Iran and the Risk Premium

It's the worst of all possible worlds: gas prices have gone up, but Americans haven't adjusted their gasoline consumption habits. Instead of using higher energy costs as a prod to use less energy (or at least use less foreign oil), we have fully acclimated to the price at the pump:

In the late 1970s, OPEC oil shocks and gas lines persuaded most Americans to sacrifice some of their pleasure trips and drives to the mall, ease up on the gas pedal, and switch to the bus or train.

But as Americans enter the sixth year of rising oil and gasoline prices, their shift in driving habits this time has been much less extensive. What's more, in recent weeks, gas consumption has gone up, not down, and drivers are changing their daily driving habits only slightly.

A recent study that Christopher Knittel, an economics professor at the University of California, Davis, helped write showed that every time from November 1975 to November 1980 that gasoline prices went up 20 percent, consumers changed their driving behavior by cutting gas consumption by 6 percent per capita nationwide.

But from March 2001 to March 2006, drivers reduced consumption just 1 percent when prices rose 20 percent. Prices swung up and down seasonally during both periods, but Mr. Knittel said the two periods were comparable because regular gasoline prices increased in both periods by about 66 percent, to $2.50 from $1.50 in real terms, set at 2000 dollars.

I hate to parrot Thomas Friedman, but we are funding both sides of the war on terror. (Not to mention Hugo Chavez and Putin.) Just look, for example, at the recent escalating tensions in Iran. It's hard to understand why Ahmadinejad would possibly kidnap 15 British sailors. Does he want to go to war? Is he spoiling for a fight? But look at how the price of oil has responded to these events. Escalating tensions cause escalating fuel prices, as the market responds to the risk premium. (According to most analysts, the risk premium accounts adds more than $10 dollars to the price of every barrel of oil.) The Iranian treasury benefits from a higher risk premium: the possibility of war props up their faltering economy.

James Surowiecki recently made a similar point:

When buying and selling oil, traders don't just look at today's supply and demand. They also try to forecast the future. And if buyers think there's a chance that supply is going to be lower down the line--because, say, Iranian oil fields will be shut down--they will be willing to pay a higher price today in order to guarantee that they will have the oil they need. That's why, in the run-up to the Iraq war, oil prices jumped more than fifty per cent. In the current confrontation between the U.S. and Iran, these same concerns create a perverse set of incentives: whenever the U.S. says things that make a military conflict with Iran seem more likely, the price of oil rises, strengthening Iran's regime rather than weakening it. The more we talk about curbing Iranian power, the more difficult it gets.

But here's the rub: the only way to make Iranian aggression unprofitable for the Iranians (and the Saudis, Venezuelans, etc.) is to reduce our own domestic consumption.* (I'm a fan of a hefty gas tax.) Until we do that, the oil market will continue to encourage petty acts of violence. The threat of war makes the bad guys very rich.

*It's also time that Bush realizes that making empty threats - "We are keeping all options on the table," etc. - comes with real costs. Everybody knows our military can't go to war with Iran right now, so why further inflame the oil markets?