during disruptions. At the same, changes in the

structure of the Australian economy and its flexibility have reduced the economic impact

of such spikes.

Importance of energy intensity

There have been noticeable reductions of oil-use intensity and energy-use intensity in

nearly all developed countries since the 1970s. Australia’s oil-use intensity has halved

since 1973-74. However, Australia’s energy-use intensity has declined at a slower rate

over the past 20 and 40 years than most other developed economies. Energy-use

intensity is relevant when oil prices spike, because prices of energy other than oil tend to

move with oil prices.


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY vi

Lower oil- and energy-intensity reduces vulnerability of economies to oil price increases.

Differences in intensity of use of oil-products and energy-use more generally lead to

differing economic effects of oil shocks between countries.

Economic effects of oil shocks have been moderated by trends towards declining oil and

energy-use intensity,

Short-term price elasticity of demand and supply declined over time

There has been a substantial reduction in short-term price elasticity of demand and

supply of oil since the mid-1980s.

The implication is that an oil shock of a particular type and magnitude would lead to a

much larger oil price spike now, under similar market conditions, than at the time of the

“first oil crisis” and “second oil crisis” of the early 1970s to early 1980s. However,

economic effects of oil price shocks have been moderated by declining oil- and energy-

use intensity, increasing real wage flexibility, exchange rate flexibility, and in some

countries better nett energy export/import positions.

Australia’s is a net energy exporter

Economic effects of different types of oil shocks vary between countries in accordance

with differences in net energy exports or imports. As these net positions have evolved

over time, economic effects of oil shocks have changed.

In countries like Australia, that are net exporters of energy, but net importers of oil, there

are effects on economic activity working in opposite directions. Higher oil prices tend to

cause a contraction of national income, while higher prices for energy commodities in

general tend to be expansionary for economies that are net exporters of energy.

The net economic effects of an oil supply shock on Australia could be insignificant or

positive overall. As Australia’s net energy export balance increases because of large

increases in exports of coal and liquefied natural gas (including coal seam methane), the

likelihood of positive overall economic effects on Australia increases.

Conclusion for Australia

Australia now has oil and refined products markets that work well and are linked closely

to global markets that ration and allocate supply well.

Price responses to oil shocks of any magnitude in terms of quantity may now be larger

than at the time of “first and second oil crises” to the extent that short-term price

elasticity of demand and supply for crude oil have declined during the intervening period.

Moreover, import parity pricing now means that global price movements are translated

fully to price movements for fuels in Australia.

Australia’s susceptibility to economic harm from oil shocks has declined since the time of

“first and second oil crises” because of lower oil-use intensity, improvements to

Australia’s position as a net exporter of energy, greater real wage flexibility, better

monetary policy and the floating exchange rate.


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY 1

1 Introduction

This report contains an historical examination of oil market responses to global oil market

crises. The examination is based on a wide-ranging literature review, and access to

Australian archived material. It discusses in detail how Australian and international oil

markets responded to selected events. In addition, it investigates the economic

consequences of various types of shocks in the context of changing economic and policy

circumstances over time, particularly in the Australian case.

Six oil market events are considered:

“first oil crisis”: Arab-Israeli War and repudiation of agreements, 1973-74

“second oil crisis”: Iranian revolution and Iran-Iraq war, 1978-80

withdrawal of Saudi Arabian support for oil price, 1985-86

“first Gulf war”: Iraq’s invasion of Kuwait, 1990-91

Venezuelan oil supply disruption and invasion of Iraq (“second Gulf war”), 2002-03

multiple oil shocks, 2003-14.

Chapter 2 of this report provides an introduction to the global oil market, including an

overview of movements in oil prices and international institutions that have influenced the

market.

Chapter 3 provides and introduction to the oil market in Australia, and relevant economic

and policy considerations.

Chapter 4 provides a general overview of international oil markets and shocks over the 1964

to 2014 period.

Chapter 5 examines the impact of the repudiation of company-government agreements and

the Yom Kippur Arab-Israeli War in 1973-74.

Chapter 6 discusses the impact of the Iranian revolution and the Iran-Iraq war in the 1979 to

1980 period.

Chapter 7 explores responses to high oil prices and withdrawal of Saudi Arabian support for

oil prices in 1985-86.

Chapter 8 discusses the impacts of Iraq’s invasion of Kuwait (“first Gulf war”) in 1990-91.

Chapter 9 examines the impact of Venezuelan strikes and another Iraq war (“second Gulf

war”) in 2002-03.

Chapter 10 explores interactions between high aggregate demand growth and supply shock

interactions over the period 2003 to 2014.

Chapter 11 reviews the economic effects of oil shocks for the global economy and for

Australia.

Chapter 12 provides conclusions.



2 The Global Oil Market

Global oil supplies have increased from around 2,869 million tonnes per annum (58 billion barrels per day) in 1973 to around 4,142 million tonnes per annum (83 million barrels per day) in 2012. Over that time, the share from the Middle East fell slightly from 36.7 per cent to 32.5 per cent.

In 2014 real terms, crude oil prices were less than US$19 per barrel in mid-1973. Oil prices rose to around US$57 per barrel in January-February 1974 during the “first oil crisis”. Spot prices rose further to around US$122 per barrel (2014 real terms) at the twin peaks of the “second oil crisis” in November 1979 and November 1980.Oil prices collapsed to around US$24 per barrel in May 1986, after Saudi Arabia substantially increased production, abandoning efforts to sustain the price at a high level. The oil price spiked briefly to US$66.50 in October 1990 during the Kuwait-Iraq crisis. After trending down in real terms for 21 years, the oil price bottomed around US$13 per barrel (2014 real terms) in January 1999, in the wake of the Asian financial crisis.

As a result of strong growth in global aggregate demand for goods and services, and various supply shocks and constraints, the spot crude oil price soared to a peak of around US$162 per barrel (2014 real terms) in July 2008, before collapsing to around US$35 per barrel in December 2008, soon after the onset of the global fincial cris. The price recovered quickly but partly in 2009-10. Since 2011, spot crude oil prices have fluctuated US$100 per barrel (2014 real terms), with small spikes for shocks associated with revolution in Libya, emabrgod on trad ewith Iran, and strife in Iraq.

Prior to the “first oil crisis” global oil markets were broadly competitive, dominated by seven major oil companies, and oil trading was dominated by long term contracts. This changed during the period from 1973 to 1980 when OPEC producers found ways of exercising their potential market power.

In contrast to the pre-1973 situation therefore, the market is now characterised by increased diversity, hedging to address price volatility, declining short-term price elasticity of demand and supply, OPEC production quotas and capacity constraints, the swing producer role of Saudi Arabia, and participation of a wide range of entities including commodities traders.

High crude oil prices during and after the “first and second oil crises” induced strong supply and demand responses with a lag of a few years. More recently, high oil prices that have persisted for most of the period from 2006 to 2014 have brought forward a supply response from conventional oil in various parts of the world, and unconventional oil particularly in the United States. This has the potential to change the oil supply balance between OPEC and non OPEC production. This will help offset the effects of rising demand. Also, high prices have induced increasing offerings of, and switching to transport vehicles with better fuel economy, reducing quantity of oil demanded.

2.1 Global Oil Production and Sources

Global oil supplies increased from around 2,869 million tonnes per annum (58 billion barrels

per day) in 1973 to around 4,142 million tonnes per annum (83 million barrels per day) in

2012 (Figure 1).



Figure 1 Global oil supplies (million tonnes)

Note: Includes crude oil, natural gas liquids, additives and other hydrocarbons.

Asia excludes China.

Source: (IEA, 2013)

Over that time the share of production from the Middle East fell slightly from 36.7 per cent to

32.5 per cent.

Figure 2 Share of production (million tonnes)

Source: (IEA, 2013)

The share of oil production from OECD countries fell from 30 per cent in 1997 to 26 per cent

in 2011 (Figure 1). Over the same period the share of oil production from OPEC Countries

increased from 30 per cent in 1997 to 36 per cent by 2011.



Figure 3 Production by country grouping

Source: (IEA, 2012)

2.2 History of Oil Shocks, Prices and Evolution of

Oil Market

2.2.1 References to Crude Oil Prices

Throughout this report, historical prices of crude oil have been mentioned on numerous

occasions in the text. In addition, time series of crude oil prices have been displayed in

charts. Prices quoted in the text do not always align with prices in charts, because of

different bases. Often, prices in the text refer to peak and trough spot prices of available

benchmark prices, while prices shown in charts are averaged over months or quarters and

benchmarks have changed in long-term series. In addition, prices in charts may be based

on an average of contract and spot prices (for example, see Figure 5). When real prices

have been quoted or charted, the year to which prices have been adjusted for earlier or later

inflation has been specified.

2.2.2 Pre-1973

From 1918 until the 1940s, crude oil prices trended down. Then, prices rose significantly

until the early-1950s, after which they displayed a downward trend for more than 20 years

until 1973. The real price downtrend was not significantly disrupted by the Suez Crisis in

1956, formation of OPEC in September 1960, or the 6-day Arab-Israeli war in 1967.

However, the Suez crisis did accelerate the development of much larger oil tankers, and this

facilitated globalisation of oil markets. The international market was basically competitive

until 1973.

-

10.0

20.0

30.0

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100.0

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1967

1969

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1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

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2007

2009

2011

MB/d

OECD Non-OECD OPEC



Figure 4 Crude oil prices from 1918 to 2012

Note: 1918-1944 US average. 1945-1983 Arabian Light posted at Ras Tanura. 1984-2012 Brent dated.

Source: (BP, 2013)

In circumstances of chronic oversupply in the United States for decades prior to the 1970s,

output was constrained by government regulation to levels well below capacity to support

prices, and ostensibly, to conserve resources. During the 1960s, this surplus capacity was

whittled away and was eliminated by the early-1970s. This also eliminated the world’s

emergency oil capacity.

Booming global economic conditions in the early 1970s, in combination with crude oil prices

pegged by agreements between Middle East producers and international oil companies,

whittled down spare capacity there too.

2.2.3 Oil Shocks and Prices since 1973

With spare capacity gone, OPEC producers found a way to exercise their potential market

power in 1973. They repudiated agreements and demanded higher production-based taxes

and participation in production. Fear raised prices and these were supported by tax

increases. The Yom Kippur war provided an excuse for Arab nations to cut production. The

process of ratcheting up prices through creation of fear and demands for higher producing

government revenues continued. The broadly competitive market was replaced by one

characterised by exercise of substantial market power.

Movements in crude oil prices from 1973-74 are shown in nominal and real terms in Figure

5.

During the “first oil crisis” in 1973-1974, the real price of crude oil tripled to around US$57

per barrel in 2014 terms over a few months. Subsequently, the real oil price fluctuated

around US$52 per barrel until the second half of 1978, as circumstances developed to

create the “second oil crisis” linked to the Iranian revolution and then the Iran-Iraq war.

The peak price during the “second oil crisis” was more than double the real price level

established as a result of the “first oil crisis”. The price of about US$122 per barrel (2014

price terms) was the highest crude oil price recorded since 1864 when the price was about

US$124 per barrel (2014 price terms). The price spike was driven by a combination supply,

aggregate demand and speculative demand shocks.

0.00

20.00

40.00

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120.00

140.00

1918

1923

1928

1933

1938

1943

1948

1953

1958

1963

1968

1973

1978

1983

1988

1993

1998

2003

2008

$US/bbl

$ money of the day $2014



Figure 5 Crude oil prices quarterly from 1970 to 2014 (US$ per bbl)

Note: Prices reflect the average price of crude imported into the United States.

Real 2014 price curve adjusts nominal prices for U.S. inflation.

Source: (EIA, March 2014)

As a result of progressive nationalisation of oil companies’ producing assets in the Middle

East and North Africa during the 1970s, governments transitioned from collection of

production-based taxes to selling oil. This institutional change made it more difficult to

ratchet up oil prices. Instead of raising production taxes on oil companies in concert to put a

floor under the oil price, OPEC governments had to agree among themselves on production

rates and market shares and rely on others not to cheat. That did not work well.

As crude oil prices declined following the “second oil crisis” in 1979-80, Saudi Arabia was

left with most of the burden of cutting production to try to support the price, while other

OPEC members cheated. The price decline was propelled by the global economy sliding

into recession in the early-1980s and the operation of market forces. Historically high oil

prices for a decade had induced:

substantial exploration around the world

technical research and innovation in respect of exploration and extraction methods

considerable expansion of production in non-OPEC countries

research and innovation regarding more efficient use of oil products

conservation of petroleum products and switching to other fuels.

In the meantime, a transition from an administered oil price regime involving long-term

contracts with pre-determined posted oil prices to a spot trading system in the early 1980s

represented a major structural transformation of the oil market. The perceived greater

volatility of spot prices, encouraged development of oil derivatives or futures, and markets in

which to trade them. These instruments provided hedging mechanisms for producers and

users of crude oil. A result was reduction of responsiveness of hedged entities in both

groups to spot oil price changes, meaning lower price elasticity of demand and supply. This

increased oil price volatility, encouraging further development of markets for oil derivatives.

After Saudi Arabia withdrew its support for the oil price, progressively raising its production

in the second half of 1985 and the first half of 1986, the crude oil price slumped by nearly 70

per cent. Notwithstanding pervasive suspicion and mistrust among OPEC members, a

temporary production agreement was reached in August 1986. It resulted in a turn-around

in the spot price of crude oil. This was reinforced by another agreement in December 1986

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

Jan

1974

Jan

1976

Jan

1978

Jan

1980

Jan

1982

Jan

1984

Jan

1986

Jan

1988

Jan

1990

Jan

1992

Jan

1994

Jan

1996

Jan

1998

Jan

2000

Jan

2002

Jan

2004

Jan

2006

Jan

2008

Jan

2010

Jan

2012

Jan

2014

Nominal Real

Arab oil embargo nominal prices rise from $2/bbl to $10/bbl

Irania n revolution

Iran - Iraq war

End of administrative priocing

Invasion of Kuwait OPEC quota increases,

Asian financial crisis

OPEC target reductions, tight stocks

Second Gulf crisis

Demand growth in China takes off

Hurricanes Katrina and Rita hit the US Gulf Coast

Tight spare capacity, crude outages in Nigeria, Iraq, North Sea

Global financial

crisis

Arab spring



to cut production by 5 per cent. By January 1987, crude oil spot prices had risen to around

US$45 per barrel in real 2014 terms, compared to about US$68.50 in November 1985.

Subsequently, crude oil prices remained relatively steady in a range of around US$33 to

US$43 per barrel in real 2014 terms from early-1987 to mid-1990.

Following the short-lived price spike in September and October 1990 that was associated

with Iraq’s invasion of Kuwait, the real spot of crude settled in the range of US$33-43 per

barrel (2014 price terms) for more than two years. Thereafter, the price displayed a strong

downward trend until the beginning of 1999, when it bottomed at less than US$13 per barrel

in 2014 price terms. The decline had been particularly marked over the preceding two

years, helped by the negative (reduced) aggregate demand shock of the Asian Financial

Crisis.

The “clumsy cartel”, as Morris Adelman (1995) described OPEC, had not been able to halt a

strong 18-year downtrend in the real crude oil price. As global aggregate demand

recovered following the Asian financial crisis, OPEC members constrained production.

Therefore, the real crude oil price began to recover strongly in 1999 and 2000. Then it lost

more than half of those gains in 2001. A recession in the United States economy was an

important contributory factor. The oil price remained in the doldrums for about 12 months,

starting to recover in 2002.

The crude oil price spiked in early-2003, triggered by loss of production in Venezuela and

Iraq, following internal political turmoil and a United States led invasion, respectively.

However, the price spike was short-lived and not large.

In the meantime, events of great economic importance were occurring that would lead to

dramatic changes in the crude oil market. First, partly by design (in response to declining

real prices and production quotas that had not worked well), and partly because of internal

and external conflicts involving major oil exporters, OPEC members had not increased

aggregate capacity since 1973. Second, short-term price elasticity of demand and supply

have declined to much lower levels than applied until the mid-1980s, meaning that a shock

to quantity demanded or supplied would have much bigger effect on the crude oil price than

at the time of the “first and second oil crises”. Third, the global economy grew strongly from

the second half of 2003, supported by extraordinarily fast, sustained, commodity-use-

intensive growth in China, India and some other developing economies.

As a result of these circumstances, a series of supply shocks, and a preceding 22-year

downtrend in real crude oil prices, the oil price surged from under US$35 per barrel in early-

2003 to around US$162 per barrel (2014 real terms) in July 2008, a record high price. The

crude oil collapsed following the global financial crisis, but recovered quickly as a result of

continuation of oil-intensive growth in major developing economies and constrained capacity

in OPEC countries. The crude oil price has fluctuated around US$100 per barrel (2014 real

terms) since 2011, apart from small spikes in 20011 and 2012 linked to supply shocks

associated with revolution in Libya and embargos on trade with Iran.

High oil prices that have persisted for most of the period from 2006 to 2014 have brought

forward a supply response from researchers, explorers and producers focussed on

conventional oil in various parts of the world, and unconventional oil particularly in the

United States. This has the potential to change the oil supply balance between OPEC and

non OPEC production. Ultimately, it will help offset the effects of rising demand. But, high

prices have also induced increasing offerings of, and switching to transport vehicles with

better fuel economy, reducing quantity of oil demanded.



2.3 Institutions

Three international institutions played an important role in oil market developments over the

period examined for this report - the Organisation of Petroleum Exporting Countries (OPEC)

and the International Energy Agency (IEA).

2.3.1 Organisation of Petroleum Exporting Countries (OPEC)

OPEC was formed in September 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.

These founding members were later joined by nine others: Qatar (1961); Indonesia (1962) –

suspended its membership from January 2009; Libya (1962); United Arab Emirates (1967);

Algeria (1969); Nigeria (1971); Ecuador (1973) – suspended its membership from December

1992-October 2007; Angola (2007); and Gabon (1975–1994).

OPEC's stated objective is to co-ordinate and unify petroleum policies among member

countries, in order to secure fair and stable prices for petroleum producers; an efficient,

economic and regular supply of petroleum to consuming nations; and a fair return on capital

to those investing in the industry.

2.3.2 International Energy Agency

The International Energy Agency (IEA) was founded in 1974 by OECD countries in

response to the 1973-74 oil crisis. Its stated aim is to help countries co-ordinate a collective

response to major disruptions in oil supply through the release of emergency oil stocks to

the markets. The organisation’s prime focus on maintaining systems for coping with oil

supply disruptions, but it also provides a forum for cooperation on energy policy formation,

sharing of energy statistics, cooperation in energy programs, and dialogue with non-OPEC

member countries.

Membership now includes Australia, Austria, Belgium, Canada, Denmark, Finland, France,

Germany, Greece, Ireland, Italy, Japan, Luxembourg, The Netherlands, New Zealand,

Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United

States. The Commission of the European Communities takes part in the work of the IEA

(IEA, 1994). As will be discussed later, Australia did not join the IEA until 1979.

Membership of the IEA carries with it certain obligations with respect to energy security.

This includes the requirement for member countries to hold at least 90 days stocks of net oil

imports. During declared oil crises, member countries may also be required to reduce

consumption or supply oil to other member countries to help member countries manage

their oil markets until the crisis has subsided.

2.3.3 International Energy Forum

The International Energy Forum (IEF) was formed in 1991 and now has 76 member

countries. The IEF charter outlines a framework for a global energy dialogue through an

intergovernmental arrangement. Member countries account for around 90 per cent of global

oil supply and demand.

One of the projects undertaken under the IEF is the Joint Oil Data Initiative (JODI). JODI is

a comprehensive collection of oil market data.



3 Australian Economy, Policy and Oil

The structure and regulation of the Australian economy changed significantly over the review period. Significant changes included the floating of the Australian dollar in December 1983, deregulation of the petroleum market during the1980s, and microeconomic reform and labour market innovations during the 1980s and beyond.

The fall in the exchange rate to around US$0.40 by the late 1990s was important to the extent that it tended to offset the impact of falling global crude oil prices. By the same token, the rise in the exchange rate to around US$0.98 was an important buffer to rising oil prices in the in the 2004-2008 period. This has been also important in recent years with the rise in the exchange rate to near parity.

Petroleum fuels have been a major component of energy in Australia. The share of total energy supply (energy units) provided by petroleum in 1974- 75 was 51 per cent. By 2011-12, this had declined to 39 per cent.

The outlook for domestic production of petroleum in the late 1970s was commonly perceived to be a decline in domestic petroleum production leading to a relatively rapid decline in liquid fuels self-sufficiency from the relatively high level of around 70 per cent at that time, unless further oil discoveries were made. There are several reasons why this decline did not occur. First, the rise in oil prices in the 1980s led to further development of petroleum fields in Gippsland and the Cooper Basins. Second, the development of new production associated with the North West Shelf project meant that production of domestically produced petroleum increased to its highest level ever by 2002, before declining again as other fields continued to decline.

Before the 1970s, several small onshore fields and important offshore fields in Bass Strait were developed in Australia. By the beginning of the 1970s, there were several oil fields in production: Moonie in Queensland, Barrow Island in Western Australia, Cooper Basin fields, and the offshore Barracuda, Halibut and Kingfish fields in the Gippsland Basin. These developments resulted in a substantial increase in production of crude oil (and gas) in Australia.

At that time there were eight refineries operating in Australia, drawing in part on the increasing production of indigenous crude oil.

In 2003, Mobil announced suspension of operations at the Port Stanvac refinery in South Australia placing it in a care-and-maintenance mode. The company announced the permanent closure of the refinery in 2009.

Further closures of refineries were announced after that date. Shell closed its refinery at Clyde in Sydney in November 2013, and Caltex will close its refinery at Kurnell also in Sydney in June 2014. On 4 April 2014 BP announced its intention to close its refinery at Bulwer Island in Brisbane. The Australian downstream petroleum market is undergoing significant restructuring of ownership at the time of writing.

Changes in the regulation and taxation of petroleum production and consumption in Australia are important to understanding the response in Australia to interruptions in global oil supplies.

The price of domestically produced crude oil was regulated in the 1970s, at first to ensure that Moonie oil was absorbed by refineries, but subsequently to hold prices of domestically crude oil below world prices (import parity) as world oil prices rose in response to the “first oil crisis”.

This reduced the price impact on Australia of rises in World oil prices and accordingly the incentives for oil conservation and exploration and development in a world of higher oil prices.

Australia introduced import parity pricing for crude oil in 1978. However, arrangements for an economically inefficient levy on production of crude oil remained. This situation was gradually overcome with the gradual introduction of the Petroleum Resource Rent tax, commencing with new offshore fields in 1988, and concluding with its extension to all offshore and onshore petroleum projects by 2012.

3.1 General Economic Context

Consideration of the impact of global oil supply developments on Australia cannot be

meaningfully conducted without reference to general economic and policy settings that



applied at the time. This section discusses general economic conditions that applied over

the review period, and then examines the petroleum sector in that context.

The structure and regulation of the Australian economy changed significantly over the

review period. Significant changes included the floating of the Australian dollar in December

1983, deregulation of the petroleum market during the1980s, microeconomic reform, and

labour market innovations in the 1980s and beyond.

Over the period from 1970 to the current day, growth in Gross Domestic Product (GDP)

ranged between 6 per cent and minus 2 per cent (see Figure 2). In 1970, GDP growth was

4 per cent. However, if tell to 1.9 per cent by 1975 and maintained a range of 1.8 per cent

and 4 per cent in the 1970s. In the mid-1970s, decline of Australia’s terms of trade, global

recession, and the 1973-74 oil price surge (“first oil crisis”), in the context of an inflexible

exchange rate, led to stagflation conditions.

GDP growth was maintained at around 3 per cent during the early part of the 1980s,

notwithstanding the “second oil crisis” of 1979-80, but fell dramatically in 1983, in the context

of global recession, before recovering to over 4 per cent in the latter part of the 1980s.

These growth fluctuations had more to do with wider economic circumstances than oil

market conditions.

GDP growth again faltered in1992 following a recession that began to have in impact in

1990, before the Iraq-Kuwait oil shock of 1990-91. Subsequently, growth lifted again to the

4 per cent level. The oil price was not a significant driver of these developments.

During the 2000s, GDP growth rates ranged between 2 and 3 per cent. The impact of an oil

shock associated with strife in Venezuela and the “second Gulf )ar” in late-2002 and early-

2003 was mild. Again, these fluctuations had more to do with general economic conditions

and uncertainty than with the short, sharp oil price spike.

Figure 6 Growth in GDP

: Source: Australian Bureau of Statistics

Movements in the US/Australian dollar exchange rates have not necessarily been driven by

global oil prices, but the impact of movements in the Australian dollar have been important

factors in the price of petroleum products in Australia and related incentives for petroleum

exploration and production in Australia. Movements in the US/Australian dollar exchange

rate are shown in Figure 7.

-4

-2

0

2

4

6

8

Jan

-19

60

Jan

-19

63

Jan

-19

66

Jan

-19

69

Jan

-19

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Jan

-19

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Jan

-19

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Jan

-19

81

Jan

-19

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Jan

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Jan

-19

96

Jan

-19

99

Jan

-20

02

Jan

-20

05

Jan

-20

08

Jan

-20

11

Per cent



The US/Australian dollar exchange rate was pegged to the US dollar during the 1970s and

was above parity. Over the same period, the price of crude oil produced in Australia was

regulated with price falling below import parity levels as oil prices rose during the decade.

This, together with the impact of the exchange rate and relatively low fuel excise levels

meant that petroleum product prices were low in Australia relative to the rest of the world.

This supressed to some extent the impact of rises in world crude oil prices during the period

of the 1973-74 and 1978-80 oil crises.

The exchange rate was deregulated on 12 December 1983, after which it fell significantly.

During the latter part of the 1980s, the exchange rate fell to as low as US$0.60, ending up at

US$0.80 by 1990. This fall in the exchange rate increased the impact of high oil prices

during the early 1980s. This was offset by the collapse in crude oil prices during the second

half of the 1980s.

The fall in the exchange rate to around US$0.40 by the late 1990s tended to offset the

impact of falling global crude oil prices. By the same token, the rise in the exchange rate to

around US$0.98 was an important buffer to rising oil prices in the in the 2004-2008 period.

This has been also important in recent years with the rise in the exchange rate to near

parity.

Figure 7 Australian/US Dollar Exchange Rate

Source: RBA

The seasonally adjusted unemployment rate varied between 4 per cent and 12 per cent over

the review period (Figure 8). Negative global economic conditions influenced the peaks in

the unemployment rate in 1983 and 1993.

0.0000

0.2000

0.4000

0.6000

0.8000

1.0000

1.2000

1.4000

1.6000

May

-19

70

Au

g-1

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2

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4

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Feb

-20

04

May

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Au

g-2

00

8

No

v-2

01

0

Feb

-20

13



Figure 8 Unemployment rate – Australia (seasonally adjusted)

19

Source: RBA

Inflation has fallen from a peak of 17 per cent in 1974 to an average around 2.5 per cent

during the 2000-2014 period (Figure 9). The high inflation period from the mid-1970s to the

mid-1980s coincided with similar problems in major economies and widespread stagflation

problems. This was caused by poorly targeted, stop-start monetary policy in major

economies, rather than oil shocks.

Figure 9 Change in Consumer Price Index

Source: RBA

Figure 10 shows a strong correlation between oil market events and annual changes in the

automotive fuels price index occurring around 1980, at a time of high crude oil prices and

the move to import parity pricing for crude oil in Australia. They also peaked around the

time of the Kuwait invasion and around 2000 with recovery from historical low oil prices in

the context of the end of the Asian financial crisis and application of targeted OPEC quota

reductions.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Feb

-19

78

Mar

-19

80

Ap

r-1

98

2

May

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84

Jun

-19

86

Jul-

19

88

Au

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0

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Oct

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94

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De

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8

Jan

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Feb

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03

Mar

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r-2

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Jun

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Jul-

20

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Per cent

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10.0

15.0

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-19

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Oct

-19

62

May

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65

De

c-1

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7

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19

70

Feb

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73

Sep

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Ap

r-1

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8

No

v-1

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0

Jun

-19

83

Jan

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86

Au

g-1

98

8

Mar

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91

Oct

-19

93

May

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96

De

c-1

99

8

Jul-

20

01

Feb

-20

04

Sep

-20

06

Ap

r-2

00

9

No

v-2

01

1Per cent



Figure 10 Percentage change in automotive fuels price index

Source: RBA

These observations are discussed in more detail in the body of this report.

3.2 Oil and the Australian economy

Petroleum fuels have been a major component of energy in Australia. The share of total

energy supply (energy units) provided by petroleum in 1974- 75 was 51 per cent. By 2011-

12, this had declined to 39 per cent (Figure 11). The main causes of this decline are

improvements in vehicle fuel economy and substitution of natural gas particularly for

heating.

Figure 11 Primary energy consumption in Australia by fuel source (energy

units)

Source: (BREE, 2013)

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Sep

-197

3

Nov

-197

5

Jan-

1978

Mar

-198

0

May

-198

2

Jul-1

984

Sep

-198

6

Nov

-198

8

Jan-

1991

Mar

-199

3

May

-199

5

Jul-1

997

Sep

-199

9

Nov

-200

1

Jan-

2004

Mar

-200

6

May

-200

8

Jul-2

010

Sep

-201

2

Per cent

0.0

1 000.0

2 000.0

3 000.0

4 000.0

5 000.0

6 000.0

7 000.0

1973

-74

1976

-77

1979

-80

1982

-83

1985

-86

1988

-89

1991

-92

1994

-95

1997

-98

2000

-01

2003

-04

2006

-07

2009

-10

PJ/a Renewables

Gas

Oil

Coal



Australia’s dependence on petroleum fuels is driven by transport demand. In 2011-12,

transport accounted for 74 per cent the consumption of petroleum fuels in Australia (Figure

12).

Figure 12 Consumption of petroleum by end use


The proportion of production of domestic crude oil to net consumption of petroleum fuels

increased from 70 per cent in 1973-74 to 98 per cent in 1983-84. It had declined to 44 per

cent by 2011-12 (Figure 13). The causes of this decline have been ongoing growth in

demand for petroleum fuels and decline in the production of crude oil from existing

producing fields, notably the Gippsland and Cooper basins.

Figure 13 Consumption and domestic production of petroleum fuels in

Australia


The outlook for domestic production of petroleum in the late 1970s was commonly perceived

to be a decline in domestic petroleum production leading to a relatively rapid decline in liquid

fuels self-sufficiency from the relatively high level of around 70 per cent at that time, unless

-

500

1,000

1,500

2,000

2,500

2008-09 2009-10 2010-11 2011-12

PJ/a

Lubricants Oils and solvents

Residential

Commercial services

Transport

Manufacturing andconstruction

Wood, paper and printing

Food, beverages and textiles

0.0

500.0

1000.0

1500.0

2000.0

2500.0

3000.0

1973

-74

1975

-76

1977

-78

1979

-80

1981

-82

1983

-84

1985

-86

1987

-88

1989

-90

1991

-92

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

2007

-08

2009

-10

2011

-12

PJ/a

Indigenous production Consumption



further oil discoveries were made. There are several reasons why this decline did not occur.

First, the rise in oil prices in the 1980s let to further development of petroleum fields in

Gippsland and the Cooper Basins. Second, the development of new production associated

with the North West Shelf project meant that production of domestically produced petroleum

increased to its highest level ever by 2002, before declining again as other fields continued

to decline.

The oil-use-intensity of the Australian economy halved over the period from 1973-74 to

2011-12 from 2.9 PJ per $A billion of GDP to 1.6 PJ per $A billion of GDP (Figure 14).

Figure 14 Oil intensity of the Australian economy (PJ/$billion GDP)

Source: Australian Energy Statistics (BREE, 2013)

3.3 Petroleum market arrangements

3.3.1 General background

The market and policy environment applying in the petroleum industry has evolved

significantly over the forty years from 1974 to 2014. These changes have important

implications for the way in which the Australian petroleum supply chain responds to

interruptions in global supply chains.

The lead up to the 1970s saw the development of a number of small onshore fields in

Australia. The most significant of these were the onshore fields in the Cooper Basin in

South Australia. More important were the offshore fields in the Gippsland Basin in Bass

Strait. By the end of the 1960s there were several oil fields in production: Moonie in

Queensland, Barrow Island in Western Australia and Barracuda, Halibut and Kingfish in the

Gippsland Basin.

The producing fields and refineries operating in Australia during the 1970s were significantly

different to those that apply in 2014. While Australia had seen some small oil field

developments in Queensland and Western Australia two significant oil and gas fields had

been brought on stream in the late 1960s. The Cooper Basin oil and gas project in South

Australia and the larger oil and gas field in the Gippsland Basin commenced in 1963. These

developments resulted in a significant increase in production of crude oil (and gas) in

Australia.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1973

-74

1975

-76

1977

-78

1979

-80

1981

-82

1983

-84

1985

-86

1987

-88

1989

-90

1991

-92

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

2007

-08

2009

-10

2011

-12

PJ/$billion



At that time there were eight refineries operating in Australia, drawing in part on the

increasing production of indigenous crude oil. The refineries were in the following locations:

Queensland – BP at Bulwer Island Brisbane

Queensland – Caltex at Lytton Brisbane

New South Wales at Shell at Clyde

New South Wales at Caltex at Kurnell

Victoria – Mobil at Altona Melbourne

Victoria - Shell at Geelong

South Australia – Mobil at Port Stanvac

Western Australia – BP at Kwinana

In 2003 Mobil announced suspension of operations at the Port Stanvac refinery in South

Australia placing it in a maintenance mode. The company announced the permanent

closure of the refinery in 2009.

Further closures of refineries were announced after that date. Shell closed its refinery at

Clyde in Sydney in November 2013 and Caltex will close its refinery at Kurnell also in

Sydney in June 2014.

On 4 April 2014 BP announced its intention to close its refinery at Bulwer Island in Brisbane.

In parallel with these developments, there has been an increased involvement by non-major

oil companies in import terminals in Australia. Trafigura acquired terminal and downstream

operations of Neumann Petroleum and Gull Petroleum. These companies operate import

terminals in Queensland and Western Australia, respectively. Trafigura is planning a new

import terminal in Mackay. Stolthaven acquired Marstel Terminals Pty Ltd and has

commenced a major investment in a new import terminal at Newcastle. ANZ Terminals has

commissioned a new import terminal at Port Adelaide.

In late 2013, BP Australia made arrangements to sell its downstream assets in South

Australia to Peregrine Fuels and Shell sold its Geelong refinery and downstream assets to

Vitoils.

The downstream petroleum market is undergoing significant restructuring of ownership at

the time of writing.

3.3.2 Regulation and taxation of petroleum

Fuel was first taxed in Australia in 1901, when a customs duty was applied as a revenue

measure to certain imported petroleum products.1 Excise duty was not imposed at this time

as oil was not refined domestically in Australia until 1928. In 1929, when domestic refineries

were established and locally produced petroleum products entered the market,2 the

government of the day introduced excise duty on petrol3. This was extended in 1957, when

excise duty on diesel was introduced to ensure that operators of diesel vehicles contributed

to the maintenance of roads. A history of fuel taxation is provided at Appendix A.

1 These products were kerosene, naphtha, benzene, benzoline and gasoline. Kerosene was generally used for lighting at that time, while the other products were used mainly as industrial solvents.

2 At the time Australia had eight main refineries owned by the four major oil companies (Caltex, BP, Mobil and Shell). These major refineries had a total capacity of around 860,000 barrels per day There were also a number of mini refineries located around Australia.

3 Referred to as motor spirit, or as gasoline in relevant Customs and Excise legislation.



As discussed below, excise duty was also levied on production of crude oil and LPG from

Australian fields. The incidence of excises on petroleum products and on indigenous

petroleum production is important to consideration of the price of petroleum products,

returns to production, and price signals to consumers and producers.

3.3.3 1970 to 1980

Commonwealth Government involvement in the pricing and allocation of domestically

produced crude oil began in 1965. Its purpose was to encourage Australian refiners to take

expensive crude oil from the Moonie oil field in Queensland. The government set the price

of crude oil produced from Moonie above import parity and required the refiners to absorb

the Moonie production under a crude oil allocation scheme.

With the availability of much larger production from the newly commissioned fields in Bass

Strait, the price of domestically produced crude oil was set in 1970 at 1968 import parity

prices for a period of five years.

With the rise in world crude oil prices in 1973, this regulated price became very attractive to

refiners. By 1975, the regulated domestic price was about one quarter of the import parity

price. Accordingly, in 1975, the government of the day introduced a levy in the form of an

excise duty of $2 per barrel on domestic production, but this did not lift the price to refiners

to full import parity as the world price rose beyond US$10 per barrel. While the regulated

price of crude oil was attractive to refiners, it was also recognised that it acted as a

disincentive to further exploration and development of crude oil in Australia. In response,

the Government announced a policy for new oil, under which oil discovered after September

1975 would receive import parity price less the $2 per barrel levy. The levy on new oil was

abolished in 1976.

The net effect of this was two prices for crude oil produced from Australian fields. By 1977,

old oil was priced around $2.33 per barrel, while new oil was receiving around $11 per

barrel. The price of petroleum products were at a level lower than import parity with

imported products.

A review of these arrangements by the Industries Assistance Commission (1976) drew

attention to problems with these arrangements including:

encouraging too much consumption of a scarce resource

discouraging investment in further development of fields discovered before September

1975

delaying the development of substitutes

creating inefficiencies in the marketing of crude oil to refineries because of

inconsistencies in the application of the crude oil allocation scheme to end products.

In 1977, the Government announced a phased introduction of import parity pricing. Under

these arrangements:

fields producing less than 6 million barrels per day received full import parity prices

for larger fields, producers received full import parity prices for production up to 6 million

barrels per day or a specified proportion of production, whichever was the greater, but

paid a $3 per barrel levy.

remaining production (controlled oil) from larger fields received the controlled price which

was $2.33 per barrel at the time, while refiners paid $5.33 per barrel for this oil, including

$3 per barrel crude oil excise.



By 1978 therefore, the average price of domestically produced crude oil was significantly

lower than the import parity price applying at the time. This dampened the impact of rising

global oil prices on prices for petroleum products in Australia. The impact of this is

discussed in more detail at the end of this section.

The 1978 Federal Budget introduced full import parity pricing for crude oil produced in

Australia. Refiners paid full import parity price for domestically produced oil, while

producers still received the prices set out in the 1977 policy. The difference was collected

by the Government through the crude oil levy.

Box 1 Import parity pricing (IPP)

Import parity pricing of crude oil means that the price paid for domestic crude produced in Australia is set at a level equivalent to the price of an equivalent imported crude oil (allowing for quality differentials). Prior to 1978 the price paid by domestic refineries for crude oil produced in Australia was controlled by regulation. Initially the price was higher than IPP but as the price rose above US$3 per barrel the IPP exceeded the regulated price for domestic crude.

Australia introduced import parity pricing for domestically produced crude oil in 1978

Source: (Treasury, 2001)

The world price for crude oil rose significantly after these arrangements were introduced. In

response, the arrangements for pricing of old oil were further amended in 1979 for the

pricing of the parity component of old oil. Under these arrangements:

large fields (production in excess of 15 million barrels per year) received $9.59 per barrel

indexed to the CPI

intermediate fields (production between 2 million barrels and 15 million barrels per year)

received $10.66 per barrel indexed to 25 per cent of the import parity price increase

small fields (production less than 2 million barrels) received import parity less the $3 per

barrel levy.

For the remaining production from intermediate and large fields (controlled production),

producers received a much lower price for old oil: $ 2.71 per barrel in 1979.

By the end of the 1970s, prices of crude oil reflected import parity prices. However

producers received less than import parity pricing for old oil depending on production levels.

This was the only oil produced in Australia at that time.

Therefore, prices of petroleum products reflected import parity pricing levels (inclusive of

crude oil excise duty), plus fuel excise and customs duties, which by that time applied to

petrol, diesel, jet fuel and fuel oil.

3.3.4 1980 to 1990

The arrangements for crude oil pricing and taxation established in 1979 continued through

to 1983. By 1983, producers were still receiving a lower price for production of controlled

oil, although it had risen to $2.70 per barrel by 1983.

In 1984, the government of the day announced that new oil would also be taxed, albeit at a

lower rate than old oil. The government also announced its intention that that all new

offshore petroleum projects that had not reached the development stage by 1983 would be

subject to a Petroleum Resource Rent Tax (PRRT).

The PRRT was enacted on 15 January 1988. At that time, PRRT applied to all offshore

areas except Bass Strait and the North West Shelf. In addition, the legislation applied



retrospectively to exploration permits awarded on or after 1 July 1984, and recognised

expenditures incurred on or after 1 July 1979.

The PRRT was extended to the Gippsland fields in Bass Strait in 1990. After 1990

therefore, petroleum whether produced domestically or imported was priced at import parity

levels. Production taxes applying in Australia included:

a resource rent tax applying to all offshore fields under the jurisdiction of the

Commonwealth except the North West Shelf project

traditional gross value and volume-based resource taxation arrangements — royalties

and excise — applied onshore, in coastal waters, and to the North West Shelf project

area in Australia. There was an exemption on the crude oil excise for the first 30 million

barrels of production in new offshore projects where royalties and excise applied.

The introduction of these arrangements meant that crude oil and LPG produced in Australia

was priced at import parity levels, and by inference, all petroleum products were priced at

import parity prior to the addition of the fuel excise.

In 1980, the fuel excise on ethanol was removed. Six-monthly CPI indexation of other fuel

excise rates was introduced in 1983.

3.3.5 1990 to present day

Taxation of petroleum production remained unchanged until 1 July 2012, when the PRRT

was extended to include all onshore and offshore oil and gas projects, including the North

West Shelf, oil shale projects and coal seam gas projects. Under these arrangements all

liquid petroleum fuels in Australia were subject to PRRT.



4 Markets and Oil Shocks, 1964-2014

Key Points

The term “oil shock” refers to a large shift (disruption) in supply or demand for oil, or the growth of one relative to the other that is generally unanticipated. Oil shocks may occur in crude oil markets or refined product markets. A shock in one will be translated into a shock in the other.

Shocks may take the form of a supply disruption or constraint, a shift in aggregate demand for goods and services generally, or an oil demand or supply shift resulting from changes in expectations. More than one type of shock may occur around the same time. These may exert reinforcing or offsetting influences.

Prices reflect the behaviour of participants in markets. Prices adjust as participants change their behaviour to take advantage of, or to protect themselves from perceived changes in market circumstances. Adjustments continue until markets clear, eliminating potential shortages or surpluses.

The history of oil shocks and evolution of the oil market over the past 50 years (summarised in chapter 2 and discussed in some depth in chapters 5-10) has not provided any evidence to suggest that crude oil and refined product markets would not swiftly ration and reallocate supply efficiently to avoid shortages. However, the short-term responsiveness of quantities demanded or supplied to changes in price (price elasticity of demand and supply) is such that the scale of the price change that is required to clear the market following an unanticipated shock to supply or demand is likely to be proportionately much larger than the change in quantity. So, relatively small changes in quantities lead to relatively large changes in prices of crude oil and refined products in the short-term.

Prices and markets would not be able to perform these functions if government intervened to constrain prices of crude oil inputs to refineries or prices chargeable by refiners or importers for products following a supply-reducing or demand-increasing oil shock. Shortages would arise and persist. Then, scarce supply would have to be rationed by queuing or some administrative device or some combination of the two. Market-determined prices are far superior at rationing supply and allocating resources efficiently, than queuing and administrative allocation. The market system allocates resources to their highest valued uses. Queuing and administrative allocation do not. For example, attempts by the United States Government to control oil and refined product prices following the “first and second oil crises” resulted in queues, chaos, administrative bungles, and misallocation of resources.

Suggestions that speculation in markets for financial oil derivatives drove up the oil price in the 2005-2008 period were found not to be soundly based.

4.1 Types of Oil Shocks

The term “oil shock” refers to a large shift (disruption) in supply or demand for oil, or the

growth of one relative to the other that is generally unanticipated. If a major oil market event

is widely anticipated well in advance, market participants will adjust in advance to

accommodate the anticipated circumstances. The adjustment process will be smooth. In

contrast, if a major event affecting the oil market is largely unanticipated until it is imminent,

the adjustment process will be more traumatic. Prices will move quickly and substantially to

clear the market in the very short-term, inducing changes to quantity demanded and

supplied, with accompanying price moderation as time elapses.

There have been several high profile examples of major oil shocks over the past 40 years.

Historically, combinations of different types of oil shock appear to have been the most

common occurrence. Analysis of the circumstances of these shocks can reveal how

different types of oil shock may combine or act in isolation in some circumstances to

influence prices. Such analysis provides an important foundation for prediction of the effects

of major oil shocks of various types in current economic circumstances.



Most and political media discussion of oil shocks, and until a decade ago, most academic

analysis of the phenomena has related to major disruptions in the crude oil market.

However, the oil shock concept could also be applied to similar phenomena in markets for

refined oil products.

Economic analyses of oil shocks were initiated following a major disruption to the crude oil

market in 1973-74 that was linked to a major international political event, the Yom Kippur

Arab-Israeli war. Interest in the topic increased following further international political and

crude oil market turmoil in 1979-80. These crude oil shocks often were referred to as the

“first and second oil crises”.

Relatively little attention has been given to shocks in the market for refined products.

Moreover, the limited literature available on this topic is recent.

Crude oil shocks appear to have attracted much greater attention than refined oil product

shocks for two reasons. First, since 1973, there have been several high profile political

events with associated with crude oil supply disruptions and/or fears of supply loss, while

distinct refined oil product shocks that could be described as major have been rare. A

notable exception is the substantial impact of Hurricanes Karina and Rita on production of

both crude oil and refined oil products in the Gulf of Mexico and US Gulf coast in late-2005.

Second, the short-term price elasticities of demand and supply of crude oil are extremely

low compared to those for most other goods and services, and also are lower than for

refined products.

4.1.1 Crude Oil Shocks

For about 30 years after the first oil crisis, economic analyses of shocks in the crude oil

market focussed on major supply-side events. There was considerable discussion of the

severe oil shocks of 1973-74 (following an Arab-Israeli war) and 1979-80 (in response to the

Iranian revolution, followed by the Iran-Iraq war). Then, a new analytical focus was provided

by the sharp oil price drop in 1986 (withdrawal of Saudi Arabian support for the oil price).

Later, interest in the economic effects of oil supply shocks was renewed by upward spikes in

oil prices in 1990-91 (following Iraq’s invasion of Kuwait), and in 2002-03 (linked to the

Venezuelan crisis and another Iraq war), although the price movements in 1990-91 and

2002-03 were much smaller than the price spikes associated with the1970s oil shocks.

Over the past decade, and particularly the past six years, there has been considerable new

economic literature on crude oil shocks, and there has been a substantial shift in focus

towards analysis of demand-side shocks, as well as supply shocks. The recent literature

has been concerned with:

distinguishing between types of oil shock and their causes

reconsideration of causes of pre-2004 shocks

analysis of causes of the extraordinary rise in oil prices after 2003 and prior to October

2008, the subsequent oil price slump in late-2008, which continued in 2009, and the

strong oil price revival in 2010 and 2011

concerns about the influence of activity in oil futures markets on spot prices for crude oil

interactions between and unravelling of different types of oil shocks and underlying

causes

differing effects of the various types of oil shock on aggregate economic activity.

Over the past 5 years, various analysts (for example, Kilian, 2008c, 2009a; Baumeister,

Peersman, Van Robays, 2010; Dvir, Rogoff, 2010, 2014; Fattouh, Kilian, Mahadeva, 2013;

Kilian, Murphy, 2014) have explained that crude oil price shocks can be triggered by:



oil supply shocks – disruptions to physical availability of crude oil that move oil quantities

and prices in opposite directions

aggregate demand shocks – changes to global economic activity causing shocks to

demand for crude oil that move oil quantities and prices in the same direction

speculative oil-specific demand shocks – resulting from forward-looking behaviour,

involving buying or selling of oil for precautionary, price hedging, investment or purely

speculative purposes (which may overlap) in response to “expectations shifts” or

changes in perceptions of uncertainty in relation to future supply and demand and

consequent prices, again with quantities and prices moving in the same direction

speculative oil supply shocks – arising from oil producers adjusting production rates and

therefore, the amount and timing of extraction of oil in situ (below-ground inventories) to

capitalise on future price changes, involving movements of quantities and prices in

opposite directions

combined shocks – more than one of the types of shock above exert reinforcing or

offsetting influences on crude oil prices around the same time.

It has been observed that the various forms of shock have different economic effects and

these can vary greatly between economies in accordance with differences in their industrial

structures. Oil supply shocks and speculative supply shocks tend to move economic activity

in the opposite direction to oil prices. Aggregate demand shocks tend to move oil quantities,

oil prices and economic activity in the same direction. Speculative oil-specific demand

shocks tend to shift economic activity in the opposite direction to oil quantities and prices. A

more detailed discussion of economic effects of oil shocks is presented in chapter 11.

Before 2007, oil supply shocks attracted much more attention than demand shocks for five

reasons. First, supply shocks tended to be associated with dramatic, high profile political

and military events, notably conflicts in the Middle East, or other spectacular occurrences,

such as damage to oil production and refining facilities in the Gulf of Mexico caused by

Cyclones Katrina and Rita. Second, aggregate demand shocks have been less dramatic,

affecting prices over time, rather than abruptly. Third, aggregate demand shocks have

sometimes induced or facilitated behaviour causing supply shocks, but this has often been

overlooked, and the consequences of the shocks have been entangled and difficult to

distinguish. Fourth, a dramatic rise in crude oil prices in 2007 and 2008 in the context of

strong demand for commodities from China and other rapidly developing economies

induced analysts to focus attention on the role of global economic growth in driving up oil

prices. Fifth, oil-specific and oil product-specific speculative demand shocks may have been

triggered by supply shocks and aggregate demand shocks, adding to the entanglement of

causes and consequences.

Similarly, speculative demand and supply shocks received little attention until recently. Both

appeared to have been overlooked while attention remained focussed on high profile supply

shocks.

4.1.2 Refined Oil Product Shocks

Lutz Kilian (2010b) has undertaken preliminary work to extend the categorisation of crude oil

shocks above to include shocks to the automotive fuel market. This was exemplified by

reference to oil refinery (refined product supply) shocks. He also suggested that the

concept of speculative oil demand shocks in response to “expectations shifts” could be

extended to oil products, but did not develop this line of analysis. He focussed mainly on

comparison of oil refinery supply shocks and the flow-on of the various types of crude oil

shocks to refined product prices.



Economic modelling by Kilian (2010b) indicated that an unanticipated disruption of U.S. oil

refinery output would cause an immediate and highly statistically-significant increase in the

real price of automotive fuel that would remain statistically significant for three months.

Kilian explained that the modelling results were consistent with the petroleum product price

effects of damage to oil refineries caused by Hurricane Katrina, which hit the United States

Gulf (of Mexico) Coast in late August 2005. This severe weather event and Hurricane Rita

which hit the Gulf Coast a month later caused the largest refined product supply shock in the

world over the past few decades. These weather events also disrupted supply of crude oil,

but release of crude oil from the United States government’s oil stockpile eased the crude oil

shock.

Obviously, a major refined product supply shock would result in considerable uncertainty

regarding its duration and significance. It would also cause changes in perceptions of

uncertainty regarding future shortfalls that could persist even after supply had been restored

to pre-shock levels. It is difficult to assess how much a speculative demand shock arising

from such “‘expectations shifts” would add to the price increase from the short-term oil

product supply shock, and how long the effects on real refined product prices would persist.

Because refined oil product prices rise and fall with crude oil prices, crude oil supply shocks

and precautionary crude oil demand shocks would translate into refined product shocks. In

contrast, aggregate demand shocks affect crude oil prices because demand for crude oil is

derived from demand for refined products.

As for crude oil, more than one shock may apply simultaneously. Again, contemporaneous

shocks may also interact.

Therefore, refined oil product price shocks could derive from:

crude oil supply shocks (pass through of crude oil price changes)

crude oil speculative supply shocks (pass through of crude oil price changes)

aggregate demand shocks (global growth of demand for goods and services generally)

speculative crude oil demand shocks (pass through of crude oil price increases)

speculative refined oil product demand shocks

refined product supply shocks

combined shocks.

4.2 Oil Market Responses to Shocks

4.2.1 Roles of Oil Markets and Prices

Prices reflect the behaviour of participants in markets. Prices adjust as participants change

their behaviour to take advantage of, or to protect themselves from perceived changes in

market circumstances. Adjustments continue until markets clear, eliminating potential

shortages or surpluses.

A large scale, unanticipated interruption of supply of crude oil and refined oil products would

create fear of shortages. This fear would induce market responses. The responses would

be global in scope, because crude oil and refined products are traded in highly integrated

global markets.

A major interruption of supply from some source would induce those obtaining crude oil or

refined products from that supply source to seek to purchase supplies elsewhere. In the

absence of excess capacity large enough to cover the shortfall, the purchasers seeking

supply from alternative sources would bid up prices in competition with those already



supplied from those sources. Sellers would require higher prices for their scarcer supply.

So, prices would be bid up in integrated international markets. Higher prices would reduce

quantities demanded, effectively rationing available supply. Higher prices would also call

forth supply of additional quantities from higher cost spare capacity. Quantities of crude oil

and refined products made available in these ways would be reallocated to those prepared

to pay higher prices.

If fears of shortages were caused by a major demand surge or increase in demand growth

that is not widely anticipated, the responses of market participants would again raise prices.

Higher prices would ration existing supply, call forth some additional supply, and reallocate

existing and new supply in accordance with willingness to pay.

If precautionary or speculative buying occurred in anticipation of further price increases, the

additional demand would lift prices. This would ration supply more strictly, increase the

inducement to produce additional quantities, and further reallocate supply.

Consistent with this qualitative analysis, the history of oil shocks over the past 40 years has

not provided any evidence to suggest that crude oil and refined product markets would not

swiftly ration and reallocate supply efficiently to avoid shortages. However, the

characteristics of these markets are such that the scale of the price change that is required

to clear the market following an unanticipated shock to supply or demand is likely to be

proportionately much larger than the change in quantity, as discussed in the next sub-

section.

Prices and markets would not be able to perform these functions if government intervened

to constrain prices of crude oil inputs to refineries or prices chargeable by refiners or

importers for products following a supply-reducing or demand-increasing oil shock.

Shortages would arise and persist. Then, scarce supply would have to be rationed by

queuing or some administrative device or some combination of the two. These

circumstances occurred in the United States following the “first and second oil crises”.

Market-determined prices are far superior at rationing supply and allocating resources

efficiently, than queuing and administrative allocation. The market system allocates

resources to their highest valued uses. Queuing and administrative allocation do not.

These devices do not provide incentives to producers to increase quantity supplied and

consumers to reduced quantity demanded to clear the market. Queuing is biased towards

users with lower time values. Administrative allocation is inefficient because the information

requirements for efficient centralised allocation are extremely demanding and arbitrariness

is inevitable.

4.2.2 Price Elasticity of Demand and Supply

Crude Oil

In the economics literature, responsiveness of quantity demanded to price changes is

measured by price elasticity of demand, which is defined as the percentage change in

quantity demanded divided by the percentage change in price (a negative number).

Responsiveness of quantity supplied to price changes is measured by price elasticity of

supply, which is calculated as the percentage change in quantity supplied divided by the

proportionate percentage in price (normally a positive number).

In the crude oil market, price elasticities of demand and supply are very low relative to

corresponding figures for most other goods and services. This has important implications

for the magnitude of oil price changes in response to supply and demand shocks. These

implications can be illustrated by simple mathematics.



A hypothetical supply shock removing (or adding) Ss per cent of global crude oil production

would require a percentage increase (or reduction) in price of ∆ to clear the market,

eliminating a potential shortage or surplus caused by the supply shock at the price applying

before the shock. This market-clearing process would be accomplished by a combination of

a percentage change in quantity demanded of ∆ x Ed and a percentage change in quantity

supplied of ∆ x Es, where Ed and Es represent short-term price elasticity of demand and

short-term price elasticity of supply, respectively. This can be expressed in mathematical

terms: (∆ x Ed) – (∆ x Es) = Ss. Therefore, the percentage change in price is represented

by the supply shock divided by the difference between the price elasticity of demand and the

price elasticity of supply. This can be expressed in mathematical terms: ∆ = Ss/(Ed – Es).

If the supply shock, Ss, is a reduction of 5 per cent (–5 per cent) when Ed is –0.05 and Es is

+0.05, the percentage in price, ∆, is an increase of 50 per cent. Conversely, a supply

increase of 5 per cent, with the same values of Ed and Es leads to a reduction in price of 50

per cent. Smith (2009a, p. 155) observed that values of –0.05 and +0.05 for short-term

price elasticities of demand and supply for crude oil, respectively, were indicative of

estimates in the economics literature on the crude oil market.

Revising the calculation with the values of Ed and Es suggested by Kilian and Murphy

(2014, 2012), –0.26 and 0.01, respectively, indicates a 5 per cent reduction in supply would

cause a price increase of 19.2 per cent in the short-term. Using median values of Ed and

Es for the last few years of around –0.15 and 0.01, respectively, as estimated by

Baumeister and Peersman (2013b), a reduction in supply of 5 per cent would cause a price

increase of more than 31 per cent in the short-term.

Using similar reasoning, a hypothetical demand shock of Ds per cent of global oil

consumption would require a price change of ∆ per cent to clear the market. The shock

would be eliminated by a change in quantity supplied of (∆ x Es) per cent and a change in

quantity demanded of (∆ x Ed) per cent. In mathematical terms, Ds = (∆ x Es) – (∆ x Ed)

and ∆ = Ds/(Es – Ed). Assuming a positive demand shock of 2 per cent in global oil

consumption, and inserting the values of Ed and Es suggested by Baumeister and

Peersman (2013b), the resulting price change would be an increase of around 12.5 per

cent.

Price elasticities of demand and supply for goods and services in general (including oil and

refined oil products) tend to rise (ignoring the negative sign of price elasticity of demand)

with elapsed time after a price or quantity change as adjustment opportunities become

increasingly accessible by economic entities. In other words, demand and supply become

more price-elastic.

With sufficient time, entities could change consumption, production, exploration, investment,

research and development activities to reduce fuel-use, increase recovery from petroleum

reservoirs, expand exploration programs, and develop and deploy new technologies and

techniques.

Demand for crude oil derives from demand for refined oil products (principally for transport

use). If demand for products rises, derived demand for crude oil rises. Then, in the

absence of offsetting increases in supply, product and crude oil prices rise too. If the supply

of crude oil is cut, prices of crude oil and products rise, in the absence of an offsetting

reduction in demand.

In response to a large fuel price increase, car users might switch to public transport for trips

to and from work and/or reduce discretionary driving in the very short-term. Because car

users are heterogeneous, some individuals will respond sooner and to a greater extent than



others. However, the longer higher fuel prices persist, the greater such responses would be

in aggregate.

With more lapsed time, individuals and businesses might switch to vehicles with lower fuel

consumption in response to substantially higher fuel prices, when vehicles are scheduled for

replacement or perhaps sooner if private benefits are perceived to outweigh private costs.

Vehicle owners may even seek information and participate (or require drivers of their

vehicles to participate) in educational programmes showing how fuel can be saved by

modifying driving and maintenance practices. Manufacturers might increase emphasis on

improving fuel economy in planning for their new models. They may accelerate research

and development activities focused on lowering fuel consumption through improvements to

internal combustion engines, transmissions, tyres and vehicle mass without compromising

safety. In addition, manufacturers may accelerate research and development activities in

respect of petrol-electric and diesel-electric hybrids, electric vehicles, and hydrogen fuelled

vehicles. Indeed, all of these behavioural changes have occurred over the past 7 years as a

result of the 2003-2008 price surge and persistence of high prices over the past 3 years.

In both the short-term and long-term, price elasticity of demand for refined oil products is low

compared to price elasticity of demand for other goods and services in the same time-frame.

This has resulted from the relatively high costs associated with switching to alternatives.

Price elasticity of demand for products ex-refinery is higher (ignoring the negative sign) than

for crude oil, because the crude oil price accounts for only part of the ex-refinery price of

refined products. Price elasticity of demand for products is higher again at the point of use

because of taxes and distribution and retailing costs and margins.

On the supply side, crude oil production can be increased in the short-term in response to a

large price increase only if there is excess production capacity and no effective constraints

on utilisation of that excess capacity. Such constraints have been applied in Saudi Arabia,

the largest producing country (more than 10 per cent of global oil production) for lengthy

periods during the past 40 years (Nakov, Nuño, 2013). Meanwhile, crude oil producers

elsewhere have operated close to capacity.

It takes time and investment to activate spare crude oil production capacity and much more

time to increase capacity. With time, various investments can be made to increase the

production rate and extent of recovery of oil from producing reservoirs. With more time,

other known deposits, which were previously sub-marginal, but economic at higher prices,

can be brought into production. In longer time-frames, new deposits can be discovered,

assessed, and developed, but this could take a decade or more because of various lags in

the investment process, even if increased exploration activity yields relatively early, positive

outcomes. Of course, exploration may not produce positive results relatively quickly,

because better-than-marginal deposits are scarce and the degree of scarcity increases with

the economic surpluses they can yield.

Marian Radetski and others (2008) identified various time-consuming activities that delay

new production from deposits:

perception of trends and opportunities and then making decisions to respond

planning and undertaking exploration programmes

assessment and investment decision processes

planning and design activities

government regulatory processes

arrangement of funding

construction and commissioning of projects.



For reasons outlined above, the long-term can be a long time coming, and long-term price

elasticity of supply can be expected to be very low. However, price elasticity of supply is still

substantially higher in the long-term than in the short-term.

Extremely low price elasticities of demand (ignoring the sign) and supply in the short-term,

and elasticities that are still very low relative to most other goods and services in the long-

term are important explanatory factors for pronounced price effects of oil shocks that seem

much larger than the shock to supply or demand in percentage terms.

Refined Oil Products

The phenomena of very low price elasticity of demand for refined petroleum products in the

short-term, rising elasticity with the elapse of time, and relatively low elasticity in the long-

term compared to most other goods and services have been described above. It has also

been explained that these elasticities are greater at the point of use than ex-refinery, and

the price elasticity of demand for crude is even lower.

Price elasticity of supply for refined products in the short-term depends on the availability of

spare production capacity. This in turn depends on the level of global economic activity, the

short-term availability of suitable crude oil feedstock, the timing of scheduled maintenance,

re-scheduling flexibility, occurrences of unscheduled downtime, and inventories.

As time passes, capacity of existing refineries may be expanded and new refineries built, so

that price elasticity of supply rises over time. However, the rate of increase of supply

elasticity over time is limited by various lags related to perception of opportunities, design,

planning, investment decisions, regulatory requirements, funding, construction, and

commissioning issues. It is notable that construction of new refineries in advanced

economies has been severely impeded by regulatory processes in some cases.

Low price elasticities of demand (ignoring the sign) and supply in the short-term are

important explanatory factors for pronounced short-term price effects of refined oil product

shocks that are much larger in relative terms than the shock to supply or demand. For

example, a supply shock of a 5 per cent reduction in global supply of refined products would

translate into a market clearing price increase of 25 per cent, based on the formula derived

in the previous sub-section, and assumptions of a short-term price elasticity of demand of –

0.1 and a short-term price elasticity of supply of 0.1.

The short-term price effects of refined product shocks could be expected to be smaller in

percentage terms than for equivalent crude oil shocks, because price elasticity of demand

would be higher (ignoring the negative sign) than for crude oil as explained above, and price

elasticity of supply typically would not be any less than for crude oil.

In the long-term, price elasticity of demand and price elasticity of supply could be expected

to be higher for refined oil products than for crude oil. The former would apply because of

the gap between prices of crude oil and refined product prices. The latter would result from

the scarcity of above-marginal deposits that tends to increase with the size of the economic

surpluses they can yield.

4.2.3 Estimates of Price Elasticity of Demand and Supply

An oil shock – a large shift in supply or demand for oil, or the growth of one relative to the

other that is generally unanticipated – is typically a short-term phenomenon. Therefore,

estimates of short-term price elasticity of demand and supply are more relevant than

estimates of long-term elasticities.



Crude Oil

Short-Term Price Elasticity of Demand – Crude Oil

An econometric study by Christiane Baumeister and Gert Peersman (2013b) found that

there has been a substantial decrease in short-term price elasticities of demand (ignoring

the negative sign) for crude oil since the mid-1980s. That is, short-term price elasticity of

demand has become more inelastic. Their analysis indicated that short-term price elasticity

of demand declined (ignoring the sign) from about –0.6 in the late1970s and early-1980s to

around –0.15 during the period 2005-2010. The decline was particularly strong between the

mid-1980s and early-1990s.

Joyce Dargay and Dermot Gately (2010) estimated long-run price elasticities of demand for

crude oil (and product categories) using data for the period 1970 to 2008. They found that

elasticities for the 1971-1989 period were about 4.33 times those for the 1989-2008 period.

This is consistent with the trend for short-term elasticities documented by Baumeister and

Peersman (2013b).

Noureddine Krichene (2002) estimated short-term price elasticity of demand for crude oil

using a simultaneous equation model of world crude oil and gas demand and supply. For

the period, 1973-1999, his estimate was –0.02, compared to –0.06 in the 1918-1973 period.

John Cooper (2003) estimated short-run and long-run price elasticities of demand for crude

oil for 23 countries. His estimates were based on data for the period 1979-2000. Estimated

elasticities for France and the United States were at the top of the range. Short- and long-

run elasticities of –0.069 and –0.568, respectively, were estimated for France. For the

United States, the corresponding figures were –0.061 and –0.453, respectively. Australia

was towards (but not at) the bottom of the range with short- and long-run elasticities price

elasticities of demand of –0.034 and –0.068, respectively. Cooper’s estimates suggest an

overall global short-run price elasticity of demand for crude oil that is one-third of the

estimate provided by Baumeister and Peersman (2013b) for the past few years.

James Smith (2009a) observed that a value –0.05 for short-term price elasticity of demand

for crude oil and a figure of 0.05 for short-term price elasticity of supply were indicative of

estimates in the economics literature on the crude oil market. Smith’s indicative figure for

short-term price elasticity of demand for crude oil is consistent with Cooper’s estimates. His

indicative value for short-term price elasticity of supply is more than double the estimates

provided by Kilian and Murphy (2014), and for the last 5 years by Baumeister and Peersman

(2013b).

Kilian and Murphy (2014) provided a much higher estimate of short-run price elasticity of

demand for crude oil than other econometric analysts. Their estimate was –0.44. By way of

comparison, Baumeister and Peersman (2013b) arrived at a 1974-2010 sample average of

their median estimates of –0.26. “One reason” that Kilian and Murphy nominated for the

difference between their estimate and those made by others was “that standard econometric

estimates of the crude oil demand elasticity fail to account for the endogeneity of the price of

crude oil.” They did not elaborate.

Baumeister and Peersman (2013b) pointed out that the model used by Kilian and Murphy

assumed a stable relationship between prices and quantities demanded over the entire

post-1973 period. This assumption does not appear to be reasonable. Relaxation of this

assumption could be expected to lower the short-term price elasticity of demand for crude oil

provided by Kilian and Murphy (2014).

On the other hand, Kilian and Murphy (2014) pointed out that their estimate and the lower

estimates of others did not allow for the behaviour of crude oil users in respect of depletion



or accumulation of inventories. They argued that it was more useful for policy purposes to

produce estimates of price elasticity of demand that incorporated inventory responses.

They observed that such an elasticity estimate had not previously been estimated or even

discussed elsewhere in the relevant economic literature. Kilian and Murphy described it as

a “price elasticity of demand in use”, and referred to the conventional concept as “price

elasticity of demand in production”. They provided an estimate of –0.26 for the short-term

price elasticity of demand for crude oil in use.

Kilian and Murphy (2014) argued that this estimate suggested that even the inclusion of

inventories does not overturn their finding that the short-run price elasticity of oil demand is

much higher than previously thought. Of course, if the price elasticity of demand estimates

of others were adjusted to take account of inventories to produce “in-use” estimates, they

would be lower than presented above.

Short-Term Price Elasticity of Supply – Crude Oil

Kilian and Murphy (2014) argued that there is a consensus in the relevant economic

literature that short-run elasticity of supply for crude oil is close to zero, if not effectively

zero. It appears that they were referring to the very short-term. They pointed out that, even

if there is spare capacity, the response of oil supply to price signals within a month would be

negligible because of effort and costs required to activate that spare capacity. Kilian and

Murphy did not estimate short-run elasticity of supply for crude oil, but in their modelling,

they imposed an upper bound of 0.025 on this price elasticity.

Jochen Güntner (2014) estimated short-run elasticity of supply for crude oil for 20 producing

countries, rather than on a global basis like Baumeister and Peersman (2013b). He

provided estimates in the context of aggregate demand shocks, and separately in the

context of speculative demand shocks. The estimates related to a response period of one

month. In addition, Güntner’s modelling indicated supply responses to separate aggregate

demand and speculative oil-specific demand shocks over periods of up to 2 years. For each

case, he assumed the short-term elasticity of demand in use to be –0.26, as estimated by

Kilian and Murphy (2014).

In some cases, Güntner estimated that short-term price elasticities of supply were negative.

This means that quantity supplied by some countries falls in the short-term if price rises. For

example, an estimate of –0.05 for short-term price elasticity of supply means that a 10 per

cent increase in price results in a 0.5 per cent reduction in quantity suppled. In contrast, a

price increase normally would be expected to induce some increase in quantity supplied.

Some key points from Güntner’s analysis follow.

Estimates of price elasticities of supply within a response period of one month for

individual producing countries typically are statistically indistinguishable from zero at

conventional significance levels, meaning that most individual oil producing countries do

not respond to demand-induced oil price changes within a month.

The precision of estimates for individual producing countries varied greatly. Countries

for which estimates were relatively imprecise tended to be those in which production had

been affected by international conflict, internal political upheaval or natural disasters. In

those cases, fluctuations in oil production were largely idiosyncratic.

For aggregate demand shocks, estimates of price elasticity of supply within a response

period of one month are negative for 6 of 12 individual OPEC countries analysed and for

OPEC countries as a group, but almost indistinguishable from zero at –0.0004 for the

group. Estimates are also negative for 6 of 8 non-OPEC countries, but positive for non-

OPEC countries as a whole.



For speculative oil-specific demand shocks, estimates of price elasticities of supply

within a response period of one month are negative for 7 of 12 individual OPEC

countries analysed and for OPEC countries as a group. Estimates are more strongly

negative for individual OPEC countries and the group (–0.0310), than for aggregate

demand shocks. In contrast, 7 of 8 non-OPEC countries and the group (0.448,

statistically significant at the 5 per cent level) had positive price elasticities of supply.

For Saudi Arabia, which accounts for about 10-13 per cent of global production and 20-

25 per cent of the world’s proven reserves, price elasticity of supply (one month

response period) was estimated to be 0.013 for aggregate demand shocks and –0.2648

(and statistically significant at the 10 per cent level) for speculative oil-specific demand

shocks.

Over a period of 2 years, aggregate demand shocks tend to lead to a slight expansion of

total non-OPEC production. Meanwhile, the response of total OPEC production is

“hump-shaped” – initially negative, then rising to a peak after about 8 months, becoming

negative after around 12 months, and staying negative at least out to month 24.

However, the majority of OPEC countries broadly maintain production steady, while

Saudi Arabia and United Arab Emirates increase supply for up to 24 and 15 months,

respectively.

Over 24 months from a speculative demand shock, total OPEC production, including the

largest producer, Saudi Arabia, displays a statistically significant reduction. In contrast,

total non-OPEC production experiences a statistically significant expansion.

Güntner suggested that the behaviour of Saudi Arabia, and to a lesser degree, the United

Arab Emirates, in response to an aggregate demand shock may indicate a price stabilising

motive or the flexibility provided by spare capacity. Güntner also observed that a dominant

producer like Saudi Arabia had an incentive to curtail production in response to an increase

in speculative demand to restrict the build-up of inventories generally associated with that

form of demand shock. This would help avoid future excess supply.

In an earlier study of the oil market during periods from 1918 to 1973 and 1973 to 1999,

Noureddine Krichene (2002) estimated short- and long-run price elasticities of supply for

crude oil. His estimates of short-term price elasticities of supply were –0.08 and –0.07,

respectively. These estimates suggest that a 10 per cent increase in price would have led

to reductions in quantity supplied of 0.8 per cent and 0.7 per cent in the earlier and later

periods, respectively.

It is easy to understand how short-term price elasticity of supply could be a small positive

number or zero. In the short-run, quantity supplied by each producer is limited by existing

capacity. A price or quantity change may induce a change in quantity or price, respectively,

with a significant lag. Production may be limited by existing sales contracts. Producers may

eschew production adjustments until the price trend is perceived to be persistent. They may

refrain from increasing production in response to a price rise to preserve the higher price,

recognising that short-term price elasticity of demand is very low. Quantities supplied by

OPEC oil producers may be limited by production quotas, but that would depend on quotas

being honoured (Krichene, 2002).

Explanations of production falling (rising) in response to a price increase (fall) are not as

obvious. Krichene (2002) did not clearly address the issue of a rationale for such an

occurrence. However, one possible rationale is that production might be cut to take

advantage of an anticipated price increase. Indeed, a dominant producer might cut

production to help realise a price increase. It appears that Saudi Arabia exhibited such

behaviour during the “first and second oil crises” and in 2005-2007.



Baumeister and Peersman (2013b) found that there has been a substantial decrease in

global short-term price elasticity of and supply for crude oil since the mid-1980s. The trend

to more inelastic supply was particularly marked between the mid-1980s and early-1990s.

This paralleled a similar phenomenon highlighted by Baumeister and Peersman in respect

of short-term price elasticity of demand in the same time-frames. Short-term price elasticity

of supply was estimated to have fallen from about 0.4 in the mid-1980s to about 0.01 in

2010 in the context of aggregate demand shocks and, and from about 0.5 to around 0.17 in

the same time period, in the context of speculative oil-specific demand shocks.

Reasons for Declining Short-Term Crude Oil Price Elasticities

There are various reasons for reductions in short-term price elasticities for crude oil since

the mid-1980s, particularly in the period to 1991. A non-exhaustive range of reasons has

been articulated by Baumeister and Peersman (2013b). These reasons have been

summarised below.

First, from the early-1980s, there was a major structural transformation of the oil market. An

administered oil price regime involving long-term contracts with pre-determined posted oil

prices transitioned to a spot trading system (Hubbard, 1986). The perceived greater

volatility of spot prices, encouraged development of oil derivatives or futures and markets in

which to trade them. These instruments provided hedging mechanisms for producers and

users of crude oil. A result was reduction of responsiveness of hedged entities in both

groups to spot oil price changes, meaning lower price elasticity of demand and supply. This

increased oil price volatility, encouraging further development of markets for oil derivatives.

The quarterly trading volume of oil futures rose quickly from 1983 and plateaued in 1990,

when price elasticity of demand dropped to its lowest level. Volumes rose gradually from

the late-1990s and surged from 2005.

Second, the oil shocks of the 1970s (first and second oil crises) encouraged oil conservation

activities, and switching to alternatives to oil. However, responses were lagged. These

responses would have resulted in reduced price elasticity of demand for crude oil from the

early-1980s.

Third, the speculative demand component of total crude oil demand tends to increase as

capacity utilisation rates increase from already high levels. This makes total crude oil

demand even more price inelastic.

Fourth, declining price elasticity of demand reduces incentives for dominant reserve-owning

countries to increase capacity. Indeed it appears that for more than 25 years, some OPEC

members may have deliberately limited growth of production capacity in the context of

substantial reserves for the purpose of maintaining high prices, as Radetzki (2008), Smith

(2009a,b) Hamilton (2009a, b), Dvir and Rogoff (2010), and Kaufmann (2011) have argued.

This has been facilitated by wars, internal strife and governments’ short-term budget

requirements in other OPEC countries. The capacity restraint has reduced short-term price

elasticity of supply. Resulting increases in price volatility may have increased uncertainty

regarding returns to exploration and development investment, discouraging investment

elsewhere and exacerbating low short-term price elasticity of supply.

Long-Term Price Elasticity of Supply of Crude Oil

Krichene (2002) estimated that long-term price elasticity of supply of crude oil had fallen

substantially from 1.1 in the 1918-1973 period to 0.1 in the 1973-1999 period. He argued

that this was explained by a change from a competitive market structure to a one involving a

cartel (OPEC). He described the latter as a “market-maker” structure.



This is consistent with evidence that OPEC members may have deliberately or inadvertently

limited growth of production capacity for more than 25 years in the context of substantial

reserves, with the result that prices have been supported at higher levels than otherwise.

Such constraint would reduce price elasticity of supply in the long-term, as well as the short-

term.

Refined Oil Products

Price Elasticity of Demand - Products

There are many widely-cited estimates of short- and long-term price elasticity of demand for

automotive fuel for various OECD countries.4 Invariably, estimated long-term price

elasticities have been substantially higher (ignoring the negative sign) than short-term price

elasticities, consistent with expanding opportunities to adjust fuel-use that become available

as time elapses.

Dargay and Gately (2012) found that long-term price elasticity of demand for oil products

used in transport was very much lower (ignoring the negative sign) than for oil products

used for other purposes. The significance of this finding is indicated by the proportions of

refined products used for transport and other purposes. In OECD countries, transport

products account for around 58 per cent of all oil products. The transport percentage is not

as high in other countries as a group.

Carol Dahl (2012) reviewed hundreds of studies relating to price elasticities of demand (and

income elasticities) for petrol and diesel in about 65 countries. She found that the range of

price elasticities of demand for diesel tended to be slightly higher (ignoring the sign) than

those for petrol, although the median elasticity estimate for petrol was about double that for

diesel.

Consistent with Dahl’s findings regarding differences between estimates of elasticities for

petrol and diesel, the Australian Bureau of Infrastructure Transport and Regional Economics

(2008) suggested that price elasticity of demand for diesel fuel in trucks was less in the long-

term than for petrol and diesel in light vehicles. In contrast, Matthew Chesnes (2009)

indicated that price elasticity of demand for diesel could be double or more (ignoring the

negative sign) the price elasticity of demand for petrol.

Among OECD countries, estimates of price elasticity of demand for transport fuel tend to be

considerably lower for Australia, Canada and the United States than for European countries

(Breunig, Gisz, 2009; Brons, Nijkamp, Pels, Rietveld, 2008; Graham, Glaister, 2002; Espey,

1998).

Dargay and Gately (2010) have estimated that long-term price elasticities of demand are

much lower in non-OECD countries that are growing relatively quickly, than in OECD

countries overall. Dahl’s (2012) wide-ranging review of price elasticities of demand for

petrol and diesel confirmed that long-term elasticities were lower for rapidly developing

economies than OECD countries, but Dahl’s results indicated the difference was not large.

Unfortunately, Dargay and Gately (2010), and Dahl (2012) did not investigate short-term

elasticities.

An oil shock – a large shift in supply or demand for oil, or the growth of one relative to the

other that is generally unanticipated – would affect product prices globally. Therefore, it is

4 For example, see Espey (1998), Graham and Glaister (2002), Hughes, Knittel and Sperling (2008), Brons, Nijkamp, Pels,

Rietveld (2008), Breunig and Gisz (2009), Hymel, Small and Van Dender (2010), Dahl (2011), and Lin, Prince (2013).



appropriate to use price elasticity estimates representative of global demand, not those

relating to one country or region, when estimating impacts on prices in Australia. For OECD

countries, surveys by Molly Espey (1998) and Daniel Graham and Stephen Glaister (2002)

suggested estimates of short-term price elasticity of demand around –0.25. A different

survey approach used by Brons, Nijkamp, Pels and Rietveld (2008) suggested short-term

price elasticity of demand estimates around –0.35.

Tomas Havranek, Zuzana Irsova and Karel Janda (2012) undertook a meta-analysis of

estimates of price elasticities of demand for petrol for countries around the world. They

produced an average estimate of short-run price elasticity of demand of –0.09. Havranek

and others (2012) argued that other surveys of price elasticity of demand provided greatly

overstated averages because of selection bias. They explained that this occurred because

insignificant or positive sign estimates of price elasticity of demand were rarely reported,

while implausibly large negative sign estimates were typically included.

For Australia, Robert Breunig and Carol Gisz (2009) estimated the short-term price elasticity

of demand for petrol to be in the range –0.1 to –0.14. Graham and Glaister (2002) reported

a short-term price elasticity of demand of –0.05 for Australia.

Kent Hymel, Ken Small and Kurt Van Dender (2010) estimated short-term price elasticities

of demand for the United States of –0.054 to –0.075, depending on the data set used. Jon

Hughes, Chris Knittel and Dan Sperling (2008) provided comparable United States

estimates. An estimate of –0.07 was provided by David Coyle, Jason DeBacker and

Richard Prisinzano (2012).

Kilian and Murphy (2014) criticised the estimates by Hughes, Knittel and Sperling, but did

not refer to similar contemporaneous estimates. They also criticised earlier estimates by

other economic analysts.

Kilian and Murphy argued that the estimates of Hughes, Knittel and Sperling were too low

(ignoring the negative sign), because they did not take into account endogeneity of the price

of crude oil and products, and did not adequately allow for the influence of unpredictable

changes in global oil production. Kilian and Murphy (2014) provided an estimate of

approximately –0.26. However, Kilian and Murphy’s analysis unrealistically assumed a

stable relationship between prices and quantities demanded over the entire post-1973

period.

Econometric analysis by Small, Van Dender (2007a,b); Hughes, Knittel, Sperling (2008) and

Hymel, Small, Van Dender (2010) indicates that the short-run price elasticity of demand for

automotive fuel has declined considerably since the late-1970s and early-1980s. This

finding is consistent the results of surveys of multiple estimations of elasticities based on

data from different time periods (Greene, 2012). In addition, the finding is compatible with

analysis by Baumeister and Peersman (2013b) indicating that short-run price elasticity of

demand for crude oil declined substantially between 1984 and 1990.

However, the data underpinning the estimates usually relate to time periods ending around

2005 (2010 in Baumeister and Peersman). These estimates may have been influenced by

high income growth and relatively low fuel prices in the late-1990s and before 2005,

because short-term price elasticity of demand tends to be lower when fuel prices are lower

and incomes are higher (Hymel, Small and Van Dender (2010; Sentenac-Chemin, 2012). In

the context of higher fuel prices, and negative or low income growth in many countries for

some years after the global financial crisis, price elasticity of demand could be expected to

be higher. Indeed, Cynthia Lin and Lea Prince (2013) estimated that in the context of

“levelling per capita income” and high petrol prices in the period 2008-2012, the short-term



price elasticity of demand for petrol in the United States to be –0.068, compared to –0.029

in the period 2000-2006.

Allowing for lower price elasticities of demand in China and other rapidly growing, non-

OECD economies than in the OECD overall, and price elasticities of demand for products

that are no less than and may be up to twice those for crude oil suggests short-term price

elasticities of demand for automotive fuel in the range –0.1 to –0.17 for rapidly growing non-

OECD countries, and an indicative overall global range of –0.15 to –0.25

Price Elasticity of Supply - Products

Estimates of price elasticity of supply of refined products are not readily available. ACIL

Allen was able to find only one estimate of short-run elasticity of supply.

David Coyle, Jason DeBacker and Richard Prisinzano (2012) estimated that short-run

elasticity of supply of petrol was 0.29, based on United States quarterly tax data for the

period 1990 to 2009.

4.2.4 Effects of Highly Price Inelastic Demand and Supply

It has been established that there has been a substantial reduction in short-term price

elasticity of demand and supply of oil since the mid-1980s. Consistent with this finding, it

has been shown that short-term price elasticity of demand for transport fuel has also fallen

substantially in the same time-frame. Most of the fall occurred between from 1984 to 1991.

The striking fall in price elasticities has important implications for the consequences of future

oil shocks. For example, change in elasticities suggests that a crude oil shock involving a 5

per cent reduction of supply would have resulted in a price increase of less than 7 per cent

in the late-1970s or early-1980s, but a price increase of more than 29 per cent now. Both

demand and supply have become so price inelastic in the short-term that small

unanticipated changes in supply or demand can cause large price spikes. The implication is

that an oil shock of a particular type and magnitude would lead to a much larger oil price

spike now than at the time of the “first oil crisis” and “second oil crisis” of the early 1970s to

early 1980s.

The magnitude of future oil price spikes will also be influenced by the size of oil shocks

(measured by quantity changes at the original price). Baumeister and Peersman (2013b)

investigated shock sizes over time. Their research indicated that the average variability of

exogenous oil supply shocks has declined steadily since Iraq’s invasion of Kuwait in 1990.

The average variability of aggregate demand shocks declined from the mid-1980s, but has

risen since the early-2000s. The average variability of speculative, oil-specific demand

shocks has been lower in recent years than in the 1970s and 1980s.

The striking fall in price elasticities of demand and supply is consistent with higher oil price

volatility and lower volatility of oil production from the mid-1980s until 2003 (Baumeister,

Peersman (2013b). During this period, lower price elasticities of demand and supply were

the main reason for higher price volatility. The increase in the magnitude of aggregate

demand shocks from 2003 combined with the striking fall in price elasticities of demand and

supply underpinned the extraordinary rise in oil prices from 2003 to 2008 and the rapid

recovery from late-2009.



4.3 Physical Oil Markets, Derivatives Markets, and

Inventories

A major structural transformation of the oil market commenced in the early-1980s. An

administered oil price regime involving long-term contracts with pre-determined posted oil

prices transitioned to a spot trading system (Hubbard, 1986). This resulted in concerns

about volatility of spot prices. Oil financial derivatives, such as futures, and markets in

which to trade them were developed. These instruments provided hedging mechanisms for

producers and users of crude oil, and investment or speculative opportunities to other

parties prepared to be involved on the other side of the derivatives transactions. One result

of these hedging mechanisms was reduction of responsiveness of hedged oil producers and

consumers to spot oil price changes, meaning lower price elasticity of demand and supply.

This further increased spot oil price volatility, encouraging further development of oil

financial derivatives and markets for these instruments.

The quarterly trading volume of financial oil derivatives rose quickly from 1983 and

plateaued in 1990 when price elasticity of demand dropped to its lowest level. Trading

volumes rose gradually from the late-1990s.

From 2005, trading volumes of financial oil derivatives soared, as the spot oil price surged.

The coincidence triggered concerns among commentators and politicians in the United

States that the dramatic rise in spot crude oil price from 2006 to mid-2008 was driven by

financial speculators.

These concerns attracted interest from many economic analysts. A flood of articles in peer-

reviewed economic journals followed.5 Convincing evidence to support the concerns was

not found. Some relevant points follow.

First, futures prices tended to follow rather than lead spot prices. This undermines the claim

that financial speculators drove up oil prices.

Second, producers hedging against price falls, and users hedging against price rises

needed others to take the opposite side if financial derivatives transactions. These

counterparties helped create a market for risk, allowing producers and users of oil to reduce

their exposure to oil market risk, and improving the efficiency of resource allocation.

Third, if speculation in oil futures and other financial oil derivatives markets drove up crude

oil price, it should be reflected by increases in inventories. This applies because arbitrage

opportunities between markets for oil and markets for financial oil derivatives would result in

increased demand for oil inventories when futures are overpriced relative to physical spot

oil. Convincing evidence of speculation in financial oil derivatives markets spilling over into

the market for physical oil was not found in analyses of inventory movements.

5 For example, see Alquist, Gervais (2013), Knittel Pindyck (2013), Smith (2012), Sanders, Irwin (2013), Kilian (2014), Kilian,

Murphy (2014), Hamilton (2009a,b), Fattouh, Kilian, Mahadeva (2013), Büyükşahin, B., Harris, J. (2011).



5 Repudiation of agreements and Yom Kippur Arab-Israeli War, 1973-74

Key Points

International

In the “first oil crisis” in 1973-1974, the real price of crude oil tripled to around US$57 per barrel in 2014 terms in a period of a few months. Thereafter, the real oil price fluctuated around US$52 per barrel until the second half of 1978.

Multiple factors contributed to the price spike,

Longstanding United States excess capacity was whittled away by the early 1970s.

Strong global growth in the early 1970s eliminated spare capacity in the Middle East by early-

1973 in the context of oil company-government agreements that pegged prices.

OPEC exercised market power by repudiating agreements and ratcheting-up prices by creating

fear, raising production taxes to support higher prices, cutting production, creating more fear,

raising taxes again, and repeating the fear and tax cycle.

The ratcheting-up process commenced before the Yom Kippur war, but the Arab-Israel conflict

provided an excuse to accelerate the process with production cuts.

Aggregate demand and speculative oil-specific demand shocks contributed, as well as supply

shocks.

The Arab oil embargo on oil sales to the United States and the Netherlands was ineffective.

The international oil market transitioned from being basically competitive to one characterised by exercise of substantial market power.

Excess capacity in OPEC countries prevailed by the last quarter of 1974.

Consequences in the global market

The oil market worked, notwithstanding OPEC market power.

The oil price spiked to clear the market (avoid shortages) in the short-term.

The United States was an exception, because the government tried to override the market with

price controls and administrative allocation of oil and refined products

Over the time, the market continued to work as high prices encouraged supply of additional

quantities, and reduction of quantities demanded. The market adjusted down prices as these

efforts succeeded.

Australia

The huge increase in the US$ oil price in 1973 and 1974 translated into smaller absolute and relative increases in $A terms because the $A was above parity with the US$. However, undervaluation of the $A meant that the $A price increase was greater than it would have been if the Australian currency had been floated in March 1973, at the same time as major currencies.

On the other hand, Australian fuel users did not have to bear the full effect of the 1973-74 international oil price spike in $A terms, because of government-determined pricing arrangements in place at the time for domestically produced crude oil.

While the US$ crude oil price more than tripled in real terms, the Australian price of petrol rose by



only 20 per cent. The government introduced full import parity pricing of crude oil in 1978, after which prices of petrol tracked more closely with movements of world prices of crude oil. Oil product shortages did not occur in Australia.

Consumption levels of petroleum products had been rising relatively quickly in the years leading up to 1974. However, the price rises and a decline in growth of economic activity associated with a downturn in Australia’s terms of trade appear to have arrested the rate of increase of consumption.

Consumption levels of petroleum products had been rising relatively quickly in the years leading up to 1974. However, the price rises and a decline in growth of economic activity associated with a downturn in Australia’s terms of trade appear to have arrested the rate of increase of consumption. Indeed, consumption remained steady around 36,000 ML per annum for the two following year.

Production of crude oil in Australia increased from 1960-61 to 1976-77 as the Bass Strait fields were brought on line. Net imports of crude oil and other petroleum refinery feedstock were relatively steady over the 1973 to 1976 period, suggesting that there was no interruption to imported crude supplies over the period.

Refinery production that had been increasing during 1970 to 1973 plateaued during in line with the plateauing of demand over the same period. Net imports of petroleum products ranged between 2,500 ML per annum and 1,800 ML per annum over the 1972-73 to 19777-78 period. Overall there was no disruption of supplies.

After the crisis period, economic conditions generally deteriorated, with year on year quarterly inflation increasing from 2 per cent per year in 1970 to 16 per cent per year by 1975, before falling back to 12 per cent per year. Growth of GDP fell from 7 per cent per year to one per cent per year over the same period. The major determinants of these changes were a substantial improvement in Australia’s terms of trade because of a commodity price boom in the early-1970s, a pegged US$/$A exchange rate that was not adjusted adequately or quickly enough, and then a decline in Australia’s terms of trade from early-1974 and lagged exchange rate devaluation.

5.1 Preceding Circumstances

Real crude oil prices trended down from 1918 until the 1940s, shifted up until the early-

1950s, and then displayed a downward trend for more than 20 years until 1973. The real

price downtrend was not significantly disrupted by the Suez Crisis in 1956 or the 6-day

Arab-Israeli war in 1967.

In the case of the 1967 conflict, Arab oil producers deployed the “oil weapon”: a selective

embargo on shipments to the United States, United Kingdom, and to a lesser extent,

Germany. The embargo failed. Supplies from various sources were redistributed to beat

the embargo. The maximum loss of production was about 1.5 million barrels per day out of

a total world production of 35.6 million barrels per day. This was made up by drawing on

stocks and increases in production elsewhere.

For decades prior to the “first oil crisis”, the United States had substantial surplus capacity

that could be called on at times of crisis, such as during World War 2 and more limited

events in 1951 (Korean War), 1956 (Suez Crisis) and 1967 (6-day war). Surplus capacity in

the United States had been maintained through regulation by the Texas Railroad

Commission, Oklahoma Corporations Commission, Louisiana Conservation Commission.

Output was constrained to levels well below capacity. This was done to support prices, and

ostensibly to conserve resources, in circumstances of potential chronic oversupply.

However, excess capacity in the United States was whittled down in the 1960s. By the

early-1970s, it had been eliminated, and so had the world’s emergency oil capacity

(Yergin,1991).

In 1972, prices of other mined commodities and agricultural commodities began to climb in

real terms, in response to strong growth of global aggregate demand. Those prices surged

during 1973. Lutz Kilian (2010a) explained that the growth of aggregate demand was

stimulated and supported by a “dramatic increase in worldwide liquidity”.



Crude oil prices did not move up strongly with other prices of other commodities. Crude oil

prices did not take-off until late in 1973. There were two reasons for this anomaly. First,

there was substantial excess global supply of crude oil. Second, the 5-year Tehran/Tripoli

agreements between oil companies and Middle Eastern producing countries limited oil price

increases. These agreements provided a moderate improvement in government receipts

per barrel of crude oil extracted in exchange for assurances that governments would allow

oil companies to extract as much oil as they saw fit.

Nevertheless, nominal crude oil prices rose faster than provided under the agreements,

because governments increased their share of revenue and resource rents through taxes

effectively linked to quantity produced, and by taking part ownership of production that was

referred to as “participation” (Adelman, 1995). However, nominal crude oil price increases

were more than offset by rising inflation and, in the case of prices denominated in United

States dollars, by depreciation of that currency (Kilian, 2009b, 2010c; Radetzki, 2006,

2008).6

With demand for petroleum products and derived demand for crude oil growing strongly in

response to strong growth of global economic activity, oil companies expanded oil

production from spare capacity with moderate increases in payments per barrel to host

governments. By the beginning of 1973, many Middle Eastern countries were producing at

levels close to nominal capacity, with the exception of Saudi Arabia. However, early in

1973, Saudi Arabia increased its production further (Adelman, 1995; Kilian, 2009b).

While consumption of crude oil continued to grow in 1973, the rate of growth slowed.

However, growth of demand for crude oil remained strong, because of inventory-building to

avoid anticipated increases in the government take through higher tax and “participation”.

This build-up of inventories extended beyond crude oil to refined products. As demands

from Middle Eastern countries for higher government “takes” from taxation and

“participation” increased during 1973, fear of realisation of higher payments to government

and consequent higher prices added to speculative demand for inventories of crude oil and

refined products. This led to higher prices, which were followed by concerted increases in

government “takes”, which then supported prices at higher levels. The Tehran/Tripoli

agreements had been effectively repudiated before the Arab-Israeli war in October 1973

(Adelman, 1995).

5.2 Political Conflict Trigger

The Yom Kippur Arab-Israeli war commenced on 6 October 1973. On 17 October 1973, the

Organisation of Arab Petroleum Exporting Countries (OAPEC) agreed on production cuts of

5 per cent per month, commencing immediately and continuing until Israel withdrew

completely from Arab land that had been occupied in June 1967, particularly Jerusalem, and

restored legal rights of Palestinian people. A few days later, Saudi Arabia and Kuwait

applied larger cuts.

OAPEC also announced an embargo against the United States and the Netherlands, and

reduced shipments to some other countries as punishment for presumed support of Israel.

6 Radetzki (2006, 2008) pointed out that the acceleration of inflation was not caused solely by strongly growing aggregate

demand. The boom in commodity prices had been preceded by two consecutive years of widespread crop failures.



5.3 Policy Tactics and Market Responses

The real price of crude oil more than tripled to around US$57 per barrel in 2014 real terms in

a period of a few months. Following the events of 1973-74, the real oil price fluctuated

around US$52 per barrel until the second half of 1978 as circumstances developed to create

the “second oil crisis”.

The peak reduction in OAPEC production occurred in December 1973. It was about 8 per

cent of pre-shock global production. The peak reduction in global production was about

6.75 per cent in the same month. The average reduction in the global production rate

during the period October 1973 to March 1974 was 4 per cent (Hamilton, 2009b).

Figure 15 1973-74 Oil Price Surge

Note: Oil prices shown are Dubai spot prices. Real prices were calculated using the US GDP deflator

Source: (OECD, 2011)

The embargo on oil supplies to the United States and the Netherlands, and reduced

shipments to some other countries were ineffective. Market forces induced diversion of

shipments to get around the embargo. The embargo imposed no differential pain upon the

targeted countries. The embargo was formally terminated in March 1974 (Adelman, 1995;

Darmstadter, 2013).

The pattern of ratcheting-up crude oil prices, which was established before the war,

continued during the remainder of 1973. The announcements regarding production cuts

created fear, inducing speculative demand for oil, which drove up the price. The floor price

was set by the tax “take”, which was nearly doubled on 16 October, and then more than

doubled from the higher base in late-December 2003. Morris Adelman’s description of the

mechanism in the period October-December 1973 has been re-produced in Box 1.

On 4 December 1973, Saudi Arabia announced, without explanation, cancellation of the

additional production cut of 5 per cent scheduled for the month. By mid-December 1973, it

was becoming clear that production losses were not as severe as had been originally feared

(Adelman, 1995).

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

1970 1971 1972 1973 1974 1975 1976 1977

$US/bbl

Nominal price Real price, 1970 US dollars



Box 2 Speculative Demand and Taxes in “First Oil Crisis”

“Over the three months October through December, total lost output was about 340 million barrels, which was less than the inventory build-up earlier in the year. Considering as well some additional output from other parts of the world, there was never any shortfall in supply. It was not loss of supply but fear of possible loss that drove up the price. Nobody knew how long the cutback would last or how much worse it would get. Additional cuts were scheduled.

Precautionary demand was driven by the fear of dearth. Oil might be only a small fraction of a buyer’s total cost of operation, but without it, a factory, or a power plant, or a truck fleet would stop dead. The loss was so great that it paid to take out expensive insurance against even a minor probability. Panic aside, it made sense for refiners and users to pay outlandish prices for oil they did not need.

Speculative demand included those seeing a quick turnover profit or crude oil buyers trying to buy sooner rather than later. But an additional factor may have been even more important: oil product prices were largely controlled by contract or government. Every buyer and seller at the much lower mainstream prices knew that if the production cuts continued, those prices would also rise. Moreover, OPEC had nearly doubled the per barrel tax in October and would again.

Thus, buyers and sellers could hold crude oil or products with little downside price risk. Their increased demand raised prices all the more. “The spot crude oil market dropped dead last week ... as sellers decided to hang on to every barrel.” [Petroleum Intelligence Weekly Special Report, October 1990). Those with stocks of oil or products sold as little as possible. Some sought to buy for an immediate resale gain, others to hold for higher prices soon. Thus the effects were out of all proportion to a loss of at most 9 percent for a month.

Not the amount of cutback or ‘shortfall’ but the fear of dearth did the damage.”

Source: Adelman (1995), pp. 110, 112.

Prior to the oil shock, from mid-1972 to the end of September 1973, monetary authorities

had raised official interest rates substantially on a progressive basis, because of concerns

about economies overheating. This was temporarily reversed in response to the sharp rise

in oil prices in October 1973. After further dramatic increases in oil prices in January 1974,

monetary authorities resumed progressive-raising of official interest rates. They peaked in

mid-1974. The monetary policy tightening reduced aggregate demand and therefore,

derived demand for crude oil.

By mid-January 1974, crude oil was in substantial excess supply. Morris Adelman (1995)

explained that if crude prices had been ruled by supply and demand in a competitive market,

the price surge of 1973 would have been reversed. However, the market was not

competitive. The OPEC membership group, which included non-Arab countries, such as

Iran and Venezuela, as well as OAPEC members, had substantial market power and they

had worked out how to exercise it to raise prices further, even with excess capacity also

growing (Adelman, 1995; Krichene, 2002). The mechanism they used is described below.

During 1974, the relevant governments raised their “take” through tax and “participation”

arrangements by more than 50 per cent. The governments raised their taxes and sales

prices of their “participation” oil in concert and generally refrained from offering lower prices

to sell more oil. This raised contract prices. Meanwhile, open market crude oil and refined

product prices typically rose through speculative demand in anticipation of the government

action pushing up official prices. With prices set in these ways, the market determined

quantity demanded. Production was adjusted to match that quantity (Adelman, 1995).

Marian Radetzki (2008) pointed out that adjustments to quantities did not have to be large to

validate large price increases in the short-term because of highly price inelastic demand and

supply for oil. But, price elasticities increase over time, so adjustments have to increase to

support price increases. These phenomena are explained in Chapter 4.



By August 1974, excess capacity in OPEC countries had risen to about 20 per cent of actual

capacity. Excess capacity grew further. In addition, by the end of 1974, crude oil and

product storage tanks everywhere were full (Adelman, 1995). Meanwhile, the global

economy was sliding into recession, helped along by monetary policy tightening and high

crude oil prices that reduced purchasing power of consumers.

An important point is that the oil market worked in avoiding shortages, notwithstanding

OPEC market power. The oil price spiked to clear the market (avoid shortages) in the short-

term. The United States was an exception, because the government tried to override the

market with price controls and administrative allocation of oil and refined products, as

discussed in a subsequent sub-section. Over the time, the market continued to work as

high prices encouraged supply of additional quantities, and reduction of quantities

demanded, as consumers of oil products and manufacturers of oil product-using vehicles

and equipment found ways of reducing usage and switching to alternatives. The market

adjusted down prices as these efforts succeeded.

5.4 Causes of the 1973-74 Price Shock

For many years after the “first oil crisis”, it was common for commentators to attribute the

severe price spike to production cuts by Middle Eastern producers, and an oil embargo

against the United States and some other countries following the Arab-Israeli (Yom Kippur)

war in October 1973. This perception was buttressed by data showing a drop in production,

as well as the spectacular price increase. The diagnosis was simplistic.

Analysis of the circumstances of the 1973-74 oil crisis has revealed that the price surge was

attributable not just to an oil supply shock. Two other types of shock also played important

roles, and the various shocks interacted. Specifically, aggregate demand and speculative

oil-specific demand shocks also contributed to the price spike. In addition, the nature of the

supply side shock was more complicated than just production cuts to support Arab interests

in conflicts with Israel.

Lutz Kilian (2009a,b, 2010a) highlighted the importance of an aggregate demand shock for

the 1973-74 oil price spike. Kilian (2010a) attributed the growth of aggregate demand in the

early-1970s in substantial part to major shifts in monetary policy in many OECD countries

around the same time, leading to a “dramatic increase in worldwide liquidity”. This

occurrence was linked to weakening of constraints on national monetary policies because of

the breakdown of the Bretton Woods fixed exchange rate regime that had been devised in

1944. The Bretton Woods regime was abandoned completely by major economies in March

1973, when their currencies were floated. Kilian (2010a, p. 62) explained:

“As the world economy entered uncharted territory in the early 1970s with the emergence of

flexible exchange rates and as the long post-war expansion appeared to come to an end, there

was much uncertainty among policy-makers and the public about the rules of the game. Policy-

making entered a stage of experimentation and learning. There was increased concern about

the level of employment and central bankers felt the responsibility to stimulate employment by

loosening monetary constraints, even if that perhaps meant some moderate inflation. There

was a collective sense in industrialised countries that some action was required.”

The aggregate demand shock resulted in production levels close to capacity in the Middle

East and globally (Adelman, 1995; Radetzki, 2008; Kilian, 2009a,b). This provided OAPEC

producers with an opportunity to exploit their potential market power, and they took it.

Production cuts ostensibly made to advance Arab interests in an ongoing conflict with Israel

were actually a means of exercising potential market power.

Radetzki (2006, 2008) pointed out that crude oil prices rose much more than other mined

commodity prices that had been pulled up strongly by an aggregate demand shock. He



attributed the difference to the price and supply management actions of OPEC, large sales

of metals from the United States Government’s strategic stockpiles between mid-1973 and

mid-1974, and sales in late-1974 of excess stocks of metals held by Japanese companies.

As explained by Morris Adelman (1995) and Marian Radetzki (2008), OPAEC producers,

and OPEC producers more generally, ratcheted up prices by creating fear and therefore

speculative demand, and then increased production-based tax rates to hikes to put a floor

under the higher price. Meanwhile, quantities supplied by OPEC producers were adjusted

to validate higher prices. Radetzki (2008) pointed out that the supply adjustments required

to validate higher prices were only small in the short-term, because short term price

elasticity of demand was highly inelastic (very low, ignoring the sign), and short-term price

elasticity of supply of non-OPEC producers was too.

The supply adjustments by OPEC to validate higher prices could be categorised as

additional supply shocks or speculative supply shocks, as suggested by Lutz Kilian and Tom

Lee (2014). Alternatively, these supply adjustments could be interpreted as reflecting

speculative demand by OPEC producers for their own oil. They can exercise this demand

by holding larger below ground inventories that can be extracted and sold at higher prices

later. Meanwhile, withholding supply from the market supports higher prices now.

Noureddine Krichene (2002) explained that a major change occurred in the international

crude oil market in 1973-1974. Krichene (2002, p. 558) observed that this market:

“moved from a competitive system to a cartel structure, with profound implications for the

structure of the demand and supply model.”

James Hamilton (2009b) acknowledged that an aggregate demand shock contributed to the

1973-74 crude oil price spike, but considered the supply shock to be more important. He

argued that available estimates of price elasticities (see chapter 4) did not render it

implausible to attribute most of the price change to the supply shock. Hamilton doubted that

speculative demand contributed to the spike, because inventories of crude oil and refined

products declined for 3-4 months from October 1973. He argued that if speculative buying

had been occurring, it should have been evidenced by a build-up of inventories.

However, the decline of inventories for 3-4 months does not indicate the absence of a

significant speculative demand shock. The initial decline in inventories may simply mean

the expected run-down in inventories in response to the supply shock outweighed the

influence of speculative demand for 3-4 months. The later build-up of inventories to levels

above those prevailing before the shock is consistent with the existence of a speculative

demand shock. This view is consistent with the analysis of Dvir and Rogoff (2010).

In any event, Adelman (1995) explained that that there was a substantial build-up of

inventories from the beginning of January 1973 to early-October 1973. He estimated that

the increase in crude oil inventories was substantially in excess of 552 million barrels (2

million barrels per day), compared to lost output of 340 million barrels in the three month

period, October to December 1973. In addition, he argued that outside the oil industry there

had been substantial build-up of inventories of refined products during 1973 prior to

October. Then, inventory levels climbed again to the capacity of available storage during

1974.

Kilian (2009b, 2010c) argued that a comparison of the spectacular surge in the oil price and

the earlier spike in prices of other mined commodities suggested that up to 75 per cent of

the increase in the real price of crude oil could be explained solely by strong growth of

demand for crude oil driven by growth of global economic activity. Moreover, analysis of the

change in supply indicated that less than 25 per cent, and probably only about 20 per cent

of the oil price spike could be attributable to an oil supply shock, leaving 75 per cent to 80



per cent of the price spike to be explained by growth of aggregate demand and oil-specific

speculative demand.

5.5 United States Price Control

In mid-1971, the United States Government implemented general price controls to deal with

inflation. By July 1973, three versions, labelled “phases,” of price controls had been tried.

None had worked well.

In August 1973, “Phase IV” was implemented. This phase of controls was directed at the oil

industry. Price controls on oil were to apply “indefinitely”. Price controls had previously

been time-limited. Under Phase IV, price controls on many other products were eliminated.

Phase IV rice controls applied to crude oil and to various downstream costs, rather than

directly to retail prices of refined products. Costs could be passed on to consumers, but

profit increases were not allowed. Price increases had to be approved by the Cost of Living

Council (CLC). It is not clear how the CLC distinguished between costs and profit.

Phase IV price controls included an innovation that was intended to increase the supply of

oil from wells in the United States. Oil was categorised as “old oil” or “new oil”. Old oil in a

particular year was defined as the amount of oil pumped from a working field in the previous

year, apart from “stripper oil” (oil from wells producing less than 10 barrels per day). The

price allowed for old oil was far below (36-43 per cent of) the market price. New oil covered

domestically-produced oil not categorised as old oil, and imported oil. New oil received

approximately market prices.

Production from existing wells fell for two reasons. First, production from thousands of wells

with low production rates was reduced further so that they would qualify as stripper wells

that would attract market prices for oil. Second, the low price for old oil discouraged

investment to offset declining production rates (Grossman, 2013).

New oil prices could not be passed on to product prices without CLC endorsement. The

CLC decided it would allow oil companies to pass on international oil price increases, but

only once a month. Often, refiners delayed supplies of refined oil products until the next

price increase was granted. Fuel service station owners closed temporarily or restricted

sales to a small amount per vehicle pending the next price increase (Grossman, 2013).

A system of administrative allocation was introduced in October 1973 for aviation fuel,

heating oil, diesel fuel and propane. From 27 December 1974, the United States

Government extended administrative allocation to other refined oil products and crude oil.

The outcome was chaos.

Petrol allocations were much too small in some cases, particularly urban areas, and much

too large in others, typically rural locations. Refiners were not able to meet some

allocations. In January and February 1974, there were trucking strikes in various locations.

Trucks circled the White House in protest. The strife continued until truckers were added to

the list of priority users allowed 100 per cent allocations. Airline pilots threatened a

nationwide strike (Grossman, 2013).

In addition, because administratively-determined prices did not reduce quantity demanded

and increase quantity supplied in the United States sufficiently to clear the market, and

because administrative allocation was seriously flawed, scarce supply was rationed and

allocated by queuing. Indeed, queues more than 1.5 kilometres long were common at

service stations in the United States. Consumers effectively paid more than the

administratively-determined price for fuel by spending time in queues (Barzel, 1997;

Grossman, 2013; Adelman, 1995, 2004; Kilian, 2008b).



Peter Grossman (2013) commented:

“As of February 1974, U.S. policy had made a shambles of the domestic market for oil

products. …. with governments controlling prices and now all quantities as well, market forces

that would have gotten supply to match demand were thwarted. U.S. policy had left nothing

that resembled a functioning market.”

Suggestions that these problems were caused by the OAPEC embargo on oil supplies to

the United States were not correct. The Netherlands which was also subject to the embargo

did not experience shortages that had to be resolved by queuing. The chaos in the United

States was caused by price controls and administrative allocation.

The pain caused by the “first oil crisis” was much more severe in the United States than

elsewhere because of the price control regime. The additional pain was imposed by the

United States Government, not by OAPEC (Adelman, 2004; Radetzki, 2011). Morris

Adelman, (2004, p. 19) commented:

“We ought not blame the Arabs for what we did to ourselves.”

5.6 Impacts on the Australian economy

During the period from 1973 to 1977, international crude oil prices moved differently in

Australian dollar ($A) terms than in United States (US$) dollar terms, because of changes in

the US$/$A exchange rate.

The Bretton Woods (1944) fixed exchange rate regime came under extreme pressure in the

early 1970s. Substantial changes were made in 1971. Late in the year, the $A, which had

been pegged to the pound sterling was revalued upwards and re-pegged to the US$, rather

than pound. Subsequently, the US$ was devalued relative to other major currencies in

December, taking the $A down with it. The $A was revalued upwards by 7 per cent relative

to the US$ in late 1972. The US$ was devalued again in February 1973. The $A was

revalued by 11 per cent relative to the US$ and then re-pegged to it. Major currencies were

floated in March 1973, but the $A was not floated at that time, still being tied to the US$.

The $A was revalued again by 5 per cent in September 1973 to US$1.4875 = $A1.00.

Despite the revaluations, the $A depreciated relative to other key currencies, because the

US$ was under persistent downward pressure.

In the meantime, Australia’s terms of trade had risen substantially because of a global boom

in commodity prices, other than oil prices, that continued into the first quarter of 1974.

Because revaluations of the $A did not adequately reflect these conditions, Australia

experienced a marked acceleration of inflation that dissipated some of the benefits of the

commodity price boom.

The huge increase in the US$ oil price that occurred late-1973 and the first half of 1974

translated into smaller absolute and relative increases in $A terms because of the higher

value of the $A. The disparity in crude oil price movements is shown Figure 16. However,

pegging of the $A meant that the $A price increase was greater than it would have been if

the Australian currency had been floated in March 1973, when other major currencies were

floated.



Figure 16 Crude oil price, US$ and $A

Note: Crude oil prices are yearly average based on Arabian light crude ex Ras Tanura.

Exchange rates are averaged quarterly.

Source: ABS and BP statistical year book.

However, Australian fuel users did not have to bear the full effect of the 1973-74

international oil price spike in $A terms, because of pricing arrangements in place at the

time for domestically produced crude oil. As discussed in section 3.3 above, the price of

domestic crude oil was controlled and did not rise with the rise in global oil prices. Changes

in international crude oil prices in $A terms and changes in the capital city average petrol

price in Australia are shown in Figure 17.

Figure 17 Crude oil prices and petrol prices

Note: Crude oil prices are yearly average based on Arabian light Ras Tanura.

Petrol prices are quarterly average for capital cities.

Source: ABS and (BP, 2013)

The pricing policies at the time acted to constrain the rise in the price of petroleum fuels in

Australia attenuating the impact on quantity demanded. On the other hand, pegging the $A

to the US$, rather than floating it, added unnecessarily to the increases in fuel prices.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

Mar

-70

Aug

-70

Jan-

71

Jun-

71

Nov

-71

Apr

-72

Sep

-72

Feb

-73

Jul-7

3

Dec

-73

May

-74

Oct

-74

Mar

-75

Aug

-75

Jan-

76

Jun-

76

Nov

-76

Apr

-77

Sep

-77

$/bbl

Crude oil price A$ (nominal) Crude oil price US$ (nomimal)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

0

2

4

6

8

10

12

14

16

18

20

Mar

-70

Sep

-70

Mar

-71

Sep

-71

Mar

-72

Sep

-72

Mar

-73

Sep

-73

Mar

-74

Sep

-74

Mar

-75

Sep

-75

Mar

-76

Sep

-76

Mar

-77

Sep

-77

Crude oil $A/bbl

Petrol c/l

Petrol price (nominal) Crude oil price A$ (nominal)



The distribution of petrol prices around Australia was not widely spread (Figure 19). Petrol

prices in Brisbane Canberra and Sydney tended to be higher than in Melbourne, Adelaide

and Perth. Prices continued to rise in all capital with some short term dips reflecting the rise

in crude oil prices internationally, but attenuated by the price controls on domestic crude oil.

Figure 18 Capital city petrol prices

Source: ABS

Consumption levels of petroleum products had been rising relatively quickly in the years

leading up to 1974. However, the price rises and a decline in growth of economic activity

linked to a downturn in Australia’s terms of trade and an underlying global economic

downturn appear to have arrested the rate of increase of consumption. Indeed,

consumption remained steady around 36,000 ML per annum for the two following years

(Figure 19).

Figure 19 Consumption of petroleum products


5

7

9

11

13

15

17

19

21

23

Mar

-70

Aug

-70

Jan-

71

Jun-

71

Nov

-71

Apr

-72

Sep

-72

Feb

-73

Jul-7

3

Dec

-73

May

-74

Oct

-74

Mar

-75

Aug

-75

Jan-

76

Jun-

76

Nov

-76

Apr

-77

Sep

-77

c/l

Sydney Mebourne Brisbane Adelaide

Perth Hobart Darwin Canberra

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

19

60

-61

19

64

-65

19

69

-70

19

73

-74

19

74

-75

19

75

-76

19

76

-77

19

77

-78

ML /a



Production of crude oil in Australia increased from 1960-61 to 1976-77 as the Bass Strait

and Cooper basin fields were brought on line (Figure 20). Imports of crude oil and other

petroleum refinery feedstock were relatively steady over the 1973 to 1976 period,

suggesting that there was no interruption to imported crude supplies over the period.

Figure 20 Production and imports of crude oil and refinery feedstock


Refinery production that had been increasing during 1970 to 1973 plateaued during in line

with the plateauing of demand over the same period (Figure 21).

Figure 21 Refinery production


Net imports of petroleum products ranged between 2,500 ML per annum and 1,800 ML per

annum over the 1972-73 to 19777-78 period. Overall there was no disruption in supplies.

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Figure 22 Net imports of petroleum products


The year on year CPI rose rapidly from 1973 onwards (Figure 24). The rise in petrol prices

was around 15 per cent from 1973 to 1975. This contributed into the inflationary pressures

arising during that period. However, the major determinant of the acceleration of inflation

was the early-1970s commodity price boom and the accompanying strong improvement of

Australia’s terms of trade in the context of an administered exchange rate that was not

revalued adequately and quickly enough to avoid undervaluation for significant periods of

time.

Rising petrol prices did not greatly affect the travelling patterns of Australian drivers over the

period from 1973 to 1977 (Figure 23).

Figure 23 Billions of km travelled

Source: ABS

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NSW VIC QLD SA WA TAS NT ACT



Figure 24 Percentage change in CPI from previous quarter

Source: ABS

The growth rate in GDP over the period is shown in Figure 25. GDP growth had been falling

from a high of around 7 per cent per annum in the late 1960s to 4 per cent per annum by

1972. GDP growth fell to around 2.6 per cent per annum in 1973 and rose to 4 per cent per

annum in 1974 before falling again to around 2.3 per cent per annum in 1975.

Figure 25 Annual GDP growth rate

Source: ABS

This period of Australian economic history was somewhat turbulent. It was characterised by

rising inflation in the context of a surge in prices commodities and a pegged exchange rate,

and then imported staglation in the context of a global recession with the exchange rate still

not sufficiently flexible.

5.7 Policy Issues and Policy Responses

There were three major policy features of the 1973 to 1978 period.

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First, the attempt to control crude oil and refined products and allocate supplies

administratively in the United States was a dismal failure. The United States created

shortages that did not appear elsewhere where the market was allowed to work.

Second, regulation of prices in Australia for domestically-produced crude oil reduced the

impact of rising crude oil prices on petroleum product prices in Australia. This reduced the

impact on petroleum product consumption in Australia at the time. Consumers did not

respond as much as they might have to the higher prices, exacerbating concerns about oil

security going forward. The muted price impact also reduced adverse effects on economic

activity.

Third, the exchange rate for the Australian dollar was pegged to the United States dollar,

which was under considerable downward pressure in the early-1970s, and revaluations

occurred at significant intervals. In this context, a strong improvement in Australia’s terms of

trade because of a commodity price boom in the early-1970s meant that the Australian

dollar was undervalued at the time of the huge spike in the US$ crude oil price.

Consequently, the $A price increase for imported crude oil and refined products was higher

than it should have been and the inflation rate climbed to an unnecessarily high level.

Australia made a policy error when it did not allow the Australian dollar to float in early-1973,

when major currencies were floated.

The Whitlam government lost office in 1975 and the incoming Fraser Government did not

initially react to pressures to form an energy department as had been done in Washington.

However the ongoing concerns over oil supplies increased in political debate in the period

leading up to 1978. A National Energy Advisory Committee Chaired by Greg Lynch a

former Esso CEO was established to provide advice to the Government on energy policy

and a National Energy Office was established in the then Department of National

Development in 1978. However, it was not until the following year that a formal energy

policy was announced by the Government.

While there was considerable public debate on the security of global oil supplies, the main

impact of the 8 per cent reduction in production by OPEC countries was an initial 20 per

cent rise in petrol prices followed by further rises. However the rise in petrol prices was not

as high as the greater than 200 per cent increase in US$ global oil prices, because of price

regulation on domestic production of crude oil. Growth in consumption of petrol stalled with

the rise in prices, but there were no shortages of fuel. The main focus of policy was the

emergence of domestic production of crude oil and the pricing policies that were to apply to

that production.



6 Iranian Revolution and Iran-Iraq War, 1978-80

Key Points

International

During the “second oil crisis” the crude oil price peaked twice around US$122 per barrel in real 2014 terms. The first peak, which has been linked to the Iranian revolution, occurred in November 1979. The second peak, associated with the Iran-Iraq war, occurred in November 1980. The peak price was more than double the real peak price of US$57 per barrel attained in the “first oil crisis”.

For around 20 years, the traditional view was that the huge 1979 price spike was caused by disruption of Iranian supply. However, it is now clear that this was only a partial cause. Aggregate demand growth contributed. Supply shocks included opportunistic production cuts by Saudi Arabia and production restraint by other OPEC members. This and speculative demand driven by fear supported ratcheting-up of official or contract prices. Views differ on the relative importance of supply, aggregate demand and speculative demand shocks.

The view that the price spike in 1980 that followed commencement of the Iran-Iraq war was attributable solely to the associated negative supply shock is no longer widely supported. Nevertheless, the negative supply shock was more important than the supply shock from loss of Iranian production. An aggregate demand shock was more important than in 1979, and speculative demand was less important. The Saudi and OPEC tactic of raising contract or official prices to support spot price increases exacerbated the price spike. Unexpectedly large supply increases, reflecting in part the growing importance of non-OPEC oil producers, provided a lagged, offsetting positive supply shock.

Consequences in the global oil market

Around the world, where markets were allowed to work, they did. Higher crude oil and refined product prices cleared the market. Higher prices reduced usage, increased quantities supplied from other sources, and reallocated available supply in accordance with willingness to pay.

The contrast with the United States was marked. While in 1979 it had started to remove its oil price control and administrative allocation regime and on a staged basis, the dismantling did not happen soon enough to avoid shortages, queues, and administrative allocation blunders.

Australia

There were no interruptions to supply to or in Australia.

The dramatic rise in the international oil price translated into a rise in the price of petrol in Australia from 22 cents per litre to 35 cents per litre in nominal terms. While the US$ price of crude oil declined substantially by 1983, the price of petrol in Australia continued to rise reaching 44 cents per litre by 1983. The move to import parity pricing for crude oil to refiners and to a lesser extent, exchange rate depreciation were contributing factors.

Arrangements for pricing of crude oil to producers however continued the disconnect between the price that was received by producers and the international price. This discouraged the development of new, but more marginal fields, and resulted in ongoing negotiations between government and the producers to make adjustments to encourage development of new fields.

Consumption of petroleum products rose to just under 40,000 ML per annum by 1979-80 before falling to 37,800 ML per annum by 1982-83. The decline in consumption was met by mainly from reduced production from Australian refineries – production fell from 37,000 ML per annum in 1977-78 to 35 ML per annum by 1982-83. Imports fell from 4,000 ML per annum to 2.500 ML per annum over the same period.

Road use as indicated by kilometres travelled rose slightly over the period with no major decreases.

Inflation ranged between 8 per cent and 12 per cent over the period, 1979 to 1983. GDP growth was around 3 per cent per annum until 1983, when it fell to minus 2 per cent. Australia went into recession at that time. This was not related to the rise in petrol prices



The “second oil crisis” was associated with the Iranian revolution in late-1978 and early-

1979, and the Iran-Iraq war, which commenced in September 1980.

The “second oil crisis” involved a huge increase in the real price of crude oil. The peak price

during the “second oil crisis” event was more than double the peak real price level of US$57

per barrel (2014 terms) established as a result of the “first oil crisis”. The price of about

US$122 per barrel (2014 price terms) was the highest crude oil price recorded since 1864

when the price was about US$124 per barrel (2014 price terms).

Daniel Yergin (1991) described the “second oil crisis” as “the great panic”. This label

derived from the strong influence of speculative demand on crude oil prices during the

events associated with the “second oil crisis”, particularly the Iranian revolution phase.


During and after the “first oil crisis”, Middle Eastern and North African countries

progressively took over oil companies’ producing assets, continuing a process commenced

before the “first oil crisis”. Consequently, governments transitioned from collection of

production-based taxes to selling oil. This institutional change made it more difficult to

maintain a floor under the crude oil price following spot price surges caused by speculative

demand increases induced by fears regarding supply that they had sought to create or

exploit. While the companies remained as agents of the resource-owning governments, the

latter could raise their production-based taxes in concert and let the companies compete

above the floor set by costs plus tax. Without the companies, OPEC governments had to

agree among the group on production rates and market shares and rely on others not to

cheat (Adelman, 1995).

Following the “first oil crisis” of 1973-74, the real oil price fluctuated around US$52 per barrel

(2014 prices) until 1978. Early in 1978, the oil price declined in the context of excess supply

of crude oil estimated to be in the range of 1-3 million barrels per day.

In the second half of 1974, the global economy slid into recession. Monetary authorities had

been raising official interest rates since early-1972 because of concerns about economies

overheating. Inflation continued to rise after economic activity peaked – a stagflation

problem. Tightening of monetary policy that was continued to deal with inflation worsened

the recession. High oil price prices may have exacerbated the problem, because they

reduced the purchasing power of households.

The “first oil crisis” triggered a decision by the United States Government in 1975 to

establish a Strategic Petroleum Reserve (SPR). Potentially, it provided the United States

Government with an important policy instrument in the event of subsequent oil shocks.

Peter Grossman (2013), among others, has observed that while the SPR may have been

useful as an insurance policy, like most insurance policies it involved costs, and in the case

of the SPR, the cost arguably was higher than the benefits.

In response to the 1974-1975 recession, monetary authorities in major economies reverted

to expansionary policies. Economic activity grew strongly. Inflation followed with a lag.

Also, early in 1978, the governments of the United States and Saudi Arabia entered into an

agreement that Saudi Arabia would maintain oil output and the United States would not

purchase oil for its Strategic Petroleum Reserve. The agreement was not announced at the

time. Similarly, an agreement between OPEC members in May 1978 to apply production

controls was not revealed at the time (Adelman, 1995).



Crude oil prices strengthened in May1978, but no major price recovery occurred until

August. Spot prices rose in August and September in anticipation of higher official prices at

a forthcoming OPEC meeting.

In Iran, dissatisfaction with the regime of the Shah had been growing steadily because of

adverse consequences of poor economic management of the massive increase in Iran’s oil

revenues resulting from the “first oil crisis”. Large amounts of money were spent on poorly

conceived modernisation projects. The waste of resource misallocation was compounded

by corruption. Large numbers of people flooded into cities from rural areas seeking

opportunities associated with the modernisation program. Iran’s infrastructure could not

cope with the additional pressure. Electricity blackouts were frequent and prolonged,

Tehran’s roads were clogged, and Iran’s railway system was overcrowded and

overwhelmed. Food production declined and prices rose substantially. Inflation soared

(Yergin, 1991).

6.2 Iranian Revolution

6.2.1 Unfolding of Events

Dissatisfaction with the Shah’s regime escalated during 1978. People turned increasingly to

traditional, and then more fervent, fundamentalist Islam in pursuit of greater certainty and

regime change. In January 1979, the Shah’s regime savagely ridiculed Ayatollah Khomeini,

a Shiite Islamic cleric, who was an implacable opponent of the Shah. The response was

riots in the holy city of Qom. Some demonstrators were killed by troops. Riots and

demonstrations backed by Islamic leaders spread across Iran, resulting in more deaths and

more antagonism against the Shah’s regime. In August, several movie theatres were burnt

by Islamic fundamentalists because they showed “sinful” movies. In one case, a movie

theatre was locked with 500 patrons inside and then the building was burned (Yergin 1991).

Riots and demonstrations continued. Strikes spread across the Iranian economy in

September and October. At the end of October 1978, Iranian oil workers went on strike.

Iranian production in November was 3.5 million barrels per day, compared to 6 million

barrels per day in September. Spot oil prices rose. Saudi Arabia and other Persian Gulf

producers did not increase production. However, the United States honoured its agreement

not to buy oil for the Strategic Petroleum Reserve. Other producers covered the potential

shortfall (Adelman, 1995).

The Shah installed a military government that was able to restore order in the oil industry

temporarily. Iranian exports resumed in early December, and spot prices fell.

Ayatollah Khomeini promised that December 1978 would be a month of vengeance and

“torrents of blood”. Huge demonstrations were held across Iran. Opposition to the Shah

strengthened further. Military support for the Shah crumbled. Meanwhile, the Shah’s most

important ally, the United States, dithered (Yergin, 1991).

By mid-December 1978, the oil industry was again in the grip of strikes and production

declined rapidly. Oil workers refused to supply refined products to the military, helping to

immobilise it. An attempt was made to murder the general manager of the Oil Service

Company (Osco) that operated the oil fields in Iran’s largest producing area on behalf of a

consortium of oil companies. Soon afterwards, the assistant general manager who

threatened to dismiss some potential strikers was murdered.

Exports of oil from Iran had ceased by the last week of December. Osco’s western

employees were evacuated in late-December and early January. The Shah departed in

mid-January. By mid-February 1979, the regime of Ayatollah Khomeini was in charge in



Iran (Yergin, 1991). Iranian oil production was only 0.4 million barrels per day in January

and 0.76 million barrels per day in February 1979.

6.2.2 Market and Policy Responses

Morris Adelman (1995) explained that there was adequate spare production capacity in late-

1978 and the first half of 1979 to cover disruption of supply from Iran. In addition, crude oil

inventories rose contra-seasonally in the last quarter of 1978. Speculative buying was

induced by strong fear of supply disruptions and wide anticipation that OPEC would

increase official crude oil prices at its meeting in December 1978. These expectations were

realised. Following the OPEC meeting, increases in official prices were advised for each

quarter of 1979, the annual rate of increase being 14.5 per cent. Then, the December

Iranian production disruption occurred.

Spot crude oil prices rose in January 1979 (a chart of the rise in the price of Arabian Light

Crude is provided in Figure 26). Major oil companies had been involved in heavy

speculative buying of crude oil for the first three weeks of the month, because of concerns

about production cuts by OPEC. This pushed up spot prices. In late January, Saudi Arabia

announced an immediate cut in production of 2 million barrels per day. This created further

uncertainty about supply. Speculative demand increased and producers and inventory

holders became more reluctant to produce or sell (speculative supply shock). Crude oil

prices continued to rise in February. OPEC governments raised official prices towards spot

levels.

Figure 26 Crude oil price

Note: Crude oil price in nominal terms based on Arabian Light Crude posted at Ras Tanura

Source: (BP, 2013)

Iranian production revived in early-March, averaging 2.22 million barrels per day for the

month. In April, production in Iran averaged 4.13 million barrels per day and remained

about that level in May 1979 (Adelman, 1995).

Spot oil prices declined in late-March and early April 1979. Saudi Arabia cut its production

again from 9.5 million barrels per day to 8.5 million barrels per day in early April. Spot oil

prices increased more than in January and February combined. Official prices followed.

While the rise in spot prices temporarily ceased after Saudi Arabia raised its output to 9.5

million barrels per day in July 1979, other governments cut production and OPEC

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governments continued raising official prices. Spot prices surged again late in 1979,

following a series of increases in Saudi Arabian export contract prices, increases in official

prices by other OPEC governments, production cuts by some governments, and renewed

fears about supply. The fears were inflamed by potential military conflict in the Middle East

resulting from hostages taken from the U.S. embassy in Iran, and the Soviet Union’s

invasion of Afghanistan. Spot prices reached a new high of around US$122 per barrel

(2014 price terms) in November 1979. Adelman (1995) explained that the Saudi Arabian

tactic of not assuring market participants about the future Saudi Arabian production level

had generated new fears about supply and consequent speculative buying.

In less than 12 months, spot crude oil prices had jumped by about 135 per cent from about

US$52 per barrel (around which prices had settled after the “first oil crisis”) to around

US$122 per barrel in real 2014 terms.

Spot prices turned down from December 1979 and continued a downward trend through to

August 1980, but official prices continued to rise, albeit more slowly. By August 1980,

official and spot prices were similar. During the period of price decline, inventories

accumulated and OPEC Middle Eastern (excluding Iranian) excess capacity approximated

to 20 per cent of capacity 1980 (Adelman, 1995).

Expansionary monetary policies in response to the 1974-75 recession had not only helped

the oil price spike, but also caused substantially higher inflation. During 1979, monetary

authorities (central banks) in major economies progressively tightened monetary policy to

deal with inflation, but inflation persisted. It dipped with a recession early in 1980. The

reduction in aggregate demand led to lower derived demand for crude oil, reinforcing the oil

price downturn from December 1979.

Again, the oil market worked, notwithstanding OPEC market power. The oil price spiked to

clear the market (avoid shortages) in the short-term. Again, the United States was an

exception as price controls and administrative allocation of oil and refined products

remained in place, as discussed in a subsequent sub-section. As time elapsed, the market

continued to work, with high prices encouraging activities leading to supply of additional

quantities, and reduction of quantities demanded as consumers of oil products and

manufacturers of oil product-using vehicles and equipment sought to find ways to reduce

usage and switch to alternatives. The market adjusted prices down as these efforts yielded

results.

The United States resumed purchases of oil for its Strategic Petroleum Reserve in

September 1980. It had honoured its agreement not to make SPR purchases refrained from

purchases since early-1978, even though Saudi Arabia had cut production during the

Iranian crisis dishonouring its promise to maintain its production level.

6.2.3 Petrol Queuing Returned in the United States

Around the world, where markets were allowed to work, they did. Higher crude oil and

refined product prices cleared the market. Higher prices reduced usage, increased

quantities supplied from other sources, and reallocated available supply in accordance with

willingness to pay.

The United States had started to remove its oil price control and administrative allocation

regime and on a staged basis, starting in 1979. But, the dismantling of this regime did not

happen soon enough to avoid another fiasco. An excerpt from Daniel Yergin’s (1991)

description of the debacle is provided in Box 2.

Joel Darmstadter (2013, 2014) observed:



“The stultifying and perverse impact of price controls ….. helped spur the staged removal of oil

price controls between 1979 and 1981, and more broadly served to discourage such regulatory

interventions as a major line of defence in future energy and economic upheavals.”

Box 3 Yergin on Petrol Queuing in United States

“To the American public the re-emergence of gas(oline) lines, which snaked for blocks around gasoline stations, became the embodiment of the panic. The nightmare of 1973 had returned. Owing to the disruption of Iranian supplies, there was in fact a shortage of gasoline. Refineries that had been geared to Iranian light and similar crudes could not produce as much gasoline and other lighter products from the heavier crudes to which they were forced to turn as substitutes. Inventories of gasoline were low in California, and after news reports and rumours of spot shortages, all 12 million vehicles in the state seemed to show up at once at gasoline stations to fill up. Emergency regulations around the country made matters worse. Some states, in an effort to avoid running out of supplies prohibited motorists from buying more than five dollars’ worth at any one time. The results were exactly the opposite of what was intended, for it meant that motorists had to come back to gas stations that much more frequently. Meanwhile, price controls limited the conservation response; and indeed, if gasoline prices had been decontrolled, the gas lines might have disappeared rather quickly. At the same time, the federal government’s own allocation system froze distribution patterns on a historical basis and denied the market the flexibility to move supplies around in response to demand. As a result, gasoline was in short supply in major urban areas, but there were more than abundant supplies in rural and vacation areas, where the only shortage was tourists. In sum, the nation, through its own political immobilism, was rationing gasoline through the mechanism of gas lines. And, to make matters worse, gas lines themselves helped beget gas lines. One estimate suggested that America’s motorists in the spring and summer of 1979 may have wasted 150,000 barrels of oil a day waiting in line to fill their tanks!”

Source: Yergin (1991), pp. 691-692.

6.2.4 Causes of the Oil Shock

For around 20 years after the Iranian revolution, the traditional view was that the huge price

spike in 1979 was caused by disruption of Iranian supply. However, it is now clear that this

was only a partial cause of the price spike. Views differ on the relative importance of supply,

aggregate demand and speculative demand shocks.

Lutz Kilian (2009a, 2010a,c) and Lutz Kilian and Daniel Murphy (2014) attributed the price

surge to a resurgence of global economic activity (an aggregate demand shock), combined

with strong speculative demand, particularly late in 1979. The aggregate demand shock

was underpinned by loosening of monetary policy by governments of major economies in

response to recession in the second half of 1974 and 1975. Speculative demand was

driven by perception of increased risk of further oil supply interruptions caused by military

conflict in the Persian Gulf, and anticipated growth of demand for oil. Inventory behaviour

was consistent with the speculative demand element, falling sharply initially after the supply

shock and then rising above pre-shock levels by May 1979. Their diagnosis of causes and

their relative contributions was supported by econometric analysis using a structural vector

autoregressive (VAR) model.

James Hamilton (2009b) argued that Kilian (2009a) had overemphasised the roles of

aggregate and speculative demand and played down too much the relative importance of

supply shocks. He did not dispute Kilian’s view on the role of an aggregate demand shock.

He focussed mainly on the significance of speculative demand, suggesting that inventory

behaviour was not consistent with a major explanatory role for this form of oil shock, and

price elasticity of demand estimates did not render it implausible to attribute most of the

price change to the supply shock. Subsequent detailed analysis of the relationship between

speculative demand and inventory movements by Kilian and Murphy (2014), and earlier



analysis by Yergin (1991) and Adelman (1995) of inventory changes in the context of the

aftermath of the Iranian revolution contradicted Hamilton’s view.

Peter Grossman (2013) observed that speculative demand had been a major factor

explaining the price spike in response to the Iranian revolution. Grossman referred to a

“crisis of confidence”.

Daniel Yergin (1991) noted that oil demand had risen strongly in the period 1976-1978.

However, he highlighted the importance of speculative demand driven by fear in driving up

oil prices in response to the Iranian revolution. Yergin’s explanation is shown in Box 3.

Box 4 Daniel Yergin on Panic, Speculative Demand and Inventories

“Why should a 4 or 5 per cent loss of supplies have resulted in a 150 per cent increase in the price (in nominal terms)? The answer was panic. …….

It was buyers, stunned by the unfolding spectacle, fearing a repetition of 1973, gripped by panic, who inadvertently made the shortage worse by building up inventories – as they had done in 1973. The world oil industry maintains billions of barrels of oil in inventories – supplies in storage – on any given day. Under normal circumstances, they were the stocks necessary for the smooth operations of the highly capital-intensive ‘machine’ that extended from the oil field through the refinery to the gasoline station. …. On top of that base requirement, the industry held a sort of insurance cushion: additional stocks to protect against any unexpected shifts in supply or demand – say a sudden surge of oil use in winter … or a two-week delay in the arrival of a tanker because storms had disrupted loading facilities. ….

Of course, it was expensive to hold inventories. The oil had to be bought, facilities maintained, money tied up. So companies did not want to hold more inventories than their normal experience suggested they needed. If they thought that prices were going to go down because consumption was sluggish, they reduced inventories, and as quickly as they could, with the idea of buying later when the price would be lower. That was exactly what the industry was doing during the soft market conditions through most of 1978. By contrast, if companies thought that prices were going to go up, they bought more of today’s cheaper barrels so that they would have to buy less of tomorrow’s more expensive oil. And that was what happened, with extraordinary vengeance and fury, in the panic of 1979 and 1980. In fact, the companies bought well in excess of anticipated consumption, not only because of price, but also because they were not sure they would be able to get any oil later on. And that extra buying beyond the real requirements of consumption, combined with hoarding, dizzily drove the price, which was exactly what companies and customers were struggling to avoid in the first place. In short, the panic of 1979-80 saw self-fulfilling and ultimately self-defeating, prophecy on a truly colossal scale. The oil companies were not alone in panic buying. Down the consumption chain, industrial users and utilities also furiously built inventories as insurance against rising prices and possible shortages. So did the motorist. Before 1979, the typical motorist in the Western world drove around with his tank only one-quarter full. Suddenly worried about gasoline shortages, he too started building inventories, which is another way of saying that now he kept his gas tank three-quarters full. And suddenly, almost overnight, upwards of a billion gallons of motor fuel were sucked out of gasoline station tanks by America’s frightened motorists.

The rush to build inventories by oil companies, reinforced by consumers, resulted in an additional three million barrels per day of ‘demand’ above actual consumption. When added to the 2 million barrels per day of nett lost supplies, the outcome was a total shortfall of 5 million barrels, which was equivalent to about 10 per cent of consumption. In sum, the panic buying to build inventories more than doubled the actual shortage and further fuelled the panic. That was the mechanism that drove the price from US$13 to US$34 dollars a barrel.”

Source: Yergin (1991), pp. 685-687.

Morris Adelman (1995) and Marian Radetzki (2008) emphasised the importance of

opportunistic production cuts by Saudi Arabia, speculative demand driven by panic, and

ratcheting-up of official or contract prices in conjunction with production restraint. Adelman

(1995, p. 181) summarised his analysis of causes as follows:

“There would have been no spot price increases in 1979 had not Saudi Arabia deliberately

refused to expand output, then cut production at crucial moments. The result was to panic the



market. And even then, spot prices would have later sunk or collapsed …… had not the whole

group ratcheted up official prices and restrained production in concert.

The Saudi output cuts of January 1979 and April 1979 were an attempt to fine-tune the market

with coarse instruments and achieve a tight supply situation. They did not plan a panic, but

made one and exploited it. …… they broke agreements with the U.S. government, knowing it

would publicly approve everything they did.”

Opportunistic production cuts and production restraint were mechanisms used to support

the 1973-1974 change from a “competitive” market system to a “cartel” or “market-maker”

structure, as identified by Krichene (2002). The results could be categorised either as

speculative supply shocks or as speculative demand shocks, caused by by OPEC members

withholding supply or demanding their own oil, respectively.

6.3 Iran-Iraq War

6.3.1 The Conflict and Its Origins

On 22 September 1980, Iraqi warplanes and heavy artillery attacked multiple targets in Iran.

Iraqi troops started to push into Iran along a broad front.

The commencement of war between Iraq and Iran been preceded by various border

incidents over a period of several weeks. However, the motives for the invasion of Iran by

Iraq were numerous and based on longstanding antagonism. These motives included

(Yergin, 1991; Adelman, 1995):

previous hostilities dating back nearly 5000 years – Mesopotamia versus Elam; Arabs

versus Persians

arbitrary creation of nations and their boundaries in the Middle East in the first half of the

twentieth century

economic importance to both countries of the Shatt-al-Arab area that extends along their

common boundary for nearly 200 kilometre – Persian Gulf access and oil infrastructure

hatred between Saddam Hussein and Ayatollah Khomeini

agitation of the Shiite majority in Iraq against the Sunni-based ruling regime in Iraq was

been stirred up by Iranian Shiite clerics

weakened Iranian military following the lranian Revolution

annexation of Khuzistan which had a substantial minority Arab population and 90 per

cent of Iran’s oil reserves.

The early stages of the Iran-Iraq war abruptly removed about 4 million barrels of oil per day

from the market, as each party attacked the oil producing, processing and exporting facilities

of the other. While Iranian oil exports were reduced by the war, Iraqi exports almost ceased,

because Iraqi access to the Persian Gulf was cut off by Iranian attacks and Iran persuaded

Syria to cut off Iraqi exports through Syria by pipeline (Yergin, 1991).

Saddam Hussein’s aim of a short, sharp “blitzkrieg” victory was thwarted. Iranian forces

withstood the initial attacks and hit back quickly. Arabs in Khuzistan saw the Iraqi forces as

invaders, not liberators. Ayatollah Khomeini’s position in Iran was strengthened by the

invasion. Young Iranians rushed to be martyrs in human wave assaults on Iraqi forces

(Yergin, 1991).

6.3.2 Market and Policy Responses

Commencement of the Iran-Iraq war reversed a 10-month decline of spot crude oil prices.

Over the next two months, spot crude oil prices rose by about 20 per cent, back to the peak

previously attained in November 1979. This occurred despite the existence of inventories



large enough to last for a year, an increase in Saudi Arabian production from 9.5 million

barrels to 10.4 million barrels per day, production increases elsewhere in OPEC and outside

of OPEC, and remaining excess capacity of 10 per cent of capacity in Saudi Arabia and 20

per cent in other OPEC nations excluding Iran and Iraq (Adelman, 1995).

Saudi Arabia progressively raised its contract or official price. However, Saudi Arabia kept

its contract price below other producing countries, which kept their contract prices below the

spot price. This allowed Saudi Arabia to produce more without sacrificing price reductions.

The oil price surge was dampened by an initial run down of inventories and unexpectedly

large production increases in various countries. Later, inventories climbed above levels

attained before the Iran-Iraq war for two reasons: some resurgence of speculative demand,

and supply responses that exceeded expectations.

The spot price declined markedly in the period February to July 1981, and then more slowly

through to September. This was assisted by some selling of inventories by refining

companies because of high holding costs. Meanwhile, contract prices were raised

progressively. Adelman (1995) argued that government increases in contract prices had

slowed the decline of spot prices.

By July 1981, spot prices were back at the level applying in August and September 1980

before the war. They had converged to Saudi Arabian and non-Saudi contract prices that

had been rising (Adelman, 1995; Kilian, Murphy, 2014).

6.3.3 Causes of the Oil Shock

The traditional view was that the price spike that followed commencement of the Iran-Iraq

war was attributable solely to the associated negative supply shock. This view has been

challenged over the past decade.

Lutz Kilian and Daniel Murphy (2014) argued, with the aid of modelling using a structural

VAR model, that aggregate demand growth was perhaps even more important than at the

time of the Iranian revolution about 21 months earlier. The economic intuition underlying

this is that monetary policy had been eased in response to a recession that commenced in

early-1980. Consequently, aggregate demand and economic activity recovered prior to the

Iran-Iraq war and governments. Governments tightened monetary policy again as the

inflation rate rose (Barsky, Kilian 2004; Kilian, 2010a).

Modelling by Kilian and Murphy indicated that the supply shock was relatively more

important than in the earlier spike, and speculative demand was relatively less important.

They noted that unexpectedly large supply increases, reflecting in part the growing

importance of non-OPEC oil producers, had provided a lagged, offsetting positive supply

shock.

This was consistent with Adelman’s (1995) analysis of the Iran-Iraq war shock. However,

Adelman also explained that the price spike was exacerbated by the tactic of Saudi Arabia

and OPEC more generally of raising contract or official prices to support spot price

increases.

6.4 Impacts on the Australian Economy

Movements in crude oil prices in nominal US$ and A$ terms are shown in Figure 27. The

price was moderated in 1980 and 1981 by appreciation of the $A relative to the US$. As a

result of depreciation of the $A in 1982, by mid-1982, the international crude oil price

expressed in Australian dollars exceeded the price in US dollars.



Figure 27 Crude oil price A$ and US$

Note: Crude oil prices are quarterly average based on the price of crude oil imported into the US

Source: (EIA, March 2014)

With the move to import parity pricing in Australia in 1978, petrol prices continued on a rising

trend. It is not clear why petrol prices did not follow the trend of $A crude oil prices after the

June quarter of 1981, other than that it was preceded by a transition to full import parity

pricing in 1980.

Figure 28 Crude oil prices and petrol prices - A$ terms “second oil crisis”

Note: Crude oil prices are yearly average based on Arabian light Ras Tanura.


Source: ABS and (EIA, March 2014)

Petrol prices in the capital cities tracked closely together with only slight divergences over

the period of the Iran revolution and the Iran-Iraq war from 1979 to 1981 (see Figure 29).

0.0

5.0

10.0

15.0

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35.0

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45.0

Mar

-78

Jul-7

8

Nov

-78

Mar

-79

Jul-7

9

Nov

-79

Mar

-80

Jul-8

0

Nov

-80

Mar

-81

Jul-8

1

Nov

-81

Mar

-82

Jul-8

2

Nov

-82

Mar

-83

Jul-8

3

Nov

-83

$/bbl


0.0

10.0

20.0

30.0

40.0

50.0

0

5

10

15

20

25

30

35

40

45

50

Mar

-78

Aug

-78

Jan-

79

Jun-

79

Nov

-79

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-80

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-80

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-81

Jul-8

1

Dec

-81

May

-82

Oct

-82

Mar

-83

Aug

-83

Crude oil $A/bbl

Petrol c/l




Figure 29 Capital cities petrol prices (nominal)

Source: ABS

The rise in fuel prices did not have a noticeable short term effect in 1979 and 1980, although

demand growth flattened over that period. The ongoing rise in prices, however, appears to

have had a lagged effect with demand for petroleum products falling from 1980 onwards,

although recession in 1982 and 1983 would have contributed (Figure 30).



Production and imports of crude oil and refinery feedstock were relatively flat over the 1979

to 1981 period (Figure 31), as was refinery production. Net imports made up the balance of

demand for refinery feedstock (Figure 32). Australian light sweet crude was balanced by

imports of heavier crudes necessary to meet Australian refinery requirements.

0

10

20

30

40

50

60

Mar

-78

Jul-7

8

Nov

-78

Mar

-79

Jul-7

9

Nov

-79

Mar

-80

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0

Nov

-80

Mar

-81

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1

Nov

-81

Mar

-82

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-83

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Nov

-83

c/l



33 000

34 000

35 000

36 000

37 000

38 000

39 000

40 000

41 000

19

77

-78

19

78

-79

19

79

-80

19

80

-81

19

81

-82

19

82

-83

19

83

-84

ML /a





Refinery production also fell from around 4,000 ML per annum to 2500 ML per annum by

1983-84 (Figure 32).



Net imports fell from 2,500 ML per annum in 1979-80 to a net exporting position of around

400 ML per annum in 1983-84. Supply of petroleum products to the Australian market was

never interrupted over the period.

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

1977

–78

1978

–79

1979

–80

1980

–81

1981

–82

1982

–83

1983

–84

ML/a


25 000

27 000

29 000

31 000

33 000

35 000

37 000

39 000

1977

–78

1978

–79

1979

–80

1980

–81

1981

–82

1982

–83

1983

–84

ML/a





Australian road users did not significantly change their driving habits. There was no

significant change in the trend of a gradual increase in kilometres travelled (Figure 34).


Source: ABS

Inflation rose over the period from 8 per cent in 1978 to around 11 per cent in the June

quarter of 1981 (Figure 35). Then, inflation shifted up again reaching a peak of 12 per cent

by the September quarter of 1982. However this was driven by broader economic factors as

well as ongoing increases in fuel prices. One factor was significant depreciation of the

nominal exchange.

–1 000

– 500

0

500

1 000

1 500

2 000

2 500

3 000

1977

–78

1978

–79

1979

–80

1980

–81

1981

–82

1982

–83

1983

–84

ML/a

0

2

4

6

8

10

12

Mar

-77

Aug

-77

Jan-

78

Jun-

78

Nov

-78

Apr

-79

Sep

-79

Feb

-80

Jul-8

0

Dec

-80

May

-81

Oct

-81

Mar

-82

Aug

-82

Jan-

83

Jun-

83

Nov

-83






Source: ABS

GDP growth fell back from 4 per cent to 3 per cent over the period and remained at around

that level before falling in 1982 well past the time of the Iran-Iraq war.

Figure 36 GDP growth rate

Source: ABS

In summary the impact for the effects of the Iranian Revolution and the Iran-Iraq war on

global oil supplies and crude oil prices did not interrupt supplies to Australia. The increases

in petrol prices that occurred after the Australian dollar oil price peaked may have been

related to the decision to move to import parity pricing for domestically-produced crude oil.

The impact of the price rises on demand for petroleum fuels was not immediate. Demand

growth did however flatten as prices rose, but it was not until two years later that demand

began to fall.

0.0

2.0

4.0

6.0

8.0

10.0

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16.0

Mar

-197

7

Aug

-197

7

Jan-

1978

Jun-

1978

Nov

-197

8

Apr

-197

9

Sep

-197

9

Feb

-198

0

Jul-1

980

Dec

-198

0

May

-198

1

Oct

-198

1

Mar

-198

2

Aug

-198

2

Jan-

1983

Jun-

1983

Nov

-198

3


-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Jan-

1977

Jan-

1978

Jan-

1979

Jan-

1980

Jan-

1981

Jan-

1982

Jan-

1983




6.5 Australian policy issues and responses

The public debate and concern over oil security and energy policy became stronger over the

1979 to 1982 period. After a Ministerial reshuffle, a new portfolio of Resources and Energy

was established and the Australian Government announced a new energy policy in 1979.

The policy was generally aimed at “securing Australia’s energy future”, but was in practice

driven by a desire to reduce Australia’s dependence on oil from the Middle East. The four

themes of the policy were:

promote exploration and development Australia’s oil and gas resources

energy substitution

energy conservation

support the development of alternative energy sources.

The excise on LPG was removed and subsidies for the conversion of vehicles to LPG were

introduced.

Taxation arrangements on the production of indigenous crude oil remained in place, and

new oil remained free of excise. The move to import parity pricing for crude oil to refiners

and to a lesser extent, exchange rate depreciation were contributing factors. Arrangements

for pricing of crude oil to producers, however, continued the disconnect between the price

that was received by producers and the international price. This discouraged the

development of new but more marginal fields, and resulted in ongoing negotiations between

government and the producers to make adjustments to encourage development of new

fields.

The National Energy Research and Development Programme was established and the

energy statistics programme in the Department was strengthened. A number of issues were

referred to the National Energy Advisory Committee (NEAC) for advice. Among those

matters referred was the question of whether Australia should implement a stock-holding

policy. The NEAC advice was that Government investment in stocks would not be an

economic proposition. The matter subsequently went to Cabinet, which decided that a

stock-holding policy was not justified on economic as well as policy grounds.

The government also established two advisory committees:

the National Petroleum Advisory Committee (NPAC) comprised of industry and

government representatives to advise on oil supply arrangements

the National Oil Supplies Emergency Committee (NPAC) comprising industry and

government representatives to advise on management of energy emergencies.

NPAC subsequently recommended that arrangements be established between governments

and industry to manage significant national emergencies. This resulted in the passing of the

Liquid Fuels Emergency Act (1984). The Act established arrangement for the declaration of

a National Liquid Fuels Emergency by the Minister and arrangements for governments to

intervene in the allocation of fuels in an emergency.

In response to the price rises, consumption of petroleum products fell by around 4 per cent

over a period of four years. The move to import parity pricing for crude oil meant that

domestic fuel prices continued to rise. This, along with policy statements to encourage

energy conservation, may have prolonged the impact on fuel consumption.



7 Responses to high oil prices and withdrawal of Saudi Arabian support for the oil price, 1985-86

Key Points

International

In the early 1980s, the global economy slid into recession. Growth of demand for oil stalled. Meanwhile market forces were working. Increasing quantities of oil were supplied and declining quantities were demanded in response to the dramatic price increases associated with the “first and second oil crises”. As time elapsed, economic entities were able to take advantage of increasing adjustment opportunities. Oil consumption in 1983 was down about 11.5 per cent from its peak in 1979. OPEC was experiencing increasing difficulties holding up the oil price.

By July 1981, spot prices were back at the level applying in August and September 1980 before commencement of the Iran-Iraq. Thereafter, prices steadily declined. By 1983, Saudi Arabia was bearing most of the burden of cutting production to try prop-up oil prices. In mid-1985, Saudi Arabia was producing around 2.5 million barrels a day (about 22.5 per cent of capacity), compared to about 10.4 million barrels per day (93 per cent of capacity) following commencement of the Iran-Iraq war less than 4 years earlier.

In mid-1985, Saudi Arabia abandoned its attempts to support the crude price by curtailing output. Saudi Arabia’s production rose from about 2.5 million barrels per day in July 1985 to about 6.25 million barrels per day in July 1986. This positive oil supply shock, combined with speculative selling of inventories drove down the oil price by nearly 70 per cent from November 1985 to May 1986. In 2004 real terms, the price fell to about US$24, compared to US$68.50 in November 1985, US$122 at the peaks in the “second oil crisis”, and about US$19 before the “first oil crisis”.


Notwithstanding pervasive suspicion and mistrust among OPEC members, agreements were reached in August 1986 and December 1986 to cut production. This and speculative demand supported price recovery. By January 1987, crude oil spot prices had risen to around US$45 per barrel in real 2014 terms, compared to about US$68.50 in November 1985.

Australia

Although US dollar oil prices fell over the period from 1981 to 1985, Australian dollar oil prices rose from $34 per barrel to $40 per barrel in nominal terms as the exchange rate depreciated. Oil prices then fell sharply from $39 per barrel to $18 per barrel by June 1986, a fall of around 28 per cent.

Petrol prices continued to rise from 30 cents per litre in 1981 to 70 cents per litre in 1986, before falling to 64 cents per litre in June 1986, with the collapse of the oil price. This fall of 8 per cent was far less than the fall in the price of crude oil, even after allowing for the impact of fuel excise which made up around half of the cost of petrol at the time.

Road-use declined by about 10 per cent from 1985 to 1986 before continuing to rise at the longer term trend after that.

Consumption of refined oil products fell significantly with the recession in 1982-83 and lagged responses to high prices. Consumption recovered from 1984-85, but by 1986-87, still had not re-attained the 1980-81 level of about, 37,900 ML. Refinery production was steady at around 35,000 ML per annum to 36,000 ML per annum. Net imports were 239 ML per annum in 1982-83 and minus 399 ML per annum in 1983-84. Net imports rose to 1,500 ML per annum in 1986-87 as demand rose and refinery production declined.

By 1985-86, inflation had returned to the long term trend of 2 per cent per annum and economic growth had returned to around 4 per cent per annum after falling to minus 2 per cent during the recession in 1983. Australia accompanied major economies in sliding into recession.

The Liquid Fuels Emergency Act (1984) was passed. The Act included provisions for declaration of a liquid fuels emergency by the relevant Commonwealth Minister that provided powers to intervene in the market. However, the market had worked effectively to avoid shortages during the oil crises of the preceding decade. It was continuing to work to induce more production and less consumption of



oil.

7.1 Oil Market Circumstances, 1981-1985

Around mid-1981, the global economy slid into recession. With growth of economic activity

stalled, growth of demand for oil stalled too.

In 1980, the central bank in the United States initiated a major shift in monetary policy.

Monetary authorities in other major economies made similar changes. Fighting inflation was

given primacy over reducing unemployment. The monetary authorities persisted with tight

monetary policy despite inflation being slow to come down – despite the coincidence of high

inflation and high unemployment, an occurrence referred to as stagflation. This major shift

in monetary policy ended the boom-bust cycle and recurring stagflation problem of the

preceding decade (Kilian, 2010a).

The early-1980s recession coincided with the effects of market forces. Increasing quantities

of oil were supplied and declining quantities were demanded in response to the dramatic

price increases associated with the “first and second oil crises”. As time elapsed, economic

entities were able to take advantage of increasing adjustment opportunities so that price

elasticities of demand and supply increased (became more elastic). Historically high oil

prices for a decade had induced:

substantial exploration around the world

technical research and innovation in respect of exploration and extraction methods

considerable expansion of production in non-OPEC countries

research and innovation regarding more efficient use of oil products

conservation of, and switching from oil products to other fuels.

In 1983, oil consumption in the non-communist world was about 45.7 million barrels per day,

down 6 million barrels a day from the peak consumption year, 1979. During the same

period, non-OPEC production had risen by 4 million barrels per day. In addition, economic

entities that had built up inventories substantially in anticipation of a shortage wanted to sell

and run them down to avoid associated holding costs and to beat price reductions (Yergin,

1991).

Over a longer period, the changes were more marked, and OPEC’s difficulties in controlling

prices increased, as noted by Radetzki (2008, p. 160):

“In the 1980s, OPEC experienced increasing difficulties in its efforts to control oil prices. The

longer-run elasticities turned out much higher than the short-run ones. World demand for oil

stagnated in response to the elevated price levels. The compound rate of global demand

growth (for oil) between 1973 and 1986 was no more than 0.4 per cent. Demand in the OECD

fell by 14 per cent in the period, despite a 40 per cent expansion in the area’s GDP. Supply

outside OPEC, which had been stagnant at 18-19 million barrels per day until 1977, rose to

27.7 million by 1985. From a full-capacity utilisation output at 30.8 million barrels per day in

1979, OPEC had to reduce production to 16.2 million in 1985, to maintain the high price.”

Spot crude oil prices declined inexorably from the peak attained in November 1980 to the

pre-war level in July-September 1981. In July 1981, with the global economy sliding into

recession, OPEC members demanded that Saudi Arabia either cut production from the level

(about 10.4 million barrels per day) it was increased to after the start of the Iran-Iran war, or

raise contract prices. This was intended to halt the sliding spot price. It would have allowed

OPEC members other than Saudi Arabia to sell more oil at existing prices. Saudi Arabia

refused. In the period from late August to mid-October, some OPEC members (but not



Saudi Arabia) cut their contract prices. In September, some oil companies started selling

down their large holdings of oil inventories at discounts of 3-4 per cent to spot and contract

prices.

For the next 4 years, the “clumsy cartel”, as Adelman (1995, 2004) described OPEC,

struggled to hold up the crude oil price. The limit to the price set by substitution and

conservation activities by consumers and non-OPEC production was actually below the mid-

1981 level.

In 1983, OPEC members had to reduce their contract or official prices, but could not bring

themselves to discuss prices again for another 2-3 years. They agreed on a production

quota for the whole group, 17.5 million barrels per day, but could not agree on production

cuts to support any given crude oil price level. According to the OPEC communiqué, Saudi

Arabia was to “act as the swing producer to supply the balancing quantities to meet market

requirements”. So, the country with the largest reserve position in the world was allocated

the responsibility of changing its production rate to maintain the crude oil price level

(Adelman, 1995; Yergin, 1991).

Saudi Arabia was already bearing most of the burden of production cuts to protect the crude

oil price and this continued until the second half of 1985. Saudi Arabia’s share of OPEC

exports declined from 47 per cent in 1981 to 19 per cent in 1985. In mid-1985, Saudi Arabia

was producing around 2.5 million barrels a day (about 22.5 per cent of capacity), compared

to about 10.4 million barrels per day (93 per cent of capacity) following commencement of

the Iran-Iraq war less than 4 years earlier. Radetzki (2008) noted that Saudi Arabia’s action

was crucial to maintenance of the price of crude oil.

Adelman (1995, pp. 235) summarised OPEC’s and Saudi Arabia’s price and production

dilemma in the following terms:

“With the (international oil) companies gone, the OPEC governments had to fix production and

set down market shares in black and white. Any change in planned total output unlocked

everyone’s demands for a larger share of the market, and the whole deal had to be remade.

…. In March 1982, they made a loose allocation agreement, which was not well observed, and

then the firm agreement of March 1983, which was not well observed either.

Each cartel member wants to shove the burden of curtailment on to others. When smaller

cartel members cheat by producing more and shading the price, the largest producer fears

retaliating, lest the whole arrangement crumble. The Saudis’ share of OPEC exports fell from

47 per cent in 1981 to 19 per cent in 1985. The others must have known that the Saudis could

not tolerate exports around one million barrels per day, but they could not achieve agreement

to alleviate the Saudis’ plight.

The only Saudi weapon was to threaten to cut prices. But after a while, nobody believed their

threats. , and by mid-1985, their partners were openly contemptuous. Indeed, even if another

single member believed the threat, what was he to do? Unless all members would cooperate, it

was not worth any single member’s time.”

7.2 Saudi Arabia’s Abandonment of Price Support

In the second half of 1985, Saudi Arabia abandoned its attempts to support the crude price

by curtailing its own production. Saudi Arabia started to raise its production rate in August

1985. It kept doing so until November 1985. At the end of the month, Saudi Arabia

suspended its official prices. It moved production rates up again from May to July 1986.

Saudi Arabia’s production rose from about 2.5 million barrels per day in July 1985 to about

6.25 million barrels per day in July 1986. During this same period, Saudi Arabia’s

production capacity utilisation rose from about 22.5 per cent to more than 56 per cent

(Adelman, 1995; Hamilton, 2009a).



7.3 Market Responses to Positive Oil Supply Shock

The unexpected major increase in oil production was a positive oil supply shock. It was

followed with a lag by a sharp fall in the real crude oil price. Initially, announcements of

Saudi Arabia’s new production policy had little effect in the context of a price upswing

associated with temporary suspension of exports from Iran’s Kharg Island terminal (following

an Iraqi air attack) and from Russia (production problems).

From November 1985 to May 1986, the drop in the spot crude oil price was nearly 70 per

cent. In 2004 real terms, the price had fallen to about US$24, compared to US$122 at the

peaks associated with the Iranian revolution and Iran-Iraq war, and about US$19 before the

“first oil crisis”.

Notwithstanding pervasive suspicion and mistrust among OPEC members, a temporary

production agreement was reached in August 1986. It resulted in a turn-around in the spot

price of crude oil. This was reinforced by another agreement in December 1986 to cut

production by 5 per cent. By January 1987, crude oil spot prices had risen to around US$45

per barrel in real 2014 terms, compared to about US$68.50 in November 1985 (Hamilton,

2009a; Adelman, 1995).

7.4 Causes of Oil Shock

The substantial unexpected increase in Saudi Arabia’s production rate, following its

abandonment of support for the oil price through progressive production cuts, was a positive

oil supply shock. This pushed the real price of crude oil down.

Kilian and Murphy (2014) argued that a speculative demand drop, reflected by reduction of

stocks, reinforced the oil price fall. They explained that this shift in speculative demand was

caused by changes in price expectations as a result of altered perceptions of OPEC’s

market power. They pointed out that while inventories rose initially, as expected, because of

the increase in Saudi Arabian production, they subsequently declined consistent with a

downward speculative demand shock.

Kilian and Murphy (2014) indicated that after the price collapse, OPEC talks directed

towards agreement on production cuts led to increased speculative demand. This brought

forward price effects of production cuts.

7.5 Impacts in Australia

World crude oil prices fell steadily over the 1981 to 1986 period. The Australian dollar was

floated in 1983. It depreciated substantially against the US dollar from the second quarter of

2003 until early-1987 before stabilising. Consequently, the crude oil price in $A terms rose

until the second half of 1985, while the US$ crude oil price was steadily declining. The

continuing depreciation muted the 1985-86 collapse of the international crude oil price in $A

terms (Figure 37).



Figure 37 Crude oil price in A$ and US$

Note: Crude oil prices are quarterly average based on the price of crude oil imported into the US

Source: (EIA, 2014) ABS

Nominal petrol prices continued to rise from November 1980 until late-1985, notwithstanding

sliding US$ oil prices. This can be only partly explained by depreciation of the $A and

resulting behaviour of crude oil prices in $A terms (Figure 38). The indexation of fuel excise

in 1983 would have contributed in part to this rise. Also, the domestic fuel market may have

still been adjusting to the move to import parity pricing. However, the extent of the rise in

petrol prices appears anomalous.


Note: Crude oil prices are quarterly averages based on the price of crude oil imported into the U.S. Petrol prices are quarterly average for capital cities.

Source: ABS and (EIA, March 2014)

Fuel prices in capital cities tended to track closely (Figure 39). Prices in Tasmania diverged

slightly being up to 10 per cent higher than other capital cities by 1986. Apart from that

0.0

5.0

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Mar

-80

Aug

-80

Jan-

81

Jun-

81

Nov

-81

Apr

-82

Sep

-82

Feb

-83

Jul-8

3

Dec

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May

-84

Oct

-84

Mar

-85

Aug

-85

Jan-

86

Jun-

86

Nov

-86

$ /bbl

Crude oil price A$ (nominal) Crude oil price US$ (nomimal) 1.80

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

0

10

20

30

40

50

60

Mar

-80

Oct

-80

May

-81

Dec

-81

Jul-8

2

Feb

-83

Sep

-83

Apr

-84

Nov

-84

Jun-

85

Jan-

86

Aug

-86

Mar

-87

Oct

-87

Crude oil $AUS/bbl

Petrol c/l

Petrol price (nominal) Crude oil price US$ (nomimal)



divergence there does not appear to have been any significant regional differences in the

impact of ongoing fuel supplies.


Source: ABS

Consumption of petroleum products fell in 1982-83 (Figure 40). This was however driven by

the deepest post war recession that Australia had experienced. Major economies were also

affected by recession at this time. In addition, there was a lagged response to high prices in

the preceding 10-year period. Consumption of petrol recovered in the following year and

continued its gradual rise despite the also rising petrol prices, but by 1986-87 still had not re-

attained the 1980-81 level.

The focus of Australian political debate was more on macroeconomic policy and

microeconomic reform, than on the oil market.



0

10

20

30

40

50

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70

Mar

-80

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-80

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81

Jun-

81

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-81

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-82

Sep

-82

Feb

-83

Jul-8

3

Dec

-83

May

-84

Oct

-84

Mar

-85

Aug

-85

Jan-

86

Jun-

86

Nov

-86

Apr

-87

Sep

-87

c/l



34 000

34 500

35 000

35 500

36 000

36 500

37 000

37 500

38 000

38 500

19

80

-81

19

81

-82

19

82

-83

19

83

-84

19

84

-85

19

85

-86

19

86

-87

ML /a



Australian production of crude oil and condensate increased by 40 per cent over the 1982 to

1984 period (Figure 41). Much of this increase was driven by exports of crude oil and

condensate from the North West Shelf gas project, which commenced production in 1984.

Imports of refinery feedstock for Australian refineries were largely steady at 10,000 ML per

annum.



Refinery production was also steady at around 35,000 ML per annum over the 1982 to 1988

period (Figure 42).



Net imports of petroleum products declined from 1,750 ML in 1980-81 to net exports of 400

ML in 1983-84 as a result of increased refinery production, before moving back above 1,750

ML in 1986-87.

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

1980

–81

1981

–82

1982

–83

1983

–84

1984

–85

1985

–86

1986

–87

1987

–88

ML/a


25 000

27 000

29 000

31 000

33 000

35 000

37 000

1980

–81

1981

–82

1982

–83

1983

–84

1984

–85

1985

–86

1986

–87

ML/a





Rising fuel prices did not appear to moderate distance travelled by Australian road users. It

continued to increase at a steady rate (Figure 44).


Source: (BTRE, 2012)

The consumer price index fell in 1983-84, as the recession took hold. GDP growth fell to

minus 0.5 per cent in 1983-84, as the Australian economy slid into recession like major

economies (Figure 45 and Figure 46).

–1 000

– 500

0

500

1 000

1 500

2 000

1980

–81

1981

–82

1982

–83

1983

–84

1984

–85

1985

–86

1986

–87

ML/a

0

2

4

6

8

10

12

14

Mar

-80

Aug

-80

Jan-

81

Jun-

81

Nov

-81

Apr

-82

Sep

-82

Feb

-83

Jul-8

3

Dec

-83

May

-84

Oct

-84

Mar

-85

Aug

-85

Jan-

86

Jun-

86

Nov

-86

Apr

-87

Sep

-87





Figure 45 Percentage change in quarterly CPI from previous year

Source: ABS


Source: ABS

7.6 Australian Policy Issues and Responses

While the ongoing issues of the role of OPEC in attempting to maintain oil prices though

production quotas was an ongoing concern in the energy debate, the impact of the global

recession in 1983 and the ongoing microeconomic reform agenda were more dominant

issues of national policy.

Australia joined the IEA in 1979 and was participating in activities under the energy

programme. The focus of national energy policy was on encouragement of Australian

petroleum exploration and development, encouragement of alternative energy supplies, and

energy conservation.

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Mar

-198

0

Sep

-198

0

Mar

-198

1

Sep

-198

1

Mar

-198

2

Sep

-198

2

Mar

-198

3

Sep

-198

3

Mar

-198

4

Sep

-198

4

Mar

-198

5

Sep

-198

5

Mar

-198

6

Sep

-198

6

Mar

-198

7

Sep

-198

7

Mar

-198

8

Sep

-198

8


-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-

1980

Jan-

1981

Jan-

1982

Jan-

1983

Jan-

1984

Jan-

1985

Jan-

1986

Jan-

1987

Jan-

1988




Introduction of the Petroleum Resource Rent Tax in 1988 in offshore areas except Bass

Strait and the North West Shelf partly resolved the issue of differential taxation on new oil.

The government also introduced a programme of offshore exploration licence releases

which ultimately resulted in some successful discoveries in the offshore Otway and Bass

Basins and in the offshore basins of Western Australia and the Northern Territory.

A Liquid Fuels Emergency Act was passed in 1984 which provided arrangements for

preparation for, and responses to liquid fuels supply disruptions. This provided for the

Minister to declare a liquid fuels emergency, and arrangements for the allocation of

wholesale product supplies while emergency arrangements were in place.

However, not even the “first and second oil crises” of the preceding decade generated liquid

fuel emergencies. The market system had effectively avoided shortages. Prices adjusted to

circumstances to clear the market. The collapse of the US$ oil price in 1986 showed how

high prices could induce increasingly large reductions in quantity demanded and in quantity

supplied as economic entities had time to adjust their behaviour.



8 Iraq’s invasion of Kuwait, 1990-91

Key Points

International

Iraq’s invasion of Kuwait for economic and political reasons on 2 August 1990 was followed by a United Nations-sanctioned embargo that removed nearly 4.6 million barrels per day of Iraqi and Kuwaiti oil from the market. On 16 January 1991, after Iraq failed to withdraw, international military forces attacked Iraqi forces, and by late-February had overwhelmed and ejected them from Kuwait.

In July 1990, OPEC excess capacity excluding Iraq and Kuwait was at least 5 million barrels per day. Also, inventory levels were unusually high. The global economy had already slid into recession.

OPEC members did not make their production intentions clear during August 1990. Indeed, statements seemed to have been designed to obfuscate not elucidate.

The real crude oil price rose to a peak of US$66.50 per barrel (real 2014 price) in October 1990, around double the price before the invasion, and not far below the real price before Saudi Arabia stopped supporting the oil price in late-1985. The price rise was quicker than in 1973 and 1979, and the downturn commenced much sooner, less than three months after the invasion.

Saudi Arabia lifted its production rate in September to 7.6 million barrels per day, compared to 5.4 million barrels per day in July 1990. By the end of the year, Saudi Arabia’s production rate reached 8.4 million barrels per day. Other OPEC members followed. By the end of October 1990, the daily rate of OPEC production exceeded the pre-invasion level and rose further by the end of the year. By November 1990, the real spot crude oil price was back in the range of US$33-43 per barrel (2014 price terms) where it had been from early-1987 to mid-1989.


The price spike was driven by an oil supply shock (two-thirds), reinforced by speculative demand (one-third) linked to fear and uncertainty. It was capped by higher production, and then driven down by unwinding of speculative demand.

Again, market forces worked. Price spiked to clear the market and then declined as economic entities adjusted their behaviour in response to the price spike.

Australia

The increase in crude oil prices was muted in Australia in the second quarter of 1990 by appreciation of the $A relative to the US$. In the fourth quarter of 1990, the price spike was accentuated by depreciation of the $A. The lower $A then muted the price decline at the end of 1990 and in 1991. Oil prices in Australian dollar terms rose by 33 per cent and petrol prices increased by 17 per cent, with fuel tax accounting for the difference.

Growth in consumption of petroleum products that had been 2.5 per cent per annum in the two previous years fell to zero in 1990-91. Refinery production increased by around 1,500 ML per annum and was offset by an equivalent decline in imports.

Declaration of a liquid fuels emergency under the Liquid Fuels Emergency Act 1984 was not found to be necessary. Consultation through the National Oil Supplies Emergency Committee was undertaken and regular briefings to the IEA were made.

Australia was able to meet its commitments under the IEA energy program by reducing demand. This can be seen in a 1 per cent reduction in vehicle kilometres driven over the period. This was achieved by the impact of the price rise and an economic recession, with no government intervention.

Economic growth fell from 4 per cent to zero in 1991. This was attributable to a global economic recession, not the spike in oil prices.


During the period from early-1987 to mid-1990, spot crude oil prices were relatively steady,

moving generally in a range of around US$33 to US$43 per barrel in real 2014 terms, with



low points in mid-1988 and early-1990. Consumption in market economies grew strongly

until early-1990. Non-OPEC production increased only slightly. OPEC production rose from

around 18.2 million barrels per day in 1987 to 23.5 million barrels per day in 1990. OPEC

spare capacity declined, but remained substantial in the first half of 1990, particularly in

Saudi Arabia.

The Iran-Iraq war ended in a stalemate on 20 August 1988 after nearly 8 years of fighting. It

was expected that both countries would try to increase production rapidly. Nevertheless,

after the cessation of war, the spot crude oil price recovered from a relatively low point in

mid-1988.

By mid-1990, the global economy had slid into a recession. This preceded Iraq’s invasion of

Kuwait. The origins of the latter event can be traced back to Iraq’s difficult economic

position at the end of the Iran-Iraq war and political ambitions of Saddam Hussein.

Iraq had large international debts and was struggling to service them. It was also supporting

an army of one million people (from a population of 18 million) and wanted to re-build its

infrastructure and production capacity. Iraq wanted more oil revenue, particularly from

higher prices.

Activity to increase production capacity in Iraq and Iran renewed friction in OPEC regarding

production quotas. Making room for production increases by Iraq and Iran would mean

quota cuts for others. However, Kuwait and United Arab Emirates were producing above

their quotas and wanted large quota increases. Kuwait announced plans to increase its

production capacity. Iraq saw them as obstacles to higher prices and oil revenue for Iraq.

After the Iran-Iraq war, Iraq requested that Kuwait waive a debt of US$14 billion owed by

Iraq that had had built up during the war. Talks on the matter broke down late in 1989. In

1989, Iraq accused Kuwait of using directional drilling to steal oil from Iraq’s part of the

Rumaila oil field and demanded compensation. Kuwait disputed the allegation and refused

to pay.

Iraq also recognised that successful annexation of Kuwait would have meant Iraq controlled

20 per cent of OPEC production and 25 per cent of world oil reserves. It would have

allowed Iraq to clear its debts, and greatly enhance its economic position, its influence in

OPEC, and its international importance.

8.2 Invasion

Saddam Hussein claimed that Iraq really belonged to Iraq, but it had been stolen away by

“Western imperialists”. On 2 August 1990, Iraq invaded Kuwait and was in control of the

country after two days of intense fighting. Kuwait was annexed by Iraq.

Saddam Hussein assumed that he could take over Kuwait and the response would be

confined to complaints. He was wrong.

On 5 August, United Nations members applied a trade blockade or embargo on Iraq and

Kuwait. This abruptly removed nearly 4.6 million barrels per day of Iraqi and Kuwaiti oil out

of the international market.

In late-1990, the United States issued Iraq with an ultimatum to leave Kuwait by 15 January

1991 or face war. After Iraq failed to comply, United States and other military forces

attacked Iraqi forces in Iraq and Kuwait. Military conflict continued until late-February 1991.

Iraq’s military forces were overwhelmed and ejected from Kuwait, but Iraqi troops set fire to

oil wells in Kuwait as they retreated. The United States-led forces stopped short of

Baghdad, and did not take control of Iraq or depose Saddam Hussein.



8.3 Market and Policy Responses

Morris Adelman (1995) pointed out that estimates of capacity indicated that OPEC excess

capacity excluding Iraq and Kuwait was at least 5 million barrels per day and likely to be as

high as 6.5 million barrels per day. Of course, this excess capacity could not be activated

immediately. Moreover, OPEC members would have to decide to do so.

For the next month, OPEC members did not make their intentions clear. Indeed, statements

seemed to have been designed to obfuscate not elucidate.

However, inventory levels were unusually high. Therefore, a stock buffer was available.

The real crude oil price spiked to a level around double the price before the invasion. The

peak in October 1990 of US$66.50 per barrel (real 2014 price) approached the real price

(US$68.50 per barrel) prevailing before Saudi Arabia abandoned its pre-1986 support for

the oil price through cuts to its own production.

The upward price movement associated with the Kuwait invasion was quicker than in 1973

and 1979. Also, the downturn commenced much sooner, less than three months after the

invasion (Adelman, 1995; Hamilton, 2009b).

The average global reduction in the oil production during the August-October 1990 period

was 2.9 per cent. It peaked at over 6 per cent a month after the invasion (Hamilton, 2009b).

However, Saudi Arabia lifted its production rate substantially in September to 7.6 million

barrels per day, compared to 5.4 million barrels per day in July 1990, before the invasion of

Kuwait. By the end of the year, Saudi Arabia’s production rate had risen to 8.4 million

barrels per day. Other OPEC members followed. By the end of October 1990, the daily rate

of OPEC production exceeded the pre-invasion level. It was higher again by the end of the

year (Adelman, 1995; Hamilton 2009b; Nakov, Nuño, 2013).

By November 1990, the real spot crude oil price was back in the range of US$33-43 per

barrel (2014 price terms) where it had been from early-1987 to mid-1989. The crude oil

price stayed in that range for more than two years.

Again, market forces worked. Price spiked to clear the market and then declined as

economic entities adjusted their behaviour in response to the price spike.

8.4 Causes of the Price Shock

The traditional view is that the supply shock was responsible for the price spike. However,

the reality was more complicated.

Daniel Yergin (1991) and Marian Radetski (2008) pointed out that speculative demand and

associated inventory-building had played an important part in the price spike. Morris

Adelman (1995, p. 293) elaborated:

“Thus, the 1990 oil crisis was like the others: there was no shortage, but the threat of shortage

generated precautionary demand for more inventories, which raised prices, which brought

additional speculative demand. Expectation of a higher price is a self-fulfilling prophecy.”

Kilian and Murphy (2014) suggested that the increase in speculative demand commenced 2-

3 months before the conflict, because of increasing tension in the Middle East. However,

the potential price effects of this demand shock were offset by rising crude oil production.

The price spike was not underpinned by a positive aggregate demand shock. Indeed, as

Claudio Morana (2013) pointed out, the global economy slid into recession in the second

quarter of 1990.



After the supply shock, there was an initial decline in inventories. However, the reduction

was small in the context of the size of the supply shock. This suggested further speculative

demand.

Kilian and Murphy (2014) argued that after the invasion of Kuwait, a speculative demand

shock was operating simultaneously with the supply shock. The speculative demand shock

was tending to increase inventories, while the supply shock was causing them to be run

down.

Meanwhile, both shocks contributed to the sharp increase in real crude oil prices. Results of

VAR modelling undertaken by Kilian and Murphy (2014) suggested that the supply shock

was responsible for about two-thirds of the price spike, and the speculative demand shock

was responsible for the other third.

Kilian and Murphy (2014) explained that the decline in real oil prices from late October 1990

was caused almost entirely by a decline in speculative demand, rather than increased oil

production. This was reflected by a decline in inventories. The underlying shift in

expectations was attributed to removal of a previously perceived threat to Saudi Arabian oil

fields by Iraq following large scale movements of United States and other forces to the

region (Kilian, Murphy, 2014).

Adelman (1995, p.296) argued that additional factors contributed to the short duration of the

oil price surge and the decline in speculative demand. Of particular importance was the

behaviour of Saudi Arabia, which helped to create speculative demand and then helped to

reverse it:

“After a month’s silence let the price rise, they (Saudi Arabia) increased output and let it be

known they would keep it high. That was a far cry from 1979-1980, when their prolonged

refusal to ensure more supply kept driving up the price for over a year.”

Also, Adelman (1995) argued that knowledge in the market that strategic petroleum

reserves in the United States, Germany and Japan might have been used to address the

Kuwait “crisis” moderated the surge of speculative demand. One way in which it did this

was by helping to quell panic in governments.

Adelman (1995) noted that some “token sales” were made from strategic petroleum

reserves after crude oil prices had turned down and sales from strategic reserves were no

longer needed. He commented that if large or unlimited amounts had been offered for sale

or if options for future sale had been offered when the Kuwait “crisis” began, the price

upheaval could have been prevented.

The global economic recession that commenced in the second quarter of 1990 would have

contributed to the decline in crude oil prices from the peak in October 1990. Econometric

modelling by Morana (2013) indicated that the price spike contributed to the recession to a

small extent.

8.5 Impact on Australia

The increase in crude oil prices was muted in Australia in the second quarter of 1990 by

appreciation of the $A relative to the US$. In the fourth quarter of 1990, the price spike was

accentuated by depreciation of the $A. The lower $A then muted the price decline at the

end of 1990 and in 1991 (Figure 47).




Note: Crude prices are yearly average based on Brent crude prices

Source: (BP, 2013), RBA

The increase in crude oil prices translated into a 25 per cent increase in petrol prices from

around 60 cents per litre to 80 cents per litre. Because fuel tax comprised just under 50 per

cent of petrol prices at the time, petrol prices rose less in relative terms than crude oil prices.


Note: Crude prices are yearly average based on Brent crude prices.


Source: RBA, (BP, 2013)

The impact of the price rises was felt uniformly around the country (Figure 49). Fuel prices

in Brisbane tracked below the other capitals as a result of subsidy paid by the Queensland

Government.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

Mar

-87

Jul-8

7

Nov

-87

Mar

-88

Jul-8

8

Nov

-88

Mar

-89

Jul-8

9

Nov

-89

Mar

-90

Jul-9

0

Nov

-90

Mar

-91

Jul-9

1

Nov

-91

Mar

-92

Jul-9

2

Nov

-92

$ /bbl


0.0

10.0

20.0

30.0

40.0

50.0

60.0

0

10

20

30

40

50

60

70

80

90

Mar

-87

Aug

-87

Jan-

88

Jun-

88

Nov

-88

Apr

-89

Sep

-89

Feb

-90

Jul-9

0

Dec

-90

May

-91

Oct

-91

Mar

-92

Aug

-92

Crude oil $AUS/bbl

Petrol c/l





Source: ABS

The price rises and the economy sliding into recession before the oil price spike, perhaps

reinforced by government calls to conserve fuels, resulted in a fall in the rate of growth of

consumption of petroleum products and an absolute fall in consumption in 1991 (Figure 50).



Production of crude oil remained steady over the period of the 1990-91 oil shock. Net

imports of refinery feedstock declined after 1989-90, but recovered in 1991-92( Figure 51).

0

10

20

30

40

50

60

70

80

90

Mar

-87

Jul-8

7

Nov

-87

Mar

-88

Jul-8

8

Nov

-88

Mar

-89

Jul-8

9

Nov

-89

Mar

-90

Jul-9

0

Nov

-90

Mar

-91

Jul-9

1

Nov

-91

Mar

-92

Jul-9

2

Nov

-92

c/l



38 000

38 500

39 000

39 500

40 000

40 500

41 000

41 500

42 000

19

87

-88

19

88

-89

19

89

-90

19

90

-91

19

91

-92

ML /a



Figure 51 Production of crude oil and net imports of refinery feedstock

Source: (BREE, 2013):

Production from Australian refineries increased from 37,000 ML per annum in 1987-88 to

41,000 ML per annum in 1991-92 (Figure 52). Meanwhile, Australia became a net exporter

of petroleum products in 1990-91 with exports of 1,100 ML per annum of petroleum products

in that year (Net imports of petroleum products increased from around 500 ML per annum in

1988-89 to around 1200 ML per annum in 1989-90 before reversing to net exports of

petroleum products in 1990-91. This was caused by the decline in growth in demand in

1990-91.

Figure 53).



Net imports of petroleum products increased from around 500 ML per annum in 1988-89 to

around 1200 ML per annum in 1989-90 before reversing to net exports of petroleum

products in 1990-91. This was caused by the decline in growth in demand in 1990-91.

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

19

87–8

8

19

88–8

9

19

89–9

0

19

90–9

1

19

91–9

2

ML/a


25 000

27 000

29 000

31 000

33 000

35 000

37 000

39 000

41 000

43 000

19

87–8

8

19

88–8

9

19

89–9

0

19

90–9

1

19

91–9

2

ML/a





At no stage were petroleum supplies interrupted during this period and no direct

interventions by governments in the markets occurred.

The distance travelled by vehicles fell in most states in response to the impacts of fuel price

increases and the economic downturn, and remained on a lower trajectory than previously

(Figure 54). This was an important factor in Australia meeting its obligations under the IEA

Treaty to reduce its call on global oil supplies.


Source: ABS

A global recession that commenced before the Iraq-Kuwait oil shock and continued

afterwards had more impact on the Australian economy than the oil price spike. Inflation fell

to between zero and 1 per cent in the 1991 and 1992 and GDP growth fell below zero in

1991 and not far above it in 1992 (see Figure 55 and Figure 56).

–2 000

–1 500

–1 000

– 500

0

500

1 000

1 500

19

87–8

8

19

88–8

9

19

89–9

0

19

90–9

1

19

91–9

2

ML/a

0

2

4

6

8

10

12

14

Mar

-87

Jul-8

7

Nov

-87

Mar

-88

Jul-8

8

Nov

-88

Mar

-89

Jul-8

9

Nov

-89

Mar

-90

Jul-9

0

Nov

-90

Mar

-91

Jul-9

1

Nov

-91

Mar

-92

Jul-9

2

Nov

-92






Source: ABS


Source: ABS

8.6 Australian Policy Issues and Responses

Australian and state/territory governments activated the preliminary arrangements that had

been put in place in accordance with the Liquid Fuels Emergency Act (1984). The National

Oil Supplies Emergency Committee was the main intergovernmental forum for consultation

on situation assessment and met at least once a week to discuss the process as well as

share briefings.

There was consumer response to higher fuel prices, lower economic activity, and perhaps

publicity about the need for energy conservation. These factors resulted in a decline in

consumption of petroleum during and after the oil shock.

The decline in consumption and an increase in production from domestic refineries allowed

Australia to reduce its imports and meet its IEA obligations to reduce its call on global oil

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Mar

-198

7

Jul-1

987

Nov

-198

7

Mar

-198

8

Jul-1

988

Nov

-198

8

Mar

-198

9

Jul-1

989

Nov

-198

9

Mar

-199

0

Jul-1

990

Nov

-199

0

Mar

-199

1

Jul-1

991

Nov

-199

1

Mar

-199

2

Jul-1

992

Nov

-199

2


-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-

1987

Jan-

1988

Jan-

1989

Jan-

1990

Jan-

1991

Jan-

1992




supplies. Australia did not encounter a supply obligation under the IEA arrangements as a

result.

While there was a decline in consumption, at no time was a fuel shortage experienced, and

no interventions by governments were necessary. The situation did not reach the stage

where a National Liquid Fuels Emergency had to be declared.

By mid-1991, oil prices in $A terms had fallen back to their previous levels, and consumption

of petroleum fuels recovered, but not to its previous growth trajectory.



9 Venezuelan oil supply crisis and Iraq War, 2002-03

Key points

International

The crude oil price trended down strongly from the second quarter of 1993 until January 1999, when it bottomed at less than US$13 per barrel in 2014 real terms. The decline was particularly marked in 1997 and 1998, helped by the negative aggregate demand shock of the Asian Financial Crisis.

The oil price recovered strongly in 1999 and 2000, but lost more than half of those gains in 2001 in the context of a recession in the United States. The oil price started to recover in 2002.

In December 2002, a general strike was called in Venezuela in protest against the regime of Hugo Chávez. Oil production fell from 3.1 million barrels per day to less than 0.2 million barrels per day. The strike gradually broke down and by mid-February 2003, Venezuelan oil production had recovered to around half of the pre-strike level. Production capacity had been damaged by poor shut-down procedures and replacement of half of the workforce by less experienced personnel. The pre-strike production level still has not been re-attained.

On 20 March 2003, United States-led military forces invaded Iraq over alleged “weapons of mass destruction” and other issues. The attack on Iraq temporarily stopped Iraqi oil production. Iraq’s production capacity before the attack was just under 3 million barrels per day. Because of ongoing internal strife, production did not attain pre-war levels until 2009.


The real oil price rose in response to the Venezuelan event and inventories fell. An increase in speculative demand because of fear of the consequences of potential of conflict between the United States and Iraq dampened the decline in inventories, but reinforced the oil price rise.

The combined Venezuelan and Iraqi supply shocks generated a minor, short-lived oil price spike, because supply losses were more than offset by an unexpected increase in global oil production early in 2003 – a countervailing positive supply shock. This reversed the speculative demand shock.

Australia

The rise in the crude oil price that began in March 1999 was amplified in Australian dollars owing to a decline in the exchange rate at that time. Oil prices in US dollar terms increased by nearly 200 per cent from an historical low to US$30 per barrel by September 2000, while oil prices in Australian dollars increased by over 200 per cent to $A55 per barrel.

Petrol prices rose 50 per cent to 92 cents per litre by September 2000. Capital city petrol prices rose consistently with this average rise. Brisbane prices were lower as a result of the subsidy on petrol that applied in Queensland.

Price rises associated with the Venezuelan and Iraq oil shocks were significantly smaller in absolute and relative terms. They attained levels similar to those attained in 2000.

Consumption of petroleum products increased from 49,000 ML per annum in 1998-99 to 52,000 ML per annum in 1999-2000 and fell back to 48,300 ML per annum in 2000-01, when there was an economic downturn. Consumption rose strongly in 2002-03, as the economy recovered, notwithstanding a small price spike associated with the Venezuelan and Iraq oil shocks. These changes in consumption were met mainly from a change in net imports.

Vehicle kilometres travelled fell by around 5 per cent in the larger states over the period over the period but recovered soon after.

Economic growth that had been between 4 per cent and 5 per cent per annum over the 1993 to 2000 period fell to 2 per cent in 2001 before recovering to 4 per cent per annum in 2002, and settling to just over 3 per cent in 2003. Thereafter, growth picked up.

A national liquid fuels emergency was not called at the time of the Venezuelan and Iraq oil shocks. Consultations through NOSEC were the main means of coordination between the Commonwealth, State and Territory Governments and industry.



There were no interruptions in supply. Price movements ensured the market cleared globally and in Australia.


Following the short-lived price spike in September and October 1990 that was associated

with Iraq’s invasion of Kuwait, the real spot of crude settled in the range of US$33-43 per

barrel (2014 price terms) for more than two years. By the third quarter of 1993, the global

economy had recovered from recession, but this was not able to support the crude oil price.

The oil price displayed a strong downward trend from the second quarter of 1993 until the

beginning of 1999, when it bottomed at less than US$13 per barrel in 2014 real terms. The

decline had been particularly marked in 1997 and 1998, helped by the negative (reduced)

aggregate demand shock of the Asian Financial Crisis (Radetzki, 2008; Smith, 2009a;

Kilian, Lee, 2014).

Venezuela helped the price slide with its 40 per cent increase in oil production between

1992 and 1998. It ignored its OPEC production quota, causing acrimonious discussion

within OPEC.

In December 1998, with Venezuela deep in economic crisis, because of historically low

crude oil prices, Venezuelan voters went to the polls to elect a new President. Hugo

Chávez was the surprise winner with 57 per cent of the vote, defeating the candidates of the

two dominant political parties that had been discredited in the Venezuelan community.

Before the election, Venezuela had started to move away its policy of pursuit of more oil

revenue through greater production, but Chávez explicitly abandoned that policy. Indeed,

Venezuela became the strongest advocate in OPEC for production cuts and compliance

with quotas (Yergin, 2011).

As OPEC members constrained production, global aggregate demand recovered following

the Asian Financial Crisis. So, real crude oil prices began to recover.

Chávez took control of the electoral council, abolished the upper house of parliament,

turned the remaining house into a rubber stamp, stacked the judiciary with supporters,

removed parliamentary oversight of the army, and set up a parallel military force of urban

reservists. He also politicised management of the state oil company, PDVSA, and shifted

financial control of the company to his government. After being re-elected in 2000, Chávez

further increased his control over Venezuela and PDVSA. Dissatisfaction with Chávez’s

regime in Venezuela grew substantially during 2001.

After the oil price recovered strongly in 1999 and 2000, it lost more than half of those gains

in 2001. A recession in the United States economy was an important contributory factor.

The oil price remained in the doldrums for about 12 months, starting to recover in 2002.

Following the 11 September 2001 terrorist attacks in the United States, Iraq became a focus

of international attention, because of Saddam Hussein’s regime’s perceived links with

terrorism, concern about possession of “weapons of mass destruction” by Iraq, Saddam

Hussein’s intransigent and ruthless rule, and issues regarding reliability of intelligence on

activities in Iraq. Another consideration was the importance of Iraq’s oil reserves and

production.

By early-2002, a broad coalition of trade unions, business groups and the Catholic Church

was opposed to the extent of Chávez’s power and the way he had wielded it. Discontent

with Chávez’s regime led to a protest march by one million people in Caracas. Protestors

were killed and wounded near the presidential palace when guards loyal to Chávez opened

fire on those at the front of the crowd. A subsequent attempt by some senior military officers

to make Chávez resign was foiled by others. In December 2002, unions and business



groups united to call a general strike in attempt to call a referendum on governance by

Chávez’s regime (Yergin, 2011).

9.2 Closely-Spaced Supply Shocks

In December 2002, a general strike in Venezuela almost halted oil production. Output fell

from 3.1 million barrels per day to less than 0.2 million barrels per day.

Chávez did not yield to the strikers demand for a referendum on his governance. The strike

gradually broke down over several weeks. By mid-February 2003, Venezuelan oil

production had recovered to around half of the pre-strike level. Exports re-commenced in

April 2003. However, PDVSA’s capacity to produce had been damaged by haphazard shut-

down procedures at the time of the strike and the subsequent replacement of half of the

workforce by less experienced personnel (Yergin, 2011). Venezuela’s pre-strike production

level still has not been re-attained.

In March 2003, gangs attacked oil production sites in the Niger Delta in Nigeria to steal oil

and extort money from oil companies. The oil companies evacuated their personnel. The

result was a temporary shut-down of over 0.8 million barrels per day of oil production, about

one third of Nigeria’s production rate.

On 20 March 2003, military forces from the United States, United Kingdom and some other

countries invaded Iraq over “weapons of mass destruction” alleged to be held by Iraq, and

other issues. Baghdad was captured by 9 April 2003. The attack on Iraq temporarily

stopped Iraqi oil production. It was estimated that Iraq’s production capacity before the

attack was just under 3 million barrels per day (Yergin 2011).

Iraqi oil production facilities survived the war largely unscathed. However, looting in the

electricity sector following the war meant that electricity was not available to many oil fields

and three surviving refineries. Therefore, they could not operate.

Substantial effort to restore production brought output up to about 80 per cent of the pre-war

rate on average for 2004. However, subsequent attacks by insurgents disrupted production

and exports, with the result that they persisted at only two thirds or less of pre-war capacity

of just under 3 million barrels per day. Production did not attain pre-war levels until 2009.

The combined oil supply shock initially was similar in magnitude to the 1970s supply cuts

(Kilian, 2008b; Kilian, Murphy, 2014).

9.3 Market Responses

The real oil price rose in response to the Venezuelan event and inventories fell. An increase

in speculative demand because of fear of the consequences of potential of conflict between

the United States and Iraq dampened the decline in inventories, but reinforced the oil price

rise.

However, the combined Venezuelan and Iraqi supply shocks did not generate a large oil

price spike, because they were more than offset by an unexpected increase in global oil

production early in 2003 – a countervailing positive supply shock. This reversed the

speculative demand shock. The price spike was minor and short-lived.

The positive oil shock led to inventory accumulation. Reversal of the speculative demand

shock worked in the opposite direction (Kilian, Murphy, 2014).



9.4 Causes of the Small, Short-Lived Price Spike

The negative supply shocks associated with Venezuelan internal strife and Iraqi war events

were accompanied by a positive supply shock and speculative demand shocks. The

negative supply shock was reinforced by a speculative demand shock. The positive supply

shock tended to offset the negative supply shock. It induced reversal of the speculative

demand shock.

The negative supply shocks and a reinforcing speculative demand shock occurred in the

context of a surge in global economic activity that had commenced in 2003. Later, an

offsetting positive supply shock was reinforced by reversal of the speculative demand

(Barsky, Kilian, 2004; Kilian, 2009a,b).

9.5 Impact on Australia

Crude oil prices in Australian dollars moved with the US$ oil price and the exchange rate

(Figure 57). The Australian dollar appreciated inexorably in 2003. It had depreciated 2000

and 2001.


Note: Crude oil prices based on quarterly Brent prices

Source: (BP, 2013), ABS

Petrol prices rose in response to the increase in crude oil prices in line with the import parity

pricing policy for crude oil that then applied (Figure 58). However, petrol price movements

were muted in relative terms because of the fuel tax wedge. Capital city petrol prices

followed crude oil price rises, with Brisbane prices being lower because of the subsidy

arrangements that applied at the time (Figure 59).

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

Mar

-95

Sep

-95

Mar

-96

Sep

-96

Mar

-97

Sep

-97

Mar

-98

Sep

-98

Mar

-99

Sep

-99

Mar

-00

Sep

-00

Mar

-01

Sep

-01

Mar

-02

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04

$ /bbl





Note: Crude oil prices based on quarterly average Brent prices

Source: (BP, 2013), ABS


Source: ABS

Rising fuel prices and an economic downturn resulted in consumption falling in 2000-2001,

before recovering on a lower trajectory than before the Venezuelan crisis (Figure 60).

Domestic production of crude oil and condensate increased over the period to 40,000 ML

per annum, while net imports of refinery feedstock fell over the period (Figure 61).

0.0

10.0

20.0

30.0

40.0

50.0

60.0

0

10

20

30

40

50

60

70

80

90

Mar

-87

Aug

-87

Jan-

88

Jun-

88

Nov

-88

Apr

-89

Sep

-89

Feb

-90

Jul-9

0

Dec

-90

May

-91

Oct

-91

Mar

-92

Aug

-92

Crude oil A$/bbl Petrol

c/l


0

20

40

60

80

100

120

Mar

-95

Sep

-95

Mar

-96

Sep

-96

Mar

-97

Sep

-97

Mar

-98

Sep

-98

Mar

-99

Sep

-99

Mar

-00

Sep

-00

Mar

-01

Sep

-01

Mar

-02

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04

c/l







Figure 61 Production and of crude oil and net imports of refinery feedstock


Refinery production remained reasonably steady over the period at around 47,000 ML per

annum over the 1996-97 to 2002-03. Australia exported small amounts of petroleum

products over much of that period (Figure 63).

40 000

42 000

44 000

46 000

48 000

50 000

52 000

54 000

19

93

-94

19

94

-95

19

95

-96

19

96

-97

19

97

-98

19

98

-99

19

99

-00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

ML /a

0

10 000

20 000

30 000

40 000

50 000

60 000

1993

–94

1994

–95

1995

–96

1996

–97

1997

–98

1998

–99

1999

–00

2000

–01

2001

–02

2002

–03

2003

–04

ML/a








The fuel price rises did not appear to have affected distances travelled in Australia during

the Venezuelan-Iraq oil shock, with the longer term trend continuing (Figure 64). This is not

surprising as the price spike was small.

25 000

30 000

35 000

40 000

45 000

50 000

1993

–94

1994

–95

1995

–96

1996

–97

1997

–98

1998

–99

1999

–00

2000

–01

2001

–02

2002

–03

2003

–04

ML/a

–4 000

–2 000

0

2 000

4 000

6 000

8 000

1993

–94

1994

–95

1995

–96

1996

–97

1997

–98

1998

–99

1999

–00

2000

–01

2001

–02

2002

–03

2003

–04

ML/a




Source: (BTRE, 2012)

Growth in the year on year CPI increased from around zero in 1997 to as high as 6 per cent

in 2001 before settling back to 3 per cent by 2002 (Figure 65). GDP growth fell from 4 per

cent per annum in 1999 to 2 per cent in 2001, before recovering to 3 per cent by 2003

(Figure 66). The lower level of economic activity in 2001 combined with the temporary

increase in petrol prices is likely to have contributed to the contraction in consumption of

petroleum products in that year.


Source: ABS

0

2

4

6

8

10

12

14

16

18

Mar

-95

Sep

-95

Mar

-96

Sep

-96

Mar

-97

Sep

-97

Mar

-98

Sep

-98

Mar

-99

Sep

-99

Mar

-00

Sep

-00

Mar

-01

Sep

-01

Mar

-02

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04



-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Mar

-199

3

Nov

-199

3

Jul-1

994

Mar

-199

5

Nov

-199

5

Jul-1

996

Mar

-199

7

Nov

-199

7

Jul-1

998

Mar

-199

9

Nov

-199

9

Jul-2

000

Mar

-200

1

Nov

-200

1

Jul-2

002

Mar

-200

3

Nov

-200

3





Source: ABS

:

9.6 Policy Responses and Issues

The combined Venezuelan and Iraqi supply shocks were more than offset by an unexpected

increase in global oil production early in 2003. Therefore, the oil price spike was small and

shortlived. Australia did not experience a shortage of petroleum product supplies. The rise

in prices combined with lower economic growth resulted in consumption of petroleum fuels

falling. Domestic production of petroleum products by Australian refiners was maintained

and Australian suppliers imported more petroleum products when required to meet growth in

demand after the initial fall in consumption.

The oil supply situation did not reach the stage where a liquid fuels emergency had to be

declared. While NOSEC was active in consultations, the Australian supply and demand

situation was resolved through normal market mechanisms.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-

1993

Jan-

1994

Jan-

1995

Jan-

1996

Jan-

1997

Jan-

1998

Jan-

1999

Jan-

2000

Jan-

2001

Jan-

2002

Jan-

2003




10 Multiple Shocks, 2003-14

Key points

International

Early in 2003, following the Venezuelan and Iraq oil shocks, the crude oil price was around US$35 per barrel in 2014 real terms. In a preceding 21-year downtrend in real crude oil prices, an historical low price of US$13 per barrel was reached in January 1999.

The 2003-2008 surge in oil prices involved a higher spike and was more prolonged than previous oil price shocks. The price soared to around US$162 per barrel in real 2014 terms in July 2008.

The subsequent price downturn in late-2008 and early-2009 was rapid, but of surprisingly short duration compared to previous oil price slumps (Radetzki, 2011). In December 2008, it reached US$35 per barrel (2014 real terms), the level at which it had been before the 2003-2008 price ascent commenced. Prices had recovered strongly by late-2009 and have fluctuated around a relatively high level of US$100 per barrel (real 2014 terms) since 2011.

During the period from 2003 to 2014, the oil market was subjected to multiple shocks, with some acting simultaneously:

a series of positive aggregate demand shocks from 2003 to the first half of 2008

a large negative supply shock associated with Hurricanes Katrina and Rita in the Gulf of Mexico/U.S. Gulf coast area in 2005

a persistent supply shock deriving from OPEC production capacity restraint

Saudi Arabian production cuts in the 2005-2007 period

an anomalous 23 per cent decline in non-OPEC production from 2004-2008, the first significant

decrease since the “first oil crisis”

several small supply shocks in the first half of 2008

a major negative aggregate demand shock associated with the global financial crisis from the third quarter of 2008 to mid-2009

the impact of the Libyan revolution in early-2011

tension regarding Iran’s nuclear program leading to a European Union decision in early-2012 to impose an embargo on oil imports from Iran

speculative demand shocks on some occasions.

Consequences for the global oil market

It is widely acknowledged that aggregate demand shocks – positive in 2003-2008, and 2009-2014, and negative in 2008-09 – were very important. However, the positive demand shocks had greatly added force because of various supply shocks during the 2005-2014 period, particularly the under-recognised, persistent supply side shock of OPEC capacity restraint. The latter, along Saudi Arabian production cuts in 2005-2007, an anomalous decline in non-OPEC production in 2004-2008, and a series of small supply shocks in the first half of 2008 contributed to extraordinary oil price rises in 2007 and the first half of 2008.

There has been considerable debate among economists regarding the existence of speculative demand shocks in the 2003-2008 period. This matter has not yet been resolved. Moreover, there has been a more widespread debate involving finance specialists, economists and politicians in respect of the influence of activity in oil financial derivatives markets on spot prices. Most economists have argued that the effect of activity in the former has had little impact on the latter.

Australia

Movements in the US dollar price of crude oil were translated into comparable changes in the Australian dollar price. Exchange rate movements accounted for differences.

These patterns of price movements translated directly into price movements for petrol in Australia over the period. Prices of crude oil increased from $A40 per barrel in March 2004 to $A128 per barrel by November 2008. The price then fell to $A60 per barrel as a result of the effect of the global



financial on oil prices and the exchange rate. Subsequently, prices gradually rose again to $A110 per barrel by late 2013.

Over the same period petrol prices rose from 92 cents per litre in March 2004 to 154 cents per litre in November 2008. They then fell to 119 cents per litre with the GFC before continuing to rise to 158 cents per litre by late 2013.

The impact of these price rises was felt more or less uniformly across Australia. Prices in Brisbane moved back to prices in the rest of Australia after the repeal of the subsidy on petrol

Consumption of petroleum products dipped by around 2 per cent with the onset of the global financial crisis (GFC) in late-2008, driven by a fall in economic activity, notwithstanding a substantial fall in oil and petrol prices. However demand for petroleum products grew again from 2009-10 as the economy recovered from the GFC.

Vehicle kilometres driven remained steady over 2003-2014 period, with a slight dip during the GFC in some states. There were no interruptions to supplies of petroleum products.

Year on year quarterly inflation fell from as high as 5 per cent prior to the GFC to as low as 1 per cent in the September quarter of 2009, and ranged between 1 per cent and 3 per cent in the following years to the present time.

GDP growth fell from 3.5 per cent prior to the GFC to around 1.6 per cent in the first quarter of 2009. It remained at around 2 per cent in the following years before recovering to 3 per cent by 2012.

General economic conditions and recovery from the GFC appear to have been more significant influences on inflation and economic growth than perturbations in the world oil market resulting from Hurricanes Katrina and Rita, OPEC production capacity constraints, the impact of the Libyan revolution and embargos on oil imports from Iran.


The remarkable oil price surge that commenced in the second half of 2003 and lasted until

mid-2008 was preceded by a 21-year trend of declining oil prices in real terms. The low

point during this 21-year period was at the beginning of 1999, in the wake of the Asian

financial crisis, when the spot price of crude bottomed at less than US$13 per barrel in 2014

price terms. This compares with spot oil prices (all in 2014 real terms) of:

US$19 per barrel in 1973, just before the “first oil crisis”

US$57 per barrel at the height of the “first oil crisis” in January-February 1974

US$122 per barrel at the twin peaks of the “second oil crisis” in November 1979 and

November 1980

US$24 per barrel in May 1986 after the oil price collapsed because of withdrawal of

Saudi Arabian support

US$66.50 at the peak price during the Kuwait-Iraq crisis in October 1990

US$33-43 per barrel for more than two years before and after the price spike associated

with the Kuwait-Iraq oil shock.

Recovery of global aggregate demand after the Asian financial crisis, in combination with

OPEC production restraint, underpinned a real crude oil price recovery in 1999 and 2000.

However, there was a temporary reversal in 2001-02, associated with a global recession.

Early in 2003, following the Venezuelan and Iraq oil shocks, the crude oil price was around

US$35 per barrel in 2014 real terms.

10.2 Multiple Interacting Shocks

The 2003-2008 surge in oil prices involved a higher spike and was more prolonged than

previous oil price shocks. The subsequent price downturn in late-2008 and early-2009 was

rapid, but of surprisingly short duration compared to previous oil price slumps (Radetzki,



2011). Prices had recovered strongly by late-2009 and have fluctuated around a relatively

high level of US$100 per barrel (real 2014 terms) since 2011.

During the period from 2003 to 2014, the oil market was subjected to multiple shocks:

a series of positive aggregate demand shocks from 2003 to the first half of 2008

a large negative supply shock associated with Hurricanes Katrina and Rita in the Gulf of

Mexico/U.S. Gulf coast area in 2005

a persistent supply shock deriving from OPEC production capacity restraint

Saudi Arabian production cuts in the 2005-2007 period

an anomalous 23 per cent decline in non-OPEC production from 2004-2008, the first

significant decrease since the “first oil crisis”

several small supply shocks in the first half of 2008

a major negative aggregate demand shock associated with the global financial crisis

from the third quarter of 2008 to mid-2009

the impact of the Libyan revolution in early-2011

tension regarding Iran’s nuclear program leading to a European Union decision in early-

2012 to impose an embargo on oil imports from Iran

speculative demand shocks at various times.

In addition, there has been considerable debate among economists regarding the existence

of speculative demand shocks in the 2003-2008 period. Moreover, there has been a more

widespread debate involving finance specialists, economists and politicians in respect of the

influence of activity in oil financial derivatives markets on spot prices.

10.3 Strong Global Economic Expansion, 2003-2008

In 2003, a remarkable aggregate demand surge commenced, underpinned by rapid growth

in China, India and some other developing economies, in conjunction with strong growth in

major advanced economies. The pace and persistence of this global growth repeatedly

surprised observers.

This aggregate demand shock triggered and drove a strong, prolonged surge in the spot

price of crude oil. The price rose from under US$35 per barrel in early-2003 to around

US$162 per barrel (2014 real terms) in July 2008.

In the economics literature, there is widespread support for the view that a major driving

force for the 2003-2008 crude oil price surge was global aggregate demand growth. This

was particularly dependent on rapid economic growth in major developing countries that

was commodity-use-intensive (for example, see Radetzki, 2008; Kilian, 2009a,b; Smith,

2009a; Grossman, 2013; Kilian, Murphy, 2014; Kilian, Hicks, 2013). Marian Radetzki (2008)

explained the importance of the combination of rapid economic growth and the highly

mined-commodity-intensive nature of that growth in particular developing economies, as

shown in Box 4.



Box 5 Mined-Commodity-Intensive Growth

“…… the demand shock was importantly due to fast macroeconomic expansion. OECD growth rose forcefully in 2004, but the growth performance in Developing Asia was of even greater significance. For although the latter area accounted for only 27 per cent of global GDP in 2005, compared with the OECD’s 52 per cent, it is presently in a development stage much more intensive in primary materials use than the dematerialising mature OECD economies. China especially stands out in this respect. The country’s share of global GDP in 2005 (PPP terms) was assessed by the IMF at 15.4 per cent, but its share of global growth between 2000 and 2005 was 28 per cent for petroleum, 50 per cent for aluminium, 84 per cent for steel and an incredible 95 per cent for copper.

If a dollar added to the GDP in Developing Asia absorbs twice the quantity of commodities as does a corresponding dollar’s growth in the OECD countries, the two regions would contribute about equally to commodity demand growth provided that both expanded at the same rates. But since Developing Asia’s economies expanded at more than twice the OECD rate, it follows that its contribution to commodity demand growth overwhelmed that of the OECD. The importance of Developing Asia in this respect is a new phenomenon.”

Source: Radetzki (2008), pp. 70-71

The aggregate demand surge and consequent crude oil price surge were largely

unexpected. Indeed, forecasters and markets were repeatedly surprised.

When OPEC ministers met in February 2004, they expected an oil glut and price rout. This

prompted a decision and announcement that production would be cut substantially. The

announcement prompted an oil price rise. It kept on rising because of unexpected strong

growth of demand for oil underpinned by strong growth of aggregate demand (Yergin,

2011).

Kilian (2009a,b) and Kilian and Murphy (2014) identified the unexpected repeated aggregate

demand shocks from a structural VAR econometric model. Kilian and Hicks (2013)

confirmed this finding through analysis of professional forecasts of real GDP growth. The

surprises were particularly marked for China, India and other emerging economies. They

were much smaller for OECD countries in general. The repeated underestimation of

aggregate demand growth and growth of derived demand for oil persisted until the first half

of 2008 (Kilian, Hicks, 2013).

Bhar and Malliaris (2011) pointed out that the increase in the crude oil price in US dollar

terms during the 2003-2008 period was exaggerated by the decline in the US dollar relative

to other key currencies, such as the Euro, and relative to gold. They argued that oil

producers demanded compensation for the declining value of the US dollar.

10.4 OPEC Production and Capacity Constraints

The unexpected, repeated, positive aggregate demand shocks in the 2003-2008 period

occurred in the context of production and capacity constraints. Because short-term price

elasticity of supply and demand for crude oil are very low (as explained in Chapter 4), prices

had to rise substantially to clear the market in the short-term. Normally, price elasticities

increase over time as sellers and buyers have time to respond to higher prices (see chapter

4), but the normal increase in responsiveness of quantity supplied to prices was impeded

substantially from 2003 for various reasons.

First, the preceding 21 years of downtrend of real crude oil prices resulted in a prolonged lag

in perception of a rising price trend. Oil companies had constrained capital expenditure and

employment of skilled personnel because of low oil prices. Also, they were wary of investing

because of concern about another price reversal (Radetzki, others, 2008).



Second, various other lags in the process of exploring for oil, assessing and developing

resources, and obtaining funding and regulatory approvals were lengthened because there

was a series of unexpected aggregate demand shocks, not just a single shock.

Third, OPEC’s spare capacity had been reduced by the fallout from Venezuelan crisis and

Iraq war. This has been documented in chapter 9.

Fourth, there was an anomalous 23 per cent decline in non-OPEC production from 2004-

2008. This was the first significant decrease in non-OPEC production since the “first oil

crisis” (Smith, 2009a).

Fifth, Saudi Arabian production was not increased in response to the stagnation of global

production from early 2005 to 2007, and strongly rising crude oil prices at the time. Indeed,

Saudi Arabian production fell. It was about 0.85 million barrels per day lower in 2007 than in

2005 (Hamilton, 1979a,b). In contrast, it appears that from 1973 to 1985, and from 1991 to

2005, Saudi Arabia had reduced its production to support prices at times of slack demand

and raised production to take advantage of price increases resulting from supply disruptions

elsewhere, moderating the extent of price changes (Hamilton, 2009a; Nakov, Nuño, 2013;

Kilian, Murphy, 2014).7 Hamilton (2009a) commented that it appeared that Saudi Arabian

may have moved to a new price policy by cutting production when the crude oil price was

rising strongly.

Sixth, although the volume of proved reserves in OPEC countries doubled over the period

1973-2008, OPEC’s production capacity (and production) had remained approximately

unchanged since 1973 (Nakov, Pescatori, 2010; Radetzki, 2008). OPEC’s installed

production facilities were sufficient to extract just 1.5 per cent of its proved reserves each

year (reserves/production capacity ratio of nearly 67 to 1). In contrast, non-OPEC

producers had invested sufficiently in production facilities to extract 5.6 per cent of their

proved reserves each year (reserves to production capacity ratio of just under 18 to 1). It

appears that OPEC has limited oil production by avoiding provision of new production

capacity. Radetzki (2008), Smith (2009a,b), Hamilton (2009a, b), Dvir and Rogoff (2010),

and Kaufmann (2011) stressed the important contribution of OPEC constraint on capacity

expansion to rapidly increasing crude oil prices during the extraordinary 2003-2008 price

spike. Observations by Radetzki (2008) elaborating on this point are shown in Box 5.

7 Anton Nakov and Galo Nuño (2013) explained that Saudi Arabia’s behaviour in the 1973-1985 and 1991-2005 periods was

consistent with what could be expected of a profit-maximising dominant producer with spare capacity in an industry with a competitive fringe. Saudi Arabia’s dominant position is sustained by its low costs. Over the past 15 years, its spare capacity has ranged from one-third to one sixth of its production and 13 to 25 per cent of capacity, and has been comparable to the spare capacity of all other OPEC producers combined. Saudi Arabia raises output in response to negative supply shocks and positive aggregate demand shocks, but not enough to offset the shock, so that its production rises in tandem with the oil price. In response to oil shocks that reduce the oil price, Saudi Arabia reduces its production. Its profit-maximising behaviour moderates oil price volatility, but does not eliminate it.



Box 6 OPEC Capacity Constraint

“….. OPEC’s ability to command monopolistic prices would have disintegrated, much as happened with the other cartels (for mined-commodities) ….. if it had relied solely on short-term output adjustments.

The long-run tool that has held the cartel alive is a remarkable constraint on capacity expansion, whether by conscious policy or by default. ……a stark demonstration … (is provided by) oil output by region in 1979 and 2005, two years of high prices when demand was booming and global capacity was, for all practical purposes, in full use. The production numbers can therefore also be seen as indicators of existing capacity. It appears that the OECD region, deemed in the late 1970s as not very rewarding for expanding oil production, nevertheless increased its output over the twenty-six year period by 30 per cent, in line with the global total. The former Soviet Union has not increased its output at all between the two years. This is the result of a deep crisis in its oil industry after the fall of communism, from which it is still recovering. The rest of the world (RoW) outside OPEC, however, accomplished a truly remarkable 245 per cent increase. The OECD and RoW achievements contrast with those of OPEC, which records a small capacity decline. Even more remarkable is the decline in the Middle East, given its extraordinary resource wealth.

The capacity stagnation in OPEC and the Middle East has obviously been related to the short-term measures to restrict supply. There was little purpose in expanding capacity if it could not be used because of production quotas. But I conjecture that a measure of complacency also played a role. Life with the cartel was so good that capacity expansion was not felt to be urgent even in periods when quotas were not in force. The dominance of state ownership in OPEC’s oil industry is another factor explaining capacity stagnation. A majority of state-owned firms exhibit an extended record of inefficiency and in particular an inability to undertake investments in capacity expansion. Furthermore, the government owners have often depleted these firms financially for the benefit of the public budget, leaving insufficient resources for investments in expansion.

As oil prices rose to levels far above even the wildest OPEC ambitions, ……. a related factor in support of the cartel was increasingly felt. It emerged that a very large proportion of the global undeveloped yet easy to exploit, oil resources were controlled by governments that were either unwilling or unable to expand production capacity in response to the high prices. And the private oil industry that wanted and was able to invest had no access to these resources, so had to rely on highly marginal deposits from which oil could be produced only at high cost.”

Source: Radetzki (2008), pp. 162-164.

While OPEC capacity constraint was an important issue in the 2003-2008 oil price boom,

this policy tool evolved over a much longer period of time as a more potent means of

maintaining high oil prices than production quotas. The difficulties of setting quotas and

cheating by individual members had undermined the effectiveness of production quotas.

Constraint on production capacity helps to support production quotas in maintaining prices,

as well as being a powerful price maintenance tool in its own right. Adelman (2004)

considered that OPEC capacity constraints in combination represented “the real oil

problem”, not fears about oil embargos and oil running out.

Artificial production capacity constraints in OPEC could be regarded as a form of persistent

supply shock. They might be categorised as speculative supply shocks, as suggested by

Kilian and Lee (2014). Alternatively, capacity constraint could be interpreted as reflecting

speculative demand by OPEC producers for their own oil that is applied through retention of

larger below ground inventories. The intention would be to support higher prices in the

short-term and to retain more oil for extraction and sale at higher prices later.

10.5 Conventional Supply Shocks, 2003-2008

The effects of the series of aggregate demand shocks and OPEC capacity constraint during

the period from 2003 to 2008 were exacerbated by conventional supply shocks. In the third

quarter of 2005, there was a major supply shock associated with Hurricanes Katrina in the



Gulf of Mexico/U.S. Gulf Coast region. In early 2008, several small supply shocks combined

to create a supply shock of global significance.

10.5.1 Hurricanes Katrina and Rita, 2005

Supply of crude oil and refined products from the Gulf of Mexico/U.S. Gulf Coast region was

temporarily disrupted by Hurricanes Katrina and Rita in late-August 2005 (landfall, 29

August) and late-September 2005 (landfall, 24 September), respectively. This supply shock

is of interest because of the combination of crude oil and product supply shocks, the IEA

response, and the context of strongly rising demand crude oil and refined products deriving

from rapidly growth aggregate demand for goods and services globally.

Following Hurricane Katrina, Gulf of Mexico crude oil production was reduced by about 1.4

million barrels per day initially. The amount of shut-in production had declined to about 0.7

million barrels per day after 10 days and to about 0.6 million barrels per day just before

Hurricane Rita.

Refined petroleum production capacity in the Gulf of Mexico fell initially by about 2 million

barrels per day after Hurricane Katrina, with some production resuming after 1-2 weeks and

other capacity not being available for more than three months. In the month immediately

following Hurricane Katrina, the average loss of Gulf oil refinery throughput was 1.57 million

barrels per day. North American oil refinery throughputs for September 2005 were

approximately one million barrels a day lower than the same period in 2004.

The supply disruption caused by Hurricane Katrina resulted in an increase in United States

petrol prices of about 18 per cent over the next few days. Because there is an integrated

Figure 67 Singapore Export Petrol Price and Crude Oil Price Movements Compared, 2005-06

a this is a reference note

Note: Acpl refers to Australian cents per litre.

Source: Caltex Australia.



international market for refined petroleum products, as well as crude oil, this substantial

supply loss affected prices globally. This is illustrated by Figure 67, which shows export

petrol price movements from the refining and trading hub of Singapore, the benchmark for

Australian retail prices. Retail petrol prices in Europe behaved similarly. Obviously, the

integrated market moderated the effect that the supply disruption would have caused in the

United States if that economy had not been open to imports from the rest of the world.

A striking feature of Figure 67 is that petrol prices (before taxes, transport costs, and

wholesale and retail margins) rose substantially relative to crude oil prices. This could be

attributed to the structure of U.S. Government and IEA action, which moderated crude oil

prices much more than refined product prices.

On 31 August, the U.S. Government announced a decision to release Strategic Petroleum

Reserve crude oil to provide loans totalling more than 13 million barrels to refiners. On 2

September 2005, all 26 IEA members agreed to a package of emergency response

measures, including use of emergency stocks, increased production, and demand restraint

totalling 60 million barrels (2 million barrels per day). Emergency stocks of 51 million barrels

of oil and refined products were to be made available by releases from government stocks

(28.6 million barrels) and reduction of private sector stockholding obligations (22.5 million

barrels), with almost half of the emergency stock releases being in the form of refined

products. The crude oil releases were to be made from the U.S. Strategic Petroleum

Reserve and included the release announced earlier by the U.S. Government. Crude oil

production increases were to provide about 6.6 million barrels. Actual public stock releases

were less than the amounts announced (IEA, 2008).

While the supply of refined products was disrupted more than crude oil supply, the

combined U.S. and IEA response was stronger for crude oil than refined products. Another

factor that may help explain the relatively small spike in crude oil prices was reduced

demand for crude oil as a result of the reduction in refining capacity and return to normal

demand as spare capacity elsewhere was brought into service (Kilian, 2010b).

Economic intuition indicates that the IEA action would have reduced the period of time the

refined product and oil price spikes lasted. By increasing supply it would have caused a

moderation of price increases. By reducing uncertainty regarding supply, it would have

induced a reversal of speculative demand buying in response to the supply shock. This

reversal may also have prevented a higher product price peak.

In late-September 2005, more crude oil and refined products capacity was taken out of

service following Hurricane Rita. In the case of crude oil, the peak nett reduction in

production capacity was over 1.5 million barrels per day. For refining, the peak nett loss of

capacity was about 4.8 million barrels per day in early-October 2005. There was a

substantial difference between loss of capacity and loss of throughput because August is

typically the summer peak period for oil refinery throughput in the United States, with

September and October being normally characterised by depressed oil refinery throughput,

because of scheduled maintenance. The normal aggregate reduction in throughput is about

one million barrels per day.

The price impact of the Hurricane Rita supply disruption in late-September 2005 was

minimal (see Figure 67). Thereafter, crude oil and product prices continued to decline until

early December, dropping below levels attained before Hurricane Katrina.

There could be at least two reasons for these occurrences. First, earlier U.S. Government

and IEA action helped offset supply losses. Second, imports of refined products arrived in

the United States at record rates in the three weeks following the Katrina product price spike



(see Box 6). These shipments were supported by higher refined product production outside

the United States that had been induced by the Katrina price spike, as outlined below.

Aggregate OECD oil refinery throughput in September 2005 rose by 59,000 barrels a day

relative to the same month in the preceding year, despite the disruption to U.S. Gulf Coast

oil refinery operations. Oil refinery runs in OECD Europe increased by 0.427 million barrels

a day. In OECD Pacific countries, oil refinery runs increased by 0.625 million barrels per

day, compared to the previous year. The IEA explained that approximately 0.33 million

barrels a day of this 1.05 million barrel a day increase in throughput outside the U.S. could

be attributed to lower scheduled oil refinery maintenance in Europe and the Pacific,

suggesting that the remaining 0.72 million barrels a day of the extra oil refinery runs were

induced by market forces. These adjustments were reflected by increases in refining

margins indicated in Figure 67.

Box 7 Katrina and Rita Supply Shocks and Market Forces

“The Katrina-generated spike in gasoline prices sent a signal heard around the world. …… gasoline tankers raced to the U.S. and in particular to the highest priced market, the Gulf Coast. ‘The cavalry came in the form of the surge in gasoline imports’, summarised the Energy Information Administration, ‘setting all-time records in three successive weeks ...... that was critical in helping to keep gasoline prices from going higher following Hurricane Rita and to help them start dropping substantially thereafter.’’’

Source: Bradley, Tanton (2007), p. 6.

By the end of November 2005, oil refinery throughput rates for the U.S. petroleum refining

industry overall were back to normal levels for that time of year, although Gulf Coast

throughput rates still had not fully recovered to normality. As U.S. oil refinery throughput

rates recovered, imports of refined products declined (Bradley, Tanton, 2005).

It appears that action by the U.S. Government and the IEA in response to damage caused

by Hurricane Katrina, and market responses may have temporarily reversed a strong

upward movement of crude oil prices that commenced in the second half of 2003 in

response to global aggregate demand growth. The strong upward trend in crude oil prices

re-emerged from December 2005.

10.5.2 Plethora of Small Supply Shocks, 2008

The final powerful surge in the real crude oil price before it reached its peak of around

US$162 per barrel (2014 real terms) in the third quarter of 2008 was helped by several

supply upheavals in close succession in the first half of 2008 (Smith, 2009a,b).

Venezuela cut off supplies to ExxonMobil during a legal battle over nationalisation of the

company’s properties – February 2008.

Iraqi saboteurs blew up the two main export pipelines in the south of the country, cutting

exports by 0.3 million barrels per day – late-March 2008.

Nigerian oil workers went on strike, causing ExxonMobil to shut-in production of nearly

0.8 million barrels per day – late-April 2008.

Scottish oil workers went on strike, leading to closure of pipeline carrying about half U.K.

North Sea production – late-April 2008.

Nigerian production of 1.36 million barrels per day was temporarily lost, because of

attacks on oil facilities, sabotage, and labour strife –, early-May 2008.



Mexican exports fell sharply in April 2008, because of rapid decline of the huge Cantarell

field.

Nigerian production of 0.35 million barrels per day was shut-in because of attacks on

Shell and Chevron facilities – June 2008.

10.6 Speculative Demand, 2003-2008

Respected oil market specialists have disagreed on the presence of speculative demand

during the 2003-2008 period. So, the role of speculative demand in influencing prices in this

period is problematic.

However, there is agreement among economic analysts that positive speculative demand

should be reflected by increases in inventories, and negative speculative demand or

reversal of speculative demand should result in reduction of inventories. This criterion

applies regardless of whether speculative demand is present in the spot market for crude oil

or in oil futures and other financial oil derivatives markets. Arbitrage opportunities would

mean that speculation in financial oil derivatives that drives prices of those instruments up or

down would raise or lower demand for inventories in the physical oil market, pushing crude

oil prices up or down, respectively.

Differences of opinion regarding any role of speculative demand for oil in the 2003-2008

period appear to be related to different interpretations of the available inventory data.

Hamilton (2009b) and Kilian and Lee (2014) observed that reliable data on global oil

inventories are lacking. Therefore, analysts have fallen back on various proxies.

Hamilton (2009b) referred to crude oil inventories held by United States refiners. He pointed

out that in the last quarter of 2007 and the first half of 2008, when the price rise was most

dramatic, inventories were significantly below “normal” (seasonal averages for 1990-2007).

However, he noted that inventories were above “normal” from January to September 2007,

particularly in the second quarter of 2007. Hamilton concluded that the price spike occurred

because of the fundamentals of non-speculative demand and supply for crude oil: rapidly

growing demand for crude oil derived from strong aggregate demand growth, low price

elasticities of demand and supply for crude oil, and the failure of crude oil supply to respond

to high prices over time.

Smith (2009a) used the same inventory data. He arrived at the same conclusion as

Hamilton (2009b).

Smith (2009a) and Hamilton (2009b) touched on the possibility that OPEC producers,

particularly Saudi Arabia, might have withheld supply, effectively increasing inventories in

the ground, for speculative reasons. While both noted the important contribution of

production capacity constraints by OPEC members in driving up the oil price, they did not

seriously consider the possibility of a speculative motivation for OPEC, and particularly

Saudi Arabian production behaviour during the 2003-2008 oil price boom.

Kilian and Murphy (2014) used a structural VAR econometric model that allows for demand

for above ground inventories. The model operates within restrictions derived from intuitive

economic analysis. Because of unavailability of reliable global oil inventory data, Kilian and

Murphy used a proxy constructed from Energy Information Administration data. Their

modelling did not find evidence of a contribution from increases in speculative demand,

even during 2007-08 when the real crude oil price rose sharply. In contrast, they found

evidence that speculative demand shifts were important in some earlier oil price shocks, as

discussed above.



Kilian and Lee (2014) explained that models applied to detect the speculative component of

changes in the real crude oil price depend crucially on the quality of oil inventory data. So,

they tested the results of Kilian and Murphy (2014) using an alternative proxy for global

inventories compiled by the Energy Intelligence Group. Kilian and Lee (2014) found

evidence that speculative demand had raised the real crude oil price by US$5-14 per barrel

in the period from March to July 2008, but not in the period from 2003 to early-2008. They

estimated that speculative demand was responsible for only 5-15 per cent of the 2003-2008

crude oil price spike, compared to 64 per cent for aggregate demand, and 18-32 per cent for

supply shocks. The estimates of Kilian and Lee (2014) suggest that the contribution of

speculative demand to the crude oil price increase in the period from March to July 2008

would have been in the range, 14-39 per cent of that increase.

Kilian and Lee (2014) concluded that the surge in crude oil prices from 2003 to 2008 was

“driven primarily by economic fundamentals”. Kilian and Lee confirmed findings by Kilian

and Murphy (2014) that speculative demand shifts were important in various earlier oil price

shocks,

It is important to consider these views in the context of the supply position and the ongoing

behaviour of the OPEC oil cartel.

Several other respected oil market specialists have argued that the effects of the aggregate

demand shock on the crude oil price were exacerbated by speculative demand in the 2007-

2008 period. Econometric analysis by Jeff Frankel and Andrew Rose (2010) found evidence

of destabilising speculative effects arising from actions based on “bandwagon expectations”

– forecasts of future commodity prices that extrapolated recent trends – during the 2007-08

period. In other words, there was evidence of destabilising speculation based on positive

feedback trading by “noise traders” as described by De Long, Shleifer, Summers and

Waldmann (1990). Similarly, Kaufmann (2011) produced evidence of destabilising

speculation.

Frankel and Rose (2010) explained that prices for crude oil and other mined commodities

continued to rise in the 2007-08 period despite a series of downgrades of forecasts of

economic growth. Leonardo Maugeri (2009) pointed out that, from August 2007, growth of

oil production began to outstrip non-speculative demand growth, with new production

coming on line.

Leon Maugeri (2009) argued that expectations based on earlier price trends had influenced

strong increases in oil prices in 2007-08. He said that this would not have occurred without

inadequate data provision, and misleading analysis and forecasts by high profile

organisations that distorted perceptions of market fundamentals. He stated that inventories

grew as supply growth outstripped non-speculative demand growth. Maugeri claimed that

the accumulation of inventories was not included in official statistics until later.

Growth of inventories during the period 2005 to 2008 would undermine the view that

speculative demand did not contribute to the substantial rise in oil prices during this period.

This was noted by Kaufmann (2011), who presented data showing that private inventories of

crude oil held in the United States rose substantially in the period 2004 to 2008 in terms of

both volume and days of forward consumption.

In addition, it is relevant that, in effect, inventories can be raised by slowing production,

which leaves oil in reserves below ground. This can be prompted by anticipation of price

increases (Davidson, 2008; Frankel, Rose, 2010). It could be interpreted as a speculative

supply shock (Kilian, Lee, 2014) or a form of speculative demand by oil producers for their

own oil. It is noteworthy that Saudi Arabian production declined from 2005 when crude oil

prices were soaring to an historical peak in 2008. Kilian and Lee (2014) pointed out that the



price effects of a speculative supply shock could not be disentangled from estimates of price

effects of conventional supply shocks.

The constrained supply situation prevailing in the period 2005-2007 fitted neatly the

circumstances in which Dvir and Rogoff (2010, 2014) argued speculative demand would add

to price increases resulting from a persistent aggregate demand shock.

10.7 Global Financial Crisis and Recovery, 2008-2014

10.7.1 Global Financial Crisis

The 2003-2007 global economic boom, combined with production and capacity constraints,

particularly from 2005, and then some speculative demand in the first half of 2008 drove the

crude oil price from under US$35 per barrel in early-2003 to around US$162 per barrel

(2014 real terms) in July 2008. Following the onset of the “global financial crisis” in late-

September 2008, and an associated global recession – “the great recession” – the crude oil

price collapsed. In December 2008, it declined to about US$35 per barrel (2014 real terms),

the level at which it had been before the 2003-2008 price ascent commenced.

Bhar and Malliaris (2011) pointed out that the extent of the decline was exaggerated by

appreciation of the US dollar relative to other key currencies and gold following the global

financial crises. They explained that the US currency was perceived to be a “safe haven”.

Kilian (2010a,b) and Kilian and Lee (2014) argued that the collapse of the oil price in late

2008 and 2009 was caused mainly by unexpected changes in global activity combined with

“unprecedented expectations shifts” triggered by the global financial crisis. The shifts in

expectations, through speculative demand reductions, exacerbated the reduction in demand

for oil resulting from the shift in global economic activity. Kilian and Lee (2014) estimated

that negative speculative would have been responsible for about 25 per cent of the slump in

crude oil prices.

Hamilton (2008b) also suggested that the economic reversal was unexpected. However,

Frankel and Rose (2010) argued that the signs of an impending downturn were clearly

evident and publicised.

Hamilton (2008a,b) commented that the sharp global economic decline in response to the

global financial crisis was not enough by itself to explain the magnitude of the dramatic

decline in the oil price. He suggested that the effect of the severe economic reversal was

reinforced by delayed responses to high oil prices prevailing in 2007-08.

Economic recovery following the “great recession” may have been helped by the

extraordinary drop in the oil price triggered by the global financial crisis. Later, the economic

recovery was accompanied by a faster recovery of the crude oil price. It has fluctuated

around US$100 per barrel in real 2014 terms for the past three years.

Kilian (2010c), Kilian and Murphy (2014) and Kilian and Lee (2014) attributed the recovery

of the crude oil price primarily to improved global real economic activity. As in the 2003-

2008 timeframe, the improvement in economic activity and oil price recovery were

underpinned by commodity-use-intensive growth of economic activity in China, India and

other rapidly developing Asian economies.

Radetzki (2011, pp. 47-48) emphasised the importance of resurgence of commodity-use-

intensive growth in the “major emerging economies” for the rapid recovery of oil and other

commodities:

“When the most profound global economic contraction since the 1930s depression eventually

arrived in the second half of 2008, a sharp commodity price correction did indeed occur, but it



was of surprisingly short duration. By the end of 2009, commodity prices were very high again,

having recovered a major share of the preceding year’s decline. The explanation of the

surprising commodity price recovery in the midst of continuing economic gloom is that the

major emerging economies which have accounted for virtually all commodity demand growth in

the most recent decade, were little affected by the global recession. By 2009, these nations

had already resumed their very fast economic expansion and their commodity demand growth

accelerated again.”

Claudio Morana (2013) argued that two other factors contributed to the recovery of global

economic activity and the price of crude oil. He observed that there was an endogenous

contraction of real wages following the global financial crisis. In addition, expansionary

macroeconomic stabilisation policies were implemented by governments of many countries,

including China.

10.7.2 Libyan Revolution

In February 2011, violent protests against the regime of Moammar Gaddafi in Libya

escalated rapidly into an armed conflict known as the Libyan Civil War or Libyan Revolution.

As a result of the fighting, Libya’s oil production fell from about 1.8 million barrels per day to

22,000 barrels per day in July 2011.

The crude oil price rose quickly by about 26 per cent. It peaked in April 2011. Saudi Arabia

took advantage of the price spike by increasing its exports by about 15 per cent, and then

withdrew the extra exports, as the price fell and Libya’s production recovered (Cashin,

others, 2014).

With the aid of limited international military intervention sanctioned by the United Nations

Security Council, Gaddafi’s regime, which had ruled Libya for 42 years, was ousted in

October 2011. A transitional government was formed in late-November 2011.

After the return of international oil companies, Libya’s oil production rate recovered to

840,000 barrels per day in November 2011. After the election of the General National

Congress (GNC) in mid-2012, exports rose above the pre-revolution level. In mid-2012, the

crude oil price dropped to approximately the level prevailing before the Libyan revolution.

However, disillusionment with the GNC grew over the next year and the country descended

into chaos. There is now no effective government in Libya. The GNC has been plagued by

infighting. Hundreds of armed Islamist and tribal militias are vying for power and extending

their influence over elements of the GNC. Assassinations are frequent.

Strikes, blockades and protests have drastically disrupted oil production. In April 2014,

Libya’s oil output rate was only 160,000 barrels per day.

Kilian and Lee (2014) used a structural VAR econometric model incorporating inventories to

estimate the contribution of aggregate demand, supply and speculative demand shocks to

the crude oil price after 2010. They estimated that the Libyan supply shock in 2011 added

between US$7 and US$19 dollars per barrel to the oil price, and speculative demand

contributed an extra US$3 to US$13 per barrel. They observed that these impacts were

“short-lived”. Kilian and Lee indicated that an aggregate demand shock contributed about

US$25 to US$35 per barrel to the oil price. Estimates varied because of different proxies for

global inventories. Kilian and Lee (2014) estimated that in late-2011, and early-2012,

negative speculative demand lowered the oil price. Presumably, this was related to

reduction of concerns regarding Libyan oil supply.

10.7.3 Iran Tension

The United States has applied various sanctions, including trade sanctions, against Iran

since the Tehran hostage crisis in 1979. They have been rationalised by reference to



Iranian support for international terrorism, human rights violations, and refusal to cooperate

with the International Atomic Energy Agency (IAEA).

Since 2006, the United Nations Security Council has endorsed six resolutions declaring that

Iran should stop enriching uranium and to cooperate with the International Atomic Energy

Agency to facilitate verification of Iran’s assertions that its enrichment programme won’t be

used to support nuclear weapons. Iran has ignored the resolutions.

In November 2011, the United States threatened to deny international financial institutions

access to the US financial system if they provided services to Iran’s central bank in relation

to oil transactions. As a result, several countries reduced oil imports from Iran. The United

Kingdom and Canadian Governments ordered their countries’ financial institutions not to

deal with Iranian financial entities. In January 2012, the European Union (EU) froze assets

of the Iranian central bank and banned trade in gold and other precious metals with Iranian

entities. From 1 July 2012, the EU banned purchases, imports, transportation, and

insurance of Iranian crude oil. In October 2012, the EU added Iranian natural gas to the

bans. It also banned transactions with Iranian financial institutions.

In late-February 2012, Iran threatened to close the Strait of Hormuz. This and earlier

sanction announcements contributed to increases in the crude oil price totalling about 8.5

per cent. However, this occurred in the context of a looming Euro zone financial crisis and

rising United States oil production that would have muted the price spike. In addition, Saudi

Arabia increased production to take advantage of the price spike, and thereby moderated it.

The price peaked in March 2012.

Iran’s crude oil production rate was about 2.2 million barrels per day in 2011. By May 2013,

the rate was down to 700,000 barrels per day. This fall has been attributed to the sanction

announcements in late-2011 and during 2012. Kilian and Lee (2014) estimated that

concerns about Iranian supply, along with other issues at the time, added between zero and

US$9 per barrel to the oil price through speculative demand in the second quarter of 2012.

They estimated that all oil shocks (not just the Iranian embargo) added US$7 to US$19 per

barrel during the relevant time period. Their estimates varied because of use of two

different proxies for global inventories.

Kilian and Lee explained that they were not able to disentangle speculative activity

associated with Iranian tension and other issues, including a looming financial crisis in the

Euro area. Presumably the Euro crisis would have reduced speculative demand for oil, and

appreciation of the US dollar resulting from Euro concerns also would have tended to lower

the US$ oil price. Aggregate demand remained the dominant influence on the oil price in

the first half of 2012, according to the analysis of Kilian and Lee (2014). However, ongoing

OPEC capacity constraints also would have been important.

In late-January 2014, some sanctions relief was granted to Iran in return for a 6-month

commitment to curb uranium enrichment activities and not commission or fuel the Arak

heavy-water reactor. During that period, Iranian oil exports were to be lifted to one million

barrels per day.

Since mid-2012, the crude oil price has fluctuated around US$100 per barrel in real 2014

terms.

10.8 Impacts in Australia

Movements in the US dollar price of crude oil were translated into comparable changes in

the Australian price, with variations explained by exchange rate movements (Figure 68).



These patterns of price movements translated directly into price movements for petrol in

Australia over the period (Figure 68 to Figure 70). Relative fuel price movements were

muted by the fuel tax price wedge.

Figure 68 Crude oil price in Australian and US dollars

Note: Crude oil prices based on quarterly average of Brent crude oil price



Note: Crude oil prices based on quarterly average of Brent crude oil price


0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

Mar

-04

Sep

-04

Mar

-05

Sep

-05

Mar

-06

Sep

-06

Mar

-07

Sep

-07

Mar

-08

Sep

-08

Mar

-09

Sep

-09

Mar

-10

Sep

-10

Mar

-11

Sep

-11

Mar

-12

Sep

-12

Mar

-13

Sep

-13

$ /bbl


-10.0

40.0

90.0

140.0

190.0

240.0

0

20

40

60

80

100

120

140

160

180

Mar

-04

Nov

-04

Jul-0

5

Mar

-06

Nov

-06

Jul-0

7

Mar

-08

Nov

-08

Jul-0

9

Mar

-10

Nov

-10

Jul-1

1

Mar

-12

Nov

-12

Jul-1

3

Crude oil $A/bbl

Petrol c/l





Source: ABS, Automobile Association of Australia

Consumption of petroleum products dipped by around 2 per cent with the onset of the

globafinancial crisis in late-2008, driven by a fall in economic activity not withstanding a fall

in petrol prices in line with oil prices globally. However demand for petroleum products grew

again from 2009-10 as the economy recovered and petroleum prices remained on a lower

growth trajectory than prior to the crisis (Figure 71).



Production of crude oil and other refinery inputs remained steady at around 30,000 ML per

annum, while imports of refinery feedstock increased around 20 per cent (Figure 72) .

However, refinery production in Australia was relatively steady over this period (Figure 73).

The increase in refinery feedstock most likely reflects the decline in crude oil production

from Gippsland and other fields supplying Australian refineries.

0

20

40

60

80

100

120

140

160

180

Mar

-04

Sep

-04

Mar

-05

Sep

-05

Mar

-06

Sep

-06

Mar

-07

Sep

-07

Mar

-08

Sep

-08

Mar

-09

Sep

-09

Mar

-10

Sep

-10

Mar

-11

Sep

-11

Mar

-12

Sep

-12

Mar

-13

Sep

-13

c/l

Series1 Series2 Series3 Series4

Series5 Series6 Series7 Series8

48 000

50 000

52 000

54 000

56 000

58 000

60 000

62 000

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

ML /a







The balance of demand for petroleum products was met from petroleum product imports.

Net imports of petroleum products increased from 15,000 ML per annum immediately prior

to the to 18,000 ML per annum in the following year (Figure 74).

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

50 000

2003

–04

2004

–05

2005

–06

2006

–07

2007

–08

2008

–09

2009

–10

2010

–11

2011

–12

2012

–13

ML/a


25 000

30 000

35 000

40 000

45 000

50 000

2003

–04

2004

–05

2005

–06

2006

–07

2007

–08

2008

–09

2009

–10

2010

–11

2011

–12

ML/a





Vehicle kilometres travelled over this period continued to increase along longer term trends

with only a slight flattening in demand growth in the wake of the global financial crisis

(Figure 75).


Source: ABS

Year on year quarterly inflation fell from as high as 5 per cent prior to the global financial

crisis to as low as 1 per cent in the September quarter of 2009, and ranged between 1 per

cent and 3 per cent in the following years to date (Figure 76).

GDP growth fell from 3.5 per cent prior to the global financial crisis to around 1.6 per cent in

the first quarter of 2009. It remained at around 2 per cent in the following years before

recovering to 3 per cent by 2012 (Figure 77).

General economic conditions and recovery from the global financial crisis appear to have

been more significant influences on inflation and economic growth than perturbations in the

0

5 000

10 000

15 000

20 000

25 000

2003

–04

2004

–05

2005

–06

2006

–07

2007

–08

2008

–09

2009

–10

2010

–11

2011

–12

ML/a

0

2

4

6

8

10

12

14

16

18

Mar

-04

Aug

-04

Jan-

05

Jun-

05

Nov

-05

Apr

-06

Sep

-06

Feb

-07

Jul-0

7

Dec

-07

May

-08

Oct

-08

Mar

-09

Aug

-09

Jan-

10

Jun-

10

Nov

-10

Apr

-11

Sep

-11





world oil market resulting from Hurricanes Katrina and Rita, the impact of the Libyan

revolution and the embargo by the European Union on oil imports from Iran.


Source: ABS


Source: ABS

10.9 Policy responses and issues

Disruptions in the global oil market caused by OPEC capacity constraints, hurricanes in the

Gulf of Mexico, the Libyan crisis, and embargos affecting oil imports from Iran have not

caused shortages in Australia or elsewhere.

Consultations within the NOSEC community have been active over all of those periods.

However, interventions as a result of these events have not been necessary. Markets have

worked well in allocating scarce supply. There have been adjustments to domestic refiner

production and imports of both refinery feedstock and refined products as the need arose.

0.0

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006

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Some domestic supply chain issues have from time to time caused supply shortfalls. The

most notable was the closure of two refineries in Victoria in late 2012. This resulted in some

stockouts in Victoria for a period of about two weeks. This event however was not driven by

international supply disruptions.

Shortages occurred because oil companies chose to allocate supply administratively, rather

than allow price to ration and allocate supply.



11 Economic Effects of Oil Shocks

Key Points

Analyses of economic effects of oil shocks have focussed on the price movement aspect of oil

shocks. The economic effects of oil shortages have not been analysed, because the operation of

markets has avoided shortages wherever markets have been allowed to work.

The economic effects of oil shocks are highly context-dependent. While various potential

determinants of economic effects of oil shocks have been nominated, a consensus has not yet been

reached on the explanatory power of all of them.

A popular contemporary view is that the economic consequences of an oil shock depend crucially on

its cause or causes. Attention has been focussed on the differing economic effects of aggregate

demand shocks, oil and refined product supply shocks, speculative, oil-specific demand shocks, and

combined shocks. Combinations of oil shocks have been the norm since the early-1970s.

Over time, the economic effects of oil shocks of different types and combinations of them may have

been modified by various other economic shocks or changes in circumstances. Several have been

discussed by economists:

changes in nett energy export/import balances over time and across countries

declining oil and energy intensity at different rates over time and across countries

declining short-term price elasticity of supply and demand

changing magnitudes of oil shocks

OPEC’s changed price control policy

productivity shocks



greater exchange rate flexibility.

While there is some controversy regarding the relative importance of some of these factors, all but

one point towards smaller economic effects of oil shocks in Australia now than in the 1970s and

early-1980s. The one factor that would work the other way is the decline in the short-term price

elasticity of supply and demand since the early-1980s. This phenomenon means an oil shock of a

particular size in quantitative terms would lead to larger short-term price movements now than at the

time of the “first and second oil crises”.

From the 1970s until about five years ago, the conventional view among macroeconomic

specialists was that substantial changes in the price of crude provided global economic

shocks that inevitably caused economic fluctuations in major economies. This perception

derived from episodes of “stagflation” -- low growth, high unemployment and high inflation --

that plagued most advanced economies in periods following the “first and second oil crises”.

This view of the role of oil shocks as a source of economic fluctuations was challenged by

Robert Barsky and Lutz Kilian (2002, 2004). They observed that oil shocks were



idiosyncratic, and occurred in varying economic and policy circumstances. They also

pointed out that these differences were important determinants of the economic effects of oil

shocks. Later, the oil shocks in the 2003-2008 period and subsequent oil market events

induced others to reconsider the conventional view.

During the 2003-2008 period, the price of oil rose in real terms by about 375 per cent,

compared to increases of about 200 per cent during the “first oil crisis” (1973-1974), about

215 per cent the “second oil crisis” (1979-1980), and about 540 per cent in the 1973-1980

period. During these oil shocks, petroleum expenditure as a percentage of global GDP grew

from about 1.8 per cent to 5.25 percent (2003-2008), 1.5 per cent to 4.5 per cent (1973-

1974), and 4 per cent to 7.5 per cent (1979-1980).8 These relative changes reflected

movements in oil-use intensity as well as oil prices.

Although the magnitude of the 2003-2008 shock was comparable to the scale of the 1973-

1981 shocks, the episodes of “stagflation” that followed the “first and second oil crises” were

not repeated during and after the 2003-2008 period. Indeed, “stagflation” did not occur in

the wake of any of the oil shocks since the “first and second oil crises”.

The largest and most prolonged shock subsequent to the “first and second oil crises” was

the 2003-2008 price surge. During this period, economies grew strongly and inflation

remained relatively low in major economies. The global financial crisis that commenced in

late-2008 was associated with a recession, but not high inflation. Swift recovery of oil prices

from late-2009 (associated with macroeconomic stimulus packages and resumption of rapid

growth in major developing economies), and subsequent persistence of oil prices around

US$100 from 2011 have not scuttled growth or caused acceleration of inflation.

Economic analysts have offered several explanations for differing economic effects of oil

shocks over time. Also, some analysts have sought to explain differing economic effects

across countries.

There is agreement that other important economic shocks or changes have coincided with

oil shocks. There is also agreement that the economic effects of oil shocks are highly

context-dependent.

While various potential determinants of economic effects of oil shocks have been

nominated, a consensus has not yet been reached on the explanatory power of all of them.

A catalogue and review of explanations follow.

All of the analyses of economic effects of oil shocks have focussed on the price movement

aspect of oil shocks. The economic effects of oil shortages have not been analysed,

because the operation of markets has avoided shortages wherever markets have been

allowed to work.

11.1 Economic Effects Depend on Shock Type and

Nett Energy Exports/Imports Position

A popular contemporary view among economists interested in analysis of oil shocks is that

the economic consequences of an oil shock depend crucially on its cause or causes.9 So,

8 Data on oil price increases has been reproduced from previous chapters. Figures on petroleum expenditure as

percentages of global GDP are from Segal (2011) and Allsopp and Fattouh (2011).

9 See Kilian, 2010a; Baumeister, Peersman, Van Robays (2010); Peersman, Van Robays (2012), and Cashin, Mohaddes, Raissi, Raissi (2014).



there are important differences between the economic effects of aggregate demand shocks,

oil and refined product supply shocks, and speculative oil-specific demand shocks.

The differences between economic effects of the various types of oil shock have important

implications for formulation of macroeconomic policy responses. Policy responses should

differ according to the cause or causes of the shocks. The policy task may be complicated

by the contemporaneous operation of more than one type of shock. Historical occurrences

of multiple shocks have been documented in chapters 5-10 above.

Economic effects of different types of oil shocks also vary between countries in accordance

with differences in nett energy exports or imports. As these nett positions have evolved over

time, economic effects of oil shocks have changed.

The different economic effects of various types of shocks in the context of different energy

export/import positions are discussed below.

11.1.1 Oil Supply Shock

An oil supply shock would cause markedly different effects in nett oil-importing countries,

than in countries that are nett exporters of oil, nett exporters of oil and other energy, or nett

exporters of energy but not oil.

Nett oil-importing countries would experience a permanent fall in real economic activity and

an increase in inflationary pressures as a result of an oil supply shock. Monetary authorities

might respond with an interest rate increase to address any expected increase in core

inflation, or with an interest rate reduction to address a decline in economic activity.

Monetary intervention would be influenced by exchange rate movements.

Nett exporters of oil and other forms of energy, such as Norway and Canada, could be

expected to experience a permanent rise in real economic activity, because of the

expansionary effects of higher prices for the oil and other energy products that they

produce. Exchange rate appreciation would tend to offset inflationary pressures from higher

oil product prices and increased economic activity.

Countries like the United Kingdom, which are nett oil exporters, but net importers of other

forms of energy, could experience effects on economic activity working in opposite

directions. Any reduction in economic activity would tend to be transitory. Inflationary

pressures would tend to increase because of higher prices of energy products. The relative

importance of nett oil exports and nett imports of other energy forms would determine the

extent to which exchange rate movements offset or exacerbate inflationary pressures, and

the resulting likelihood of intervention by monetary authorities to adjust interest rates.

In countries like Australia that are nett exporters of energy, but nett importers of oil, there

would be effects on economic activity working in opposite directions. Higher oil prices would

tend to cause a contraction of national income, while higher prices for energy commodities

in general would tend to be expansionary for economies that are nett exporters of energy.

Again, any reduction in economic activity would tend to be transitory, depending on the

relative importance of the opposing forces. These same opposing forces would also

determine the direction and magnitude of movements in the exchange rate and the nature

and extent of any monetary intervention. The nett economic effects of an oil supply shock

on Australia could be insignificant or positive overall. As Australia’s nett energy export

balance increases because of large increases in exports of coal and liquefied natural gas

(including coal seam methane), the likelihood of positive overall economic effects on

Australia increases.



The economic intuition above has been supported by economic modelling by Baumeister,

Peersman and Van Robays (2010), Peersman and Van Robays (2012), and Cashin,

Mohaddes, Raissi and Raissi (2014). This work is referred to below as BPV (2010), PV

(2012) and CMRR (2014), respectively. BPV (2010) and PV (2012) applied a structural

VAR model to 12 advanced economies: United States, Japan, Switzerland, France,

Germany, Italy, Spain, United Kingdom, Canada, Australia, and Norway. CMRR (2014)

deployed a global VAR model comprising 38 country and region-specific models involving

50 countries.

11.1.2 Aggregate Demand Shock

An unexpected large increase in global economic activity – a positive aggregate demand

shock – would increase demand for crude oil. This would result in a much larger percentage

increase in crude oil and refined product prices in the short-term because of low price

elasticity of demand and supply.

Unlike the supply shock case, there would be a transitory increase in both real national

income and inflationary pressures in all countries. If the positive aggregate demand shock

persists, because the rate of growth of global economic activity is persistently higher than

expected, inflationary pressures and higher than expected growth of real national income

and inflationary pressures would persist.

A persistent, positive aggregate demand shock would cause relatively large increases in

prices of all mined commodities, not just oil. It would also cause relatively large price

increases for other natural resource-based commodities, such as food and fibres. Large

commodity price increases would occur because, to varying degrees, these natural resource

based commodities are characterised by relatively low price elasticities of demand and

supply. Because Australia is a large producer of a diverse range of commodities, it could be

expected to be particularly affected by such an aggregate demand shock, which has been

exemplified by the commodity price booms of the 1970s and 2004-2008, and revival of the

latter in 2010-2011 (see chapters 5, 6 and 10).

The potentially strong increase in inflationary pressures in a major commodity producer like

Australia during a commodity price boom should be ameliorated by a floating currency. This

occurs through appreciation of the nominal exchange rate (the value of the Australian dollar

relative to other currencies). An interest rate response could also be invoked to dampen

inflationary pressures and ensure real exchange rate appreciation. Unlike the oil supply

shock case, nett energy importers experience temporary increases in economic activity

following an aggregate demand shock. An increase in global aggregate demand increases

demand for goods and services produced by nett energy importers, as well as demand for

oil, other energy sources, and other commodities.

Like commodity producers, commodity importers have to deal with an increase in inflation.

However, in the case of commodity importers, inflation may be exacerbated by exchange

rate depreciation. In contrast, exchange rate appreciation tends to moderate inflation in nett

commodity exporting countries. This may mean central banks raise short-term interest rates

to a greater extent in commodity-importing countries following an aggregate demand shock.

The ultimate nett effect on economic activity and inflation will depend on several factors

(CMRR, 2014; PV, 2012).

Again, the economic intuition above has been supported by results of VAR modelling

undertaken by BPV (2010), PV (2012) and CMRR (2014).



11.1.3 Speculative Oil-Specific Demand Shock

The effects of speculative, oil-specific demand shocks differ considerably from effects of oil

supply shocks and aggregate demand shocks. However, speculative, oil-specific demand

shocks typically have been triggered and accompanied by oil supply and aggregate demand

shocks, as discussed in chapters 5-10.

The oil price effect of an increase in speculative oil-specific demand would tend to cause a

temporary reduction in real national income and a temporary increase in the price level.

Intuitively, however, one would expect that there were would be countervailing effects for

countries that are nett oil exporters or nett energy exporters. Higher prices for energy

commodities would be stimulatory in nett energy exporting economies, countering to some

degree the effects of higher prices of energy products on economic activity. Similarly, these

higher export prices would tend to cause exchange rate appreciation.

Surprisingly, this intuition was not supported by results of structural VAR econometric

modelling by BPV (2010) and PV (2012). They found that nett oil exporters and nett energy

exporters would experience temporary reductions in real national income, although not as

large as for nett energy importing countries. For Australia, they found that the reduction in

real national income would be less than in comparable countries, Canada, Norway, and the

United Kingdom.

Also, the modelling indicated that exchange rates in nett energy-exporting countries would

not respond significantly to a speculative demand increase, and inflationary effects would

not differ greatly from those in nett energy importing countries. For Australia, they found a

larger effect on the price level than for other developed nett energy-exporting countries and

nett energy-importing countries.

BPV (2010) and PV (2012) did not provide an explanation for their apparently counter-

intuitive modelling results.

11.1.4 Refined Products Supply Shocks

The world’s largest refined product supply shock over the past few decades was associated

with temporary loss of refining capacity along the United States Gulf Coast because of

Hurricanes Katrina and Rita in late August 2005 and late September 2005, respectively.

This shock, which also involved a crude oil supply shock, has been discussed in sub-section

10.5.1 of chapter 10.

The increase in refined product prices resulting from a refined product supply shock would

tend to cause a temporary reduction in national income and an increase in the price level in

countries around the world. Obviously, there would be an additional hit to national income in

the country hosting the disabled refining capacity. In countries with spare refining capacity,

there would be a temporary stimulus to economic activity that would help offset the effects of

higher refined product prices in other parts of the economy.

Nett energy-exporting countries, such as Australia, would not gain from higher prices of

other energy products, unlike the case of a crude oil supply shock, because crude oil prices

would not rise and induce increases in prices of other energy products. When refining

capacity is lost, demand for crude oil from that source disappears. The previous demand

level can be restored only to the extent that there is spare refining capacity elsewhere.

Consequently, crude oil prices could fall or remain unchanged (Kilian, 2010b).

The economic effects in Australia of a refined product supply shock in the form of a loss of

refined capacity elsewhere would be a temporary loss of real national income and a higher



price level. The loss of national income from the increase in product prices following the

shock would be offset only to the extent that Australian refineries could expand production.

11.1.5 Compound Shocks

Analyses of historical oil shocks has shown that more than one type of shock and underlying

cause may be operating around the same time. Indeed multiple simultaneous shocks have

been more common than one type of shock in isolation over the past 40 years. This is clear

from case studies discussed in chapters 5-10.

The 2003-2008 period exemplifies the occurrence of multiple or compound shocks. The

persistent aggregate demand shock in the period, 2003-2008, was obviously a refined oil

products shock, as well as a crude oil price shock, because demand for crude oil derives

from demand for refined oil products. During this period, there was also a persistent supply

shock resulting from OPEC capacity restraint. In addition, there was a combined crude oil

and refined oil products supply shock caused by Hurricanes Katrina and Rita in late-2005.

The hurricanes shock was accompanied by a speculative demand increase (shock) for

refined products. Then, Saudi Arabia reduced its production in 2006 and 2007. The last six

months of the 2003-2008 aggregate demand shock also was marked by multiple small

supply shocks, and arguably, a speculative demand shock.

When different types of shocks occur around the same time, the differing economic effects

of the shocks and their underlying causes would have to be taken into account to predict

nett economic outcomes and to consider policy responses. These deliberations should

include consideration of the economic implications of interactions between causes that may

be reinforcing or countervailing in nature. The required analysis will be complex.

11.2 Changes Across Time and Countries

Different types of oil shock and mixes of types of oil shock have occurred at various times.

Actual occurrences are discussed in chapters 5-10 above.

Over time, the economic effects of oil shocks may have been modified by various other

economic shocks or changes. Several relevant economic changes have been discussed in

the relevant economic literature:

changes in nett energy export/import balances over time and across countries

declining oil and energy intensity at different rates over time and across countries

declining price elasticity of supply and demand

changing magnitudes of oil shocks

OPEC’s changed price control policy

productivity shocks



greater exchange rate flexibility.

11.2.1 Nett Energy Export/Import Balances

Susceptibility to economic harm from (vulnerability to) oil price increases tends to decline as

nett oil export/import positions improve.

Nett oil-importing/exporting and nett energy-importing/exporting positions have changed

over time to varying degrees across countries. Norway, Australia, Canada and the United

Kingdom (in that order) have significantly improved their positions since the 1970s and early



1980s. The current LNG capacity construction boom in Australia will further improve

Australia’s nett energy export position. Japan and European countries have made moderate

improvements that are significantly less than those for Norway, Australia and Canada. Until

recently, the United States had improved its position only slightly. However, oil and gas

from shale have changed this position dramatically in recent years. There is potential for the

United States to improve this position further if current government constraints on exports

are removed.

11.2.2 Energy Intensity

There have been noticeable reductions of oil-use intensity and energy-use intensity in nearly

all developed countries since the 1970s. However, the differences between countries

remain substantial, particularly in respect of oil-use intensity. Data provided by PV (2012),

Brantley Liddle (2012), and Voigt and others (2014) indicate that Australia’s energy-use

intensity has declined at a slower rate over the past 20 and 40 years than most other

developed economies.

Lower oil- and energy-use-intensity reduces vulnerability of economies to oil price increases.

Differences in intensity of use of oil-products and energy-use more generally lead to differing

economic effects of oil shocks between countries. Energy-use intensity is relevant when oil

prices spike, because prices of energy other than oil tend to move with oil prices.

Olivier Blanchard and Jordi Galí (2010) pointed out that the decline in oil intensity since the

1970s has been “large enough to have quantitatively significant implications.” Their analysis

based on a structural VAR econometric model indicated that this change clearly accounted

for part of the changed economic effects of oil shocks over time.

Anton Nakov and Andrea Pescatori (2010) explained that declining oil-use intensity is likely

to reduce the volatility of economic activity and the pass-through of oil price changes to the

inflation rate. With the aid of simulations based on a DSGE model, they estimated that

diminished reliance on oil could explain around 33 per cent of the reduced volatility of

inflation and around 18 per cent of the reduced volatility of growth of economic activity since

1984.

Oil-use intensity differences may reflect different patterns of settlement, population density,

and phases of economic development. Oil-use intensity differences may also result from

different policy positions. For example, oil-use intensity – measured by final consumption of

oil products (tonnes of oil equivalent) per unit of GDP, averaged for the period 1986-2008 –

is higher in Canada (101), the United States (91) and Australia (73) than in Japan (65),

Germany (63), Spain (63), France (60), Switzerland (60), Norway (59), the United Kingdom

(52), Italy (48), and other European economies (Peersman, Van Robays, 2012). Taxes on

transport fuels are an important contributing factor. These imposts are substantially lower in

the United States, Canada, and Australia, than in Japan and Europe.

Energy-use intensity reflects a country’s industrial structure and climatic conditions, as well

as its oil-use intensity. For example, Australia’s energy-use intensity reflects substantial

coal-fired smelting activity and other processing of mined commodities, as well as relatively

high transport fuel-use.

11.2.3 Price Elasticity of Supply and Demand

Baumeister and Peersman (2013b) have estimated that short-term price elasticity of

demand for crude oil became significantly more inelastic or lower (ignoring the negative

sign) from the mid-1980s. In addition, they observed that short-term price elasticity of

supply had become highly inelastic over time. This means an oil shock of a particular type



and magnitude in terms of quantity would lead to a much larger oil price change now than at

the time of the ”first and second oil crisis” in the period from the early 1970s to early 1980s.

It follows that a quantitative oil shock of a particular type and magnitude would have greater

economic effects now than in the period from 1973 to 1983. Of course, this depends on

other relevant circumstances, such as oil shock size, oil-use intensity and nett energy

import/export balance, remaining unchanged.

11.2.4 Magnitudes of Oil Shocks

The magnitude of future oil price spikes will be influenced by the size of oil shocks

measured by the shift in quantity supplied or demanded at the original price, as well as by

very low short-term price elasticity of supply and demand. Baumeister and Peersman

(2013b) analysed shock sizes over time. They concluded that the average variability of

exogenous oil supply shocks has declined steadily since Iraq’s invasion of Kuwait in 1990.

The average variability of aggregate demand shocks declined from the mid-1980s, but had

risen since the early-2000s. The average variability of speculative, oil-specific demand

shocks has been lower in recent years than in the 1970s and 1980s.

Nakov and Pesctori (2010) did not distinguish between different types of oil shocks. They

argued that major shocks had made a smaller contribution to volatility of economic activity

and inflation since 1984. Using a DSGE model, they estimated that this factor explained

about 17 per cent of the moderation of volatility of inflation and 11 per cent of reduced

volatility of growth of economic activity.

The striking fall in price elasticities of demand and supply from the mid-1980s resulted in

higher oil price volatility, notwithstanding lower volatility of oil production from the mid-1980s

until 2003 (Baumeister, Peersman, 2013b). The increase in the magnitude of aggregate

demand shocks from 2003 combined with the striking fall in price elasticities of demand and

supply underpinned the spectacular rise in oil prices from 2003 to 2008 to an historical peak,

and the extraordinary price recovery from late-2009.

11.2.5 OPEC’s Changed Price Control Policy

In the early-1980s, OPEC transitioned from a policy of setting prices to controlling OPEC

production. The transition was identified, described and explained by Adelman (1995). It is

apparent from the discussion in chapters 6 and 7 of this report.

Luís Aguiar-Conraria and Yi Wen (2012) argued, with the aid of a simple economic model,

that oil shocks are much more likely to contribute to macroeconomic instability driven by

self-fulfilling expectations in oil importing countries when OPEC sets oil prices, than when it

controls production. This likelihood increases with higher oil imports relative to GDP.

Oil shocks by definition are largely unexpected, and therefore the context is aggregate

uncertainty. Then, self-fulfilling expectations relating to fear of oil price rises or further

increases induce speculative demand that helps drive up the price. These self-fulfilling

expectations also lead to pessimism regarding the economic consequences of higher oil

prices that leads to lower economic activity. According to the modelling, undertaken by

Aguiar-Conraria and Wen (2012) such macroeconomic fluctuations are much more likely to

occur following oil shocks when OPEC sets oil prices, rather than the quantities of oil

produced by members.

The analysis of Aguiar-Conraria and Wen (2012) appeared to be focussed on oil supply

shocks, but allowed for speculative demand to be triggered. Aggregate demand shocks

were not analysed.



11.2.6 Productivity Shocks

Nakov and Pescatori (2010) estimated, with the aid of a DSGE model, that about 57 per

cent of the reduced volatility in growth of economic activity since 1984 could be attributed to

a favourable shift of the distribution of shocks to total factor productivity. Individual shocks

tended to be smaller and more evenly distributed over time. This factor was estimated to

have made only a trivial contribution (2 per cent) to reducing the volatility of inflation since

1984.

11.2.7 Monetary Policy and Real Wage Flexibility

Paul Segal (2011), Olivier Blanchard and Jordi Galí (2010), and Olivier Blanchard and

Marianna Riggi (2013) argued that improved credibility of monetary policy and declining real

wage rigidity (increasing real wage flexibility) were important economic changes that could

have modified the transmission mechanism of oil shocks to economic activity and inflation.

Segal (2011) pointed out that the macroeconomic impact of an oil price shock can be

decomposed into two stages. First, higher petroleum product prices raise the domestic

price level, meaning lower real money balances, higher interest rates, lower demand, and

therefore, reduced economic activity. This stage suggests that monetary loosening is

appropriate. Second, demands for higher wages and prices of goods and services in

general to compensate for increases in oil product prices could lead to a wage-price spiral

and raise the expected core inflation rate. This stage suggests that tightening of monetary

policy is appropriate. The response by the monetary authority would depend on the

perceived relative strength of the two opposing effects.

Segal observed that monetary policy had become less strict, rather than stricter, in response

to oil price shocks since the mid-1980s. Therefore, tighter monetary policy could not explain

why pass-through of oil price spikes to core inflation was much lower in the period from

2003, than in the period from the early-1970s to the mid-1980s. However, he argued that

monetary policy had become more credible, meaning that workers and enterprises expected

that any wage-price spiral would be crushed by an interest rate response, and therefore,

they eschewed wage and price demands to compensate for higher oil prices.

Segal also suggested that since the 1980s, bargaining power of workers had declined,

because of weaker unions, international capital mobility, and globalisation. This had

increased real wage flexibility and reduced pass-through of higher oil prices to core inflation

via a wage-price spiral.

Segal considered that high oil prices had little macroeconomic impact over the past decade,

because they did not raise the inflation rate, and therefore, interest rates were not raised in

response, with the result that the effect on economic activity had been minimal. Christopher

Allsopp and Bassam Fattouh (2011) endorsed this view.

The analysis of Blanchard, Galí and Riggi was underpinned by deployment of a structural

VAR econometric model and a new-Keynesian model. They explained that the relative

importance of higher real wage flexibility and more credible monetary policy depended on

the nature of inflationary expectations. If these expectations are partly affected by the

current level of inflation, the large decline in real wage rigidity since the 1970s is the more

important of the two economic changes, with a smaller contribution from more effective

monetary policy. If expectations regarding inflation are based partly on past (lagged)

inflation, more credible monetary policy is relatively more important than greater real wage

flexibility.

Using a DSGE model, Nakov and Pescatori (2010) estimated that better monetary policy

was responsible for about half of the reduced volatility of inflation since 1984. However,



they attributed only about 4 per cent of reduced volatility of economic activity since 1984 to

better monetary policy. Their model did not allow for changes in real wage flexibility.

Claudio Morana (2013) argued that an endogenous contraction of real wages and

expansionary monetary and fiscal policies in many countries, including China, following the

“global financial crisis” contributed to the resilience of the global economy to the

extraordinary oil price surge that peaked in mid-2008, and the onset of the “global financial

crisis” in September 2008.

Lutz Kilian (2010a) stressed that oil shocks did not necessarily cause stagflation. He

pointed out that, after the early-1980s, no oil shock had been associated with stagflation

(stagnant economic activity, perhaps with high unemployment, in conjunction with high

inflation).

Kilian (2010a) attributed periods of economic volatility and stagflation during the 1970s and

early-1980s to stop-start monetary policy that switched often between targeting economic

activity and inflation. He said that economic volatility and stagflation were not caused by the

“first and second oil crises”. He explained that a major shift in monetary policy in many

major economies at the beginning of the 1970s following the breakdown of the Bretton

Woods fixed exchange rate regime had contributed to the oil shocks and to the economic

volatility and stagflation in the decade from the early-1970s to the early-1980s.

Circumstances changed after 1980, as a result of another major shift in monetary policy in

the United States and other major OECD economies. The new approach gave inflation

priority over the level of economic activity. The monetary authorities persisted with tight

monetary policy even though inflation was slow to come down in the context of recession.

This monetary policy shift ended the boom-bust cycle and recurring stagflation problem of

the preceding decade. It restored the credibility of monetary policy and provided economic

entities’ expectations with an inflation target “anchor”.

Kilian (2010a) observed that no direct evidence had been presented by Blanchard and Galí

(2010) to support their hypothesis that real wages had become more flexible since the

1980s, but said that greater real wage flexibility may have occurred. He argued that

changes in the mix of types of oil shocks over time could fully explain the diminished

economic effects of oil shocks in the post-2002 period compared to the 1973-1982 period.

Kilian (2010a, p. 71) explained:

“To the extent that global aggregate demand shocks have increased in importance in recent

years, one naturally would expect precisely the diminished unemployment response (to oil

shocks) documented by Blanchard and Galí (2010), even in the absence of structural changes

in labour markets.”

However, Segal (2011) expressed doubt regarding the plausibility of Kilian’s point about the

differential economic effects of different types of oil shock. Segal (2012, p. 183) claimed

Kilian’s (2009a) analysis:

“….. fails to show that the marginal impact of a given price rise differs according to the cause of

the rise.”

11.2.8 Exchange Rate Flexibility

An important relevant policy change for Australia was the move to a floating exchange rate

in December 1983. Australia lagged behind major economies that floated their currencies

more than a decade earlier in March 1973.

A floating exchange rate meant that changes in the nominal exchange rate could occur

automatically in response to shocks, allowing changes to the real exchange rate to occur

without high inflation, and allowing more moderate adjustments in monetary and fiscal policy

to stabilise the economy.



11.3 Implications for Australia

The economic changes described above have implications for Australia’s vulnerability to

(susceptibility to economic harm from) oil shocks. Australia’s vulnerability would now be

greater than at the time of “first and second oil crises” to the extent that price elasticity of

demand and supply for crude oil have declined during the intervening period. On the other

hand, Australia’s susceptibility to economic harm from oil shocks has declined since the time

of “first and second oil crises” because of changes in the mix of types of oil shock, OPEC’s

change from setting prices to controlling production, lower oil-use intensity, improvements to

Australia’s position as a nett exporter of energy, greater real wage flexibility, better targeted

and more credible monetary policy, and the floating exchange rate.



12 Conclusions

Apart from events during the second world war, global oil markets were broadly competitive

from 1918 to 1972. This changed during the period from 1973 to 1980 when OPEC

producers found ways of exercising their potential market power.

However, their approach to exercising market power was undermined by progressive

nationalisation of oil companies in the Middle East and North Africa. Nationalisation meant

that governments had to sell oil, agree on production quotas, and rely on other members not

cheating. The second and third issues proved to be difficult to tackle. Saudi Arabia has

played a critical role in preserving OPEC influence on oil prices. It bore most of the burden

of OPEC’s desire to maintain high oil prices after the “first and second oil crises” by cutting

production substantially while losing considerable market share to other OPEC countries.

When Saudi Arabia abandoned its efforts in the second half of 1985 and increased

production substantially over several months, the crude oil price collapsed. This helped

restore some discipline within the “clumsy” OPEC cartel.

Saudi Arabia typically has had substantial excess capacity because of production restraint.

Since the 1980s, Saudi Arabia has tended to increase production to take advantage of rising

prices following oil shocks, but not enough to eliminate price spikes, and it tended to reduce

production as prices declined. However, in the 2003-2008 oil shock, Saudi Arabia departed

from this pattern by cutting production after 2005 with prices already rising strongly.

Another development of great importance is that partly by design (in response to declining

real prices and production quotas that had not worked well), and partly because of internal

and external conflicts involving major oil exporters, OPEC members have not increased

aggregate capacity since 1973. Saudi Arabia has restrained investment in more capacity by

design. OPEC capacity constraints and restraint have resulted in a persistent negative oil

shock that has often been overlooked. It maintains upward pressure on oil prices.

Until a decade ago, the conventional view was that major price spikes were caused by major

exogenous supply shocks. This view not only overlooked the existence of the persistent

supply shock noted above, but also ignored the importance of aggregate demand shocks

and speculative demand shocks, and .potential contributions from oil producers restraining

production to take advantage of higher prices later (forms of speculative supply or demand

shocks). It is now widely recognised in the relevant economics literature that various types

of shocks have often occurred in close proximity in time and that the mix of shocks has

varied between major oil price events.

This recognition is not just of academic interest. It has important economic policy

implications, because different types of shocks have different economic effects in any one

country, across countries, and over time. Variations are related to matters such as energy-

use intensity, nett oil and energy imports or exports, real wage flexibility, and exchange rate

flexibility.

A phenomenon of particular importance relevant to economic effects of oil shocks of various

types over time is that short-term price elasticity of demand and supply have declined to

much lower levels than applied until the mid-1980s. This means meaning that a shock to

quantity demanded or supplied would have much bigger effect on the crude oil price than at

the time of the “first and second oil crises”. The price effects of this phenomenon could be

moderated to the extent that shocks reduce in magnitude in terms of quantity. The



economic effects have been moderated by trends towards declining oil and energy-use

intensity, more credible monetary policy, real wage flexibility, and exchange rate flexibility.

While oil price spikes understandably create concerns in the community, they are essential

to clear the market and avoid shortages in the short-term. High prices provide incentives to

seek-out and grasp opportunities to gain by further reducing quantities demanded and

further increasing quantities supplied. As time passes, increasing numbers of opportunities

to make such adjustments become practical options for economic entities.

For many years, some commentators have focussed on the “imminent” decline in oil global

oil production. Such views have been evident in some Australian studies. These concerns

have been criticised strongly both internationally and domestically. While oil supplies are

ultimately finite, the amount of economically recoverable reserves, incentives to explore, and

incentives to innovate in respect of exploration and extraction change with the price. Recent

examples of these effects include a surge in supply of oil from shale and tight structures in

the United States, and major deep discoveries under salt formations in South America.

Price flexibility has been the key to avoidance of oil shortages. In the United States, in the

1970s, when price controls and administrative allocation were applied to oil and refined oil

products, shortages and administrative allocation bungles occurred in the wake of major oil

shocks. These arrangements demonstrated how disastrous poorly thought out policy can

be to resolution of market imbalances, and protection of the interests of consumers.

In Australia, regulation of the price of domestically produced crude in the 1970s

discouraged oil conservation, exploration, and development of marginal oil fields. The

reforms to regulation and taxation of crude oil production that were implemented through

the 1980s to the current day have addressed these impediments. Australia now has oil

and refined products markets that work well and are linked closely to global markets that

ration and allocate supply well.

The challenge for policy makers in Australia as well as globally is to ensure that the markets

are not impeded by poorly thought out policies involving governments interfering with the

efficient allocation of resources during oil shocks.. The imperative during such events is to

let markets work. If there are market or policy failures impeding the efficient operation of

markets intervention is warranted provided that the benefits of intervention exceed the cost,

and the proposed intervention would yield the greatest surplus of benefits over costs.

Otherwise, the operation of markets should be left alone.

One thing the government of an individual small economy, like Australia, can’t do is

efficiently deal with perceived OPEC market power. In any event, markets have worked to

undermine that market power by encouraging less consumption and more non-OPEC

production.


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY A-1

Appendix A Fuel taxation

Table A1 History of fuel taxation in Australia

Year Event Government Policy

Objective

1901: Customs duty imposed on imported petroleum products (generally used for heating and lighting or as industrial solvents).

Revenue

1929: Excise on domestically produced petrol introduced. Revenue - hypothecation to road funding

1931: Excise introduced on coal tar and coke oven distillates. Revenue

1940: Rates of excise increased and an excise introduced on heavy fuel oil.

Revenue - assist financing Australia’s war effort

1940: Excise rate decrease for liquid fuel produced from indigenous shale and coal.

Diversify Australia’s liquid fuel supplies

1940: Assurance given to Australia’s petrol producers for protection against imported petrol for fifteen years.

Industry assistance

1957: Excise on diesel introduced for on-road use only. Exemption certificate scheme put in place for off-road diesel users.

Revenue –hypothecation to road funding

1957: Excise on aviation turbine kerosene (AVTUR) introduced. Revenue - fund aviation infrastructure

1959: Formal hypothecation of fuel taxes abolished so that excise was now a form of general revenue.

Greater flexibility in budgetary process

1961: Excise on domestically produced petrol was increased to the same rate as customs duty for imported petrol.

Eliminate margin between Australian and imported petrol

1965: Petroleum Products Freight Subsidy Scheme introduced. Reduce fuel prices in regional locations

1975: Crude oil and LPG production excise introduced to ensure the community reaped some of the benefits of increased world oil prices.

Revenue

1979: LPG for road vehicle use declared free of excise duty to encourage use of LPG.


1980: Fuel ethanol declared free of duty and ‘experimental’ licensing arrangements put in place to encourage research into use of ethanol as a fuel.


1982: Diesel Fuel Rebate Scheme introduced to replace off-road exemption certificate scheme. All off-road users required to buy duty paid fuel, with some eligible to claim a partial or full rebate.

Revenue and administrative change

1982 - 1988:

Surcharge of 1 cpl added (2 cpl from 1983) to establish a roads program under Australian Bicentennial Road Development Trust Fund.

Revenue – hypothecation for road funding

1983: Six monthly indexation, in line with CPI, introduced. Revenue - maintain real value of excise collections

1983: Excise introduced for heating oil, fuel oil and kerosene. Revenue

1986: Refined petroleum products excise raised to compensate for crude oil excise revenue decrease.

Revenue

1989: Provisions introduced to ensure that petroleum products are taxed according to stated end-use.

Revenue

1994: Excise differential introduced for leaded petrol. Environmental

1997: High Court cast doubt on the constitutional validity of State business franchise fees (refer Section 2.7 – Administration changes to fuel taxation system)

New administrative arrangement

1997: Range of measures announced to address fuel substitution activities.

Revenue


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY A-2

1998: A New Tax System (ANTS) proposal to replace the Diesel Fuel Rebate Scheme with the provision of diesel fuel credits, with partial extension of this credit to rail and road transport.

Reduced cost of business input

1999: Measures For A Better Environment package announced including some measures specifically concerning fuel taxation.10

Environmental

2000: Diesel Fuel Rebate Scheme maintained and extended to include ‘like fuels’ and to provide full rate of rebate to all categories - but proposed extension under ANTS limited to road and marine transport. Diesel and Alternative Fuels Grants Scheme introduced to reduce costs for road transport, but benefit made less available to urban areas. Intention that Energy Grants (Credits) Scheme replace both schemes on 1 July 2002.

Reduced cost of business input / environmental

2000: Excise rates on petrol and diesel cut by 6.656 cpl with the introduction of The New Tax System.

Offset GST impact on fuel prices for both consumers and business

2000: Fuel Sales Grants Scheme introduced. Maintain regional and metropolitan fuel price relativities on GST introduction

2001: Excise rate cut by a further 1.5 cpl and indexation of petroleum products excise rates abolished.

Alleviate impact of high petrol prices

Source: (Treasury, 2001)

10 These include an excise differential for low sulphur diesel (to be introduced 1 January 2003), the Product Stewardship (Oil)

Scheme (refer section 2.8), the Energy Grants (Credits) Scheme which is intended to replace the Diesel and Alternative Fuels Grants Scheme and the Diesel Fuel Rebate Scheme from July 2002. The full list of measures is described at the following Internet address http://www.pm.gov.au/news/media_releases/1999/changes3105.htm.

../../../../www.pm.gov.au/news/media_releases/1999/changes3105.htm


OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY B-1

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