.
A C I L A L L E N
C O N S U L T I N G
REPORT TO
DEPARTMENT OF INDUSTRY
SEPTEMBER 2014
OIL MARKET
RESPONSES
TO CRISES:
AN HISTORICAL SURVEY
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REPORTACIL ALLEN CONSULTING, OIL
MARKET RESPONSES TO CRISES: AN
HISTORICAL SURVEY, JUNE 2014
© ACIL ALLEN CONSULTING 2014
ACIL ALLEN CONSULTING
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
10
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
17
3.3.3 1970 to 1980
17
3.3.4 1980 to 1990
19
3.3.5 1990 to Present Day
20
4 Markets and Oil Shocks, 1964-2014
4.1 Types of Oil Shocks
21
21
4.1.1 Crude Oil Shocks
22
4.1.2 Refined Oil Product Shocks
23
4.2 Oil Market Responses to Shocks
24
4.2.1 Roles of Oil Markets and Prices
24
4.2.2 Price Elasticity of Demand and Supply
25
4.2.3 Estimates of Price Elasticity of Demand and Supply
28
4.2.4 Effects of Highly Price Inelastic Demand and Supply
35
5 Repudiation of agreements and Yom Kippur Arab-Israeli War,
1973-74
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39
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5.1 Preceding Circumstances
40
5.2 Political Conflict Trigger
41
5.3 Policy Tactics and Market Responses
42
5.4 Causes of the 1973-74 Price Shock
44
5.5 United States Price Control
46
5.6 Impacts on the Australian economy
47
5.7 Policy Issues and Policy Responses
52
6 Iranian Revolution and Iran-Iraq War, 1978-80
54
6.1 Preceding Circumstances
55
6.2 Iranian Revolution
56
6.2.1 Unfolding of Events
56
6.2.2 Market and Policy Responses
57
6.2.3 Petrol Queuing Returned in the United States
58
6.2.4 Causes of the Oil Shock
59
6.3 Iran-Iraq War
61
6.3.1 The Conflict and Its Origins
61
6.3.2 Market and Policy Responses
61
6.3.3 Causes of the Oil Shock
62
6.4 Impacts on the Australian Economy
62
6.5 Australian Policy Issues and Responses
68
7 Responses to high oil prices and withdrawal of Saudi Arabian
support for the oil price, 1985-86
69
7.1 Oil Market Circumstances, 1981-1985
70
7.2 Saudi Arabia’s Abandonment of Price Support
71
7.3 Market Responses to Positive Oil Supply Shock
72
7.4 Causes of Oil Shock
72
7.5 Impacts in Australia
72
7.6 Australian Policy Issues and Responses
77
8 Iraq’s invasion of Kuwait, 1990-91
79
8.1 Preceding Circumstances
80
8.2 Invasion
80
8.3 Market and Policy Responses
81
8.4 Causes of the Price Shock
81
8.5 Impact on Australia
83
8.6 Australian Policy Issues and Responses
88
9 Venezuelan oil supply crisis and Iraq War, 2002-03
9.1 Preceding Circumstances
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90
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9.2 Closely-Spaced Supply Shocks
91
9.3 Market Responses
91
9.4 Causes of the Small, Short-Lived Price Spike
92
9.5 Impact on Australia
92
9.6 Policy Responses and Issues
97
10 Multiple Shocks, 2003-14
98
10.1 Preceding Circumstances
99
10.2 Multiple Interacting Shocks
99
10.3 Strong Global Economic Expansion, 2003-2008
100
10.4 OPEC Production and Capacity Constraints
101
10.5 Conventional Supply Shocks, 2003-2008
103
10.6 Speculative Demand, 2003-2008
107
10.7 Global Financial Crisis and Recovery, 2008-2014
109
10.8 Impacts in Australia
112
10.9 Policy responses and issues
116
11 Economic Effects of Oil Shocks
118
11.1 Economic Effects Depend on Shock Type and Net Energy
Exports/Imports Position
119
11.2 Changes Across Time and Countries
123
11.3 Implications for Australia
127
12 Conclusions
128
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”
43
Box 3
Yergin on Petrol Queuing in United States
59
Box 4
Daniel Yergin on Panic, Speculative Demand and Inventories
60
Box 5
Mined-Commodity-Intensive Growth
101
Box 6
OPEC Capacity Constraint
103
Box 7
Katrina and Rita Supply Shocks and Market Forces
106
List of figures
Figure 1
Global oil supplies (million tonnes)
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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/$billion GDP)
15
Figure 15
1973-74 Oil Price Surge
42
Figure 16
Crude oil price, US$ and $A
48
Figure 17
Crude oil prices and petrol prices
48
Figure 18
Capital city petrol prices
49
Figure 19
Consumption of petroleum products
49
Figure 20
Production and imports of crude oil and refinery feedstock
50
Figure 21
Refinery production
50
Figure 22
Net imports of petroleum products
51
Figure 23
Billions of km travelled
51
Figure 24
Percentage change in CPI from previous quarter
52
Figure 25
Annual GDP growth rate
52
Figure 26
Crude oil price
57
Figure 27
Crude oil price A$ and US$
63
Figure 28
Crude oil prices and petrol prices - A$ terms “second oil crisis”
63
Figure 29
Capital cities petrol prices (nominal)
64
Figure 30
Consumption of petroleum products
64
Figure 31
Production and imports of crude oil and refinery feedstock
65
Figure 32
Refinery production
65
Figure 33
Net imports of petroleum products
66
Figure 34
Billions of km travelled
66
Figure 35
Percentage change in CPI from previous quarter
67
Figure 36
GDP growth rate
67
Figure 37
Crude oil price in A$ and US$
73
Figure 38
Crude oil prices and petrol prices
73
Figure 39
Capital cities petrol prices (nominal)
74
Figure 40
Consumption of petroleum products
74
Figure 41
Production and imports of crude oil and refinery feedstock
75
Figure 42
Refinery production
75
Figure 43
Net imports of petroleum products
76
Figure 44
Billions of km travelled
76
Figure 45
Percentage change in quarterly CPI from previous year
77
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Figure 46
GDP growth rate
77
Figure 47
Crude oil price in A$ and US$
83
Figure 48
Crude oil prices and petrol prices
84
Figure 49
Capital cities petrol prices (nominal)
84
Figure 50
Consumption of petroleum products
85
Figure 51
Production of crude oil and net imports of refinery feedstock
85
Figure 52
Refinery production
86
Figure 53
Net imports of petroleum products
86
Figure 54
Billions of km travelled
87
Figure 55
Percentage change in CPI from previous quarter
87
Figure 56
GDP growth rate
88
Figure 57
Crude oil price in A$ and US$
92
Figure 58
Crude oil prices and petrol prices
93
Figure 59
Capital cities petrol prices (nominal)
93
Figure 60
Consumption of petroleum products
94
Figure 61
Production and of crude oil and net imports of refinery feedstock
94
Figure 62
Refinery production
95
Figure 63
Net imports of petroleum products
95
Figure 64
Billions of km travelled
96
Figure 65
Percentage change in quarterly CPI from previous year
96
Figure 66
GDP growth rate
97
Figure 67
Singapore Export Petrol Price and Crude Oil Price Movements
Compared, 2005-06
104
Figure 68
Crude oil price in Australian and US dollars
112
Figure 69
Crude oil prices and petrol prices
112
Figure 70
Capital cities petrol prices (nominal)
113
Figure 71
Consumption of petroleum products
113
Figure 72
Production and imports of crude oil and refinery feedstock
114
Figure 73
Refinery production
114
Figure 74
Net imports of petroleum products
115
Figure 75
Billions of km travelled
115
Figure 76
Percentage change in quarterly CPI from previous year
116
Figure 77
GDP growth rate
116
List of tables
Table A1
History of fuel taxation in Australia
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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 archival evidence’ and/or ‘oral history’ or similar. 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 day. 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
 emergence of oil futures and other financial oil derivatives markets
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 a 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 restraints
 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 these producers in OPEC countries found ways
of exercising 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, 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.
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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 net 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
shocks were more than offset by an unexpected increase in global oil production early in
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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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
and 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 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 selfimposed 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.
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 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. Government intervention is
only warranted if there are market or policy failures impeding the efficient operation of
the markets and the benefits of intervention outweigh the costs. 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.
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 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 energyuse intensity, increasing real wage flexibility, exchange rate flexibility, and in some
countries better net 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.
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DRAFT
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ACIL ALLEN CONSULTING
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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2
ACIL ALLEN CONSULTING
The Global Oil Market
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. 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 financial crisis. The price recovered quickly but partly in 2009-10. Since 2011,
spot crude oil prices have fluctuated around US$100 per barrel (2014 real terms), with small spikes
for shocks associated with revolution in Libya, embargoes on trade with 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).
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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Figure 1
ACIL ALLEN CONSULTING
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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DRAFT
Figure 3
ACIL ALLEN CONSULTING
Production by country grouping
100.0
90.0
80.0
70.0
60.0
MB/d
50.0
40.0
30.0
20.0
10.0
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
-
OECD
Non-OECD
OPEC
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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DRAFT
Figure 4
ACIL ALLEN CONSULTING
Crude oil prices from 1918 to 2012
140.00
120.00
100.00
$US/bbl
80.00
60.00
40.00
20.00
1918
1923
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
0.00
$ money of the day
$2014
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$124 per barrel (2014 price terms). The price spike was driven by a combination supply,
aggregate demand and speculative demand shocks.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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DRAFT
Figure 5
140.00
120.00
100.00
80.00
60.00
40.00
ACIL ALLEN CONSULTING
Crude oil prices quarterly from 1970 to 2014 (US$ per bbl)
Tight spare capacity,
OPEC targetcrude outages in
reductions, Nigeria, Iraq, North
tight stocks Sea
End of administrative
priocing
Arab oil embargo
nominal prices rise
from $2/bbl to $10/bbl
Invasion
of Kuwait
Irania
n revolution
Iran Iraq war
Demand growth in
OPEC quota increases, China takes off
Asian financial crisis
Second
Gulf crisis
20.00
Arab spring
Global
financia
l crisis
Hurricanes Katrina and Rita
hit the US Gulf Coast
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
0.00
Nominal
Real
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
to cut production by 5 per cent. By January 1987, crude oil spot prices had risen to around
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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ACIL ALLEN CONSULTING
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-useintensive 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 early2003 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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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DRAFT
2.3
ACIL ALLEN CONSULTING
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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3
ACIL ALLEN CONSULTING
Australian Economy, Policy and Oil
The structure and regulation of the Australian economy changed 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 selfsufficiency from the prevailing level of around 70 per cent, 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.
By the beginning of the 1970s, several small onshore fields and important offshore fields in Bass
Strait were producing in Australia. Indigenous production steadily increased after that time as the
Bass Strait fields expanded and further fields were developed. These developments resulted in a
substantial increase in production of crude oil (and gas) in Australia.
In the early 1970s there were 9 refineries operating in Australia and their capacity was gradually
expanded drawing in part on the increasing production of indigenous crude oil so that by 1983 when
refinery capacity peaked there were 10 major fuel refineries, 4 lube refineries and a mini refinery
operating in Australia. At that time, refinery capacity was around 778,000 barrels per day.
Since that time there has been a rationalisation of refining capacity. In 2003, Mobil announced
suspension of operations at the Port Stanvac refinery in South Australia placing it in a care-andmaintenance 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. With
these closures there will be 4 major fuel refineries and 1 mini refinery operating in Australia with a
total capacity of 429,000 barrels per day.
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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3.1
ACIL ALLEN CONSULTING
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 War” in late-2002 and early2003 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
8
6
4
Per cent 2
0
-2
Jan-2011
Jan-2008
Jan-2005
Jan-2002
Jan-1999
Jan-1996
Jan-1993
Jan-1990
Jan-1987
Jan-1984
Jan-1981
Jan-1978
Jan-1975
Jan-1972
Jan-1969
Jan-1966
Jan-1963
Jan-1960
-4
: 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
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
10
DRAFT
ACIL ALLEN CONSULTING
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.
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
1.6000
1.4000
1.2000
1.0000
0.8000
0.6000
0.4000
0.2000
Feb-2013
Nov-2010
Aug-2008
May-2006
Feb-2004
Nov-2001
Aug-1999
May-1997
Feb-1995
Nov-1992
Aug-1990
May-1988
Feb-1986
Nov-1983
Aug-1981
May-1979
Feb-1977
Nov-1974
Aug-1972
May-1970
0.0000
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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DRAFT
Figure 8
ACIL ALLEN CONSULTING
Unemployment rate – Australia (seasonally adjusted)
19
12.0
10.0
8.0
Per cent 6.0
4.0
2.0
Jul-2013
Jun-2011
May-2009
Apr-2007
Mar-2005
Feb-2003
Jan-2001
Dec-1998
Nov-1996
Oct-1994
Sep-1992
Aug-1990
Jul-1988
Jun-1986
May-1984
Apr-1982
Mar-1980
Feb-1978
0.0
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
20.0
15.0
10.0
Per cent
5.0
0.0
Nov-2011
Apr-2009
Sep-2006
Feb-2004
Jul-2001
Dec-1998
May-1996
Oct-1993
Mar-1991
Aug-1988
Jan-1986
Jun-1983
Nov-1980
Apr-1978
Sep-1975
Feb-1973
Jul-1970
Dec-1967
May-1965
Oct-1962
Mar-1960
-5.0
Source: RBA
Figure 10 shows a strong correlation between oil market events and annual changes in the
automotive fuels price index. For example, a peak occurred around 1980, at a time of high
crude oil prices and the move to import parity pricing for crude oil in Australia. Other
examples of peaks coincide with 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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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ACIL ALLEN CONSULTING
Figure 10 Percentage change in automotive fuels price index
60.0
50.0
40.0
30.0
Per cent
20.0
10.0
0.0
-10.0
-20.0
Sep-1973
Nov-1975
Jan-1978
Mar-1980
May-1982
Jul-1984
Sep-1986
Nov-1988
Jan-1991
Mar-1993
May-1995
Jul-1997
Sep-1999
Nov-2001
Jan-2004
Mar-2006
May-2008
Jul-2010
Sep-2012
-30.0
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 201112, 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)
7 000.0
6 000.0
5 000.0
PJ/a
4 000.0
Renewables
3 000.0
Gas
Oil
2 000.0
Coal
1 000.0
2009-10
2006-07
2003-04
2000-01
1997-98
1994-95
1991-92
1988-89
1985-86
1982-83
1979-80
1976-77
1973-74
0.0
Source: (BREE, 2013)
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).
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Figure 12 Consumption of petroleum by end use
2,500
Lubricants Oils and solvents
2,000
Residential
1,500
Commercial services
PJ/a
Transport
1,000
Manufacturing and
construction
500
Wood, paper and printing
2008-09 2009-10 2010-11 2011-12
Food, beverages and
textiles
Source: (BREE, 2013)
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
3000.0
2500.0
2000.0
PJ/a 1500.0
1000.0
500.0
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
0.0
Indigenous production
Consumption
Source: (BREE, 2013)
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 to
around 15 per cent by 2005 assuming the then mean estimate of production from
undiscovered resources (National Energy Advisory Committee, 1979). 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
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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)
3.5
3.0
2.5
2.0
PJ/$billion
1.5
1.0
0.5
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
0.0
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.
Production of crude oil commenced in Australia in 1964 when the Moonie field in the Surat
Basin in South East Queensland came on stream. This was followed by the Barrow Island
oil field in the Carnarvon Basin Western Australia in 1967. Production from the Bass Strait
fields in the offshore Gippsland Basin commenced in 1969. Production of crude oil from
Australian fields increased from 14 million barrels in 1968-69 to 130 million barrels in 197273. Indigenous production steadily increased after that time as the Bass Strait fields
expanded and further fields were developed. The latter included production from the Cooper
Basin fields in South Australia commencing in 1983, and the Jackson field in South-West
Queensland commencing in 1984. By 1985-86, production had increased to around 260
million barrels (Department of Resources and Energy, 1986). In comparison, production of
crude oil and condensate from Australian fields in 2012-13 was around 134 million barrels
(BREE, 2014).
The first refinery in Australia commenced operations at Laverton Victoria in 1924. Four
major refineries came into operation in the 1950s followed by a further four in the 1960s.
Refinery capacity was subsequently expanded to handle Bass Strait and other Australian
crudes as indigenous production increased. Three lube oil refineries were also built in the
1960s and another was built in 1975.
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Refinery capacity in Australia peaked in 1983 when a total of 10 fuel refineries were in
operation together with 4 lubricating refineries and a mini refinery at Roma in Queensland.
These refineries had total capacity of around 778,000 barrels per day, which was well in
excess of the demand for petroleum products of around 560,000 barrels per day at the time.
After 1983, rationalisation of refineries began, so that by1985 the number of major refineries
had fallen to 8. The main fuel refineries operating at that time are shown below:
 Queensland
 BP, Bulwer Island Brisbane
 Ampol, Lytton Brisbane
 Moonie Oil Company, Roma
 Inland Oil Refineries, Eromanga
 New South Wales
 Shell, Clyde
 AOR (Caltex), Kurnell
 Victoria –
 Mobil, Altona Melbourne
 Shell, Geelong
 South Australia
 Mobil, Port Stanvac
 Western Australia
 BP, Kwinana
 Northern Territory
 Territory Fuels, Alice Springs
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 is to close its refinery at Kurnell also in
Sydney during 2014. On 4 April 2014, BP announced its intention to close its refinery at
Bulwer Island in Brisbane. Of the small refineries, only the Roma refinery remains in
operation today. With these closures the capacity of Australian refineries will have fallen to
around 429,000 barrels per day.
In parallel with these developments, there has been 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 and Mitsubishi has announced plans
for construction of a new import terminal at Port Bonython.
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
Vitol.
The downstream petroleum market is undergoing significant restructuring of ownership at
the time of writing.
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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.
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
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.
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 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.
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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.
In July 1979, the Government of the day established a National Petroleum Advisory
Committee comprising Commonwealth, State and Territory Governments and industry
representatives to advise on the appropriate arrangements and priority for the allocation of
liquid fuels during any period of national supply shortage of petroleum products (Department
of Resources and Energy, 1983):
Two other committees advised on general oil industry matters – an Oil Supplies Advisory
Committee and an Oil Supplies Liaison Committee. These committees reflected the close
involvement of Government in the day to day operations of the oil market. Disruptions
caused by industrial relations at Australian refineries were issues of concern along with
managing domestic production and monitoring international oil supplies.
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 crude oil allocation scheme was amended in 1985 to a partial allocation scheme and
the crude oil market was fully deregulated in 1988 with the removal of this scheme
altogether.
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.
In 1983, the Government established a National Liquid Fuels Emergency Consultative
Committee (NFECC) to develop a coordinated approach to national liquid fuels emergencies
by the Commonwealth and the State and Territory Governments.
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In 1984, the Liquid Fuels Emergency Act (1984) was passed. The Act provides the
Commonwealth with powers to meet national responsibilities in the event of a national fuel
supply emergency.
A National Liquid Fuels Emergency Response Plan was subsequently developed under the
oversight of a National Oil Supplies Emergency Committee (NOSEC).
Under the Act a liquid fuels emergency may be declared by the Governor General in the
event of an actual or likely liquid shortage with national implications. No such declaration
has been made to this date.
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.
Following a review of the Liquid Fuels Emergency Act (1984) undertaken in 2004, the
Commonwealth Government introduced periodic assessments of liquid fuels vulnerability.
Assessments were undertaken in 2008 and in 2011.
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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 20052008 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
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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.
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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
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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.
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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 subsection.
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).
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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.
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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
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 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 longterm 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 longterm 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,
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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 longrun 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
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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.
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 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 nonOPEC 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 2025 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
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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.
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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 shortterm.
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 longterm 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
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).
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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
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
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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, nonOECD 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 nonOECD 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.
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4.3
ACIL ALLEN CONSULTING
Influence of Oil Financial Derivatives on
Physical Crude Oil Market
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 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 (Peersman, Van Robays, 2012).
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 2003, there was clear evidence of increased participation by financial entities in
financial oil derivatives markets. From 2005, trading volumes in these markets soared, as
the spot oil price surged. This coincidence triggered claims that the dramatic rise in spot
crude oil price from 2006 to mid-2008 was driven by financial speculators (Masters, 2008).
Concerns regarding this matter spread among commentators and politicians in the United
States, leading to formulation of regulatory proposals to limit financial investors’ transactions
in respect of oil financial derivatives.
Those concerns attracted interest from many economic analysts. A flood of articles in peerreviewed economic journals followed.5 Indeed, issues of the Energy Journal (July 2013)
and the Journal of International Money and Finance (April 2014) were dedicated to
investigation of these concerns. The dominant view in the literature is that convincing
evidence has not been found to support the hypothesis that financial speculation was
responsible for the dramatic surge in crude oil prices from 2006 to mid-2008. Some relevant
points follow.
4.3.1
Meaning and Means of Oil Price Speculation
Oil price speculation refers to the purchase (or sale) of oil, an oil resource/reserve, or an oilrelated financial instrument in the expectation of a price increase (or reduction). In principle,
speculation differs from hedging and investment, but in practice, the distinction between
them is often ambiguous. A transaction participant may have mixed motives. Participants
on the opposite side of transactions may have different motives.
There are various ways of speculating on the price of oil. Some involve physical oil. Others
involve financial instruments related to oil.
Speculation in the physical oiI market involves adding to or running-down inventories that
normally are held by oil producers and consumers to ensure oil is available as required.
Speculative purchases of oil require availability of storage capacity and involve costs.
These comprise storage costs and the opportunity cost of capital tied up in extra inventories.
5
For example, see Alquist, Gervais (2013), Knittel, Pindyck (2013), Smith (2012), Sand(Hamilton (2009a,b), Fattouh, Kilian,
Mahadeva (2013), Büyükşahin, B., Harris, J. (2011).
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Entities rely on oil reserves to support investment in production capacity. They use that
capacity to realise the in situ value of the oil over time. They could also purchase (or sell) oil
reserves/resources or could keep oil in the ground (or increase the rate of production from
reservoirs) to speculate on higher (or lower) future oil prices.
Shares in oil producing companies provide a means of investing in oil. They also allow
hedging or speculation in respect of oil price movements.
Financial oil derivatives are mechanisms for oil pricing hedging to manage/transfer
risk/uncertainty. They can also be used to speculate on oil prices. Financial oil derivatives
are the most common means of speculating on oil prices, and are relatively low cost devices
for doing so (Knittel, Pindyck, 2013).
Financial oil derivatives can take different forms. They include futures contracts, forward
contracts, put options, call options, and other more complex instruments. The various forms
of financial oil derivatives may be referred to as oil futures.
A call option provides a right (not an obligation) to purchase oil at a specified price at a
future date or within a future time period. A put option provides a right (not an obligation) to
sell oil at a specified price at a future time or within a future time period. A forward contract
is an agreement to deliver/take delivery of a specified amount of oil at a particular (forward)
price at some future date. A futures contract is the same, except that it is “marked to
market” - a settlement and transfer of funds occurs at specified intervals to cover the
difference between the forward price and the spot price.
Typically, oil futures do not involve transfer of oil. Most contracts are “closed out” or “rolled
over” before the transfer date. Then, gains and losses are realised by cash settlements
between parties on the opposite sides of oil futures arrangements.
A speculator would hold a long position in oil futures (such as through buying oil forward) to
speculate on an increase in the price of oil. To bet on a reduction in the oil price, a
speculator would hold a short position in oil futures (such as through selling oil forward).
Each long position must be matched by a short position on the other side of the transaction.
In the absence of speculative activity in oil futures markets, hedgers taking long (or short)
positions have to find other hedgers or hedging service providers willing to take matching
short (or long) positions. Entry by speculators means there will be more market participants
to which risk can be transferred. Speculators add to trading volumes in futures markets,
improving liquidity and reducing the time and cost for hedgers to find counterparties to take
opposite positions.
If more futures market participants intend to go long than short at the prevailing price of oil
futures, the price will rise. This means the backwardation (discount of the future price
relative to the spot price) would fall or the contango (future price premium) would rise.
Conversely, if more market participants want to go short than long, the oil futures price will
fall (the backwardation rises or the contango falls).
4.3.2
Effects of Speculation on Oil Prices
Speculation on on oil price movements through changes to above ground inventory holdings
will cause oil prices to move.
Producers could speculate on oil price movements by reducing or increasing production
rates or by holding back or accelerating development. Resulting production changes will
affect prices. However, there are various practical constraints on speculation in these ways.
Buying or selling shares in oil companies is a way of speculating on oil price movements.
However, in the short-term, oil prices will not be affected. In the longer term, pushing up (or
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down) prices of oil company shares would lower (or raise) oil companies’ cost of capital.
This could encourage (or discourage) exploration and development, resulting in greater (or
lower) production and lower (or higher) crude oil prices. These price effects may not appear
for several years.
Oil futures represent the easiest, lowest cost, and most common way of speculating on oil
price movements. Speculation through oil futures could move crude oil prices through
arbitrage between oil futures and spot markets.
However, research over the past few years based on on United States Commodity Futures
Trading Commission data has found that futures prices tended to follow rather than lead
spot prices (Büyükşahin, B., Harris, J., 2011;.Smith, 2012; Knittel, Pindyck, 2013). Indeed,
this research indicates that speculation through financial oil derivatives may have produced
a slight stabilising effect on crude oil prices (Knittel, Pindyck, 2013). This undermines the
claim that financial speculators drove up oil prices in the 2003-2008 period.
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5
ACIL ALLEN CONSULTING
Repudiation of agreements and
Yom Kippur Arab-Israeli War, 197374
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$52 per
barrel until the second half of 1978.
Multiple factors contributed to the price spike,
 Longstanding United States excess capacity was whittled away by the early 1970s.
 Strong global growth in the early 1970s eliminated spare capacity in the Middle East by early1973 in the context of oil company-government agreements that pegged prices.
 OPEC exercised market power by repudiating agreements and ratcheting-up prices by creating
fear, raising production taxes to support higher prices, cutting production, creating more fear,
raising taxes again, and repeating the fear and tax cycle.
 The ratcheting-up process commenced before the Yom Kippur war, but the Arab-Israel conflict
provided an excuse to accelerate the process with production cuts.
Aggregate demand and speculative oil-specific demand shocks contributed, as well as supply
shocks.
The Arab oil embargo on oil sales to the United States and the Netherlands was ineffective.
The international oil market transitioned from being basically competitive to one characterised by
exercise of substantial market power.
Excess capacity in OPEC countries prevailed by the last quarter of 1974.
Consequences in the global market
The oil market worked, notwithstanding OPEC market power.
 The oil price spiked to clear the market (avoid shortages) in the short-term.
 The United States was an exception, because the government tried to override the market with
price controls and administrative allocation of oil and refined products
 Over the time, the market continued to work as high prices encouraged supply of additional
quantities, and reduction of quantities demanded. The market adjusted down prices as these
efforts succeeded.
Australia
The huge increase in the US$ oil price that occurred late-1973 and the first half of 1974 translated
into smaller absolute and relative increases in $A terms because of appreciations in the pegged or
managed exchange rate in September and December 1973. However, reductions in the pegged $A
from September 1974 onwards meant that the subsequent A$ price increases were generally greater
than the US$ price increases.
On the other hand, Australian fuel users did not have to bear the full effect of the 1973-74
international oil price spike in $A terms, because of government-determined pricing arrangements in
place at the time for domestically produced crude oil.
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While the US$ 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 early1950s, 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”.
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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.
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5.3
ACIL ALLEN CONSULTING
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
14.00
12.00
10.00
8.00
$US/bbl
6.00
4.00
2.00
1970
1971
Nominal price
1972
1973
1974
1975
1976
1977
Real price, 1970 US dollars
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).
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Box 2
ACIL ALLEN CONSULTING
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.
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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 shortterm. 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. Policymaking 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
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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
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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).
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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 appreciations in
the pegged or managed exchange rate in September qnd December 1973. The disparity in
crude oil price movements is shown Figure 16. However, reductions in the pegged $A from
September 1974 onwards meant that the subsequent $A price increases were generally
greater than the US$ price increases.
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Figure 16 Crude oil price, US$ and $A
16.0
14.0
12.0
10.0
$/bbl 8.0
6.0
4.0
2.0
Sep-77
Apr-77
Nov-76
Jun-76
Jan-76
Aug-75
Mar-75
Oct-74
Dec-73
Crude oil price A$ (nominal)
May-74
Jul-73
Feb-73
Sep-72
Apr-72
Nov-71
Jun-71
Jan-71
Mar-70
Aug-70
0.0
Crude oil price US$ (nomimal)
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
20
18
16
14
Petrol 12
c/l 10
8
6
4
2
0
18.0
16.0
14.0
12.0
10.0 Crude oil
8.0 $A/bbl
6.0
4.0
2.0
Mar-70
Sep-70
Mar-71
Sep-71
Mar-72
Sep-72
Mar-73
Sep-73
Mar-74
Sep-74
Mar-75
Sep-75
Mar-76
Sep-76
Mar-77
Sep-77
0.0
Petrol price (nominal)
Crude oil price A$ (nominal)
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.
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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
Sydney
Mebourne
Brisbane
Adelaide
Perth
Hobart
Darwin
Canberra
Sep-77
Apr-77
Nov-76
Jun-76
Jan-76
Aug-75
Mar-75
Oct-74
May-74
Dec-73
Jul-73
Feb-73
Sep-72
Apr-72
Nov-71
Jun-71
Jan-71
Aug-70
Mar-70
23
21
19
17
c/l 15
13
11
9
7
5
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
45 000
40 000
35 000
30 000
ML /a
25 000
20 000
15 000
10 000
5 000
1977-78
1976-77
1975-76
1974-75
1973-74
1969-70
1964-65
1960-61
0
Source: (BREE, 2013)
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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
45 000
40 000
35 000
30 000
ML/a
25 000
20 000
15 000
10 000
5 000
Production of crude oil, condensate and LPG
1978–79
1977–78
1976–77
1975–76
1974–75
1973–74
1972–73
1971–72
1970–71
1969–70
1968–69
0
Net imports
Source: (BREE, 2013)
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
39 000
37 000
35 000
33 000
ML/a
31 000
29 000
27 000
1977–78
1976–77
1975–76
1974–75
1973–74
1972–73
1971–72
1970–71
25 000
Source: (BREE, 2013)
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
2 500
2 000
1 500
ML/a
1 000
500
1977–78
1976–77
1975–76
1974–75
1973–74
1972–73
1971–72
1970–71
0
Source: (BREE, 2013)
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
Mar-70
Aug-70
Jan-71
Jun-71
Nov-71
Apr-72
Sep-72
Feb-73
Jul-73
Dec-73
May-74
Oct-74
Mar-75
Aug-75
Jan-76
Jun-76
Nov-76
Apr-77
Sep-77
10
9
8
7
6
billion km
5
travelled
4
3
2
1
0
NSW
VIC
QLD
SA
WA
TAS
NT
ACT
Source: ABS
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Figure 24 Percentage change in CPI from previous quarter
20.0
18.0
16.0
14.0
Percentage 12.0
change from 10.0
previous year 8.0
6.0
4.0
2.0
Sep-1977
Mar-1977
Sep-1976
Mar-1976
Sep-1975
Sep-1974
Mar-1975
Mar-1974
Sep-1973
Mar-1973
Sep-1972
Mar-1972
Sep-1971
Mar-1971
Sep-1970
Mar-1970
0.0
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
8.0
7.0
6.0
5.0
Annual GDP
4.0
growth rate %
3.0
2.0
1.0
Jan-1978
Jan-1977
Jan-1976
Jan-1975
Jan-1974
Jan-1973
Jan-1972
Jan-1971
Jan-1970
Jan-1969
Jan-1968
0.0
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 stagflation 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.
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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
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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 early1979, 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.
6.1
Preceding Circumstances
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).
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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
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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 late1978 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
40.00
35.00
30.00
25.00
$US/bbl 20.00
15.00
10.00
5.00
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
0.00
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:
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“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 gasoline 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, 2010c) 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.
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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 threequarters 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 net 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
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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 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
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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 $A in 1982, by mid-1982, the international crude oil price
expressed in Australian dollars exceeded the price in US dollars.
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Figure 27 Crude oil price A$ and US$
45.0
40.0
35.0
30.0
$/bbl
25.0
20.0
15.0
10.0
5.0
Crude oil price A$ (nominal)
Nov-83
Jul-83
Mar-83
Nov-82
Jul-82
Mar-82
Nov-81
Jul-81
Mar-81
Nov-80
Jul-80
Mar-80
Nov-79
Jul-79
Mar-79
Nov-78
Jul-78
Mar-78
0.0
Crude oil price US$ (nomimal)
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”
50
45
40
35
30
Petrol
25
c/l
20
15
10
5
0
50.0
40.0
30.0 Crude oil
$A/bbl
20.0
10.0
Petrol price (nominal)
Aug-83
Mar-83
Oct-82
May-82
Dec-81
Jul-81
Feb-81
Sep-80
Apr-80
Nov-79
Jun-79
Jan-79
Aug-78
Mar-78
0.0
Crude oil price A$ (nominal)
Note: Crude oil prices are yearly average based on Arabian light Ras Tanura.
Petrol prices are quarterly average for capital cities.
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).
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Figure 29 Capital cities petrol prices (nominal)
60
50
40
c/l 30
20
10
Sydney
Mebourne
Brisbane
Adelaide
Perth
Hobart
Darwin
Canberra
Nov-83
Jul-83
Mar-83
Nov-82
Jul-82
Mar-82
Nov-81
Jul-81
Mar-81
Nov-80
Jul-80
Mar-80
Nov-79
Jul-79
Mar-79
Nov-78
Jul-78
Mar-78
0
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).
Figure 30 Consumption of petroleum products
41 000
40 000
39 000
38 000
ML /a 37 000
36 000
35 000
34 000
1983-84
1982-83
1981-82
1980-81
1979-80
1978-79
1977-78
33 000
Source: (BREE, 2013)
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.
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Figure 31 Production and imports of crude oil and refinery feedstock
45 000
40 000
35 000
30 000
ML/a
25 000
20 000
15 000
10 000
5 000
Production of crude oil, condensate and LPG
1983–84
1982–83
1981–82
1980–81
1979–80
1978–79
1977–78
0
Net imports
Source: (BREE, 2013)
Refinery production also fell from around 4,000 ML per annum to 2500 ML per annum by
1983-84 (Figure 32).
Figure 32 Refinery production
39 000
37 000
35 000
ML/a
33 000
31 000
29 000
27 000
1983–84
1982–83
1981–82
1980–81
1979–80
1978–79
1977–78
25 000
Source: (BREE, 2013)
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.
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Figure 33 Net imports of petroleum products
3 000
2 500
2 000
1 500
ML/a 1 000
500
0
– 500
1983–84
1982–83
1981–82
1980–81
1979–80
1978–79
1977–78
–1 000
Source: (BREE, 2013)
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).
Figure 34 Billions of km travelled
12
10
8
billion km
6
travelled
4
2
NSW
VIC
QLD
SA
WA
TAS
NT
Nov-83
Jun-83
Jan-83
Aug-82
Mar-82
Oct-81
May-81
Dec-80
Jul-80
Feb-80
Sep-79
Apr-79
Nov-78
Jun-78
Jan-78
Aug-77
Mar-77
0
ACT
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.
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Figure 35 Percentage change in CPI from previous quarter
16.0
14.0
12.0
10.0
Percentage
change from 8.0
previous year
6.0
4.0
2.0
Mar-1977
Aug-1977
Jan-1978
Jun-1978
Nov-1978
Apr-1979
Sep-1979
Feb-1980
Jul-1980
Dec-1980
May-1981
Oct-1981
Mar-1982
Aug-1982
Jan-1983
Jun-1983
Nov-1983
0.0
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
5.0
4.0
3.0
2.0
Annual GDP
1.0
growth rate %
0.0
-1.0
-2.0
Jan-1983
Jan-1982
Jan-1981
Jan-1980
Jan-1979
Jan-1978
Jan-1977
-3.0
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.
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6.5
ACIL ALLEN CONSULTING
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.
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7
ACIL ALLEN CONSULTING
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”.
Consequences in the global oil market
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 reattained 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
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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
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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 mid1981 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).
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7.3
ACIL ALLEN CONSULTING
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 $A
terms (Figure 37).
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Figure 37 Crude oil price in A$ and US$
45.0
40.0
35.0
30.0
$ /bbl
25.0
20.0
15.0
10.0
5.0
Crude oil price A$ (nominal)
Nov-86
Jun-86
Jan-86
Aug-85
Mar-85
Oct-84
May-84
Dec-83
Jul-83
Feb-83
Sep-82
Apr-82
Nov-81
Jun-81
Jan-81
Aug-80
Mar-80
0.0
Crude oil price US$ (nomimal) 1.80
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.
Figure 38 Crude oil prices and petrol prices
60
80.00
70.00
50
60.00
40
50.00
Petrol
30
c/l
40.00
Crude oil
$AUS/bbl
30.00
20
20.00
10
10.00
Petrol price (nominal)
Oct-87
Mar-87
Aug-86
Jan-86
Jun-85
Nov-84
Apr-84
Sep-83
Feb-83
Jul-82
Dec-81
May-81
Oct-80
0.00
Mar-80
0
Crude oil price US$ (nomimal)
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
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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ACIL ALLEN CONSULTING
divergence there does not appear to have been any significant regional differences in the
impact of ongoing fuel supplies.
Figure 39 Capital cities petrol prices (nominal)
70
60
50
c/l
40
30
20
10
Sydney
Mebourne
Brisbane
Adelaide
Perth
Hobart
Darwin
Canberra
Sep-87
Apr-87
Nov-86
Jun-86
Jan-86
Aug-85
Mar-85
Oct-84
May-84
Dec-83
Jul-83
Feb-83
Sep-82
Apr-82
Nov-81
Jun-81
Jan-81
Aug-80
Mar-80
0
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 reattained the 1980-81 level.
The focus of Australian political debate was more on macroeconomic policy and
microeconomic reform, than on the oil market.
Figure 40 Consumption of petroleum products
38 500
38 000
37 500
37 000
ML /a
36 500
36 000
35 500
35 000
34 500
1986-87
1985-86
1984-85
1983-84
1982-83
1981-82
1980-81
34 000
Source: (BREE, 2013)
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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.
Figure 41 Production and imports of crude oil and refinery feedstock
45 000
40 000
35 000
30 000
ML/a
25 000
20 000
15 000
10 000
5 000
Production of crude oil, condensate and LPG
1987–88
1986–87
1985–86
1984–85
1983–84
1982–83
1981–82
1980–81
0
Net imports
Source: (BREE, 2013)
Refinery production was also steady at around 35,000 ML per annum over the 1982 to 1988
period (Figure 42).
Figure 42 Refinery production
37 000
35 000
33 000
ML/a 31 000
29 000
27 000
1986–87
1985–86
1984–85
1983–84
1982–83
1981–82
1980–81
25 000
Source: (BREE, 2013)
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.
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Figure 43 Net imports of petroleum products
2 000
1 500
1 000
ML/a
500
0
– 500
1986–87
1985–86
1984–85
1983–84
1982–83
1981–82
1980–81
–1 000
Source: (BREE, 2013)
Rising fuel prices did not appear to moderate distance travelled by Australian road users. It
continued to increase at a steady rate (Figure 44).
Figure 44 Billions of km travelled
14
12
10
billion km 8
travelled 6
4
2
Mar-80
Aug-80
Jan-81
Jun-81
Nov-81
Apr-82
Sep-82
Feb-83
Jul-83
Dec-83
May-84
Oct-84
Mar-85
Aug-85
Jan-86
Jun-86
Nov-86
Apr-87
Sep-87
0
NSW
VIC
QLD
SA
WA
TAS
NT
ACT
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).
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Figure 45 Percentage change in quarterly CPI from previous year
5.0
4.0
3.0
Percentage
change from 2.0
previous year
1.0
0.0
Dec-1988
May-1988
Oct-1987
Mar-1987
Aug-1986
Jan-1986
Jun-1985
Nov-1984
Apr-1984
Sep-1983
Feb-1983
Jul-1982
Dec-1981
May-1981
Oct-1980
Mar-1980
-1.0
Source: ABS
Figure 46 GDP growth rate
6.0
5.0
4.0
3.0
Annual GDP 2.0
growth rate % 1.0
0.0
-1.0
-2.0
Jan-1988
Jan-1987
Jan-1986
Jan-1985
Jan-1984
Jan-1983
Jan-1982
Jan-1981
Jan-1980
-3.0
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.
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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.
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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. In January 1991, the IEA coordinated a
release from strategic stockpiles held by IEA member countries around the world.
Consequences in the global oil market
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
further 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 required to contribute 46,000 barrels per day to global supplies under the IEA
contingency plan implemented in January 1991. It met its obligations through a combination of
increased indigenous production and demand restraint. Australia’s refining industry was not required
to make any adjustment ot its operations and there were no regional shortages of petroleum
products. The main effect on consumers was the higher price paid for petroleum products as a
consequence of the policy of allowing the flow through of international oil prices under the import
parity pricing policy.
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.
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8.1
ACIL ALLEN CONSULTING
Preceding Circumstances
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.
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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.
In January 1991, the IEA activated a contingency plan that committed member countries to
a combination of stock-draw, demand restraint, surge production and other measures to
achieve a target of providing an additional 2.5 million barrels of oil per day on the work
market. This was equivalent to around 7 per cent of oil consumption in IEA member
countries.
The oil price fell in the following months. However, the crude oil price stayed in a range of
US$33-43 per barrel (2014 price terms) for more than two years.
Again, market forces worked. Prices 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.
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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 23 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
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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 $A then muted the price decline at the
end of 1990 and in 1991 (Figure 47).
Figure 47 Crude oil price in A$ and US$
45.0
40.0
35.0
30.0
$ /bbl
25.0
20.0
15.0
10.0
5.0
Crude oil price A$ (nominal)
Nov-92
Jul-92
Mar-92
Nov-91
Jul-91
Mar-91
Nov-90
Jul-90
Mar-90
Nov-89
Jul-89
Mar-89
Nov-88
Jul-88
Mar-88
Nov-87
Jul-87
Mar-87
0.0
Crude oil price US$ (nomimal)
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.
The oil price and petrol prices were already near their pre-shock trend levels when the
release of IEA stocks occurred, as described above. The oil price and petrol prices fell
further in the following months.
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Figure 48 Crude oil prices and petrol prices
90
60.0
80
50.0
70
60
40.0
Petrol 50
c/l 40
30.0
30
20.0
20
Crude oil
$AUS/bbl
10.0
10
Petrol price (nominal)
Aug-92
Mar-92
Oct-91
May-91
Dec-90
Jul-90
Feb-90
Apr-89
Sep-89
Nov-88
Jun-88
Jan-88
Aug-87
0.0
Mar-87
0
Crude oil price A$ (nominal)
Note: Crude prices are yearly average based on Brent crude prices.
Petrol prices are quarterly average for capital cities.
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.
Figure 49 Capital cities petrol prices (nominal)
Sydney
Mebourne
Brisbane
Adelaide
Perth
Hobart
Darwin
Canberra
Nov-92
Jul-92
Mar-92
Nov-91
Jul-91
Mar-91
Nov-90
Jul-90
Mar-90
Nov-89
Jul-89
Mar-89
Nov-88
Jul-88
Mar-88
Nov-87
Jul-87
Mar-87
90
80
70
60
50
c/l
40
30
20
10
0
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).
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Figure 50 Consumption of petroleum products
42 000
41 500
41 000
40 500
ML /a 40 000
39 500
39 000
38 500
1991-92
1990-91
1989-90
1988-89
1987-88
38 000
Source: (BREE, 2013)
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).
Figure 51 Production of crude oil and net imports of refinery feedstock
Production of crude oil, condensate and LPG
1991–92
1990–91
1989–90
1988–89
000
000
000
000
000
000
000
000
000
0
1987–88
45
40
35
30
25
ML/a
20
15
10
5
Net imports
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 a result of the decline in growth in demand in 1990-91
(Figure 53).
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Figure 52 Refinery production
43 000
41 000
39 000
37 000
ML/a
35 000
33 000
31 000
29 000
27 000
1989–90
1990–91
1991–92
1989–90
1990–91
1991–92
1988–89
1987–88
25 000
Source: (BREE, 2013)
Figure 53 Net imports of petroleum products
1 500
1 000
500
0
ML/a
– 500
–1 000
–1 500
1988–89
1987–88
–2 000
Source: (BREE, 2013)
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.
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Figure 54 Billions of km travelled
14
12
10
billion km 8
travelled 6
4
2
NSW
VIC
QLD
SA
WA
TAS
NT
Nov-92
Jul-92
Mar-92
Nov-91
Jul-91
Mar-91
Nov-90
Jul-90
Mar-90
Nov-89
Jul-89
Mar-89
Nov-88
Jul-88
Mar-88
Nov-87
Jul-87
Mar-87
0
ACT
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).
Figure 55 Percentage change in CPI from previous quarter
3.0
2.5
2.0
Percentage 1.5
change from
previous year 1.0
0.5
0.0
Mar-1987
Jul-1987
Nov-1987
Mar-1988
Jul-1988
Nov-1988
Mar-1989
Jul-1989
Nov-1989
Mar-1990
Jul-1990
Nov-1990
Mar-1991
Jul-1991
Nov-1991
Mar-1992
Jul-1992
Nov-1992
-0.5
Source: ABS
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Figure 56 GDP growth rate
6.0
5.0
4.0
Annual GDP
growth rate %
3.0
2.0
1.0
0.0
Jan-1992
Jan-1991
Jan-1990
Jan-1989
Jan-1988
Jan-1987
-1.0
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).
Australia was required to contribute 46,000 barrels per day to global supplies under the IEA
contingency plan implemented in January 1991. It met its obligations through a combination
of increased indigenous production and demand restraint. Australia’s refining industry was
not required to make any adjustment to its operations and there were no regional shortages
of petroleum products
The main effect on consumers was the higher price paid for petroleum products as a
consequence of the policy of allowing the flow through of international oil prices under the
import parity pricing policy (Department of Primary Industries and Energy, 1991).
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.
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.
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9
ACIL ALLEN CONSULTING
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.
Consequences in the global oil market
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. 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.
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There were no interruptions in supply. Price movements ensured the market cleared globally and in
Australia.
9.1
Preceding Circumstances
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
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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 shutdown 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).
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9.4
ACIL ALLEN CONSULTING
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.
Figure 57 Crude oil price in A$ and US$
70.0
60.0
50.0
$ /bbl
40.0
30.0
20.0
10.0
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
0.0
Crude oil price A$ (nominal)
Crude oil price US$ (nomimal)
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).
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Figure 58 Crude oil prices and petrol prices
90
60.0
80
50.0
70
60
40.0
Petrol 50
c/l 40
30.0 Crude oil A$/bbl
30
20.0
20
10.0
10
Petrol price (nominal)
Sep-92
Mar-92
Sep-91
Mar-91
Mar-90
Sep-90
Sep-89
Mar-89
Sep-88
Mar-88
Sep-87
0.0
Mar-87
0
Crude oil price A$ (nominal)
Note: Crude oil prices based on quarterly average Brent prices
Source: (BP, 2013), ABS
Figure 59 Capital cities petrol prices (nominal)
120
100
80
c/l 60
40
20
Sydney
Mebourne
Brisbane
Adelaide
Perth
Hobart
Darwin
Canberra
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Mar-97
Sep-97
Sep-96
Mar-96
Mar-95
Sep-95
0
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).
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Figure 60 Consumption of petroleum products
54 000
52 000
50 000
48 000
ML /a
46 000
44 000
42 000
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
1997-98
1996-97
1995-96
1994-95
1993-94
40 000
Source: (BREE, 2013)
Figure 61 Production and of crude oil and net imports of refinery feedstock
60 000
50 000
40 000
ML/a 30 000
20 000
10 000
Production of crude oil, condensate and LPG
2003–04
2002–03
2001–02
2000–01
1999–00
1998–99
1997–98
1996–97
1995–96
1994–95
1993–94
0
Net imports
Source: (BREE, 2013)
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).
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Figure 62 Refinery production
50 000
45 000
40 000
ML/a
35 000
30 000
1999–00
2000–01
2001–02
2002–03
2003–04
1999–00
2000–01
2001–02
2002–03
2003–04
1998–99
1997–98
1996–97
1995–96
1994–95
1993–94
25 000
Source: (BREE, 2013)
Figure 63 Net imports of petroleum products
8 000
6 000
4 000
ML/a 2 000
0
–2 000
1998–99
1997–98
1996–97
1995–96
1994–95
1993–94
–4 000
Source: (BREE, 2013)
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.
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Figure 64 Billions of km travelled
18
16
14
12
billion km 10
travelled 8
6
4
2
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
0
NSW
VIC
QLD
SA
WA
TAS
NT
ACT
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.
Figure 65 Percentage change in quarterly CPI from previous year
7.0
6.0
5.0
4.0
Percentage
change from 3.0
previous year
2.0
1.0
0.0
Nov-2003
Mar-2003
Jul-2002
Nov-2001
Mar-2001
Jul-2000
Nov-1999
Mar-1999
Jul-1998
Nov-1997
Jul-1996
Mar-1997
Nov-1995
Mar-1995
Jul-1994
Nov-1993
Mar-1993
-1.0
Source: ABS
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Figure 66 GDP growth rate
6.0
5.0
4.0
Annual GDP
3.0
growth rate %
2.0
1.0
Jan-2003
Jan-2002
Jan-2001
Jan-2000
Jan-1999
Jan-1998
Jan-1997
Jan-1996
Jan-1995
Jan-1994
Jan-1993
0.0
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
short-lived. 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.
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10
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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 underrecognised, 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
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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.
10.1
Preceding Circumstances
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,
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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 early2012 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.
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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).
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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 20042008. 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.
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Box 6
ACIL ALLEN CONSULTING
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
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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.
Figure 67 Singapore Export Petrol Price and Crude Oil Price Movements Compared, 2005-06
Note: Acpl refers to Australian cents per litre.
Source: Caltex Australia.
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
international market for refined petroleum products, as well as crude oil, this substantial
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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 net reduction in
production capacity was over 1.5 million barrels per day. For refining, the peak net 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.
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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.
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 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
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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 20072008 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.
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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 lateSeptember 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 20032008 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-useintensive 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
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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).
On 23 June 2011 the IEA announced collective action in response to the disruption in
supply of Libyan light sweet crude and an anticipated increase in demand in the third
quarter of 2011. IEA member countries agreed to make available the equivalent of 60
million barrels from the emergency stockpiles of 8 larger IEA member countries. Some 38
million barrels were drawn from public stocks and 22 million barrels were made available
through lowing of stockholding obligations on industry. The collective action was terminated
on 15 September 2011 (IEA, 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,
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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.
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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
140.0
120.0
100.0
$ /bbl
80.0
60.0
40.0
20.0
Crude oil price A$ (nominal)
Jul-13
Dec-12
May-12
Oct-11
Mar-11
Aug-10
Jan-10
Jun-09
Nov-08
Apr-08
Sep-07
Feb-07
Jul-06
Dec-05
May-05
Oct-04
Mar-04
0.0
Crude oil price US$ (nomimal)
Note: Crude oil prices based on quarterly average of Brent crude oil price
Source: (BREE, 2013)
Figure 69 Crude oil prices and petrol prices
180
240.0
160
190.0
140
120
140.0
Petrol 100
c/l
80
90.0
60
40
Crude oil
$A/bbl
40.0
20
Petrol price (nominal)
Dec-13
Mar-13
Jun-12
Sep-11
Dec-10
Mar-10
Jun-09
Sep-08
Dec-07
Mar-07
Jun-06
Sep-05
Mar-04
-10.0
Dec-04
0
Crude oil price A$ (nominal)
Note: Crude oil prices based on quarterly average of Brent crude oil price
Source: (BREE, 2013)
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Figure 70 Capital cities petrol prices (nominal)
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
180
160
140
120
100
c/l
80
60
40
20
0
Series1
Series2
Series3
Series4
Series5
Series6
Series7
Series8
Source: ABS, Automobile Association of Australia
Consumption of petroleum products dipped by around 2 per cent with the onset of the global
financial 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).
Figure 71 Consumption of petroleum products
62 000
60 000
58 000
56 000
ML /a
54 000
52 000
50 000
2011-12
2010-11
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
48 000
Source: (BREE, 2013)
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.
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Figure 72 Production and imports of crude oil and refinery feedstock
Production of crude oil, condensate and LPG
2012–13
2011–12
2010–11
2009–10
2008–09
2007–08
2006–07
2005–06
2004–05
000
000
000
000
000
000
000
000
000
000
0
2003–04
50
45
40
35
30
ML/a 25
20
15
10
5
Net imports
Source: (BREE, 2013)
Figure 73 Refinery production
50 000
45 000
40 000
ML/a
35 000
30 000
2011–12
2010–11
2009–10
2008–09
2007–08
2006–07
2005–06
2004–05
2003–04
25 000
Source: (BREE, 2013)
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 GFC to 18,000 ML per annum in the following year (Figure 74).
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Figure 74 Net imports of petroleum products
25 000
20 000
15 000
ML/a
10 000
5 000
2011–12
2010–11
2009–10
2008–09
2007–08
2006–07
2005–06
2004–05
2003–04
0
Source: (BREE, 2013)
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).
Figure 75 Billions of km travelled
Mar-04
Aug-04
Jan-05
Jun-05
Nov-05
Apr-06
Sep-06
Feb-07
Jul-07
Dec-07
May-08
Oct-08
Mar-09
Aug-09
Jan-10
Jun-10
Nov-10
Apr-11
Sep-11
18
16
14
12
billion km 10
travelled 8
6
4
2
0
NSW
VIC
QLD
SA
WA
TAS
NT
ACT
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
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.
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Figure 76 Percentage change in quarterly CPI from previous year
6.0
5.0
4.0
Percentage
change from 3.0
previous year
2.0
1.0
Mar-2014
Jul-2013
Nov-2012
Mar-2012
Jul-2011
Nov-2010
Mar-2010
Jul-2009
Nov-2008
Mar-2008
Jul-2007
Nov-2006
Mar-2006
Jul-2005
Nov-2004
Mar-2004
0.0
Source: ABS
Figure 77 GDP growth rate
4.5
4.0
3.5
3.0
Annual GDP 2.5
growth rate % 2.0
1.5
1.0
0.5
Jan-2013
Jan-2012
Jan-2011
Jan-2010
Jan-2009
Jan-2008
Jan-2007
Jan-2006
Jan-2005
Jan-2004
0.0
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, government intervention as a result of these events has not been necessary apart
from discharging obligations under coordinated action under IEA emergency response plans
activated in 2005 with Hurricane Katrina and in 2011 with the Libyan crisis. Overall, 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.
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Some domestic supply chain issues have from time to time caused supply shortfalls. The
most notable was the near simultaneous shutdown of two refineries in Victoria in late 2012.
This resulted in some stock-outs in Victoria for a short period. However this event was not
driven by international supply disruptions. Shortages occurred because of the maintenance
problems in the two refineries.
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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 net 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 real wage flexibility
 more credible monetary policy
 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 (1973OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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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 19731981 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
Net 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,
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 net energy exports or imports. As these net positions have evolved over
time, economic effects of oil shocks have changed.
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).
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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 net oil-importing countries,
than in countries that are net exporters of oil, net exporters of oil and other energy, or net
exporters of energy but not oil.
Net 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.
Net 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 net 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 net oil exports and net 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 net exporters of energy, but net 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 net 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 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.
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
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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, net 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 net 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 net
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 net 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 net oil exporters or net energy exporters. Higher prices for energy
commodities would be stimulatory in net 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.
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Surprisingly, this intuition was not supported by results of structural VAR econometric
modelling by BPV (2010) and PV (2012). They found that net oil exporters and net energy
exporters would experience temporary reductions in real national income, although not as
large as for net 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 net energy-exporting countries would
not respond significantly to a speculative demand increase, and inflationary effects would
not differ greatly from those in net energy importing countries. For Australia, they found a
larger effect on the price level than for other developed net energy-exporting countries and
net energy-importing countries.
BPV (2010) and PV (2012) did not provide an explanation for their apparently counterintuitive 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.
Net 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.
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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 net
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 net 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 real wage flexibility
 more credible monetary policy
 greater exchange rate flexibility.
11.2.1
Net Energy Export/Import Balances
Susceptibility to economic harm from (vulnerability to) oil price increases tends to decline as
net oil export/import positions improve.
Net oil-importing/exporting and net 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 net 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
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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 net 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.
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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.
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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
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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 net exporter of energy, greater real wage flexibility, better targeted
and more credible monetary policy, and the floating exchange rate.
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12
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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 energyuse intensity, net 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 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
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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ACIL ALLEN CONSULTING
economic effects in Australia 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.
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Appendix A
ACIL ALLEN CONSULTING
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.
Diversify Australia’s
liquid fuel supplies
1980:
Fuel ethanol declared free of duty and ‘experimental’ licensing
arrangements put in place to encourage research into use of
ethanol as a fuel.
Diversify Australia’s
liquid fuel supplies
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
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ACIL ALLEN CONSULTING
Government Policy
Objective
Year
Event
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.
OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY
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Appendix B
ACIL ALLEN CONSULTING
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