Black Gold and Choppy Markets: The Story of Opec

5/5/2019 - Monocle Journal

The beginnings of the use of oil in America can be traced back to the Seneca tribe – part of the indigenous Native American Iroquois nation – who had found that the oil that seeped up from the earth in what would become known as Pennsylvania, could be used as a salve for wounds. When Europeans settled in the region, they experimented with using the oil in their lamps, but found that, unlike whale oil, this oil gave off an unpleasant odour when burned, as well as a lot of smoke. The oil was largely disregarded, although it proved an ongoing nuisance to salt-well operators, who frequently found that their brine was contaminated with the oil.

Black Gold

Growing ever more frustrated with the oil that continuously flooded his drill holes, one of the salt mine owners – Samuel Kier – began to experiment with the liquid during the 1850s, in the hopes of finding a way to monetise it. He had heard that in Britain, scientists had recently discovered that an oil could be produced through the distillation of coal, and that this oil could be burned and used as an illuminant. They had named the oil “keroselain”, though it later became known as kerosene. Inspired by this development in Britain, Kier similarly began distilling the oil from the Pennsylvania seeps for use in lighting. He also developed designs for lamp burners that would allow air to enter them, which made his version of kerosene burn more brightly.

Meanwhile, in New York, two lawyers had observed the growing use of coal oil for lighting, and when they heard that Kier’s kerosene was being produced from oil that seeped out of the ground right on their own doorstep, they sensed a business opportunity. Their interest was further piqued when they were informed of an analysis by a professor of chemistry at Yale University, which concluded that not only could the oil be inexpensively distilled into kerosene, but it could also be distilled into paraffin and used for a variety of manufacturing processes. The lawyers quickly formed the Pennsylvania Rock Oil Company.

One of the main investors in the Pennsylvania Rock Oil Company was James Townsend – the president of a bank in New Haven. Whilst selling shares in the new oil company, he happened to meet a former railway conductor named Edwin Drake, who he recruited to help establish the oil company in Titusville, Pennsylvania. Drake was sent to Titusville with orders to secure land titles for the company and then to begin sourcing oil. However, upon arriving in Titusville, Drake found that his belief that he could turn the oil from the seeps into a valued commodity was met with amusement from the locals, who dismissed him as “Crazy Drake”. They had never considered that the oil could have any use beyond being a home-remedy for aches and pains. Because of this, nobody had ever tried to extract the oil directly from the wells that lay beneath the earth where the oil seeped to the surface.

For many years, Americans had extracted salt by boiling the brine produced in naturally occurring salt water springs. However, as mining methods advanced, they began to drill into the earth below the springs and this enabled them to access the more concentrated brine that lay beneath the surface-level springs. Having observed the salt-miners, Drake reasoned that the same drilling method could be used to directly access the oil wells below the surface-level seeps. Initially, his employer – now renamed the Seneca Oil Company – was supportive of Drake’s idea. However, Drake soon found that it was not as easy as he had expected to drill down deep enough to reach the oil well, because as he drilled, underground water repeatedly flooded the shaft. As time wore on and his attempt to access an underground oil well bore no fruit, his company grew impatient and refused to continue to fund his experiment. Nonetheless, Drake remained determined and decided to use his personal savings to continue the endeavour. He developed a new mining method that protected the shaft from the flood of water, by first sinking a pipe into the bedrock and then drilling inside of it. Three months later, Drake’s persistence paid off when he managed to drill down to 69 feet and struck oil.

Oil extraction quickly became the primary activity in the region and by the end of 1859, 4 500 barrels of oil had been produced. By 1862, production reached three million barrels. Oil producers profited significantly as demand soared – America had entered the great era of industrialisation, and with the introduction of cars and the use of diesel in a wide array of manufacturing processes, fuel was becoming an increasingly valuable commodity. Drake, however, was not reaping any of the considerable rewards that had resulted from his ingenuity and determination. After his initial success, his connection with the Seneca Oil Company was revived in what both he and the company believed would be a successful partnership. However, Drake failed to act quickly enough to secure more land for the company, and extraction rights throughout Pennsylvania were snapped up by competing oil companies. As a result, the Seneca Oil Company severed all ties with Drake. He had also never patented his mining method and so he saw no returns from his invention. He died penniless in 1880 after years of poor health.

At this time, the US was the largest producer of oil in the world and therefore controlled the per-barrel price, which reached a peak between 1863 and 1864 of about $8 dollars per barrel (roughly $120 per barrel in today’s terms, adjusting for long-run inflation). Then in 1908, oil was discovered in Persia – now Iran – setting off a wave of exploration in the Middle East. The first Persian oil find was the result of a seven year-long exploration project that had been funded by British speculator William Knox D’Arcy, with later financial support from the Burmah Oil Company. D’Arcy had negotiated a sixty-year concession with the Mozaffar al-Din Shah Qajar for oil exploration rights in an area of 1.2 million km2 – roughly the same size as South Africa. He paid ?20 000 (about ?2.1 million in today’s terms) for oil rights to almost the whole country, with only five provinces in the north excluded from the deal. In exchange, he agreed to pay the Persian government 16% of his annual profits. Soon after striking oil, Burmah Oil formed the Anglo-Persian Oil Company – renamed the Anglo-Iranian Oil Company (AIOC) in 1935 – with D’Arcy appointed director of the company. The British government purchased 53 percent of the shares in the company, gaining direct control over the Iranian oil industry. In 1933, D’Arcy’s initial contract with the Iranian government was renegotiated. The new agreement granted Iran a flat payment of 4 shillings per ton of crude oil exported. However, the contract also denied Iran the right to exercise any control over exports.

However, in 1951, the Iranian government – then under the leadership of Mohammed Mossadeq – nationalised the oil industry and AIOC was displaced by the formation of the National Iranian Oil Company (NIOC). AIOC withdrew from Iran and Britain contested the nationalisation, but the complaint was dismissed. Britain therefore organised a worldwide embargo on Iranian oil and, with assistance from the US, staged the 1953 Iranian coup d’etat that resulted in Mossadeq being replaced as Iranian Prime Minister by the pro-Western Fazlollah Zahedi. The extent of the involvement of Western powers in overthrowing Mossadeq remained secret until 2013, when a series of declassified CIA documents were published detailing how the CIA and Britain’s MI6 had worked together to engineer the coup. With the new Prime Minister in place, an agreement was reached between the Iranian government and a consortium of oil companies led by AIOC, which changed its name to British Petroleum (BP) at this point. According to the agreement, profits would be shared on a 50-50 basis between the consortium and the government-owned NIOC.

At the time when oil had first been discovered in Iran, Saudi Arabia had not yet formally become a state and although some geologists had collected early evidence that hinted at the presence of oil in the region, any largescale exploration was impossible whilst the land was under the rule of warring tribes. However, in 1930, Al Saud leader Abdulaziz (also known as Ibn Saud) became the first monarch of the Kingdom of Saudi Arabia, after a series of victories against other tribes. In 1932, he granted Standard Oil of California (SOCAL) exploration rights on 930 000 km2 of land – roughly the size of Nigeria – and SOCAL established a subsidiary called California Arabian Standard Oil Company (CASOC), which joined with the Texas Oil Company to form CALTEX in 1936. In 1938, CALTEX struck oil in the first of many discoveries that would reveal the region to be one of the largest known sources of crude oil in the world.

Oil became a central component in the world economy, driving economic growth both in the Middle East, which derived enormous wealth from its export, and in the Western world, where oil had become a critical input for industrial processes. By 1960, 85% of the world’s oil production was owned by the “Seven Sisters” – the forerunners of BP, Chevron, ExxonMobil and Royal Dutch Shell. These were all companies that were headquartered in the developed world – a fact that had not escaped the notice of the Middle Eastern oil-producing countries, who realised that they were essentially supplying Western countries with the raw material to produce petrochemicals, which they were then buying back at a highly inflated price. In an attempt to reclaim some control over their countries’ natural resources, oil-producing countries including Iran, Iraq, Kuwait and Saudi Arabia, formed the Organisation of Petroleum Exporting Countries (OPEC) in 1960. However, the cartel wielded little influence over the price of oil until 1973, when it unexpectedly found itself in a position of global power.

Tension between the Arab States and Israel had long been a source of instability in the oil-producing region, and this culminated in a series of wars, including the 1948 Arab-Israeli War for control of former British Palestine, the Suez Crisis in 1956 and the Six-Day War in 1967. Conflict erupted yet again on 6 October 1973, when an Arab coalition attacked Israel on Yom Kippur – the holiest day observed by Jews, which also coincided with the Muslim holy month of Ramadan that year. Israel was quick to respond – aided by the supply of arms from the US.

The US Airforce delivered tanks, artillery, ammunition and supplies to Israel, enabling it to hold its own in attacks from the Soviet-backed Arab Republic of Egypt and the Syrian Arab Republic. A ceasefire was imposed on 25 October 1973, but by then the US had made itself a dangerous enemy – OPEC imposed an embargo that banned oil exports to the US (and any other country that supported Israel) and cut oil production generally. In December, OPEC further announced that its members would set their own prices for export for the first time in history. The US, which had become hugely dependent on oil, negotiated with OPEC and the embargo was lifted in March 1974. However, by then the nominal price of oil had skyrocketed, increasing from approximately $3 to $11 per barrel. This introduced enormous commodity price volatility into an international market already experiencing increased levels of instability as a result of the failure of the Bretton-Woods Agreement earlier that year.

The Bretton-Woods Agreement was established in 1944 and introduced a regulated foreign exchange system, based on fixed exchange rates. After the Second World War, many countries agreed that a new monetary regime was required to facilitate war reparations and to ensure greater international economic stability. Under the leadership of British economist John Maynard Keynes and the US’s Harry Dexter White – then the chief international economist of the Treasury – the Bretton Woods system was devised at the United Nations’ Monetary and Financial Conference, held in the town of Bretton Woods, New Hampshire.

At the time, the US held three-quarters of the world’s gold supply and so it was decided that the US dollar would be pegged to the price of gold (set at $35 per ounce), and that all other currencies would be pegged to the US dollar. Essentially, the central banks of all other countries agreed to maintain fixed exchange rates between their currencies and the dollar. This inadvertently also forced nominal interest rates to remain stable in all areas where the fixed foreign exchange rate applied. The imposition of fixed exchange rates was therefore the cause of very stable interest rates worldwide for a period of almost thirty years after World War II.

As a result of the Bretton-Woods Agreement – as well as other legislation including the Glass-Steagall Act (1933), which effectively separated commercial and investment banking activities, and the Bank Holding Company Act (1965), which limited the size of banks by making them regional institutions – throughout the 1950s and 1960s, there was very little volatility in the US economy. Banks subsequently remained relatively small and concerned themselves with the generally straightforward tasks of taking deposits and lending money for mortgages. Under these stable conditions, the American economy underwent rapid growth until the 1970s. The US had been the recipient of significant capital and interest repayments at the end of World War II and new innovative products were being manufactured on a large scale, from domestic appliances, to equipment and – perhaps most importantly – cars. The US export market was particularly active owing to the weak dollar, and America quickly became the most dominant economy in the world.

However, as the US economy boomed, the Federal Reserve was put under pressure from government to maintain low interest rates and to boost money supply, which ultimately led to inflation and the rapid devaluation of the dollar. Inflation in the US spread to other countries thanks to the US’s increasing balance of payments deficits, which, in turn, created balance of payment surpluses in trade partner countries. Soon, US dollars held by other countries exceeded the US’s depleted gold reserves and when France and the UK announced their intention to exchange their dollars for gold in 1971, President Richard Nixon announced a temporary suspension of the dollar’s convertibility to gold.

Although an attempt was made to preserve the Bretton-Woods Agreement, by March 1973, it was dissolved, as governments opted instead for a system of floating exchange rates. This introduced foreign exchange volatility, interest rate volatility and commodity price volatility into the international monetary system, altering the economic landscape significantly. To illustrate just how pronounced the effect of this volatility was on the banking world, according to the Federal Deposit Insurance Corporation (FDIC), the number of bank failures in the US between 1940 and 1970 was almost zero. However, after 1971 this number increased rapidly, reaching a peak of nearly 300 bank failures by the late 1980s. This volatility was further compounded by the sudden increase in the price of oil imported to the West from the Middle East, which almost quadrupled between 1973 and 1974. By this time, because oil had become so central to industrial processes, price volatility in oil had a direct effect on the price of all outputs of industrial processes.

Today, OPEC includes thirteen countries and it controls 42% of the world’s oil supply. The cartel aims to keep the price of oil stable by limiting production, but its power to do so is increasingly threatened by oil production in non-OPEC countries, such as Russia, Canada, China and the US. In 1973, however, the increased price of oil played a significant role in further destabilising the US economy and exacerbated the underlying economic differentials that had been obfuscated by the fixed exchange rates embedded in the Bretton-Woods Agreement, and the overly stable interest rates that resulted from this. Together, the failure of the Bretton-Woods Agreement and the OPEC Oil Crisis introduced a level of complexity and volatility into the international monetary system that had never been experienced before. And in turn, the fundamentals of the financial system, and of banking in particular, were forever changed.  



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