TCS Daily

Futures Talk

By Benjamin Zycher - January 29, 2003 12:00 AM

If I were smart, I'd be rich. Alas, I am neither; but, according to my wife, I am old. Therein lies a well-worn tale, to wit, it is difficult indeed to beat the market, despite decades of dedicated effort. Thus has Jim Glassman, honored host of TCS, hammered home an eternal truth far broader than buy-and-hold: Market prices are supremely useful as a source of information. And so with war against Saddam Hussein and the Iraqi Ba'athists perhaps imminent, let us ask what that great, booming, uncoordinated, noisy, confusing, twenty-four/seven market is telling us about the prospective increase in oil prices attendant upon military action this winter or spring.

That is a question of some interest after all, as many sophisticates, as always consumed with the plight of the common man, are concerned - deeply, deeply concerned - that for some in positions of authority in Washington, peace seems not to be the answer to those unpleasantries that came to pass on September 11, 2001, not to mention the prospect of Middle East fascism with weapons of mass destruction.

As was the case before and during the recent Afghan campaign to remove the Taliban from power, many horrors are said to be looming upon the use of U.S. military force in Iraq. The Middle East will destabilize. Unhappiness will darken the faces of the Europeans. Sleepless nights will haunt our earnest Saudi allies. We will receive dirty looks from such stalwarts as Hosni Mubarak and Assad the Child. The Arab Street will throw more rocks. The International Community will not approve. Military action in Iraq will interfere with the higher-priority hard line favored by the Left toward the well-fed mini-me Stalins in Pyongyang. Military equipment will emit carbon dioxide, and the fragile Iraqi desert will be disturbed. No more Mr. Nice Guy from al-Qa'eda, Hezbollah, and the other libertarians lurking in the Middle East shadows. War means death for children and other living things. Huge karmic retributions will be ours. Self-determination for the people of Iraq will be but a dim memory. We will have to endure more demonstrations by nude women in San Francisco. Fewer tax dollars will be available for the myriad constituencies forever engaged in a life-or-death tug-of-war over snout privileges at the federal trough. All we are saying is give peace a chance.

And for the ultimate in sophistication - for the gold standard in analytic insight - we need only recall the blessed memory of the timeless Marty Feldman in Young Frankenstein ("Blucher!") by invoking the name that reigns supreme in political discourse, that stands head and shoulders above the rest: Streisand! It's all about cheap oil. And the chemical and timber companies. Or something.

So there we have it: War is Hell. And did I forget to mention that it's all about cheap oil? With oil prices now at about $32 per barrel, much of the peace lobby argues - better sit down - that it's all about cheap oil, and simultaneously that prices will rise to $100 per barrel or more should the U.S. take military action to remove Saddam Hussein and the Socialist Ba'ath Party from power in Baghdad.

Now, even by the standards of the Left, the "cheap-oil" argument is inane, in that cheap(er) oil could have been garnered years ago simply by ending the economic sanctions regime, without all the muss and fuss of troops, ships, inspectors, Congressional Democrats, and United Nations bureaucrats. And why was cheap oil not pursued through military means before 9-11?

In any event, the argument that military action will yield a dramatic increase in oil prices is more serious; whether that outcome would be a price worth bearing is a question I leave to the Hollywood types and other such worthies smart, rich, and young... that is, very much unlike me. Let us ask instead whether $100 oil, or anything remotely approximating it, is a reasonable expectation.

At a basic conceptual level, if the market really expected $100 oil in the near future, prices would be bid up to nearly that level today, as arbitrage would eliminate the potential profits inherent in the prospect of dramatic price shifts over time. That is what it means to say that there exists a market rate of interest - a market price - linking the present with the future. This is particularly the case for a commodity like oil, the consumption and production of which are substitutable over time, in that $32 oil left in the ground today can earn an enormous rate of return if produced and sold for $100 tomorrow.

More to the point, we have data from futures prices on the beliefs of the market. The following table shows 2003 futures prices (for light, sweet crude oil) as of January 27 on the New York Mercantile Exchange.

Crude Oil Futures Prices, 2003 (dollars per barrel)
Delivery Period Price
February 34.61
March 33.28
April 32.16
May 31.12
June 30.13
July 29.19
August 28.41
September 27.81
October 27.32
November 26.94
December 26.61

The market clearly expects a moderate jump in prices in February for a temporary period, followed by a larger decline over the remainder of the year. That temporary period begins with what clearly is the market perception of a high probability of hostilities affecting aggregate world oil production, and ends with a perception of relative confidence on the timing of restored production to levels prevailing before the military action, or perhaps even higher levels. (An expectation of renewed production in Venezuela is likely to be a factor as well.) Given recent statements by U.S. public officials, as well as the political and policy implications of a failure to remove Saddam Hussein from power, the market perception of the likelihood of hostilities must be high; but conditions in the futures market for crude oil suggest an expectation of a very moderate and temporary price increase. Because the timing and duration of hostilities and the likely price increase are uncertain, it may be reasonable to expect actual price increases somewhat larger than those (about $2-$3 per barrel) implicit in the table, in that risk aversion on the part of traders might put some downward pressure on futures prices. But even if we assume an increase of, say, $10 per barrel, the (temporarily) higher price would be substantially lower in real terms than the $57 price (in 2002 dollars) observed in 1982.

What explains this market behavior? First, the higher prices caused by hostilities in the Persian Gulf will induce increased production by other producers and perhaps the use of replacement reserves in the U.S. Strategic Petroleum Reserve. If all Iraqi and, say, all Kuwaiti production were to cease during the hostilities, the reduction in output would be about 2.7-4.5 million barrels per day (mbd), depending upon assumptions about current Iraqi production. Excess production capacity outside the Persian Gulf is, conservatively, about 2-3 mbd; inclusion of Saudi Arabia increases that figure to about 5-6 mbd. In addition, the SPR holds about 583 million barrels, with a drawdown capacity of about 4 mbd. Increased Saudi production is not certain, but cooperation on their part may be more likely as the end of the Iraqi regime becomes imminent, and as substantial U.S. forces are stationed and operating nearby. The upshot is that even a serious supply disruption - say, 8 mbd, or about 10 percent of world production - would be tempered substantially by replacement supplies, even if only half of the excess production/SPR capacity were used. In that case, the net production cut, conservatively, would be about 4 mbd; under very reasonable assumptions about demand and other market conditions, that would yield a price increase of about $10 per barrel. This analysis suggests that the futures market, as described above, is (unsurprisingly) not making a systematic mistake. Second, Iraqi reserves are estimated conservatively at about 115 billion barrels; for comparison, Saudi reserves are estimated at about 265 billion barrels. While the relationship between reserves and production is not proportional, Iraqi output well before imposition of the sanctions regime was far below half that of the Saudis; and numerous geological experts argue that the true Iraqi reserve potential is far greater than that estimated officially by the U.S. Energy Information Administration. Moreover, the long-term Iraqi military threat to the Persian Gulf regimes is likely to have exerted upward pressure on oil prices, both because of a market expectation of potential hostilities at some future time, and because of resulting incentives on the part of the Saudis and others to produce less than otherwise would be the case so as to satisfy implicit Iraqi demands for higher oil prices. The Iraqi threat, therefore, has a hidden effect of cartelizing the market to some extent, an effect that would diminish or disappear were the Iraqi regime replaced. If we assume, reasonably, increased longer-term production by Iraq of 3 mbd, by the Saudis of 2 mbd, and by other Persian Gulf producers of 1 mbd, fair assumptions about market conditions suggest that world crude oil prices would fall from the current $32 (or so) per barrel to about $16-$20 per barrel. Because, again, the sale and consumption of oil are fungible over time, an expectation of falling prices in the longer term exerts downward pressure on prices in the near term.

So: Perhaps it really is all about cheap oil. Actually, that would be a non sequitur: To say that cheap oil would result is not to say that cheap oil is a primary or even secondary goal.

Markets certainly make mistakes; the telecom bubble was not merely a bad dream. But in the alternative universe inhabited by much of the peace lobby, markets matter not, evidence is unworthy of examination, endless inspections will make the world safe, the Israelis are the threat to peace, the French are deep thinkers, international organizations are fonts of wisdom, and war never solved anything. Would you take investment advice from such sophisticates? I might. But, then, I'm not smart. Or rich. Or young.

Benjamin Zycher is a senior economist and fellow at the Pacific Research Institute. Email:

TCS Daily Archives