War for Oil Price Relief?

I recently saw an article talking about how oil was about to hit $40 per barrel. The US economy cannot survive for very long if it stays at that kind of price level. Unfortunately, I fear that we have reached a point where the timing of the commencement of hostilities will be dictated by the need to provide price relief in the oil markets. While the war still won’t be about the oil (it’s more about liberation of an oppressed people and a pre-emptive defense of the American way of life), this will give the appeasement wackos there war for oil ammunition for the next round of the longer term battle.

I don’t believe that the US (or our allies) are intended to go into Iraq and take over the oil fields for the purpose of pumping massive quantities of oil for our SUVs. We may temporarily appropriate some of the oil revenues to offset some of the costs of occupation and rebuilding, but ultimately the Iraqis will benefit from the oil revenues.

But that still leaves the question of how a war will reduce the price of oil if the US doesn’t take the oil fields as the spoils of war. It’s actually pretty simple. The price of oil, like every other commodity, is priced based on two factors: the intrinsic value and the risk premium. Oil’s intrinsic, or real, value seems to be right around $14-$15 a barrel. We know this because when the world is calm and the oil supplies are safe and stable, oil tends to bottom out around $16-$18 a barrel. In a peaceful environment, the risk premium is mainly related to the chance of a ship sinking or a pipeline leaking or the very remote risk of a sudden war at that time.

In a turbulent time like today, the risk of oil supplies being interrupted greatly increases. The real value of oil hasn’t gone up – it’s still around $14-$15 a barrel – but the risks have. As a result, the oil importers are willing to pay much much more than intrinsic value to ensure that they will get a shipment that allows them to keep their refineries open and their people employed.

What worries me is that if we back down right now and say “Oops. Sorry. Just kidding, go ahead and keep on ignoring the UN and keep on oppressing your people” we will permanently raise the risk premium on imported oil. The long term risk premium is now around $2-$4 a barrel. To give in now, would embolden the maniacal dictators of the region and would great increase the chances of an interruption in the supplies of oil. As a result the risk premium would rise in relation to the perceived new risks in the oil market.

Despite all the efforts of the environmentalists (and as a result of the efforts of the environmentalists), the US is still way too dependent on oil. Our entire transportation system is based on the consistent and cheap supply of oil. Our road vehicles run on gas or diesel, our railroads run on diesel, and our airlines are dependent on a ready supply of avgas. According to the Department of Energy, just over 20% of our national energy production for 1999 was from oil (couldn’t find more update numbers, sorry).

Unfortunately, there is not a quick fix to the situation. The critical area in our information-based economy is to reduce the amount of oil used in the production of electricity. The most efficient way to do this, in my opinion, is to expand our use of nuclear energy. It would be interesting to see if the environmentalists would support a coal plant over a nuke plant. That issue, by itself could become a defining choice in the maturation of the environmentalist movement in the US. I have heard unsubstantiated rumors in the past that the railroads were looking at coal power again, as coal is – supposedly - significantly less expensive than oil, even when oil trades at $20 a barrel. A diversification of power sources in the railroad system can’t hurt as the railroads use copious amounts of diesel fuel. We need to get an reliable automobile powered by a fuel cell out in the dealer showrooms and on the road. The airlines would do well to look for alternative sources of power, but I’m not aware of any out there and I also think that the airlines are going to be supplanted to a large degree by the internet. Airlines derive a huge chuck of their business from business travelers. The internet is taking those travelers away, leaving just the low yield tourist. The airlines are going to have to go through a massive restructuring and as they find ways to cut costs, competition is going to drive the consumption of avgas down.

It is a pity that the efforts of our troops to liberate a people and to protect American values are going to be lost in the rhetoric of “war for oil.” Yes, war will reduce the risk premium on oil prices, but oil isn’t the overriding concern. We need to explore alternative fuel sources and take this argument away from those who are simply anti-American. It’s too bad we haven’t done it already and that we can’t do it in time to get the debate down to facts, not rhetoric.