🔋Crude Awakening Pt. 3

Takeaways and implications for our future based on the consequences of the oil crisis in 1973.

Oct 19, 2022

This is part 3 of a 3 part series on the 1970s and how the environment of that time compares/contrasts to what we are going through today. More importantly, what does it mean for the world moving forward in terms of the economy, energy policy, and more. If you enjoy, press the heart button above or below I would greatly appreciate it! :)

Part 1

Part 2

Stagflation? There are big differences between the 1970s and today - ABC News — abc

Oil and Inflation

Last week I compared and contrasted the period immediately following the OPEC oil embargo in 1973 to the world today. In it, found here, were some key comparisons that helped us understand what may be on the horizon, some key historical points that have led to the macro picture today, as well as distinguish it as a unique period in history. Today will be about what may happen next based on that time period, and what the implications of the early 1970s mean for us moving forward today.

As I briefly mentioned last week, the price of oil globally has not spiked in a similar fashion to that of the 70s. This can be attributed to in part by more diversified oil production, tapping the strategic petroleum reserve, and lockdowns in China stifling significant oil demand. Europe has not fared as well due to their heightened dependence on Russia oil and gas supply and seen prices for energy and electricity skyrocket. While it is unknown how well Europe will fair this winter and next due to their ability to price out emerging markets countries for natural gas and the US becoming the largest natural gas exporter to Europe improving their chances, it is conceivable that a financial crisis could start as a result. Due to the extensive energy bailouts and bond purchasing programs by the Bank of England, these policies contradict the stated efforts to tighten financial conditions to fight inflation. Europe seems to be in a tricky dilemma that could conceivably spell disaster through continued rampant inflation or financial market collapse in banks, pension funds, or a sovereign default.

As a consequence of inflation becoming entrenched psychologically like what was seen in the 70s, prices tend to spiral out of control. If people are worried that things will be more expensive in the near future, it pushed their spending habits forward. This causes people to rush out and buy things, shelves to empty, and reserves to be drained. This causes shortages that in turn contribute even more to inflation. This is a phenomena we saw acutely during the pandemic and one we could see again if inflation became entrenched again today.

Economy

The Federal Reserve was unable to cushion the blow dealt to the economy by the surprise jump in oil, as it was still trying to catch up with runaway inflation—inflation that resulted in part from misguided political pressure to keep interest rates low. Stagflation took hold, as inflation soared and the economy suffered the double whammy of the highest energy prices on record and higher interest rates. Stocks crashed: The S&P 500 lost 43% in 12 months, the most since the Great Depression of the 1930s and a drop not exceeded until Lehman Brothers collapsed in 2008.

WSJ

DJI (stock market) in dark blue, oil in orange, inflation in light blue, and federal funds rate (interest rates) in yellow. Start and end of the embargo are denoted by the black vertical lines.

Inflation was rising before the oil embargo, and in response the federal reserve was raising interest rates. Like the WSJ article said, the majority of the oil embargo occurred while interest rates were decreasing (simulative/easy monetary policy) which only exacerbated the inflation problem. Following the end of the embargo, the US would enter a recession that coincided with an end to the fed funds rate tightening cycle and a further drop in the stock market. The bear market was not over until inflation had peaked.

Today is different as the federal reserve has been late to hike interest rates for inflation, however they now are committed to keep and hold interest rates high unlike the mistakes made in the 70s. The question today is whether the worst is really over? There is a case for peak inflation in July which would be good for markets, but if inflation is unable to stay down it could spell further trouble for the markets. Anything could happen, but we have not seen the plethora of issues that wrought 1970s yet if it is truly another global energy crisis.

DJI (stock market) in dark blue, oil in orange, inflation in light blue, and federal funds rate (interest rates) in yellow. Vertical lines represent dates of the onset of the Russian invasion of Ukraine and the Nordsteam 1&2 sabotage.

Nixon actually urged the federal reserve (an “apolitical” organization) to lower interest rates to stimulate the economy as he was concerned he would not get re-elected if the country entered a recession. Nixon is quoted as saying,

We'll take inflation if necessary, but we can't take unemployment.

What is ironic then is that unemployment ticked up regardless, and really began to pick up in the months following the conclusion of the embargo. Nixon handed the reigns to Ford halfway through the doubling of the unemployment rate from Oct ‘73 to May ‘75. What is ironic today is that the federal reserve is seemingly saying the opposite. They have implied that there will be “pain” and they will do whatever it takes to reign in inflation. Once the interest rate hiking cycle begins, unemployment rate tends to tick up 1-3 years later which is an unfavorable environment politically as well.

Unemployment rate in blue, federal funds rate (interest rates) in yellow. Black lines represent start of hiking cycle and red lines represent start of significant rise in unemployment.

Signposts

Signs that the past is rhyming would be a crashing stock market, resurging or inability to lower inflation to the target of 2%, government rules/regulations to limit energy use, and price controls. US/Russia today are both stronger than US/Saudi Arabia then as the US is more energy independent and Russia has other major buyers of oil and resources (China and India). With the strength of the Ruble despite sanctions, Russia is much less likely to cave into any deal with the US as quickly as Saudi Arabia. Many nations in the 70s distanced themselves from the US as they did not want to get hit with an embargo themselves. India today is a prime comparison as they are buying as much Russian energy as they can against the wishes of the US. Division within the EU or NATO today could be similar consequences we have yet seen.

After the embargo, exploration and development of other forms of energy were increased. From new oil production in Alaska to new nuclear reactors, energy became a priority. We could be on a similar path today as nuclear and renewables gain favor. It is also entirely possible that further oil and gas production ensues in light of the Russian supply that came offline. Conservation efforts picked up steam, and could be something we see again if energy issues become bad enough.

I have yet to hear of any threats of jail for not complying with current energy policies like was seen in the Netherlands in the 70s, but going forward if things get worse I wouldn’t rule it out. Protests have been increasing in Europe and emerging markets . Potential hardship this winter or next could spell further unrest or even authoritarian measures similar to those implemented during the COVID pandemic.

Paul Volker, federal reserve chair ‘79-’87 is largely credited for finally breaking the back of inflation with his big interest rate hikes and willingness to let unemployment rate rise. The high debt to GDP causes more problems this time around compared to the 80s because the cost of servicing debt becomes more difficult as interest rates rise. With Volker as inspiration today, an increase in unemployment rate is likely due to the fast hiking cycle undertaken by the fed in recent months. Those very interest rates could spell default issues for sovereign nations with dollar based debt, business, and individuals alike.

Conclusion

By defaulting from the gold standard and pursuing reckless monetary policy (excessive government spending largely due to Great Society social programs and the Vietnam war), other countries (OPEC in this case) felt that it was not fair in the early 70s. This is the “Keynesian” economic policy experiment of government funding through budget deficit and little in the way of fiscal restraint. Since the US had been issuing new money for its own benefit, there was a market distortion for the price of oil. In reality, one country cannot “print” oil, but the benefits of easy money and cheap oil prices bided a long period of prosperity prior to the 1970s. The price of oil clearly needed an adjustment, brought forth in a horrific way by the oil crisis that ensued. The lack of investment/ability for the US to continue increasing oil production was also in part due to low prices of oil, ironically exacerbating the issue.

The energy mistakes of then and today can ultimately be traced back to policy mistakes by the governments involved. Their policies in response to the issues do little to tame inflation, make living conditions worse, and in many cases seek to exacerbate the issues they attempt to resolve such as destroy market forces, impose regulations and restrictions on the people, and contribute to worse economic conditions through increases in unemployment and inflation.

The 1970s as a whole were a period of lackluster stock performance with high inflation eating away at people’s purchasing power. Hard assets like gold and oil vastly outperformed the stock market index by a significant margin in the decade. The actions, agreements, and policies of the time had long lasting impacts and spurred major secular changes in trends into the present. To name a few; unbacked fiat currency, increasing income inequality, divergence in political ideology, ballooning government debt, loss of meaning/purpose, increasing incarceration rate, higher healthcare expenditure per capita, and much more.

Only time will tell how closely the 2020s rhyme with the 1970s, how we may fare compared to those at the time, and whether the stagflation today will be a worthy comparison. I think it wise to know what the signs of worsening stagflation like the 70s may be so we may have some idea of what is possible and probable from a macro and government policy perspective, and how to be prepared individually for various conditions. May history serve as a guide and lessons be learned from its mistakes. Until next week,

-Grayson

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