Demand for Oil and Excess Supply Since 1980

Dynamic forces of oil supply and demand led to all excess supply in world markets since 1980, which in turn led to a de facto decline in the price of oil even before OPEC's London agreement of March 1983 in which the official price was reduced by approximately 14 percent. This oil glut in world markets was the result of at least three mutually dependent dominant forces: high oil prices, increase in production, and reduction in demand.

First, following the initial leap of 1973 the price of oil was once again drastically increased in l979. This rise led to a substitution of other sources of fuel and a reduction in real income, which contributed eventually to a decline in the demand for oil after a three-year time lag. Since there was still a shortage of oil in world markets in 1979, its price surpassed even the benchmark price of $34 per barrel that would he established by OPEC in Geneva in October 1981. As a consequence of high oil prices, alternative sources of energy expanded, including coal production, the use of solar energy in home treating, and greater electricity production from nuclear energy, though the latter has suffered from a crisis in public confidence. Additionally, funds were allocated by Occidental Petroleum, Exxon, and others for research and development of synthetic fuels. With the decline in the price of oil, however, such projects have either been canceled or put on hold until the expected upturn in oil prices occurs once again.

Higher oil prices also encouraged energy conservation efforts, as consumers attempted to lower their oil bills. Demand for small, gas-efficient cars skyrocketed. Consumers insulated their homes in an attempt to reduce energy costs. Businesses also worked to reduce their energy bills by becoming energy conscious and by eliminating wasteful practices.

Worldwide recession of the early eighties led a decline in growth rates and gross national products of the developed countries by an average of 0.5 percent. The decrease in the United States was 1.8 percent, that of Canada was 5 percent, all of West Germany 1.3 percent.8 Income effects from the rise in the price of oil coupled with the world recession reduced demand for oil and, therefore, oil revenues.

A second factor in the oil glut was the increase in world oil production--a predictable economic consequence of rise in its price. World oil supply peaked in 1979, at it level of approximately 66 million barrels a day. 9 It is important to note that in spite of a small decline in the U.S. supply, world oil production until the end of 1979 had increased across the board in all blocs-OPEC or non-OPEC, Communist or non-Communist, developed or developing. The only two blocs that continued to increase their production in spite of the oil glut were Communist countries and the less-developed non-OPEC countries. Another significant observation refers to the Saudi oil production policy in the late seventies. It was designed to increase its oil supplies drastically for both economic reasons and political considerations (of which the latter is beyond the scope of this paper). Saudi Arabia increased its oil production to make up for the reduction of Iraqi and Iranian oil supplies, which resulted from their war efforts. Furthermore, it meant to force other OPEC members to agree on a lower, more reasonable unified price than was prevailing at a time when demand exceeded supply and was thus pushing oil prices even higher than the neglected official price set by OPEC. Saudi Arabia, having the world's greatest flexibility in oil production, can easily adjust its production from as low as 2.5 million barrels a day to as high as 11 or even 12. Therefore, it was able to achieve the objectives it set for itself during this period.

Meanwhile, carried away with the moment of increased oil production, countries failed to gauge exactly the level of oil supplies that should clear the market at a certain administered price. In fact it is impossible to determine such an equilibrium point since there can never be perfect knowledge of' the world oil market; nor is it conceivable to have a unified and a flexible production policy among all nations. At any rate, with the increase in oil production, its supply surpassed its demand; hence since 1982 an oil glut replaced the oil shortage.

A third factor in the oil glut was decreased demand for oil. The 1980 economic recession, which had plagued the world economy and which had markedly reduced the productive capacity of industrial nations by its greatest percentage decline since World War II, was a dominant force in reducing the demand for oil yet further. As their gross national products headed downward because of the recession, industrial nations reduced their imports. This, in turn, led to a reduction in foreign exchange earnings of the less-developed countries. These had, therefore, to curtail their purchases from abroad, including imports of oil. A multiplier effect of all such factors had a marked effect on the demand for oil in world markets.

Interaction of demand and supply in the international oil markets has dictated a reduction in its price since l982 in spite of OPEC's attempts to maintain its pricing policy. OPEC had to respond to market shortages by reducing its price several times since its London agreement of March 1983 and before an all-out price war broke out at the end of 1985. It should be noted, however, that in spite of the decline in the price of oil as denominated in U.S. dollars, it was increasing when measured in terms of other currencies during the period of a strong dollar in 1984 and 1985. Using the Business International Money Report's average monthly foreign exchange rates, I calculated the price of oil in British Pounds and Swiss francs at an equivalent of $29 a barrel from March 1984 to February 1985, as presented in Table 1.

Nevertheless, in spite of an apparent gain to oil exporters, petroleum markets were depressed even before the marked decline in the exchange rate of the dollar in the latter part of 1985 and in 1986. A fall in U.S. interest rates and ever-increasing deficits in the U.S. balance of payments imposed a downward pressure on the exchange rate of the dollar.

The sharp drop in the price of oil in 1986 resulted from the price war in international oil markets. It was thus forced down to below $10 a barrel. This, together with the fall in the exchange rate of the U.S. dollar, substantially diminished oil revenues.

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