Oil Shock

The 1973 Crisis and its Economic Legacy

Elisabetta Bini, Giuliano Garavini, Federico Romero, Elisabetta Bini, Giuliano Garavini, Federico Romero

• Publisher: I.B. Tauris
• Year: 2016
• ISBN:
  9780857729583
• Edition: 1
• Topic: Technology & Engineering
• Subtopic: Chemical & Biochemical Engineering
• Index: Technology & Engineering

The 1973 'Oil Shock' is considered a turning point in the history of the twentieth century. At the time it seemed to mark a definitive shift from the era of low priced oil to the era of expensive oil. For most Western industrialized countries, it became the symbolic marker of the end of an era. For many oil producers, it translated into an unprecedented control over their energy resources, and completed the process of decolonization, leading to a profound redefinition of international relations.This book provides an analysis of the crisis and its global political and economic impact. It features contributions from a range of perspectives and approaches, including political, economic, environmental, international and social history. The authors examine the origins of what was defined as an 'oil revolution' by the oil-producing countries, as well as the far-reaching effects of the 'shock' on the Cold War and decolonization, on international energy markets and the global economy. In doing so, they help place the event in its historical context as a key moment in the transformation of the international economy and of North-South relations.

PART 1

Origins

1

The Shocking History of Oil

Bernard Mommer¹

There can be no question that, in the history of oil, the year 1973 was indeed a pivotal year of global significance. But for all of the universal agreement on this point, perceptions as to what actually happened that year, and what was so shocking about it, can be very disparate, depending essentially on the conception of the history of oil that a given observer subscribes to. In general terms, there are two fundamentally different understandings about the role which natural resource ownership is supposed to play in that history. One posits that natural resource ownership is an issue of minor importance, which has no incidence whatsoever on the formation of oil prices, and therefore merits no academic attention. According to this viewpoint, the history of global oil is, basically, the aggregate history of the oil and gas companies that make up the industry.

The second viewpoint is that, on the contrary, natural resource ownership is of great relevance to the formation of prices and, therefore, must on no account be disregarded. In other words, the landlord–tenant relationship between natural resource owners, on the one hand, and the enterprises which produce such resources, on the other, is an essential part of the history of oil.²

Natural Resources and Economics

The relevance of natural resource ownership to prices was an issue of the greatest importance in the development of economic thought, notably in the transition from Physiocracy to modern economics. According to the French school of Physiocracy,³ there were only two factors of production: land and labour (the former the dominant one, the latter the subordinate). The British school of Political Economy,⁴ which succeeded Physiocracy, acknowledged three factors of production: capital, land and labour. But the key questions that the British school had to address were which of the first two was the dominant one, and whether labour was subordinate to capital or to land. Quite apart from this, regarding the influence of property rights on the balance of supply and demand, Adam Smith reached the conclusion that the class of landlords and the rents they exacted were to blame for rising corn prices. Smith thus referred to a monopoly rent, which Karl Marx would call an absolute rent.⁵

Some 40 years after Smith, David Ricardo⁶ argued that capital had actually managed to impose its will and rationality over land by means of free market competition, and that this prevented landed property owners from collecting anything more than differential rents. These Ricardian rents, as they would come to be called, arose because of the different natural fertility of cultivated lands supplying the market. In other words, Ricardo concluded that Smith had been wrong: private landed property had no bearing on prices. It was the growth of population (and hence of demand and, by extension, rising marginal costs) that was to blame for rising corn prices, and which explained rising rents.

With this conclusion, Ricardo cleared the way for modern economics to, once again, reduce the factors of production to two, with capital as the dominant factor and labour as the subordinate one. There was to be no place for land (i.e. non-produced means of production) in modern economics.⁷

Royalties

To sustain his thesis, Ricardo presented a model according to which tenants paid an annuity, which did not prevent them from increasing production up to the point where marginal production costs would equalize market prices (in other words, up to the point where the marginal rent was zero). This theoretical model did not apply to mineral rents, for the simple reason that the usual rent in mining was not an annuity (as was the case in agriculture), but a fixed rent per unit produced or a fixed percentage: a royalty, as it was to be called later. As a practical matter, therefore, it was indisputable that marginal rent was not zero and that, therefore, production could only be increased to the point of equalizing market prices less the royalty agreed upon. This in turn meant, obviously enough, that some marginal mineral deposits could not be exploited by mining companies, as they would not generate enough cash flows to cover costs, remunerate capital and pay such rent. (In his time, Smith had already noted the case of some coal mines that could not afford a royalty and, therefore, could ‘be wrought only by the proprietor’.⁸)

These empirical facts were highly problematic for Ricardo, who wanted to demonstrate that private mineral property could not, and did not, obstruct the flow of investment (a postulate that necessitated that some mines pay no rent, if mineral demand and supply were to match). His way of squaring this particular circle involved manipulating the definition of rent, which he took to be ‘that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil’.⁹ Thus, royalties were not rents at all (that is, remunerations paid for the use of property) but a consideration paid for the ‘valuable commodity’¹⁰ in place. Such consideration was owed to the landlords in whose property the mines happened to be, of course, but that was entirely by the by, a sheer coincidence. This was a white lie, but it served the eminently useful purpose of sweeping the problem posed by private mineral ownership under the carpet.

Ricardo’s foremost concern was to take the wind out of the sails of the critics of private property by making it clear that rents had to be brought down, albeit in a manner that did not put private landed property in question. He therefore advocated free trade, so as to bring down the price of corn through worldwide competition. Moreover, he suggested targeting differential rents through taxation, while simultaneously lowering general tax levels. According to his model, this could be done without any impact whatsoever on supply, as landlords would have no option but to accept (differential) rents as determined by the market, and whatever was left after the imposition of taxes. Thus, without formally questioning private ownership of natural resources, these resources would still be transformed, essentially, into a free gift of nature for consumers through tax reliefs. But royalties remained an unresolved issue.

Public Mineral Ownership

In Ricardo’s time, public mineral ownership played a very minor role in England, but this was generally not the case in the rest of Europe. In 1791, this issue was even the subject of a significant debate in the French National Assembly. Count Mirabeau¹¹ argued convincingly that it would be absurd to identify property rights over the surface with property rights over the mineral deposits underneath; and the absurdity would be all the greater the deeper the deposits were. For practical reasons, then, surface rights and mineral rights had to be dealt with separately. Thus, minerals were to be declared public property and subject to eminent domain rights, in order to ensure their free access from the surface, and to assign the rights for their exploration and exploitation to mining companies through concessions. These ideas were incorporated in the epochal 1791 French Mining Law.

In this way, in mining, the ideal of natural resources being a free gift of nature would be made real, inasmuch as the state would have all the rights over any rents to be collected, and consumers would benefit from lower general taxation.¹²

American Oil

The oil industry was born in Pennsylvania, USA, in 1859. The industry had to develop on the basis of mineral leases, as private landed property in the US included the mineral deposits beneath the surface. During the first 15 years or so of the history of oil exploitation, standard lease forms developed, establishing standard royalty rates of one-eighth in some regions, and one-sixth in others. The term of the leases was open-ended; that is, it extended to the final exhaustion of the reservoirs. These standard lease forms have proven extraordinarily stable. Indeed, it is no exaggeration to say that the deal struck between property owners and oil enterprises during the first 15 years of the life of the oil industry was pretty much a definitive settlement, whereby royalty owners became ‘sleeping partners’ of the petroleum industry. Standard royalties created a level field for the competing companies which, ultimately, passed on the added cost that they represented to consumers, through higher prices (pace Ricardo). Hence, an economic relationship of sorts between consumers and the natural resource owners was established, though the former admittedly never dealt with the latter directly. Consumers were represented – nolens volens – by the tenant companies. Of course, consumers could always promote legislation favouring lessors against lessees, which they duly did, and they could also rely on competition to curb monopoly rents. Differential rents, in contrast, would still be open to be collected – if they were collected at all – through higher rents, royalties and bonuses.

Nevertheless, whenever academic economists in the twentieth century stumbled across the existence of standard royalty rates, they made great efforts to construe them, against all evidence, as differential rents and to affirm, time and time again, that they had no bearing on prices. For example, Paul Davidson, when discussing the one-eighth royalty, argued that:

if marginal royalty and marginal operating costs were the only marginal costs, and since short-run profit maximization would require the firm to equate the sum of these marginal costs to price, then the short-run supply function for the firm would be obtained by elevating the marginal operating cost curve by 1/7, or 14 2/7 per cent, so as to include marginal royalty costs in the supply price.¹³

Hence, ‘royalties are an important component of the short-run supply function. Nevertheless, since royalties provisions are fixed at the outset and depend upon expectations of the future income stream from the well, royalties are, in the long run, price-determined rather than price-determining’.¹⁴ This is true: the one-eighth royalty was certainly fixed at the outset, but at the outset of the history of the American oil industry in the nineteenth century, not at the outset of production in individual leases. But this is immaterial according to Davidson: ‘Oil lands are obviously analogous to the Ricardian case of agricultural lands of differing fertilities’,¹⁵ and ‘royalty payments are […] Ricardian rent payments’.¹⁶

It seems reasonable to suggest that Ricardo himself would not have called these standard royalties ‘rents’. Much closer to Ricardo’s understanding of royalties was the popular conception of mineral deposits as a ‘natural capital’, with royalties reflecting, at least partially, its ‘depreciation’. This understanding became of practical interest in the twentieth century with the rise of corporate income taxation. American mining companies and royalty owners managed to be granted a ‘depletion allowance’ based on that very conception, which significantly reduced their taxation burden. Mineral industry and royalty owners’ income was therefore privileged, tax-wise. But in the US, nobody, either in practice or theory, dared question the legitimacy of royalties. By the same token, it could not be admitted that royalties actually had any bearing on prices, as this could easily become a first step to questioning the legitimacy of private mineral rights, something that, from a political viewpoint, was totally unacceptable in the US.

International Oil: The American Reference

The oil industry started to become truly international around the time of World War I. By the vagaries of nature, most of the locations where gigantic oil pools would be discovered lay in the territories of countries forming part of what would later be known as the Third World. Among the big international oil companies (IOCs), in turn, American concerns outnumbered all others, whether British, Dutch or French. Thus, and not surprisingly, American oil became the natural reference for oil-exporting countries. This fact was pregnant with major economic implications, as the American petroleum governance had emerged in an institutional environment characterized by private property of mineral rights, whereas in the rest of the world oil is in the public domain, and oil companies are granted access to reservoirs through concessions.

The adoption of the American Reference meant that, in time, the exporting countries would be asking for the sorts of rents and royalties customarily found on public lands in the US. Moreover, once their respective governments realized that the IOCs were subject to income taxation in their home countries with regard to profits made in the exporting countries, these governments would also claim that such taxes were rightfully owed to them and not to the governments of the IOCs’ home countries.

The process whereby these claims would e...

Table of contents

• Cover
• Half Title
• Endorsement
• Title Page
• Copyright Page
• Table of Contents
• List of Illustrations
• List of Contributors
• Introduction
• Part 1 Origins
• 1 The Shocking History of Oil
• 2 ‘First Class Brouhaha’: : Henry Kissinger and Oil Power in the 1970s
• 3 Iraq and the Oil Cold War: : A Superpower Struggle and the End of the Iraq Petroleum Company, 1958–721
• 4 Eight Squeezed Sisters: : The Oil Majors and the Coming of the 1973 Oil Crisis
• Part 2 Consequences
• 5 Shifting Sands: : The 1973 Oil Shock and the Expansion of Non-OPEC Supply
• 6 The OECD Oil Committee and the International Search for Reinforced Energy-Consumer Cooperation, 1972–3
• 7 Learning to ‘Recycle’: : Petrodollars and the West, 1973–5
• 8 Energy Hinge? : Oil Shock and Greening American Consumer Culture since the 1970s
• 9 Energy and Soviet Economic Integration: : Foundations of a Future Petrostate
• 10 Nuclear Energy and the Rise of Environmentalism in the United States
• Further Reading