Why Is Gas So Cheap?
Updating priors
When Iran effectively closed the Strait of Hormuz in March of this year, analysts predicted dire consequences. Around 20%, that’s one in every five barrels, of the world’s oil supply used to transit through this narrow body of water. For decades, Iran has effectively held the strait hostage. If attacked, they were prepared to mine, missile, and shoot any vessel that attempted to transit through. Why the Trump Administration ignored this consequence is unknown. Perhaps they thought Iran would be unable to close the strait in practice, or that the US military would be able to execute a knockout blow and render the point moot. Regardless, for the last five months the amount of oil passing through the strait has slowed to a trickle. Transit totals are thought to be only 10-20% of prewar levels.
The worst has come to pass. Yet, the feared result didn’t. Many predicted that oil prices would hit $150 a barrel if the Strait of Hormuz was closed for an extended period. Some even predicted prices would hit $200 a barrel. Instead, oil prices peaked at around $126 a barrel, and is currently trading below $90. Gas prices in the US have gone up, but we are still substantially below the $5 or $6 per gallon some predicted. Why didn’t the gloom and doom come true?
Likely a few things in tandem.
First, China. The People’s Republic was easily the world’s largest importer of crude oil. Then the war started, prices rose, and China drastically cut oil imports. Not completely, but by 40%. Overnight. No one predicted this and it has sparked a great deal of speculation. How were they able to do so? The proximate reason is that China had the world’s biggest oil reserves, likely over a billion barrels, and possibly far more. That, of course, begs another question. Why did China have such a large stockpile? It could have been that they wanted to maintain extensive reserves in case of a supply issue, like a war in the Persian Gulf. A more disturbing possibility is that China was preparing to invade Taiwan. It is distinctly possible the US-Iran war prevented a China-Taiwan war. Alternatively, China may have substituted with more Russian oil. At any rate, the lack of Chinese demand on the global market has helped cushion the blow.
Second, the Hormuz transit data may not be entirely accurate. It is currently quite dangerous to transit through the Strait of Hormuz. Doubly so if the ship in question is an oil tanker. The profits for doing so, however, would be enormous. Anyone who runs the gauntlet and emerges with a ship full of oil will be paid handsomely. Thus, it is reasonable to expect there is a decent number of tankers sneaking through the strait, either by paying off the Iranians or making a run for it. Given the lack of ships on fire or sinking, the former is more likely.
Third, necessity is the mother of invention. Because oil is so valuable, suppliers have found workarounds. Gulf nations have spent billions upgrading pipelines and improving roads. Shipping oil by sea may be one of the most effective methods of transportation, but there are alternatives. Nations that depend on oil to keep the peace are not going to let their golden goose die. It may seem ludicrous to replace one large oil tanker with 10,000 trucks, but if that’s the only way to bring black gold to the market, it’s going to happen.
Fourth, life, uh, finds a way. Petroleum has a lot of uses. As Tyler Cowen and Alex Tabarrok point out in their MRU video, there are low-value and high-value uses for petroleum. At the low end, oil can be used to make rubber ducks. At the high end, it’s used for jet fuel. As the price of oil rises, low-value users switch inputs. These changes are unpredictable and difficult to model, which is why many analysts overstated the risk of a long-term Hormuz closure.
Market economies are flexible. They will adjust to new information and adapt. Even command economies will evolve when needed. Oil is necessary for today’s economy, so many overestimate how disruptions to the current supply chain will affect the final price.
This ability to adapt needs to be learned over and over again. It calls to mind the Schweinfurt–Regensburg mission in World War II. An audacious plan, the Schweinfurt–Regensburg raid would send hundreds of American bombers from England deep into the heartland of Germany. The planes would take off from England, fly hundreds of miles over enemy territory, and bomb a series of ball bearing plants in Bavaria. Rather than flying back over Germany and returning home, the planes would then fly South over the Alps, cross the Mediterranean Sea, and land in Allied-controlled Tunisia. The plan was incredibly risky and would likely involve high casualties, but was deemed worth it because of the necessity of ball bearings for the German war effort. Destroy these plants, it was thought, and the mechanized elements of the Wehrmacht would grind to a halt.
The mission was a tactical success. The factories targeted by the Allied planes were mostly destroyed or heavily damaged. The Germans estimated that ball bearing production fell by as much as 50%. The tactical success, however, was overshadowed by the total strategic failure. Because the ball bearings were so crucial to the German war effort, vast resources were devoted to creating equipment to make them elsewhere. Existing stockpiles provided a stopgap. In a matter of weeks, ball bearing production was near its pre-raid average. The war continued without missing a beat, but at the cost of 60 bombers and over 550 Airmen. The allies were correct that preventing Germany from manufacturing ball bearings would be catastrophic. Of course, given this premise, it was shortsighted to assume that destroying a handful of factories would permanently cripple production of such a key component.
Just as the Third Reich was able to adapt to the destruction of their factories, so too is the world able to adapt to a single closed body of water. Oil is the fuel that powers the world economy. Either by substitution, adaptation, or subterfuge, people will find a way to overcome obstacles. Especially when billions of dollars are on the line.