Iraq And Oil Crunch Update See Alan

Iraq and the Oil Crunch?

Update: See Alan Richards’s reply at end

Jim Krane of the Associate Press quotes analysts who seem to blame the high price of petroleum in part on the shambles in Iraq. Iraq could be exporting nearly 3 million barrels a day (bbd) if the guerrilla war was not resulting in massive sabotage. In 2005, Iraq did only 1.4 million bbd on average, down from 2.8 mn. bbd before the American invasion. Not only is Iraqi production way off (less than a million bbd per day on average in January of this year!), but Iraq actually imports over $4 billion a year in petroleum products, taking them off the market for other consumers.

I have to be very careful how I say this, because the oil market is a complicated subject and I am not an economist. But I can’t imagine that Iraq really is much of a factor here. The world petroleum production is on the order of 86 million barrels a day. so the lost 1.4 million bbd of Iraq is about 1.6% of the total. Even if you factor in Iraq’s imports (and remember it doesn’t have much of an economy at the moment), I can’t imagine that Iraq production issues account for very much of the current price spike.

Some economists argue that there is a lot of speculation, including a security premium, built into the current price, because you have war and rumors of war (i.e. Iran) going on in the Oil Gulf. A ten percent security premium is the difference between paying $3.00 a gallon for gas and $2.70. A 10% security premium of a speculative sort, deriving from nervousness about the future of Iraq and Iran, is actually much more consequential than the 1.6% reduction in world production because of sabotage in Iraq. The NYT implies that petroleum today, like the South Seas stocks or the tulips of the 18th century, is characterized by speculative investment bubble, just because the run-up in prices attracts investors. That really isn’t an Iraq effect.

Although I am not an economist, primary commodity markets are pretty sensitive to simple things like supply and demand that most of us can grasp without greek letters. Troubles in Nigeria, Venezuela and Mexico have taken 2 million barrels a day off the market, i.e. a good 2 percent. So with Iraq, that is a 3 1/2 percent production shortfall.

The main bottleneck in supply isn’t raw petroleum production but a shortfall in world refining capacity (in other words we have more crude oil than we have gasoline). And the rapid rise in demand is partially seasonal, with Americans and Europeans hitting the road in the summer (and the anticipation of it), along with an ongoing secular upward pressure on prices coming from the with heated economies in China and India.

So you know me. If I thought Iraq was a big cause of our frustration at the pump, I’d have no hesitation in saying so. I doubt it is all that important in this regard.

One of the economists seems to be arguing that over five to ten years, Iraq could have had an impact, if there hadn’t been all that sabotage and if $30 bn. had been invested in the industry. This is true. But for this summer, there are other and bigger phenomena driving Americans’ sticker shock at the pump.

The fact is that if Americans did some serious conservation, they could reduce consumption by 1/3. Since they use about 20 million barrels a day of petroleum, they could replace the production of both Iraq and Iran (Iran produces 4 million bbd and exports 2 of it) all by themselves, just by going on the kind of diet Europe did in the early 1980s. But the last politician who dared tell you that was Jimmy Carter and no one will ever, ever go on television and talk that way again, who aspires to hold public office.


Alan Richards, a real economist, at UC Santa Cruz, replies:

‘ Dear Juan:

On the question of oil prices: I think you are underestimting the impact of the actual and threat of war in the Gulf on oil prices in your discussion today in your invaluable blog.

. The key is that the price of oil is an “asset price”. That is, the price of a barrel of oil is like the price of your house. It reflects, certainly, conditions of current supply and demand. But because oil, like your house, can be stored, forecasts of the future are critical to its current price.

The war in Iraq and, even more, the saber-rattling around Iran have deeply spooked the market. They are right to be spooked–if the U.S. persists in its confrontational stance in the region, there will be more violence, more instability, more potential oil off the market (al-Qaeda did, after all, try to attack Abqaiq…).

Even more important from an expectations perspective is that for supply to be able to keep up with demand in the future, most analysts agree that there must be much investment in oil production IN THE GULF. This is basically for reasons of geology–it’s where the oil is. Violence scares this off (as, of course, does continued nationalism and other policies already in place).

Consider the following back-of-the-envelope consideration.

1) Let’s say, as you plausibly do, that the quantity reduction is some 3.5%

2) Price has risen from (about) $26/bbl in the run-up to the war to some $73/bbl today.

3) Conventional studies of short-run price elasticity (percentage change in quantity divided by percentage change in price) are usually somehwere between 0.2 and 0.4.

So: take the midpoint estimate for elasticity: 0.3

Then: 0.3 = % change in quantity/%change in price.

So, 0.3 = .035 (= % change in quantity)/%change in price.

so: % change in price = .035 / 0.3 = 11.6%

But: the observed % change in price is roughly 94% ($73-$26/($73 + $26)/2 = 0.94. The so-called, “mid-point arc elasticity”, which uses the average of the starting and ending points as the basis for the percentage change in price calculation). Result? The observed change in price is over 800% larger than what one would expect based on previous market behavior (which is where estimates of elasticity come from).

There are then several possibilities: a) previous estimates of elasticity do not reflect current conditions–this is tantamount to saying that the oil market today is somehow fundamentally different from the way it was from 1972-2003. Maybe so, but one would then want to know how, exactly, the market has been so transformed. War and related stupidities would surely play a role here.

b) A much more plausible, and simpler, hypothesis: expectations, as argued above.

Calling these expectations, as the press often does, “speculative” leads to ideas of “herd behavior” and manias, evildoers in eyeshades, etc. Without denying that bubbles exist (I think they do), one can just say, as most economists would: “The price of an asset reflects the collective judgement–right now–of all market participants about future demand ans supply conditions”.

In short, I think you are selling short the impact of the neo-cons’ lunacy on the oil market.

And, you are, of course, entirely correct that we could, and must for other reasons, get serious about conservation.

Alan Richards

Cole: I’m deeply grateful for Professor Richards’ intervention. Just to say that the oil analysts tell me that the market is in fact radically different now than in the 1970s-1990s, and that a key difference is the massive and continuing rise in demand from South and East Asia. I did say that I thought the “security premium” was likely a much bigger part of the price rise than the reduction in Iraq production. I am persuaded that the security premium is a central part of this story and is of course deeply related to Bush administration aggressiveness in the Oil Gulf region.

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