War and Oil
How high will it go?
On February 28, Israeli and American forces launched an attack on the Islamic Republic of Iran. Israel and Iran have angrily circled each other for decades, with Iran often fighting through proxies. Yet, until recently, there hadn’t been much direct aggression between the two nations. The lack of direct conflict until last year’s joint Israeli-American bombing campaign could be attributed to several factors, not least of all the tremendous risk of a large-scale Middle Eastern conflict, but one economic factor always loomed large: the price of oil.
Iran is located, depending on your point of view, either conveniently or inconveniently, at the mouth of the Persian Gulf, which is named the Strait of Hormuz. About 20 percent of the world’s oil passes through this narrow channel before it is refined and processed around the globe. This gives Iran tremendous leverage. Even if the country is crippled militarily, it can effectively close the strait by threatening to sink any ship that tries to sail through. This happened on March 2nd, when a senior Iran Revolutionary Guard Corps (IRGC) official stated, “If anyone tries to pass, the heroes of the Revolutionary Guards and the regular navy will set those ships ablaze.” The strait has effectively been blocked, with only a trickle of tankers wanting to risk passing through. This, until last month, partially protected Iran from attack. No longer.
The price of oil has soared. In under 10 days, the price of Brent crude oil increased from $73 to $99 a barrel. Prices have since fallen to $85 a barrel, but everyone is nervously looking to see what the next few weeks hold. Much of the developed world is in the economic doldrums. A sustained increase in oil prices could trigger a recession. President Trump has tried to calm markets by claiming the war will be over soon, but people are justifiably nervous.
Prices at the pump have already begun to rise. According to AAA, the price of a gallon of gas has increased from $3.11 to $3.54 in just the last week. This may seem odd, as it takes some time, at least two weeks, for crude oil to work its way through the supply chain. The gas being sold at the pump today is made from oil that was sold before the attacks even started. How is it that prices have risen so quickly? This is because gas prices suffer from asymmetric price transmission, more colorfully known as “rockets and feathers”. When oil prices increase, gas prices tend to increase sharply and immediately, like a rocket. When oil prices decrease, however, gas prices tend to fall gradually and with a delay, like a feather. The exact causes aren’t fully understood, but the theory is that gas station owners can tell upset consumers that gas prices had to be increased because oil prices increased, even though the gas station owner hasn’t had to pay more for gas yet. When oil prices fall, the same gas station owner can claim gas prices can’t come down until the cheaper oil is refined and resold as gas.
It may also seem odd that gas prices in the United States are increasing when the supply issue is in the Middle East. Contrary to the narratives of the 20th century, the US is not dependent on foreign oil. America is now the world’s largest producer of oil and is a net exporter of petroleum products. More oil is produced each year in the US than is consumed. The fracking revolution of the 2000s now means the US produces more oil than Saudi Arabia. So why are we affected by a war halfway around the world? Because oil is traded on a world market. When there is a supply issue in the Middle East, some refineries are willing to pay more for oil from elsewhere. Sellers of oil then raise their prices to meet this increased willingness to pay.
An interesting additional wrinkle to the US oil industry is that although the US is a net exporter of petroleum products, we still are a net importer of crude oil. A lot of the oil pumped from North Dakota is high-quality, while the refineries in Louisiana are designed to refine low-quality oil. Thus, a lot of American oil is exported abroad to be refined, while foreign oil is refined in the US. As long as international shipping is functioning well this isn’t a problem. To the contrary, it allows different countries to specialize in different types of refineries and avoids unnecessary duplication of refinery capacity. When something like the closure of the Strait of Hormuz occurs, however, it causes problems.
If oil prices stay high, the political pressure to end the war will certainly rise. Even those who support the war in Iran will not want to pay $3.50 or $4.00 for a gallon of gas. If this comes to pass, it will be interesting to see how the administration responds. They could end the war preemptively.
Another option would be to revisit the Jones Act, an absurd rule that mandates that ships that travel between two US ports be American vessels. US ship construction is in dire straits, and there aren’t nearly enough ships to transport oil between various American ports. Thus, American refineries are often forced to source oil from abroad rather than buy American oil. This paradoxically increases our reliance on foreign oil and increases prices. One study found that in 2018-2019, gas prices on the East Coast would be a full $0.60 a gallon cheaper if the Jones Act were repealed, and gas could be transported from the Gulf Coast to New England on a foreign vessel.1 So if gas prices stay high, the Trump Administration has a few levers to bring prices back down.
The same study also found prices on the Gulf Coast would increase by $0.30 a gallon if the Jones Act was repealed.