The oil price shock of 1990, during a period of increasing political tensions between several countries of economic importance with fundamental developments in the financial and economic systems taking place in most countries, turned out to be one of the most significant events of that decade. Questions like “What caused the prices of oil to nearly double?”,”What was its relationship with the Iraq invasion of Kuwait and what should be the course of recovery?” were lingering in the air thereby causing confusion and chaos all around the world.
Firstly, why should the price of oil matter? The main reason behind this is that oil, being one of the key components in most production processes, affects not only the cost of production, but also significantly leads to a decline in wages and employment, as these output losses are covered by cuts in other costs. Due to its high level of utility and lack of substitutes, oil has always been one of the most crucial resources of the world. The dependency on oil has led to its economic and strategic importance which subsequently validates why the prices of oil matter so much to the world.
The 1990s were a period of political instability in the countries of the Middle East. The economic situation before the Gulf War was highly concerning and additionally when Iraq invaded Kuwait (due to disputes and misunderstandings between the two biggest exporters of oil), the oil prices surged upwards. Many suspected that threat of invasion loomed over the country of Saudi Arabia as well, which was the worst-case scenario. This wasn’t new to the eyes; the world had suffered oil price shocks before, perhaps of greater magnitude than this one, but the situation was worrisome nonetheless, for both these countries accounted for a staggering 9% of the world oil production, producing 4.3. million barrels of oil per day. In July 1991, the price of oil was $21, $28 in August, and when the invasion took place, it rose to $46 in mid-October which was the Oil Price Shock of 1990.
Many argue that the cause behind this rise was solely based on Iraq’s invasion of Kuwait; however, prices were rising much before the invasion took place. Oil and Petroleum Exporting Countries (OPEC) negotiations to bring down the supply of oil led to a rise in prices initially. The United Nations (UN) on August 6, 1990, passed the sanctions forbidding Kuwait and Iraq to export oil. This resolution led to nearly a 7% decrease in world output as two of the biggest suppliers of oil were out of the game. This embargo combined with Iraq’s invasion and OPEC negotiations took no time to cause a rapid rise in oil prices. After the invasion caused the rapid increase in prices, they finally began to decline after nearly 5 months, a much shorter duration than expected. Soon after the invasion, many countries took to precautionary measures and maintained high levels of inventories for anticipatory increasing demand. Observing that the situation wasn’t about to get much better, many countries decided to increase their supply of oil, thus wiping out the excess demand created and completely offsetting the loss of 4.3 million barrels.
After the commencement of Operation Desert Storm began in mid-January 1991, which was the US military intervention to combat the occupying Iraqi forces, prices took a plunge and fell back down to about $20, thus reaching the same level from where it started. The reason behind this quick recovery was the ease in tensions between these countries that led to an increase in business and consumer confidence. Many people wonder why the oil price shocks of the early 1990s weren’t as confounding to the world as the previous oil price shocks of the 1970s, specifically 1973 and 1979, and there is no single answer to that question. There’s a two-fold argument for this: the imports had taken a plunge worldwide owing to previous price shocks, and the other being equal the fall in dependency on oil as an energy resource.
Notwithstanding the short-lived effects of this oil price shock, the impact was multi-fold. The import volumes were significantly reduced to an extent. However, the trade import bills raised considerably, owing to the price inelasticity of the demand for oil due to the lack of substitutes available. These surges in import bills led to varying changes in the balance of payments of various countries, depending on their import structure, financial stability, transfers, and reserves. While countries of Brazil and India didn’t take a major hit to their GDP and GNP, others like Korea, Turkey, Yugoslavia, Thailand, and the Philippines saw a major increase in their trade deficit. The varying impact on these countries can be explained through reasons of increased export activity and curtailed imports.
More than a year later, a sharp rise in unemployment was noticed and the requirement of an immediate and suitably accommodating monetary policy was felt. However, The United States’ Federal Reserve along with the central banks of other countries worldwide decided not to tamper with the existing interest rates and pretended as if the price shock hadn’t even occurred. Earlier on in 1988, the US had increased interest rates to curb high rates of inflation (4.14%) and accelerate growth in levels of productivity and output. The inaction on part of the US also stemmed from its firm belief in the success of Operation Desert Storm. The US government also revised the Gramm-Rudman-Hollings Balanced Budget Act, by adjusting its budget according to the prevailing negative economic condition. Thus, the financial response from the world was quite mild, owing to the short-term effects of the shock.
The oil price shock of 1990 is an event of paramount importance. Though short-lived, there are various lessons to be learned from this economic crisis, as has been noticed to be put in use in successive price shocks and crashes in the 2000s. Economic structures are complicated and often take a while to grasp in all their entirety, but once understood in their true spirit, they can help prevent future catastrophic economic crises.