Chapter 36: The “Good Sweating”, How Low Can It Go?

With oil now a commodity in the 1980s and prices spiraling downward compared to the surge in the 1970s, the question was, “How low can it go?” The answer to that had huge implications on the oil companies, the future of “oil power,” global economy, and the shifting balance in world economic and political strength. Clearly, high prices favored exporting nations (OPEC and non-OPEC), and low prices favored the oil-importing nations (Germany, Japan, and the many developing nations). The U.S. had interests on both sides, as it was the world’s second-largest producer and the world’s largest importer and consumer. OPEC was not helping its own situation with failing quotas and member cheating.

The third oil shock was as dramatic as the crisis of 1973-74 (first oil shock) and 1979-81 (second oil shock) except that the consequences this time were in the opposite direction as noted in the figure below. West Texas: crude that had sold at $31.75 per barrel in November 1985 had fallen to $10 per barrel (70% drop in a few months). Not only were prices falling, but they were out of control, and, for the first time, there was no price-setting system or structure - no official OPEC price.

Of course, consumers were ecstatic as their standard of living and improved lifestyles were no longer in jeopardy. If the prices continued to stay low, there was fear that consumption/demand would rise, domestic production would decline, and imports would again flood the U.S. market.

The issue with price cut goes back to the question of: how low can it go? or where would the price fall stop? Cuts in production would make non-OPEC oil, alternative energy sources, and conservation flourish in addition to the huge revenue loss.

Ironically, whereas in the past it was high prices and limited supply that was considered a national security risk, now the risk was too low prices and overabundant supply. Eventually, it was determined by all concerned parties that $18 per barrel, $11 less than the official OPEC price of $29, was the “right” price of oil. This was the equivalent of the mid-1970s price after correcting for inflation. This was felt to be the price that would achieve all the competing objectives: make oil competitive with other sources and conservation, stimulate worldwide economic growth and demand for energy, and cap or reverse the non-OPEC production. With the consensus within OPEC, the U.S., and other non-OPEC countries for $18 per barrel, and the good faith effort of all parties, the market stabilized, and the “good sweating” eased.

Lessons learned during the Oil Shocks included the importance of stability of demand & supply and the fact that price stability and ample supplies were necessary to ensure this. As we exit the 1980s, conflict is brewing again in the Middle East.