The world watches the unfolding situation in the Middle East with trepidation. All decent people hope for a peaceful outcome of the brewing standoff with Iran over its alleged nuclear program. However, oil traders have driven up the price of oil based on quite reasonable fears of an interruption in supply, and critics of fossil fuels have pointed to this as further evidence of the need to wean America from its “addiction” to fossil fuels.
This is simply bad economics. Energy price volatility is an unfortunate reality, given the geopolitical situation. Yet free markets adequately incorporate such realities, and respond efficiently. If it really did make sense to switch to electric cars, solar power generation, etc., because of periodic disruptions in crude output from the Middle East, then that would be the free-market outcome. In any event, people who are concerned about crude from abroad should be the biggest advocates of expedited development of domestic fossil fuels.
Free Market Prices Signal Danger of Disruption
Contrary to the views of its critics, the free market is extremely well-suited to pricing in small but catastrophic risks. For example, suppose the world oil market is initially in equilibrium with the price at $75 per barrel. Yet suddenly there is an escalation in hostilities between Western nations and the Iranian government, which will probably be resolved peacefully, but might lead to a disruption in oil exports from the region (through Iran halting production and/or being embargoed, Iran mining the Strait of Hormuz, etc.).
In that unlikely but nonetheless possible scenario, perhaps the world price of oil would shoot up to (say) $150 per barrel, at least for a month or so until the Western powers could react militarily, and other producers could ramp up output. Clearly this would impose serious hardship on motorists and other energy consumers, as gasoline prices would skyrocket.
It is because of considerations such as these, that many interventionists propose that the U.S. government take steps to punish fossil fuel use and encourage alternative energy sources. The premise is that the shortsighted market is helpless in the face of such military events, and only the wise interventionists can anticipate these contingencies.
But of course that’s nonsense. The unfettered market has all sorts of mechanisms to mitigate the impact of such a scenario. For example, speculators in the oil market can look three moves ahead, just as surely as the critics of fossil fuels. If the odds of a major disruption in oil in the near future suddenly spike, then speculators will buy futures contracts (and call options or even more exotic derivatives) on crude oil, because if the spot price of oil shoots up to $150 then these contracts will pay off handsomely. The speculators will keep pushing up the futures price (and other related prices in the various commodities markets) until they think they adequately incorporate the geopolitical realities.
The story doesn’t end there. Seeing a higher price on oil futures—which are contracts promising to deliver physical oil at a future date—current producers will slow down their production, and/or they will begin to physically stockpile crude either in warehouses or tankers. For example, if the current spot price is $75 while the two-month futures price is $110, then oil producers will stop selling into today’s spot market and instead will take the other side on the futures contracts, and will set aside barrels today in order to satisfy the futures contracts when they mature in two months.
How Market Players React to New Prices
The end result of all this action and reaction is that a new equilibrium will be achieved, in which today’s spot price is higher because of the perceived risk of a future disruption. Depending on the numbers, motorists today may sharply curtail their driving (because of higher gasoline prices today), while producers begin stockpiling above-ground stocks of crude, in order to fulfill the higher volume of futures contracts.
If we step back and think about it, this free-market response is exactly what a government central planner would WANT the world to do. Namely, when there is suddenly an increased risk of a future disruption in oil exports from one region, the rest of the world should respond by economizing more carefully in the present, and building up its stockpiles of oil.
Alternative Energy Sources?
Finally, note that if the threat from a Middle East conflict were truly enough to make it efficient to begin switching out of fossil fuels, then that’s exactly what would be profitable according to market prices.
It is the job of financial market speculators to anticipate future volatility in prices and to iron out the bumps. After all, a speculator’s creed is to “buy low, sell high” when something is undervalued, and to “short-sell high, cover low” when an asset is overvalued. But by buying the initially undervalued asset, the speculator helps push its price up, and by selling the overvalued asset, the speculator helps push its price down. So contrary to conventional wisdom, speculators who are profitable actually make prices less volatile than they otherwise would be. They make the troughs higher, and the peaks lower.
It is true that geopolitical events would affect the world spot price of oil more than (say) the price of electricity generated by solar power in a U.S.-based utility. Yet this initial volatility is recognized by players in the energy markets, and is incorporated into today’s spot price of crude oil. If it currently is unprofitable to base the U.S. transportation and electrical generation infrastructure on alternative energies, this fact already takes the potential volatility of future crude prices into account.
In other words, the interventionist case seems to be saying, “Right now, before hostilities break out, consumers don’t want to drive electric cars. But just wait till war breaks out and gasoline hits $8 at the pump. Then they’ll be sorry!”
Yet that possibility is already incorporated into today’s spot price at the pump. If $8 per gallon gas (due to war with Iran) were really a major consideration for someone buying a new car, then it would also make sense for refiners to hold back their stocks until the current spot price of gasoline rose much higher.
In short, if a possible spike in gasoline prices (from a temporary disruption in Middle East exports) isn’t enough to convince major companies to change their pricing behavior in today’s markets, then it’s also not a good reason for car buyers to change their habits. It’s one thing to claim that the average motorist is too stupid to read the newspapers, but it’s absurd to say that hedge funds and multinational energy companies don’t follow the news about Iran.
Conclusion
If market prices were allowed to do their job, they would steer energy producers and consumers to the efficient response given a change in the geopolitical situation. If the government wants to implement policies to help, it could refrain from punishing financial trading in commodities markets, and it could remove the obstacles from North American fossil fuel development.
