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Oil, War, and Peace

It is impossible to fight a modern war without oil. The outcome of World War II was determined largely by who had or could get the stuff. The United States was able to enter and win the war because it had an abundant domestic supply of petroleum for its planes, ships, and tanks.

Germany and Japan had little domestic supply, and much of their military effort was aimed at capturing foreign sources. Hitler attacked Russia in part because Germany needed Russia's oil and had to try to take it regardless of the risk. When Japan bombed Pearl Harbor, it wasn't to seize all the cool surfing spots. Japan wanted to keep the United States from interfering with its plans to seize the oil resources of the Dutch East Indies.

At war's end, the United States stood alone. It had oil and lots of it. Its infrastructure was intact, while the industrial centers of Europe and Asia lay in ruins. Its economy was poised for rapid growth as millions of returning soldiers set about building their careers.

The U.S. economy developed into such a juggernaut that domestic oil production couldn't keep up. In 1949, the United States crossed over from net oil exporter to net oil importer. From there, imports kept increasing, which increased U.S. reliance on supplies from unstable and unfriendly countries. By 1972, half the oil the United States consumed was imported.

Then, in October 1973, the Yom Kippur War led to a huge shock to the politics of oil.

The conflict itself—between Israel and a coalition of Arab states led by Egypt and Syria—lasted only three weeks. It began when the Arab coalition launched a surprise invasion of territories Israel had captured during the Six-Day War six years earlier. That was followed by massive resupply efforts by the United States for its Israeli ally and by the Soviet Union for the other side.

After initial success by the Arab armies, Israeli counteroffensives pushed the Arabs back into Syria and captured the Sinai. A ceasefire was reached on October 25, leaving Israel in possession of large stretches of hitherto Arab territory.

The war had far-reaching consequences. The Arab world had sustained another humiliating defeat at the hands of its despised enemy. For its part, Israel took heavy casualties and, despite its sweeping success on the battlefield, felt the beginnings of doubt that it could always dominate the Arab states militarily. Thus came negotiations that culminated in the 1978 Camp David Accords. Israel returned the Sinai to Egypt, and the two countries settled into a none-too-friendly peace.

A more immediate blowback from the war was retaliation by the Organization of Arab Petroleum Exporting Countries (OAPEC, consisting of the Arab members of the Organization of Petroleum Exporting Countries [OPEC] plus Egypt, Syria, and Tunisia). Furious with the West for resupplying Israel, OAPEC imposed an oil embargo against Canada, Japan, the Netherlands, the United Kingdom, and the United

Nominal versus Real Price of Oil

Figure 3.1 Nominal versus Real Price of Oil

Source: Energy Information Administration. © Casey Research 2014.

States. It lasted from October 1973 to March 1974, and it hit hard. Everyone who was there remembers the gasoline shortages, rationing, and long lines at filling stations.

The embargo triggered a sharp increase in oil prices. For most of the preceding quarter-century, oil's price in U.S. dollars had risen by less than 2 percent per year. On October 16, 1973, OPEC raised its posted price by 70 percent, to $5.11 a barrel. Concurrently, oil ministers agreed to cut production by 5 percent and to continue cutting until their economic and political objectives were met. (See Figure 3.1.)

It takes time for consumers of a basic commodity like oil to adjust fully to a drop in supply. So the market's immediate response to even a modest drop in supply can be an oversized jump in price. In the case of OAPEC's announced production cuts, the market price of oil leapt from $3 per barrel to $12, setting the United States on a path of recession and ghastly high inflation that continued until the early 1980s.

Meanwhile, through self-inflicted wounds, the Soviet Union was setting itself up to lose the Cold War.

The narrative that the Soviet Union was somehow laid low by Ronald Reagan makes for a nice story, but it's largely myth. What brought the United States' erstwhile adversary to its knees was, yes, oil— or, more specifically, the way the Soviet Union fatally mishandled its vast petroleum resources.

Thanks to a rich natural endowment, oil and gas were profitable for the Soviets. Given that almost everything else in their centrally planned economy operated at a loss, the petroleum industry was the Soviets' lifeline. But they neglected that lifeline by failing to reinvest enough of the profits to increase or even maintain production rates. Instead, they diverted the revenue to support minimum living standards for the public.

Exploiting an oil field requires ongoing capital expenditures. Skimp on that spending, and production suffers. With so little capital going back into the oil fields—to drill new wells, maintain existing wells, and revitalize old wells with secondary production methods—the Soviet oil industry was withering. Of course, rising prices can offset declining production, but only as long as prices keep rising.

After the Arab oil embargo, as Soviet production continued to fall, the world price of oil plummeted. There was neither enough money to subsidize basic goods for the public nor enough to maintain the oil fields, so production was allowed to continue its slide.

The problem haunted the USSR's government for two decades. Oil production dwindled by 55 percent. Russia had long been a major producer, and now it couldn't even cover its own needs. Nor did it have the wherewithal to develop the new technologies that were driving the growth of Western economies.

The USSR's dependence on oil coupled with its failure to maintain its energy infrastructure left it brittle. The post embargo drop in world oil prices shattered it. That's the real reason the Soviet Union lost the Cold War, not Reagan's saber rattling. In 1989, the USSR broke apart.

And so the war ended. Fueled by cheap energy and control of the sector, and equipped with the intellectual capital that is a by-product of freedom, the United States emerged as the world's only superpower.

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