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Crude reality

Will a Middle Eastern oil disruption crush the economy? New research suggests the answer is no -- and that a major tenet of American foreign policy may be fundamentally wrong.

By Jeremy Kahn
February 13, 2011

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For more than a month, the world has been riveted by scenes of protest in the Middle East, with demonstrators flooding streets from Tunisia to Egypt and beyond. As the unrest has spread, people in the West have also been keeping a wary eye on something closer to home: the gyrating stock market and the rising price of gas. Fear that the upheaval will start to affect major oil producers like Saudi Arabia has led speculators to bid up oil prices — and led some economic analysts to predict that higher energy costs could derail America’s nascent economic recovery.

The idea that a sudden spike in oil prices spells economic doom has influenced America’s foreign policy since at least 1973, when Arab states, upset with Western support for Israel during the Yom Kippur War, drastically cut production and halted exports to the United States. The result was a sudden quadrupling in crude prices and a deep global recession. Many Americans still have vivid memories of gas lines stretching for blocks, and of the unemployment, inflation, and general sense of insecurity and panic that followed. Even harder hit were our allies in Europe and Japan, as well as many developing nations.

Economists have a term for this disruption: an oil shock. The idea that such oil shocks will inevitably wreak havoc on the US economy has become deeply rooted in the American psyche, and in turn the United States has made ensuring the smooth flow of crude from the Middle East a central tenet of its foreign policy. Oil security is one of the primary reasons America has a long-term military presence in the region. Even aside from the Iraq and Afghan wars, we have equipment and forces positioned in Oman, Saudi Arabia, Kuwait, and Qatar; the US Navy’s Fifth Fleet is permanently stationed in Bahrain.

But a growing body of economic research suggests that this conventional view of oil shocks is wrong. The US economy is far less susceptible to interruptions in the oil supply than previously assumed, according to these studies. Scholars examining the recent history of oil disruptions have found the worldwide oil market to be remarkably adaptable and surprisingly quick at compensating for shortfalls. Economists have found that much of the damage once attributed to oil shocks can more persuasively be laid at the feet of bad government policies. The US economy, meanwhile, has become less dependent on Persian Gulf oil and less sensitive to changes in crude prices overall than it was in 1973.

These findings have led a few bold political scientists and foreign policy experts to start asking an uncomfortable question: If the United States could withstand a disruption in Persian Gulf oil supplies, why does it need a permanent military presence in the region at all? There’s a lot riding on that question: America’s presence in the Middle East exacts a heavy toll in political capital, financial resources, and lives. Washington’s support for Middle East autocrats makes America appear hypocritical on issues of human rights and democracy. The United States spends billions of dollars every year to maintain troops in the Middle East, and the troops risk their lives simply by being there, since they make tempting targets for the region’s Islamic extremists. And arguably, because the presence of these forces inflames radicals and delegitimizes local rulers, they may actually be undermining the very stability they are ostensibly there to ensure.

Among those asking this tough question are two young professors, Eugene Gholz, at the University of Texas, and Daryl Press, at Dartmouth College. To find out what actually happens when the world’s petroleum supply is interrupted, the duo analyzed every major oil disruption since 1973. The results, published in a recent issue of the journal Strategic Studies, showed that in almost all cases, the ensuing rise in prices, while sometimes steep, was short-lived and had little lasting economic impact. When there have been prolonged price rises, they found the cause to be panic on the part of oil purchasers rather than a supply shortage. When oil runs short, in other words, the market is usually adept at filling the gap.

One striking example was the height of the Iran-Iraq War in the 1980s. If anything was likely to produce an oil shock, it was this: two major Persian Gulf producers directly targeting each other’s oil facilities. And indeed, prices surged 25 percent in the first months of the conflict. But within 18 months of the war’s start they had fallen back to their prewar levels, and they stayed there even though the fighting continued to rage for six more years. Surprisingly, during the 1984 “Tanker War” phase of that conflict — when Iraq tried to sink oil tankers carrying Iranian crude and Iran retaliated by targeting ships carrying oil from Iraq and its Persian Gulf allies — the price of oil continued to drop steadily. Gholz and Press found just one case after 1973 in which the market mechanisms failed: the 1979-1980 Iranian oil strike which followed the overthrow of the Shah, during which Saudi Arabia, perhaps hoping to appease Islamists within the country, also led OPEC to cut production, exacerbating the supply shortage.

In their paper, Gholz and Press ultimately conclude that the market’s adaptive mechanisms function independently of the US military presence in the Persian Gulf, and that they largely protect the American economy from being damaged by oil shocks. “To the extent that the United States faces a national security challenge related to Persian Gulf oil, it is not ‘how to protect the oil we need’ but ‘how to assure consumers that there is nothing to fear,’ ” the two write. “That is a thorny policy problem, but it does not require large military deployments and costly military operations.”

There’s no denying the importance of Middle Eastern oil to the US economy. Although only 15 percent of imported US oil comes directly from the Persian Gulf, the region is responsible for nearly a third of the world’s production and the majority of its known reserves. But the oil market is also elastic: Many key producing countries have spare capacity, so if oil is cut off from one country, others tend to increase their output rapidly to compensate. Today, regions outside the Middle East, such as the west coast of Africa, make up an increasingly important share of worldwide production. Private companies also hold large stockpiles of oil to smooth over shortages — amounting to a few billion barrels in the United States alone — as does the US government, with 700 million barrels in its strategic petroleum reserve. And the market can largely work around shipping disruptions by using alternative routes; though they are more expensive, transportation costs account for only tiny fraction of the price of oil.

Compared to the 1970s, too, the structure of the US economy offers better insulation from oil price shocks. Today, the country uses half as much energy per dollar of gross domestic product as it did in 1973, according to data from the US Energy Information Administration. Remarkably, the economy consumed less total energy in 2009 than in 1997, even though its GDP rose and the population grew. When it comes time to fill up at the pump, the average US consumer today spends less than 4 percent of his or her disposable income on gasoline, compared with more than 6 percent in 1980. Oil, though crucial, is simply a smaller part of the economy than it once was.

There is no denying that the 1973 oil shock was bad — the stock market crashed in response to the sudden spike in oil prices, inflation jumped, and unemployment hit levels not seen since the Great Depression. The 1979 oil shock also had deep and lasting economic effects. Economists now argue, however, that the economic damage was more directly attributable to bad government policy than to the actual supply shortage. Among those who have studied past oil shocks is Ben Bernanke, the current chairman of the Federal Reserve. In 1997, Bernanke analyzed the effects of a sharp rise in fuel prices during three different oil shocks — 1973-75, 1980-82, and 1990-91. He concluded that the major economic damage was caused not by the oil price increases but by the Federal Reserve overreacting and sharply increasing interest rates to head off what it wrongly feared would be a wave of inflation. Today, his view is accepted by most mainstream economists.

Gholz and Press are hardly the only researchers who have concluded that we are far too worried about oil shocks. The economy also faced a large increase in prices in the mid-2000s, largely as the result of surging demand from emerging markets, with no ill effects. “If you take any economics textbook written before 2000, it would talk about what a calamitous effect a doubling in oil prices would have,” said Philip Auerswald, an associate professor at George Mason University’s School of Public Policy who has written about oil shocks and their implications for US foreign policy. “Well, we had a price quadrupling from 2003 and 2007 and nothing bad happened.” (The recession of 2008-9 was triggered by factors unrelated to oil prices.)

Auerswald also points out that when Hurricane Katrina slammed into the Gulf Coast in 2005, it did tremendous damage to offshore oil rigs, refineries, and pipelines, as well as the rail lines and roads that transport petroleum to the rest of the country. The United States gets about 12 percent of its oil from the Gulf of Mexico region, and, more significantly, 40 percent of its refining capacity is located there. “Al Qaeda times 1,000 could not deliver this sort of blow to the oil industry’s physical infrastructure,” Auerswald said. And yet the only impact was about five days of gas lines in Georgia, and unusually high prices at the pump for a few weeks.

While there is an increasing consensus that oil shocks caused by disruptions in supply are not particularly harmful — and, somewhat surprisingly, have little impact on oil prices — a debate still rages among economists about whether the same can be said of oil shocks caused by increases in demand or those caused by speculators bidding prices up in anticipation of a supply disruption (such as before the first Persian Gulf War). The relation of these sorts of shocks to economic recessions is not well understood. But what’s clear is that the relationship has more to do with human perceptions than any actual change in the oil supply.

So how much should we be sacrificing to protect our oil supply? The question goes to the heart of American policy in the Middle East.

In 1997, Graham Fuller and Ian Lesser, two political analysts at the Rand Corporation with long records of US government service, estimated that the United States spent “$60 billion a year to protect the import of $30 billion worth of oil that would flow anyway.” A 2006 study by James Murphy, an economist at the University of Alaska Anchorage, and Mark Delucchi, at the University of California Davis, similarly found that when the costs of the wars in Iraq and Afghanistan were taken into account, the expenditures ranged anywhere between $47 billion and $98 billion per year. But the amount of oil coming to the United States from the region was worth less than $35 billion per year.

“Why is it that American consumers are bearing a disproportionate cost of having oil flowing to the international marketplace?” said Christopher Preble, head of foreign policy studies at the Cato Institute, a libertarian think tank in Washington, D.C.

In their Security Studies paper, Gholz and Press argue that there are indeed a few threats in the Persian Gulf that might overwhelm the oil market and threaten US energy security. One of these would be an attempt by a single power to conquer the majority of the region. Another is Iran blocking the Strait of Hormuz, the only irreplaceable sea channel. The third is revolution in Saudi Arabia. The first two scenarios are highly unlikely, Press and Gholz argue, and could be countered by moving in US forces stationed elsewhere in the world, such as the neighboring Mediterranean and Indian Ocean. (There is debate among security analysts about whether Iran has the military capability to close the strait, or could itself economically survive such a move.) A revolt in Saudi Arabia, on the other hand, is looking increasingly possible given the recent events in Tunisia and Egypt — but it could not be prevented by the US military deployed in the Gulf. Our presence could even make such unrest more likely, if soldiers became flashpoints for revolutionary anger.

Gholz’s and Press’s argument has gained some currency in academic circles. “I have believed for a long time that the US presence in the Gulf has been ‘under argued’ strategically,” Barry Posen, a professor of political science at the Massachusetts Institute of Technology, where both Gholz and Press received their PhDs, wrote in an e-mail response to questions about this topic. “Press and Gholz undermine the usual ‘simple’ arguments for being there. That leaves us looking for other arguments that may be the ‘true’ ones, or suspecting that there is no strong argument.”

But it has gained little traction so far either on Capitol Hill or in the corridors of the Pentagon. “Did it immediately change people’s minds? Not really,” Gholz said of his paper.

Auerswald, who has grown frustrated by the lack of response to his own research on this topic, said that the problem is that the fear of Middle Eastern oil shocks is now politically useful to a whole spectrum of powerful interest groups. “This argument is like the familiar old jeans of American politics,” he said. “They are nice and cozy and comfortable and everyone can wear them. Because of ethanol, the farm lobby loves it; for coal, well it’s their core argument; for the offshore drilling folks, they love it.” Even the environmental movement relies on it, he said, because they use it as bogeyman to scare Americans into taking renewable energy and energy conservation more seriously. As for the US military, “The US Navy is not interested in hearing that one of their two main theaters of operation has no justification for being,” Auerswald said.

The costs to US foreign policy, of course, cannot be calculated in dollars and cents alone, although certainly the cost here has been very high. But it looks even higher when one considers the lost opportunities and squandered chances — what we could be achieving if we weren’t so concerned about a threat that looks increasingly like an illusion.

“If we are going to commit our troops to prevent something from happening, it should be something that would be an existential threat to the United States,” said Auerswald. “Having people wait in line for five days for gas in one part of the US is not an existential threat.”

Jeremy Kahn is a journalist based in New Dehli.