Twenty Years after the Energy Crisis: What Lessons Were Learned?

Twenty years ago, some motorists acquired the foresight to bring along reading matter while sweating out the inconvenience of long gasoline lines. Those Americans would have gotten the impression from their morning papers that they were the victims of a successful effort by the Organization of Petroleum Exporting Countries (OPEC) to dictate the price and supply of world oil. During the winter of 1973–74, a quadrupling of the world oil price encouraged the belief that a new OPEC-dominated era had dawned, with profound implications for oil, energy, and economic well-being. A renewed escalation of oil prices in the wake of the 1979 Iranian revolution reinforced that belief.

Although oil-related economic and geopolitical concerns can never be totally dismissed, a closer look at what occurred in the 1970s and at what has happened since serves to correct common misimpressions about the causes and consequences of the "energy crisis." As we mark the twentieth anniversary of the gasoline lines that symbolized that crisis, the world oil market seems calm. World oil prices, adjusted for overall inflation, are today but a fraction of what they were expected to be. Still, energy experts note that the proportion of imports in U.S. oil consumption is near its historic 50 percent share. Policy analysts are again asking how important it is for the United States to limit its dependence on oil imports, whether we can do more to use energy more efficiently, and how difficult it will be to manage environmental concerns associated with energy use.

To probe just how much has been learned from the energy crisis, a symposium at the University of Tennessee in April of this year considered the subject, "Twenty Years after the Energy Shock—How Far Have We Come? Where Are We Headed?" At the symposium, we presented a paper that addressed the topic, "The Energy Upheavals of the 1970s: Socioeconomic Watershed or Aberration?" Here we present our findings organized around five broad questions.

What did the energy crisis teach us about the strengths and weaknesses of government intervention in energy markets?

The short answer: U.S. government policies facilitated and aggravated the energy upheavals of the 1970s. The effects of these policies were far greater than those of the Arab oil producers' limited 1973–74 production cutbacks and of their embargo. Among the government's counterproductive policies, three are especially worth recalling. First, price controls, which lessened incentives to find and produce natural gas, impeded a shift away from oil—this at a time when oil demand had been rising rapidly. Second, oil price and allocation controls, introduced by the Nixon administration in the early 1970s as part of a broader anti-inflation program of price and wage controls, had the effect of channeling U.S. oil demand into greater imports, rather than advancing the goal of reducing imports. This policy contributed, in due course, to abandonment of the mandatory oil import quota program, begun in 1959.

Probably the most misguided intervention during the oil price shock, however, was the entitlements program, under which refiners with access to cheap, price-controlled domestic oil in effect subsidized refiners dependent on costly imported oil. The resulting averaging of imported-oil and domestic-oil prices could not, of course, contain overall price increases as the oil import share rose, but it kept those prices below their unregulated level. The perverse result: Domestic consumption was encouraged, production discouraged. In the course of one year, the United States switched from officially restricting to effectively subsidizing oil imports—an ironic twist to the then-popular view that we were in the grip of a cartel with a demonstrated capacity and will to wreak havoc on the international economy.

Although less directly interventionist, a whole series of government programs came into being. Some—notably an attempt to establish a synthetic fuels industry—were destined to collapse quickly, though not without some hefty bail-out from taxpayers. Other efforts continue to this day.

We note here only a few of those programmatic initiatives. In 1975, Congress enacted legislation mandating automotive CAFE (corporate average fuel efficiency) standards, continued oil price controls, and created the Strategic Petroleum Reserve. In 1978, it enacted the Public Utility Regulatory Policies Act (PURPA)—which sought to promote innovative resource and technology applications in electricity generation, as governed by avoided-cost criteria—and the Energy Conservation Policy Act (ECPA), which required utilities to provide conservation services and introduced mandatory equipment efficiency standards. The Natural Gas Policy Act of 1978 provided for phased decontrol of wellhead gas prices. Separate legislation committed the nation to decontrol of oil prices. In 1980, the Energy Security Act created the short-lived Synthetic Fuels Corporation (SFC). And so on …

With benefit of hindsight, it's easy to critique some of these efforts (like the hopelessly unrealistic synfuel production targets and poor management of the SFC). But other programs deserve a more tempered judgment. To this day, for example, there are respectable arguments over the respective influence of Obligatory CAFE standards versus market forces in bringing about the impressive automotive fuel economy gains of the last twenty years. PURPA's directional nudge to much more competitive electricity generation was surely beneficial, notwithstanding some economic distortions occurring in the start-up years. And, of course, oil and gas price decontrol proved critically important.

Before long, the oil price shocks of the 1970s began to produce fundamentally changed views regarding the consequences of an interventionist government and, conversely, the value of unimpeded energy markets—a point reverted to below. While the initial response to the oil crisis, following a well-established tradition, was more government intrusion, within several years it became clear that government regulation would not only fail to extricate us from our problems; it was responsible for actually worsening the crisis. And so, by the late 1970s, even an interventionist-prone Congress began to realize that existing trends had to be reversed and that only by moving toward less regulated markets could the prevailing encouragement of economic inefficiency be reduced. That process continues to this day, notably in the case of electric and gas utilities.

What insights did the energy crisis provide about the world oil market and, by extension, other resource markets?

Early in 1994, oil was trading at around $15 per barrel. In real price terms, then, oil is back to where it was prior to the first oil shock. At the same time, OPEC's share of world oil production is markedly down from its mid-1970s high, and energy sources other than oil make up a significantly increased proportion of the global energy mix. In the United States, per capita energy consumption is below its 1973 level. These facts reflect the substantial flexibility with which both supply and demand forces can adapt to changing market conditions.

Yet recall that, amid the concern sparked by the Arab oil embargo and quadrupling of oil prices in the winter of 1973–74, smart people saw OPEC as the likely harbinger of a string of successful commodity cartels around the world. In testimony before Congress in early 1974, Fred Bergsten, then at the Brookings Institution, said, "There can now be no doubt that a large number of primary producing countries will be making steady, determined, and often concerted efforts to raise substantially their returns from a wide range of commodities which they produce. . . through the formation of new OPECs. . . [and] many of them are in an excellent position to do so." And in what seemed to signal a reversal of this country's general aversion to international commodity price agreements, in 1975 U.S. Secretary of State Henry Kissinger indicated a willingness to contemplate such agreements, at least on a case-by-case basis.

As it turned out, over the last two decades, adjustments in oil specifically and in energy generally have conformed to what our understanding of energy markets should have told us would have happened. As already noted, the energy mix shifted away from oil, particularly outside the United States. Demand slowed, and energy began to be used more economically. Incentives created by the new price realities favored exploration in and new supplies from non-OPEC oil sources (see figure, p. 18). And, in the face of these pressures from both the demand and competitive supply sides, OPEC's ability to make its members respect allotted market shares within a shrinking pie began to weaken and then falter.

Amid all this, the introduction of market instruments long utilized in other commodity markets (for example, futures and spot markets) and new business strategies (for example, dual-fuel capability by utilities) would contribute to both forestalling disruptions and cushioning the effect of those that occurred.

On a somewhat more subtle level, the past twenty years have also made clear the futility of our trying to insulate the United States from the instability of the world oil market. Back in 1974, President Nixon's Project Independence envisaged complete self-sufficiency as a viable American objective. We have since learned that the domestic economy cannot be shielded from events in the world oil market, regardless of how much oil we import. Domestic oil prices are determined by world oil prices.

We have also learned that the United States cannot influence the world oil market without taking into account the actions of the rest of the world. An increase in oil demand or oil supply, whether it originates in the United States or elsewhere, has the same effect on that market. This interdependent feature of the world oil market also means that policies implemented by the United States alone will have limited effects on the world oil market and could be offset by the actions of other countries. What has long been true for other commodities is now recognized as true for oil.

With falling world oil prices since the mid-1980s raising the imported share of U.S. oil consumption, energy dependence—and the bearing which such dependence may have on energy insecurity and economic vulnerability—remains, for many policymakers and special interests, a charged issue. (Note the successful recent petition to the U.S. Department of Commerce by the Independent Petroleum Association of America for an examination of the security implications of oil import dependence. A finding that a threat to national security exists could be used to invoke protectionist measures.)

At issue are, first, the likelihood of major oil price shocks to oil-importing countries—whether purposefully or accidentally triggered—and, second, the economic consequences of such disruptions. In the spirit of camaraderie that prevailed among oil-importing countries for a few years (partly through the existence of the International Energy Agency, which was created in 1974 to coordinate the energy policies of Western countries), there was hope of being able to stave off such impacts through the use of strategic stock-piles and coordinated demand restraint measures. In fact, that joint strategy never blossomed—in part because the OPEC threat is seen as having receded. Among the initiatives of individual countries, the most visible defensive measure continues to be the U.S. Strategic Petroleum Reserve (SPR), now amounting to nearly 600 million barrels. The evolution of the SPR as an important, but limited, thrust of U.S. energy policy was the early recognition that only at an intolerably high cost could the self-sufficiency preached by Nixon be approached, much less achieved.

Regarding the economic consequences of major oil price shocks, it is worth underscoring two points elaborated by Douglas Bohi in Energy Price Shocks and Macroeconomic Performance (RFF, 1989). First, empirically, the economic damage through lost national output and inflation accompanying the second oil price shock in 1979–80 was uncorrelated with the degree of oil import dependence. And second, conceptually, if what matters is the price of oil—the domestic price of which is determined by the world price—then reducing imports would not alone improve energy security. That recognition shifts the burden of oil import policy to stabilizing the world price of oil during crisis situations, and, to this end, the SPR can be said to offer a sort of backstop strategy, although it begs the question of what stockpile magnitude is justified on cost-benefit terms.

A more basic and unresolved question is whether the vulnerability of the economy to energy price shocks is really as great as some interpretations of the events of the 1970s would have us believe. What is less debatable is that we cannot go wrong by doing what we can to increase the elasticity of energy supply and demand. For example, we can encourage technologies that extend the range of energy options. In addition, through environmentally justified policies (such as, arguably, a higher gasoline tax), we can lower the energy intensity of the economy.

But emotions and myths continue to influence the issue of how best to protect the country from energy shocks. One example: oblivious to the price controls and allocation schemes responsible for the gasoline lines in the 1970s and to our limited capacity to influence the world price of oil, Senator Patty Murray (of Washington) recently voiced her support for an extension of the ban on Prudhoe Bay oil exports, observing that "Alaska North Slope oil provides an insurance policy to consumers on the West Coast that the giant gasoline lines of yesterday will not reappear because of the irrational acts of some Middle East despot or a group of crazed religious zealots" (Environmental and Energy Study Institute's Weekly Bulletin, March 14,1994).

What did the energy crisis reveal about our ability to analyze, model, and project energy developments?

Again with the benefit of hindsight, it's easy to point to misjudgments made fifteen or twenty years ago, and not just in the policymaking arena. Academics and business planners—in whose judgments policymakers presumably placed some confidence—also turned in a pretty spotty performance. An example in the electric utility sector was the costly failure to perceive the dramatic reduction in electricity demand brought about by higher prices (see figure below). Construction programs based on historic growth rates, and often sanctioned by regulatory commissions, soured as excess capacity, higher interest rates, and (especially in the case of nuclear plants) cost overruns all took their financial toll, at which point many regulators blamed the utilities for imprudent planning.

A key analytical problem was that econometric studies of electricity or, say, gasoline demand provided little historical empirical basis for judging elasticities: the demand—or, for that matter, supply—response to sharply higher prices. In an interesting case of asymmetry, ten-year projections made by the U.S. Department of Energy in 1975 wound up overstating energy consumption by about 25 percent, not because of faulty economic growth assumptions, but because of flawed elasticity measures. At the same time, the projection for the U.S. oil supply led to a 35 percent overstatement. But then economists have always had trouble forecasting oil supply, which after all is predicated not merely on firms' strategic behavior but on technological and geological success as well.

Forecasting failures and scorekeeping aside, the general experience of the last twenty years reminds us that society does respond rationally to economic incentives. People alter the way they consume energy; firms invest in new technology; and new institutions arise that inject greater efficiency into world energy transactions. In other words, what is taught in Economics 101 tends largely to be true. While these lessons are no guarantee against future energy shocks, the more reliable analytical insights and stronger empirical base that we now have should help us, at the very least, to avoid doing harm and, at best, define more judicious policy choices than those we embraced in the past.

How have oil and related energy shocks altered the way we think about the environmental and other social consequences of energy?

It would be wrong to ascribe to the energy upheavals of the 1970s all the credit for the way in which our consciousness has been raised on the broader social impacts and ramifications of energy—namely, environmental and public health threats, resource scarcity, and sustainability.

Those issues had drawn visible attention prior to 1973 in the academic, ideological, and policy arenas. While some expressions of concern had an alarmist edge, there were also more restrained efforts to consider the possible dilemma of having to trade environmental integrity for economic growth and resource demands. The decade preceding the first oil shock also saw enactment of important statutes directed at health, safety, and environment—for example, the Occupational Safety and Health Act and the Clean Air Act. And plenty of examples in the economic literature can be cited that argued for socially efficient means to force polluters to bear the cost of their assaults on common-property resources.

Did the oil price shocks of the 1970s constitute some kind of watershed or defining moment in our understanding of and ability to deal more rationally with energy upheavals, and more broadly, with the larger resource and environmental issues of which they are a part? Clearly, characterizations like "watershed" or "defining moment" are overly theatrical labels for the 1970s, which did not usher in an era in which cartels manipulated petroleum and everything else from Brazil nuts to bauxite. In a couple of respects, the 1970s did represent a significant benchmark: a sobering lesson on the misplaced confidence in the effectiveness of government intervention and, conversely, an appreciation (or maybe rediscovery) that markets work and that energy is not wholly different from other economic necessities bought and sold in the marketplace. At the same time, notwithstanding the sometimes diversionary and hyperbolic preoccupation with doomsday scenarios, we have developed a heightened consciousness about the prevailing and long-term social impacts of energy that we must continue facing up to. And that is welcome.