Many things will influence the long-term price of oil: climate change policy; whether peak oil happens;
the long-term ability to find oil relative to the amount of growing demand in the developing world. Those are not events that are very easily manipulated by se-curity policy. There is no U.S. military policy that can stop peak oil, if such peaking is truly happening. The military can’t create more oil underground. Whether or not we have reached peak oil is a whole other ques-tion, which I’ve written about elsewhere.
Here, the issue is oil price spikes. Let’s talk about that. The conventional wisdom goes a bit like this.
Suppose there’s a supply shock somewhere in the world. Someplace that is producing oil, for whatever reason—there’s a war, a revolution, an embargo, or something else—produces less oil. As a result, it sud-denly puts less oil into this global bathtub where oil producers are dumping oil into the world market, and oil consumers are sucking it out of different drains all around the world. If somebody’s putting in less oil, so this conventional wisdom runs, then it’ll be harder to suck oil out of each drain. There’ll be less oil in the bathtub, the flow will be slower. Prices will go up and consuming countries like the United States will feel a hit because we have to pay more for our oil.
This story underpins some American and global security policy. The problem with it is that markets adapt, even markets with cartels; in fact, in some ways, especially markets with cartels. Therefore, if one country reduces its contribution to the global supply, all the other suppliers around the world have incen-tives to change their behavior. In fact, they will try to make up the missing supply. Thus what happens is
that supply is restored. When somebody goes off pro-duction, someone else turns up their faucet a little bit because there’s an opportunity to make more money by dumping oil in the bathtub. The result is that no one actually ends up facing a dry pump. When you put gas in your car, somebody else is now pumping oil and the price doesn’t go up to a worrisome extent.
Supply is restored by natural market forces.
Thus anytime there’s a disruption in oil markets around the world, you get a kind of race in the natural market between how much oil goes offline and how quickly substitute suppliers can bring oil back online.
This determines how much the price goes up. This is normal market behavior. It doesn’t require particular foresight, or especially smart people in the oil busi-ness, although there are many such people. Nor does it take someone to plan ahead or develop a compli-cated policy. Normal market forces create that race.
As Anne Korin and Alan Hegburg pointed out, there’s a cartel involved, and what’s the whole point of cartels? It’s to damp down market forces. The car-tel would like to manipulate the price of oil. So your instincts might be to think that, yes, in normal market conditions, when there is a supply shock other sup-pliers will try to increase their output and that would keep prices relatively normal, but that the cartel will undermine this.
But it turns out that cartels are not good at prevent-ing this kind of adaptation. In fact, it’s just the reverse.
Because cartels limit outputs below what they oth-erwise would be in a competitive market, they have potential supply lying around. They have a certain level of production capacity that they are not using.
They could supply more to the market than they do because the whole point of the cartel is to drive up the equilibrium price.
What ends up happening is that when there’s a dis-ruption, all of the suppliers in the cartel—some more than others, but all—have some amount of excess ca-pacity lying around which they can turn on. This can compensate for the disruption caused by the country that has gone out of the market. In fact, the suppliers have more slack capacity lying around than perfectly competitive firms in the market because they are part of the cartel.
It turns out it’s actually even worse than that for the cartel because every time somebody goes out of the cartel, every producer in the cartel that has excess capacity wants to be the one who gets to turn on their taps and sell extra oil and make extra money to make up the capacity that was taken off the market. The dif-ferent producers in the cartel fall all over themselves in cartel negotiations saying, “Let me do it, let me do it.” Everybody wants to do it. They have great diffi-culty making a new bargain, reaching a new politi-cal agreement as to who’s going be the one that gets to pump more oil. The usual outcome of this is that everybody tries to be the one who pumps the extra oil. This means that more oil comes onto the market than was taken off by the actual disruption because the cartel members can’t reach political agreement fast enough to keep up with the dynamics of the market.
Thus it’s very hard for cartels not to oversupply dur-ing supply shocks. From our perspective as consum-ers, that’s great news because it means we’re never going to face the actual cutoff, and so the price can go back down.
This is actually what we see when we look at the evidence. If you look at a graph showing the biggest supply shocks that have happened in the past, you can see that there are a couple of times when one or two
countries had a big supply disruption.3 In each case, a declining line shows the disrupted country’s oil sup-ply after the disruption. Most of them stay down, but they try to get back up as quickly as possible to their pre-disruption production. But you can see the rest of the cartel, and in fact the rest of countries in the world, the non-OPEC suppliers, lead us back to a 0 percent disruption much quicker, in a matter of a few months, except in the one strange case of the Iranian disruption of 1979. There’s a lot of speculation about why Iran in 1979 was different. However, after most disruptions, the market can cover and compensate for them, and we are better off not trying to prevent them.
Our actions to try to prevent them are very costly and ill-advised, especially since most disruptions will go away naturally.
I mentioned that there is one case people are very afraid of, and that is when two significant oil pro-ducers go to war, a huge disruption in oil supplies is created. In fact, what happened during the war was that there was a sustained reduction in the price of oil because people were overproducing and cheating.
Among other things, the countries fighting the Iran-Iraq war wanted the income from oil so they could buy more guns and blow each other up. They needed the money. Consequently, oil production was not re-pressed. The price of oil dropped, which was good for us. Eventually, Saudi Arabia got tired of everybody cheating. Saudi was really the only country that was trying to maintain the OPEC quota, and you see the sudden price drop in about 1986 when the Saudis said,
“Screw you, we’re turning on the spigots.” The real effect was to disrupt the cartel and create downward pressure. Price shocks disrupt the cartel.
There are caveats to this story. Sometimes OPEC doesn’t control the price, and you’re back in the normal market response world. There’s a lot of debate about when OPEC is more and less important. How well the cartel is functioning varies over time. Sometimes car-tel cohesion is high, and carcar-tel members manage to cooperate to restrict supplies. Sometimes the cohesion is low, and they compete more like normal competi-tive suppliers. But as long as we’re at least somewhat in the cartel world, we are less vulnerable to spikes, to supply shocks. Sometimes there’s less slack capacity than at other times. That was true in the mid-2000s when the oil price was going way up because Chi-nese demand was growing very rapidly. During those times, you have a slightly greater likelihood of price spikes.
If you had incredible foresight, if you were God, you could adapt American security policy and say, well, we’re going to do a little bit more in the times when there’s less slack capacity or when OPEC is not being well behaved. When OPEC is working, then we’ll hold off a little bit on security policy and let things evolve. You could modulate.
But we’re not smart enough to modulate, and in fact most of our modulations wouldn’t work very well. In general, the policy should be to first stand back and let the market evolve because most of the time the market fixes these problems. In those times when after a while the market doesn’t fix things, you’ve got the Strategic Petroleum Reserve. You’ve got other con-scious policies that you can engage. Eventually, if you really wanted to and you were really in bad shape, you could use the military.