OPEC Oil Embargo, Its Causes, and the Effects of the Crisis

The Truth About the 1973 Arab Oil Crisis

gas shortage sign
•••  Photo by Owen Franken/Corbis via Getty Images

The OPEC oil embargo was a decision to stop exporting oil to the United States. On October 19, 1973, the 12 OPEC members agreed to the embargo. Over the next six months, oil prices quadrupled. Prices remained at higher levels even after the embargo ended in March 1974.

A review of the history of oil prices reveals they've never been the same since. The chart below tracks both nominal and inflation adjusted oil prices since 1946. During the OPEC oil embargo, inflation adjusted oil prices went up from $25.97 per barrel (bbl) in 1973 to $46.35 per barrel (bbl) in 1974. By comparison, the inflation adjusted oil price in 2018 is 70.62 per barrel (bbl).

OPEC continued using its influence to manage oil prices since the embargo. Today, OPEC controls 42 percent of the world's oil supply. It also controls 61 percent of oil exports and 80 percent of proven oil reserves.

Causes

In 1971, President Nixon prompted the embargo when he decided to take the United States off of the gold standard. As a result, countries could no longer redeem the U.S. dollars in their foreign exchange reserves for gold. With this action, Nixon went against the 1944 Bretton Woods Agreement. His move sent the price of gold skyrocketing. The history of the gold standard reveals this was inevitable. But Nixon's action was so sudden and unexpected that it also sent the value of the dollar down. 

The plummeting value of the dollar hurt OPEC countries. Their oil contracts were priced in U.S. dollars. That meant their revenue fell along with the dollar. The cost of imports that were denominated in other currencies stayed the same or rose. OPEC even considered pricing oil in gold, instead of dollars, to keep revenue from disappearing. 

For OPEC, the last straw came when the United States supported Israel against Egypt in the Yom Kippur War. On October 19, 1973, Nixon requested $2.2 billion from Congress in emergency military aid for Israel. The Arab members of OPEC responded by halting oil exports to the United States and other Israeli allies. Egypt, Syria, and Israel declared a truce on October 25, 1973. But OPEC continued the embargo until March 1974. By then, oil prices had skyrocketed from $2.90/barrel to $11.65/barrel. 

Effects

The oil embargo is widely blamed for causing the 1973-1975 recession. But U.S. government policies really caused the recession and the stagflation that accompanied it. They included Nixon's wage-price controls and the Federal Reserve's stop-go monetary policy. Wage-price controls forced companies to keep wages high, which meant businesses laid off workers to reduce costs. At the same time, they couldn't lower prices to stimulate demand. It had fallen when people lost their jobs.

To make matters worse, the Fed raised and lowered interest rates so many times that businesses were unable to plan for the future. As a result, companies kept prices high which worsened inflation. They were afraid to hire new workers, worsening the recession. But Fed officials learned this lesson from the history of U.S. recessions. Since then, they've been consistent in their actions. More important, they clearly signal their intentions well ahead of time.

The oil embargo aggravated inflation, already at 10 percent for some commodities, by raising oil prices. It came at a vulnerable time for the U.S. economy. Domestic oil producers were running at full tilt. They were unable to produce more oil to make up the slack. Furthermore, U.S. oil production had declined as a percentage of world output. 

It also worsened the recession. First, higher gas prices meant consumers had less money to spend on other goods and services. This lowered demand. It also weakened consumer confidence. People were forced to change habits, making it feel like a crisis that the government tried unsuccessfully to resolve. This lack of confidence made people spend less.

For example, drivers were forced to wait in lines that often snaked around the block. They woke up before dawn or waited until dusk to avoid the lines. Gas stations posted color-coded signs: green when gas was available, yellow when it was rationed, and red when it was gone. States introduced odd-even rationing: drivers with license plates ending with odd numbers could get gas on odd-numbered days. 

Congress created the Strategic Petroleum Reserve to supply at least 90 days of oil in case of another embargo. It also reduced the national speed limit to 55 miles per hour to conserve gas. Nixon instituted daylight savings time year round for 1974 and 1975.

The oil embargo gave OPEC new power to achieve its goal of managing the world's oil supply and keeping prices stable. By raising and lowering supply, OPEC tries to maintain the price between $70-$80 per barrel. Lower than that, they would be selling their finite commodity too cheap. Higher than that, the development of shale oil would look attractive.