Could 1979’s Oil Market Chaos Be Repeated?

After the first oil crisis, many politicians pompously proclaimed that they didn’t want to see their citizens freezing in the dark and took a variety of approaches to acquire oil supplies, including offering foreign aid, diplomatic steps favoring the Palestinians, and urging development of alternative energy supplies ranging from natural gas to synthetic liquid fuels. Unfortunately, the high price for oil—which few governments addressed—caused a massive recession and people freezing in the dark out of unemployment. The International Energy Agency was set up to deter an embargo and major oil users began to establish strategic reserves, partly for the same purpose.

However, the opponents of the Shah’s regime were not interested in any of these moves and the disruption from the Iranian Revolution was not deterred. When the dust had settled, the oil industry had changed substantially, the oil price rose from $44 to $98 per barrel (in 2021 dollars). Yet amazingly, the physical market was almost always balanced, indeed glutted for much of the three years. As the figure below shows, the other OPEC members were quickly able to add supply to the market so that by April 1979, total OPEC production had reached November 1978 levels.

In fact, three quarters of the oil price increase came after the 2nd quarter of 1979, when inventories were already building and building sharply, as the table below shows.

Why did inventories soar? The basic answer is uncertainty, both geopolitical and industrial. The former refers to the fact that upon achieving power in Iran, the Ayatollah Khomeini made threats against his neighbors, including both the Gulf monarchies and Iraq’s Saddam Hussein (with whom he would be at war with in less than two years). The seizure of the Grand Mosque at Mecca in November 1979 by radicals/terrorists made many fear that the Saudi government might be overthrown or the country sink into civil war. Given those ongoing threats to a major portion of the world’s oil supply, it was only rational to build inventories against such a development.

But few recall that the industry structure also underwent a revolution at that time. Although most OPEC countries had nationalized the upstream operations in their countries, most were still selling the bulk of their oil to the previous lessees, primarily the Seven Sisters. Not only did those companies lose their Iranian supply in 1979, but much of the oil they were lifting from exporting nations was cut off. Libya, for example, cancelled contracts claiming that technical problems inferred with production; the released oil was then sold on the spot market for much higher prices, as countries and companies that lost Iranian supplies offered ever-higher bids for new barrels.

It didn’t help that, at the time, most countries maintained the practice of selling oil at an ‘official sales price’ agreed to by OPEC. When the Iranian Oil Crisis began, only a few percent of the world’s oil was traded on the spot market and that was quickly snapped up by eager buyers—driving the spot price well above the official price. For an exporter, cancelling or not renewing contracts for oil trading at the official sales price paid off, as it could be resold at the higher spot price; some buyers offered extras as well. Kuwait, for example, had previously sold most of its oil to BP, Gulf and Shell, but reduced their volumes by 80% and resold the oil thus freed up to new customers, for a premium.

But this meant that those companies that lost oil supply in this manner had to seek new supplies, reduce sales to third parties—especially Japanese oil companies—who were then forced to seek their own new supplies. All while oil consuming governments urged each other not to pursue scarce spot supplies, but encouraging their own companies to find whatever they could.

The market wasn’t lacking for oil, but supplies had become extremely unreliable: a company never knew when a national oil company would abrogate its contract or a major oil company would invoke force majeure, and many more found themselves relying on short-term contracts and spot sales in the place of decades-old supply patterns. This uncertainty raised the value of inventories, explaining in part their abnormal increase. None of this is apparent in the market balances, and few are now aware of the microeconomic developments that caused this.

Cutting off Russian oil companies from the SWIFT banking system could have a similar effect. They could very well find new buyers to replace Western countries and companies: China alone imports more oil than Russia exports. But to switch those barrels around will involve a complex web of transactions as well as new logistical arrangements: moving the oil from the Baltic and the Black Sea to Asia will take weeks longer than shipping it to European markets, and in the interim, the Chinese are unlikely to yield their existing Middle Eastern barrels to thirsty European refiners. (Tanker owners will certainly profit.)

Could the oil price triple, as it did from 1978 to 1980? Probably not, as presumably releases from strategic reserves would fill many of the newly blank spots on the oil transport map. But the next few weeks could be extremely tumultuous for oil markets.