Up until the middle of the 20th century, the United States was the largest producer of oil and controlled oil prices. Here we look at the historical battle between OPEC and the United States to control oil prices and how world events influence that struggle.
The Early Years
Oil was first commercially extracted and put to use in the United States; consequently, pricing power for the fuel lay with the United States, which was, at that time, the largest producer of oil in the world. In general, oil prices were volatile and high during the early years because economies of scale during extraction and refining (which mark the current extraction and drilling processes) were not present. For example, in the early 1860s, the price per barrel of oil reached a peak of US $120 in today's terms, partly due to rising demand resulting from the U.S. civil war. The price fell by more than 60% over the next 5 years and rose by 50% during the next 5 years.
The discovery of the Spindletop refinery in eastern Texas opened the floodgates of oil in the U.S. economy. According to statistics, 1,500 oil companies were chartered within a year of the discovery. Increased supply and the introduction of specialized pipelines helped further reduce the price of oil. The supply and demand for oil rose additionally with the discovery of oil in Persia (present-day Iran) in 1908 and Saudi Arabia during the 1930s and World War I, respectively.
The use of oil in weaponry and the subsequent European coal shortage further ratcheted demand for oil, and prices came crashing down to $40 in today's terms. American reliance on imported oil began during the Vietnam war and the economic boom period of the 1950s and 1960s. In turn, this provided Arab countries and OPEC (which had been formed in 1960 to counter the hegemony of Western oil companies) with increased leverage to influence oil prices.
OPEC Gains the Upper Hand
The 1973 oil shock swung the pendulum in OPEC's favor. That year, in response to U.S. support for Israel during the Yom Kippur War, OPEC and Iran stopped oil supplies to the United States. The crisis had far-reaching effects on oil prices. They have remained at high levels since.
OPEC controls oil prices through its pricing-over-volume strategy. According to Foreign Affairs magazine, the oil embargo shifted the structure of the oil market from a buyer's to a seller's market. In the magazine's view, the oil market was earlier controlled by the Seven Sisters or seven Western oil companies that operated a majority of the oil fields. Post 1973, however, the balance of power, however, shifted towards the 12 countries that comprise OPEC. According to them, “What the Americans import from the Persian Gulf is not so much the actual black liquid but its price.”
The cartel derives its pricing power from two trends: absence of sources of energy and a lack of viable economic alternatives in the energy industry. It holds three-quarters of the world's conventional oil reserves and has the world's lowest barrel production costs. This enables it to have a wide-ranging influence over oil prices. Thus, when there is a glut of oil in the world, OPEC cuts back on its production quotas. When there is less oil, it increases oil prices to maintain stable levels of production.
A number of world events have helped OPEC maintain control over oil prices, such as the disintegration of the Soviet Union in 1991; the resulting economic tumult disrupted Russia's production for several years. The Asian economic crisis had the opposite effect: It reduced demand. In both instances, OPEC maintained a constant rate of oil production. (See also How Much Influence Does OPEC Have On The Global Price Of Oil?)
But OPEC's monopoly over oil prices seems to be in danger of slipping.
The discovery of shale in America has helped the country achieve near-record volumes of production. According to the Energy Information Administration, U.S. oil production is estimated to peak at 9.7 million barrels this year. The last time that production was this high was in 1972, when U.S. oil production peaked at 9.6 million barrels per day.
Shale is also gaining popularity beyond American shores. For example, China and Argentina have drilled more than 475 shale wells between them in the last two years. Other countries, such as Poland, Algeria, Australia, and Colombia, are also exploring the prospect of shale formations.
The Iran-U.S. nuclear deal is expected to further introduce more oil into the market. Iran, which is a founding member of OPEC, could reach 2.4 million barrels of oil by 2016. Geopolitical tensions within the Middle East, such as the rise of ISIS, whose leader has already called for the bombing of Saudi Arabia (OPEC's largest oil producer), and Yemen's disintegration could also destabilize oil supplies.
The spending habits of OPEC's Arab monarchies may also put downward pressure on oil prices. For example, Arab monarchies, which produce the bulk of OPEC's oil, are busy ramping up spending at home to avoid a repeat of uprisings (such as those that occurred during the Arab Spring) in their countries. Demand from developing economies, such as China and India, has also skyrocketed, putting additional pressure on prices in the face of constant production. (For more, see: Oil Price Analysis: The Impact Of Supply & Demand.)
The Bottom Line
Theoretically, oil prices should be a function of supply and demand. When supply and demand increase, prices should drop and vice versa. But the reality is different. Oil's status as the preferred source of energy has complicated its pricing. Demand and supply are only part of the complex equation that has generous elements of geopolitics and environmental concerns.
Regions that hold pricing power over oil control vital levers of the world's economy. The United States controlled oil prices for a majority of the previous century, only to cede it to the OPEC countries in the 1970s. Recent events, however, may end up with the pricing power swinging back towards the United States and Western oil companies.