As unrest grips the Middle East, and crude oil prices break $100 per barrel, some observers might conclude that the United States government should “obviously” take steps to reduce our economy’s reliance on oil.
However, the market economy already has mechanisms, such as futures markets, to handle volatility in commodities such as oil. Private-sector analysts are aware of the geopolitical situation and have been acting accordingly. If future disruptions in oil output were truly so serious as to make it uneconomical as a major energy source—all things considered—then the market would naturally move away from oil.
The government doesn’t need to pick winners and losers in the energy markets. If officials want to “do something,” they should free up domestic production of energy and stop the regulatory crackdown on speculation in the financial markets.
The Price of Oil Already Reflects the Risks of Future Crises
Even though they are almost universally reviled, speculators perform a vital function in the market economy. Speculators anticipate future conditions and then (unwittingly) adjust current market prices to reflect these possible scenarios.
For example, as the situation in various oil-exporting nations began deteriorating, speculators realized that there was a serious possibility of a major disruption in crude oil reaching the international market. If supply were interrupted, the price of a barrel would need to rise, to ration the remaining barrels among the competing buyers.
This is why the price of oil began to rise even before the physical disruptions. The old, everyday price of oil was too low, in light of the new political events. Seeing a price (say) of $90 per barrel, and knowing that there was a good chance oil might break $100 the following week, speculators had an incentive to start stockpiling oil and thereby push up its price right away. (In modern financial markets, futures contracts make this process smoother, as I explain here.)
Some cynics object to the “profiteering” of speculators (and “Big Oil”) when a political situation apparently gives them an excuse to raise prices, but in fact this is precisely what consumers want to happen. Speculators actually reduce price volatility over the long term, because speculators—by “buying low and selling high”—push up prices that are too low (in relation to their future level), and they reduce prices that are too high.
To repeat, this is exactly what we want speculators to do; they are providing a service to us all, as long as they correct anticipate price swings and act profitably. For example, if the speculator buys low and sells high, then he effectively moves oil from a time of relative abundance (when the price was low) to a time of relative scarcity (when the price was higher).
The current surge in oil prices not only reflects the actual state of world oil production and consumption, but also reflects the possibility that more serious disruptions could occur down the road. The government doesn’t need to stack the deck against oil; people in the private sector are already aware of these issues.
Oil Still an Efficient Energy Source
Despite the periodic reduction in supplies from unstable regions, all things considered oil remains an efficient source of energy for the United States over the foreseeable future.
For one thing, regardless of which political faction takes power (in Libya, Saudi Arabia, Iran, etc.), the group can only benefit financially if they sell their oil to the world. To win a revolution in Libya, only to renounce oil exports, would be akin to robbing a bank and then dumping the cash out the window of the getaway car. We should also remember that oil is a very fungible commodity; even if a particular regime refuses to export to the United States, other countries would simply rearrange their crude flows to offset the change.
We can certainly dream up scenarios where it really would make economic sense to switch away from oil into other energy sources, very quickly. For example, if oppressive rulers in the Middle East managed to destroy large amounts of their country’s resources, so that the price of crude spiked to (say) $400 per barrel and would remain there for years, then many Americans would rationally start abandon their SUVs (especially the older models) and switch to hybrids, electric cars, mass transit, and bicycles.
Yet notice that even in this contrived example, the government wouldn’t need to steer people into making the right choice. That’s the whole point of a market economy with its price signals. Each household would need to look at the outrageous price of gasoline (if crude really jumped to $400 per barrel), and make hard choices about how to get around town. The government wouldn’t add anything constructive by slapping an extra tax on oil, or subsidizing mass transit. All that would do is distort the true choice facing consumers.
Conclusion
The government doesn’t need to stack the deck for or against oil. Yes, there are occasional disruptions in the supply to world markets from certain regions. But the market already has mechanisms (such as the futures market) where speculators can profit in direct proportion to how well they give early warning of such disruptions. The system isn’t perfect, but government employees don’t have crystal balls either. (They certainly didn’t see Mubarak’s regime tumbling.)
All things considered, oil still remains a vital and efficient energy source in the American economy. To renounce it because of the situation in the Middle East would be akin to forcing vegetarianism on everyone after Mad Cow disease.
The government doesn’t need to pick winners and losers in the energy markets. If officials want to “do something,” they should free up domestic production of energy and stop the regulatory crackdown on speculation in the financial markets.
