The Frontal Cortex

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?


  1. #1 Michael W.
    March 30, 2007

    Good point. I think most Americans are just too rich to care about paying a few more dollars a week at the gas pump.

  2. #2 _Arthur
    March 30, 2007

    I suggested that the War in Iraq be entirely funded by a new gas tax.
    The boys would be recalled home in a record time !

  3. #3 Roy
    March 30, 2007

    Americans have learned that cutting their gas consumption will have no effect on gas prices. In a free market, prices would respond to supply and demand. It’s been decades since we had anything like a free market.

    We have already seen gasoline prices rise in the winter because of projected heating oil use, and then rise in the summer because of projected increases in travel in the summer. There is no seasonal fluctuation anymore, only artificial ‘cycles’.

    We have a contrived market, where the law of supply and demand is ‘inoperative’.

  4. #4 tekel
    March 30, 2007

    Everybody knows our military can’t go to war with Iran right now, so why further inflame the oil markets?

    Because higher gas prices means more money for Republicans. Remember this guy?

    I’m sure higher gas prices don’t bother him at all.

  5. #5 Mark
    March 30, 2007

    The point of cutting consumption is not to lower gas prices, it’s to reduce the flow of Western money into Middle Eastern pockets, and thence to other even less friendly pockets.

    It should come as no surprise that the current price of gas, and even that higher price last summer, does not reduce consumption significantly. The fact is that even at $3 a gallon, gasoline is not expensive. The proof of that is the aforestated fact: gasoline consumption has not gone down signficantly. Gas prices will probably have to pass $5 a gallon before many people change their behavior.

  6. #6 bigTom
    March 30, 2007

    I’m not convinced that this sort of fear is good for the Iranian economy. Sure they get more money for their oil, but it also scares off
    investment, which hurts.

    Of course politically we’ve never been able to sell gas taxes. A motorist screaming “the problem is I’m already paying too much!” always carries the day.

  7. #7 Louis
    March 30, 2007

    ‘The threat of war makes the bad guys very rich.’
    The Bad Guys?

  8. #8 MattXIV
    March 30, 2007

    Copy of Knittel’s paper here:

    When you adjust for inflation, the gas prices during the
    shocks in the ’70s were still higher in inflation adjusted dollars than they currently are (only the transitory spikes are hitting the ’70s level), personal incomes are higher as well, cars are more efficient, so the instrumental value of a gallon of gasoline has increased. The paper’s discussion section covers a lot of explainations. Also, as the authors note “It is important to note that these results measure consumers’ reactions to short-run changes in gasoline prices. However, it is the long-run response that is the most important in determining which polices are most appropriate for reducing gasoline consumption.” Chosing more fuel effient vehicles is a much larger factor in long run than short run elasticity. The results suggest that long run elasticity may be lower as well, but I’d suggest that the fleet turnover may be lower in the short run because the rate of price increase during the current period is lower and varies more, making consumers less certain about the extent of future prices. Also, uncertaintly seems to play a greater role in the spikes since the events that caused them in the recent period were more transitory while the Iranian revolution had more persisitent consequences.

  9. #9 Organic Chemistry Help
    May 24, 2007

    The short term problem is easy to fix, Iran is an economic mess b/c of inflation there. Wait them out, their economy will collapse and they will not be able to do anything….of course the long term problem of oil addiction is a whole different matter.

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