Historical Event

The Iranian revolution and the oil price shocks that followed catalyzed a number of important changes in petroleum markets that remain in place today. The Iranian revolution sparked the world’s second oil shock in five years. Strikes began in Iran’s oil fields in the autumn 1978 and by January 1979, crude oil production declined by 4.8 million barrels per day, or about 7 percent of world production at the time. Other producers were able to make up some of the volume, resulting in a net loss of supply of about 4 to 5 percent. Nevertheless, oil prices climbed rapidly, rising from $13 per barrel in mid-1979 to $34 per barrel in mid-1980.

But how large is the impact?

Deregulation of American fuel market Iran's revolution, 40 years onPrice controls on gasoline exacerbated shortages, by not allowing rising prices to curb demand. The controls allowed refin-Histoers to raise gasoline prices each month based on the previous month’s crude oil price. In an environment of rising prices, the price controls incentivized refiners to withhold gasoline and sell it later at higher prices, rather than selling it today. Further aggravating the shortages, the federal government had an allocation system that did not allow gasoline distribution to adjust to demand conditions around the country. Some states also established a policy rical that only allowed drivers to buy $5 of gasoline at a time, meaning that they had to buy more frequently, virtually ensuring longer lines. Crude oil markets were regulated as well. Different prices for “old” and “new” oil were a relic of the earlier oil shock in 1973-74 that established perverse incentives, reducing domestic production and increasing imports. Additionally, in April 1979, the Event

Department of Energy ordered large refiners to sell crude oil to smaller refineries that could not obtain affordable supply on the market. However, these smaller refineries were generally less complex, able to produce less gasoline from a given crude oil than their larger counterparts, deepening the supply shortage.

The situation drove a groundswell of anger against U.S. oil companies and public support for President Jimmy Carter dropped substantially. The crisis highlighted the inefficiencies inherent in government control of fuel markets, although the public wanted the government to do something about high prices and long lines. President Carter began to repeal price controls on crude oil in 1979, but the energy crisis, along with the Iran hostage situation, were significant factors in President Carter’s 1980 election loss. Soon after his inauguration, President Reagan removed the remaining federal controls on domestic production and distribution of crude oil and gasoline. Rise of non-OPEC oil production Some of the most important lingering effects of the Iranian revolution occurred afterward, as the market recovered from the price and supply shock. Oil producers around the world responded to the two crises of the 1970s by investing in exploration and production. Additionally, several large fields that had been discovered in the previous decade began substantial production.

In total, non-OPEC producers added 5.6 million barrels per day of crude oil production from 1979-85. In response, OPEC drastically cut production, setting a limit of 18 million barrels per day in March 1982, compared to the 31 million barrels per day it had been producing at the time of the Iranian revolution.

At the same time, the high oil prices of the previous years and a global recession in the early 1980s brought about declining oil demand. World oil demand fell by about 10 percent from 1979 to 1983. Because of growing supply and shrinking demand, oil prices crashed in the 1980s, declining 40 percent between 1981 and 1985 before collapsing another 50 percent in 1986, down to $12 per barrel.

Development of crude oil spot market Long-term contracts were the primary means of buying and selling oil at the time of the Iranian Revolution. Therefore, the loss of Iranian oil unevenly affected buyers during the immediate crisis. Buyers with Iranian contracts scrambled to replace the missing oil, while buyers who held contracts with other producers dealt with higher prices, but not actual scarcity.

The crude oil shortage after the Iranian revolution increased the role of the spot market, but the oversupply that followed cemented the demise of long-term contracts at set prices. The surge of supply that came online in response to the second oil shock made spot prices lower than contract prices. Right after the revolution, buyers turned to the spot market willing to pay almost anything for scarce oil. However, in the early 1980s, they turned to the spot market to shop around and find the cheapest source of supply. (SUN)