Paul Krugman
Operation Epic Fury, the U.S.-Israeli bombing campaign against Iran, began on Feb. 28. At first, the reaction of energy markets was muted. As the days passed, however, it became clear that the air strike that killed much of the Iranian regime’s top leadership had not broken that regime’s grip on power. It also became clear that despite heavy bombing, the regime retained the ability to launch drones and missiles at energy facilities and shipping in the Persian Gulf. More than two weeks after the war began, the Strait of Hormuz, a crucial choke point for world energy supplies, remains effectively closed, and nobody knows when it will reopen.
Inevitably, given these events, the prices of oil, liquefied natural gas, and fertiliser produced from natural gas have soared.
I wrote about the possible economic consequences of such price shocks last week. It has become clear to me, however, that it would be useful to provide a sort of prequel to that discussion: a review of how global energy markets work, the factors determining energy prices, and the distribution of losses and gains — for there are some winners even from bad news — as oil prices soar.
Some of the winners are obvious: Russia and oil producers everywhere except in the Persian Gulf. The losers may come as a surprise: American consumers are being hit hard even though the US produces more oil and natural gas than it consumes, while China, despite its dependence on imported hydrocarbons, is relatively insulated from this shock.
Beyond the paywall, I will address the following
- Tankers, pipelines and the geography of energy
- How high can energy prices go?
- Why domestic oil production doesn’t protect consumers
- The importance of oil intensity
There are two main hydrocarbons that matter for the world economy: Oil and natural gas. Large amounts of both are currently bottled up inside the Strait of Hormuz. However, the global distribution of pain from this blockade is different for the two fuels.
Oil is normally easy to transport either overland, via pipelines, or by sea in tankers. This ease of transportation creates a global market in which prices in different regions can’t get too far apart, because any large divergence creates an incentive to divert supplies to the high-price locations. Notably, oil extracted from U.S. shale can be shipped either via pipeline to domestic markets or overseas to European markets. This possibility of arbitrage has kept the world’s two leading benchmark prices for oil, West Texas Intermediate in the U.S. and Brent in Europe, rising in tandem since the war began.
And while the US doesn’t import natural gas, it imports a large share of its fertilizer. So urea prices have risen sharply, even in the United States — about 30 percent so far.
Furthermore, there are good reasons to worry that the price increases so far may be only the beginning.
How high can prices go?
It’s a cliché to assert that some event or policy change takes us into uncharted territory. Yet the Iran war has done just that, literally. By cutting off all shipments through the Strait of Hormuz — shipments that supplied 20 percent of the world’s oil — the war has inflicted a shock to world oil supplies that is, as Donald Trump might put it, like nothing anyone has ever seen before. You can look at charts of previous energy crises; they don’t show anything like this.
Now we’re in a situation in which the world as a whole must, one way or another, drive substantially less or find other ways to burn less oil, because unless the Strait of Hormuz is opened soon the oil simply won’t be available. To achieve demand destruction on that scale would clearly require driving the price of gasoline well above 2022 levels, which would in turn require world oil prices well above $150 a barrel, quite possibly well above $200 a barrel.
Unless the Strait is opened soon — and while this post isn’t about geopolitics, it’s very hard to see how that will happen — the energy situation will soon become very ugly.
But ugly for whom?
President Trump raised eyebrows with a social media post Wednesday in which he argued that soaring oil prices are a good thing:
He wasn’t wrong about the U.S. being the world’s largest oil producer. We are, however, also the world’s largest oil consumer, which should curb our enthusiasm. Still, the U.S. produces more oil than it consumes. Doesn’t that mean that on net we gain from higher oil prices?The answer is, what do you mean by “we”?
A rise in oil prices, which leads in turn to higher prices of gasoline, diesel, and heating oil, hurts U.S. consumers. On the other hand, U.S. oil producers do indeed “make a lot of money,” a gain that ultimately accrues to their stockholders.
A new report from the investment bank Jeffries estimates that if oil stays near $100 a barrel this will generate more than $60 billion in windfall gains for US oil companies. If oil prices go much higher, as I’ve suggested they may, the gains will be much bigger.
The crucial point is that even within the United States, consumers and the beneficiaries of higher oil prices are different people. I don’t know of data on who exactly owns oil-company stock, but if the composition of ownership resembles ownership of U.S. equities in general, a large fraction — possibly as high as 40 percent — is owned by foreigners, and of the share owned by U.S. residents, almost 90 percent is owned by the richest 10 percent, half by the richest 1 percent.
Before the Iran war, some commentators argued that the U.S. was well-positioned to weather a shock to oil prices, because as a nation, we are more than self-sufficient in oil, indeed a net exporter. But this self-sufficiency is irrelevant to the great majority of U.S. households, who are hurt by higher prices at the pump while having little or no share in the gains to domestic oil producers. In this sense U.S. households are in the same position as households in, say, Europe or Japan, even though the U.S. is a major oil producer and most other nations are not.
Is domestic production of oil always irrelevant to most people? No.
In the 1970s the U.S. imposed price controls on both oil producers and refiners as oil prices soared. These price controls had problems — they led to shortages and the infamous gas lines — but did initially limit the hardship faced by families. When the controls were gradually lifted beginning in 1979, they were followed by an excess profits tax (actually an excise tax on domestic oil) designed to capture part of the gains to oil companies.
Today, with America a net exporter of oil, the U.S. government could devise policies that would largely insulate U.S. households from the Iran war shock. But it’s hard to imagine either price controls or excess profits taxes being imposed in the current U.S. political environment.
The politics of oil prices are different in other nations. China has price controls on gasoline and other energy products that will insulate consumers if the world oil price rises above $130 a barrel. And Russia, the world’s second largest oil exporter after Saudi Arabia, has a “mineral extraction tax” tied to world oil prices, which means that soaring oil prices translate into a large gain in Russian government revenue.
Under the current rules of the game, then, the disruption of oil supplies resulting from the Iran war will hurt consumers around the world, even if they are living in countries with large domestic oil production. Companies that produce oil, and hence their stockholders, will gain. And the Russian government will be a major beneficiary.
That being said, the impact on consumers will vary around the world, because there are significant differences in how much oil nations consume relative to the size of their economies: The U.S. economy is “oil-intensive” compared with Europe and especially China.The importance of oil intensity
Rosemary Kelanic at Defence Priorities had a good op-ed in the Times about the importance of oil intensity when assessing the impacts of the Iran war. I wrote early in the war about how the economy’s oil intensity has declined since the 1970s and why that matters. But I worry that the concept may seem abstract and could use more explanation. I also think it would be useful to offer a brief explanation of the reasons the U.S. economy is more oil-intensive than the economies of other nations.
The raw fact is that other nations consume much less oil per capita than the United States. The European Union consumes less than half as much; China only about a fifth as much. However, residents of other nations also have lower incomes than Americans. In the case of Europe roughly half of this income gap is explained by shorter work hours — Europeans take vacations! — and much of the rest can be attributed to a handful of U.S. technology and financial clusters, but that’s another story. China is simply poorer, despite its rapid economic growth.
Relative oil intensity is just the ratio of oil consumption to GDP. The European and Chinese economies are both only about two-thirds as oil-intensive as the US economy.
What this means is that a spike in oil prices hits U.S. consumers harder than it hits European or Chinese consumers. This is true even though America is self-sufficient in oil while other major economies are not.
Now, because Europe and China import LNG, natural gas prices are rising sharply in their economies while mostly unaffected in the US. Even so, the overall negative effect of the Iran crisis on US consumers is probably larger than the effect overseas. Again, this is happening even though America is a net oil exporter.
Why are other economies less oil-intensive than the U.S. economy? Part of the answer is that they have been faster to adopt renewable energy, with China’s rapid move to electric cars especially impressive. But that’s a relatively recent factor.
To summarize:
Because there is effectively a single market for oil, US households are facing the same price shock as residents of other nations, even though the US is a net exporter of oil. We are somewhat insulated from the rise in prices of liquefied natural gas, but also exposed to a sharp rise in fertilizer prices. And it seems all too possible that the surge in oil prices has just begun, that prices will go much higher than they are.
There are some winners from the Iran war oil disruption: mainly oil producing companies and the Russian government. That’s cold comfort to ordinary families.
And U.S. families are arguably even more exposed than their counterparts in other advanced economies because of the U.S. economy’s high oil intensity.
I wish I could paint a less depressing picture, but that’s where we are as the war enters its third week.
This is a summary of an article by Nobel Prize-winning economist Paul Krugman, published under the same title on the US-based publishing platform Substack.