It’s About Uncertainty, Not The Barrels

Oil prices surged after the mblockive Israeli attacks on Iran because of fears that the violence will continue (which is likely) and spread (less clear). Israel has been emboldened by its success against Hezbollah and Hamas, as well as earlier strikes against Iran’s military and especially air defense systems. This comes at a time of increasing uncertainty in the oil markets, with some ***ysts predicting higher prices later this year due to tight markets and others worrying that economic uncertainty and OPEC+’s unwinding of its voluntary will raise inventories and depress prices.

Energy security ***ysts for years have feared an Iranian attack on shipping in the Straits of Hormuz, through which close to 20 million barrels a day is shipped. If that much oil supply was disrupted, prices would easily soar above $100 a barrel and the global economy would go into a tailspin. (At this writing, oil prices are about $10 a barrel higher than a few weeks ago but fluctuating wildly.)

The threat of an extended period of higher prices is definitely real. At this moment, it doesn’t appear that Iran will attack oil shipping but that could obviously change. And even if Iran’s government decides to restrict its response to missile and drone attacks on Israel, local commanders might undertake attacks on shipping.

Iran’s other ‘nuclear option,’ shutting the Straits of Hormuz is unlikely to occur, partly because of the likely U.S. response, which would probably involve strikes against missile launchers and naval bases, but in this age of asymmetrical warfare, preventing attacks on shipping is next to impossible. More worrisome, insurance rates for tankers in the Gulf will soar and some shippers will avoid the area. If military attacks continue, this could mean an extended period of tighter markets and higher prices.

Some will point to government-owned or -controlled oil stocks as insurance against a major supply disruption and indeed, the OECD nations hold roughly 1200 million barrels in strategic reserves. That would easily replace the supply lost from a total shutdown of the Straits of Hormuz for sixty days. And if only a few million barrels a day is lost because of cautious shipping owners, that amount would stretch much longer.

However, historically, governments have been slow to tap their strategic reserves, at least until the Biden Administration, often arguing that they should not be used to respond to soaring prices but to physical shortages. This is a mistake as the primary damage from oil crises has been higher prices not a lack of oil supply. The fear that shortages would mean ‘factories shutting down and people freezing’ was always misguided. In the 1970s, higher prices triggered recessions which shut down factories and left the public suffering, even when supplies were available.

I wouldn’t suggest that the U.S. or any other government immediately respond to a price spike by releasing strategic stocks, waiting until it becomes clear that the crisis will be prolonged. Attempting to manipulate prices on a daily or weekly basis is foolish and will only create confusion and havoc in markets.

But, as I pointed out nearly four decades ago, Fighting the last war : preparations for the next oil crisis, hoarding can exacerbate a crisis and send prices soaring even as supplies remain abundant. This is natural human behavior: if you are uncertain about supplies, you hang on to what you’ve got. During the Iranian Oil Crisis, global inventories built as much as 3 million barrels a day or more, as companies and large consumers chased every available barrel, the spot market trade all but disappeared, and prices tripled: not when Iranian oil production was shut in by unrest. As the figure below shows, the Shah left Iran in January 1979, and global oil production returned to normal by April. Prices at that point had risen to roughly $18 a barrel, or a 50% increase above pre-Revolution prices. But they kept rising, doubling again by mid-1980, almost a year and a half after the success of the Iranian Revolution and long after production was restored.

(Production dropped afterwards mainly due to the Iran-Iraq War and weak demand.)

Since the Iranian Revolution, it is hard to find evidence of hoarding driving up prices for any period but that has led to complacency amongst governments. As I argued in 1986, there is a tendency to blockume that future crises will resemble the previous one and prepare accordingly. After 1979, governments and academics devoted much time to responding to possible hoarding but nowadays, there are few who remember that this was once major problem.

The most salient point, often disregarded, is that hoarding is natural human behavior when there is uncertainty about supply, whether it is oil or toilet paper. Even if supply remains unaffected by the Israeli-Iranian conflict, anticipate that the market will be strongly backwardated and near-term prices elevated. Elevated oil prices could prove to be more than just insult on top of the injury of economic uncertainty, and a few months of $100 oil prices could push the world into recession.