Responding to questions from reporters yesterday, Barack Obama promised to restart a gimmicky Justice Department inquiry into whether speculators have unlawfully inflated oil prices. This task force was announced with great fanfare the last time gas prices were a big political issue, but it rarely met and didn’t accomplish much of anything. In other news yesterday, the price of Brent crude oil tumbled in response to both bad economic news from Europe and good diplomatic news from Iran. The juxtaposition should serve as a reminder that the idea of a rigorous separation between supply, demand, and “speculation” is nonsense. Speculators are speculating on, among other things, the likely outlook for supply and demand.
Under the circumstances, it’s ironic that the Obama administration is often attacked politically for its alleged softness on Iran. In the grand scheme of things, if the Iranian nuclear program really is a dire threat to American security, maybe something as petty as the fate of the economy doesn’t matter. But make no mistake, a war with Iran would have enormous consequences on the global price of oil, and it’s perfectly reasonable for speculators to take to the futures markets to try to bet on it.
How big of an impact on oil prices are we talking about? In January, UC-San Diego energy economist James Hamilton looked at four previous supply disruptions: the 1973 OPEC embargo, the Iranian Revolution of 1978, the 1980 Iran-Iraq War, and the 1990 Persian Gulf War. Hamilton found that at peak “these events took out 4-7 percent of net world productions and were associated with oil price increases of 25-70 percent.”
Iran, in case you were wondering, is currently responsible for 4.9 percent of world oil production.
So that’s big. Of course, an American or Israeli bombing of Iranian nuclear facilities wouldn’t mean that all of Iran’s oil would come off world markets. But then again, it might. This hard-to-assess probability is catnip for speculators. While it’s completely plausible to suggest that speculation is a factor in driving current prices, the speculators here are clearly the symptom, not the cause. This is what happens when there’s underlying uncertainty about whether or not 4.9 percent of global oil production is going to vanish.
But it gets worse.
Off the coast of Iran is the 21-mile-wide Strait of Hormuz between the Persian Gulf and the Gulf of Oman. About 20 percent of the world’s total global production—oil from Kuwait, Iraq, and Saudi Arabia—passes through the strait on a daily basis and could easily be disrupted by a war with Iran. If the Strait of Hormuz gets attacked by missile fire or irregular naval warfare, the effect on global oil prices would be apocalyptic.
I’m generally sanguine about the trend toward higher oil prices, but this kind of supply shock would be disastrous for the world economy. The fundamental issue is that the short-term price elasticity is low. Over the long term, people react to changes in gasoline prices by purchasing more fuel-efficient vehicles or by living someplace where they drive less. But the existing stock of cars gets replaced on a slow schedule, and the existing stock of buildings on an even slower one. So in the short term, people’s natural inclination is to respond to a small increase in the price of gasoline by consuming roughly the same amount of gas and cutting back on other things. It’s simpler to save money by switching from beef to chicken than to reduce fuel consumption. But when prices rise because of a disruption in supply, consumption has to fall. There simply isn’t enough oil to go around.
That means enormous price spikes. These work in two ways. One is that a sufficiently drastic shift in prices will lead people to undertake disruptive changes in their personal behavior. The other is that unemployment is a major fuel economizer. When households cut back on restaurant meals because all their income is going to gasoline, waitresses get laid off. When you don’t have a job, suddenly you’re not commuting, and energy consumption falls. Similarly, a collapse in factory orders means fewer and lighter trucks are on the road delivering goods. A severe recession and a major decline in the per capita level of economic activity, in other words, is the only way for the world economy to adapt to a sudden reduction in fuel quantity.
These are probabilities worth speculating over. It’s true that, absent speculation, the mere possibility of a future war wouldn’t cause oil prices to fluctuate wildly. But blaming speculators rather than the underlying geopolitics is a perverse form of shooting the messenger. The moral for politicians ought to be that in addition to the major national-security issues, the ongoing confrontation with Iran has important economic implications. As the speculators are telling us, disruptions in the availability of Iranian oil to world markets would be costly for the American economy, and broader disruptions in the Persian Gulf would be disastrous.