My Grand Strategy

[Nat Wilcox]

A couple of thoughts about the oil market.

Bill is right to note that correct thinking about oil requires thinking about the global market.

Buyer boycotts of specific producers may or may not have effects on a global commodity market. Because it is the less intuitive outcome, here's the "may not" scenario in a nutshell:

Suppose there are an equal number of red and green barrels of supplied oil coming from all producers globally (think "good guy" and "bad guy" oil) and that initially all buyers are indifferent about the color of barrels. Now let any one buyer, call her US, who represents less than half of the demand for barrels announce that they will only purchase green barrels. Because the rest of buyers are more than half of world demand, and because we assume here that they remain color-blind, they will be happy to absorb red barrels no longer acceptable to US, freeing green barrels for US. Assuming that there are many competititive non-US buyers, barrel color arbitrage amongst those many color-blind buyers will guarantee that there can be no price differential between green and red barrels in the world market. So in this highly stylized, perfectly competitive world market without transport costs, the unilateral boycott of red barrels by US has no effect whatsoever on the world price of either red or green barrels of oil. It is thus economically costless to the boycotter, but also has zero effects on red barrel producers. It is without consequence--except perhaps that the red producers call the US buyer a jerk, which could be a real political consequence.

(The basic logic above is well-known, is the nub of the problem with unilateral sanctions in any highly competitive product market, and is also the reason that Wall Street can cook up "social awareness" mutual funds that perform for all intents and purposes identically to other mutual funds.)

There are some minor stylizations above that really don't matter. But it does leave out transport costs and oil type. In reality, "the price of oil" doesn't exist: When an oil price is quoted, it is for oil of a particular type from some particular location delivered to a particular port on a particular day. There's still useful information in such prices, because all local oil markets are so heavily interlinked by easy substitutions, with the exception of transport costs and oil type (not all refineries are designed to handle every oil type). If you were to factor in the effects of transport costs and oil type, the unilateral one-buyer boycott of the red barrels would cost the boycotter a bit--but not a whole lot.

To my mind, the real problem with "separation" is a global supply shock brought about by the fall of a currently friendly big producer, like the Saudis, due to a withdrawal of our support (rather than not buying their oil). That problem is correctly noticed by Bill and others above.

And you cannot use the current price to guestimate the economic impact of such shocks. Say we take Bill's 15% reduction in world supply in some kind of Saudi crisis. Typical estimates of the responsiveness of world oil demand to changes in prices ("price elasticity") in the short run imply about .05% change in quantity demanded due to a 1% change in price; inverting that, the accommodation of a 1% change quantity demanded requires a 20% increase in price. So a 15% reduction in world supply would require a 300% increase in world prices, in order to clear world markets. This is how you get $300 a barrel oil from today's roughly $75 price.

And it doesn't stop with oil. Because all energy prices will shoot up with such an increase in oil prices as buyers who can substitute other energy sources increase demand in those markets for substitutes.

Remember that these are all short-run effects: They happen very fast, and as Bill correctly notes, they are a temporary spike. Allow enough time, and long-run price elasticity governs the response, and these are not so severe...on the order of about a .33% change in quantity demanded due to a 1% change in price. Assuming world supply stayed permanently lower by 15%, we'd be talking "only" about a 50% long-run increase in prices, say to around $120. But new sources of supply would come online over time as producers respond to the newly higher price. All of this is well-known from past experience and theoretically expected.

But it all takes time, and in the meantime a shock of that magnitude would definitely cause severe recessions around the world. And remember, recessions kill people, statistically speaking: That is also a well-known result. We aren't simply talking about delaying the purchase of salad shooters and jetskis. And it is also the poor who really take it on the chin; there's also a powerful equity argument against preventing these sorts of events.