Invading Iraq: Will Oil Prices Rise?

Believe it or not, the key to this conundrum is to realize that oil is actually priced very much like a government bond. Simply put, the owner of an oil well has a choice. Pump oil at the present price — or leave it in the ground to be pumped later.

Why is that like a government bond? Because a government bond can be sold right now — or the holder can choose to wait and sell it next year. In both cases, today’s value of the asset depends on two critical variables. They are the price that the investor can expect to get for the asset tomorrow — and the rate of interest.

But back to oil. Clearly, the owner of an oil well wants to make as much money as possible. Pumping oil today — and selling it — leaves the producer with cash that can be invested at the going interest rate.

Not pumping — keeping oil in the ground — loses the potential interest earnings. Why would anybody wait, then?

Well, the answer is that it all depends on next year’s price. If the owner of the oil well expects the price to rise by more than the rate of interest — then there is more money to be made by not pumping this year.

Why would producers expect prices to rise? Perhaps because they think there might be a war in the Middle East. That is why talk of an invasion of Iraq next year can raise oil prices today.

To make things a little more complicated: Next year, the oil producers have the same decision to make. Pump now (i.e., next year) or wait for the following year (two years from now).

The future, then, is a whole series of decisions about pumping oil. To figure out whether it is more profitable to pump or to wait, oil producers have to try to guess the entire stream of future oil prices and interest rates in order to decide whether this year’s price is high enough to justify pumping oil.

That sounds impossible. But, in fact, pricing decisions like these are made all the time in financial markets. Today’s price of, say, a 30-year bond depends on estimates of interest rates for the next 30 years.

And, in recent years, some companies have issued hundred-year bonds! Pricing those bonds requires that Wall Street analysts put hundred-year interest rate projections into their formulas.

Of course, there is a lot of uncertainty in the process. And, markets being what they are, that uncertainty (“risk”) gets a price, too.

Back to oil again: it is now clear that the decision to pump oil today — and essentially, today’s price — depend on everybody’s guesses about tomorrow’s price of oil. And those, in turn, depend on the future political situation in the Middle East.

Assume for a moment a successful invasion of Iraq. Such an outcome could change the political situation in the Middle East in a very radical way.

If the dreams of the U.S. Defense Department come true, Iraq will be well on its way to installing a secular, democratic regime by 2004.

This would also put pressure on oil producers like Saudi Arabia to reform their political systems — and move towards stability. And it would put additional pressure on rogue regional players such as Syria to clean up their act — and fast.

In other words, what arguably seems like a very dangerous political situation would change abruptly. The probability of an Islamic coup in Saudi Arabia, or a similar disastrous event in the region, would be significantly lower. With less chance of such problems, oil traders would assume that future oil prices are more likely to be low in the future.

And, remember that today’s price depends on everybody’s best guess of next year’s price, and the year after and so on. If — and it is a big if — the invasion of Iraq makes high oil prices less likely in the future — the price that producers require today to pump their oil will fall.

Up to this point, however, nobody has quite realized that a successful invasion of Iraq just might give the world economy a surprising boost.