Tag: Iran

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Economic games in the Iran war

Economists use game theory to understand decision making where the outcome for an economic actor – individual, firm, government, etc. – depends on the actions and reactions of other actors. It models how rational actors make optimal decisions based on their expectations about such actions and reactions of competitors. Sometimes these expectations will be based on considerable knowledge; sometimes they will be based on hunch or the degree of optimism or pessimism.

Perhaps the most famous game is the prisoners’ dilemma. This is where two or more firms (or people) independently attempt to choose the best strategy, thinking about how their rivals are likely to react. But they end up in a worse position than if they had co-operated in the first place. For example, if a firm is considering cutting price, it would gain market share if the other firm does not cut price; in such a scenario it is likely to gain by cutting price. If, however, the other firm is expected to cut its price, the first firm will have to cut price itself to avoid losing market share; in this scenario it will also cut price. Assuming the other firm reasons the same, the outcome is likely to be a price war, with both firms losing profit. However, if they both colluded to maintain prices or even raise them (assuming they can evade any legal restrictions on collusion), they will both gain.

Another example is the game of chicken. This is where two or more actors engage in brinkmanship, hoping that the other actor(s) will give in first. Take the above example of a price war. Assume that two firms are engaging in price cutting. They know that this will damage their short-term profit. But each hopes that the other will give up first and may then be willing to collude or, better still, be driven out of business. If either firm thinks it can win the game, it will reason that short-term pain is justified by long-term gain.

The war in Iran

A game of chicken is currently being ‘played’ by the USA and Iran. Iran is blocking the Strait of Hormuz; the USA is blockading Iranian ports, preventing ships from arriving or leaving. Both policies inflict economic pain. Blocking the Strait of Hormuz has driven up oil and gas prices and the prices of many other products exported through the Strait – products such as fertilisers, plastics, petrochemicals, sulphur, methanol and helium.

Each side hopes that the economic pain inflicted on the other will cause it to give up first.

But the game is ‘asymmetric’: the costs of continuing the blockades are different for each side and thus the pressures on each side to concede differ. For Iran, the blockade of its ports is massively curtailing its exports and is doing huge damage to its economy, already battered by bombing. But the war has so far seemed to allow the Iranian authorities to tighten their political grip and they may be prepared to play the ‘long game’ by rallying the Iranian population against the US and Israeli assault. The authorities may calculate that the Iranian people will be prepared to endure greater hardship for some time.

The USA is facing a much lower economic cost. Much of the hardship from the effective closure of the Strait of Hormuz is being borne by other countries. Energy and fertiliser shortages and the resulting rise in price of these critical inputs threaten a humanitarian disaster in some of the poorest countries. Harvests will be down, as will GDP; food prices will soar. There will be widespread economic hardship across Africa and much of Asia, particularly in those countries struggling with existing high debt burdens.

But for Donald Trump and his administration, those costs are likely to be seen as important only in so far as they affect the USA. However, oil prices are determined in international markets and, despite the US economy gaining from higher oil prices as the USA is a net exporter, the price of fuel to the US consumer has risen substantially. Petrol prices in the USA have risen some 45% since the start of the war and jet fuel prices have doubled, driving up air fares. With the prices of other key products, such as medicines, clothing and electronics increasing too, US inflation is now rising – aggravated by the effects of the tariffs on many products. These costs matter to the US consumer and, with mid-term elections approaching and with Donald Trump’s approval rate plummeting, the USA is likely to be more sensitive to short-term economic costs than Iran.

But the USA poses a much greater military threat to Iran than vice versa and this is seen in the USA as a major advantage in this high-stakes game of chicken. But the Iranian authorities’ willingness to endure further military strikes for what they see as long-term gain, may make them unlikely to concede first.

Podcast and video

Articles

Questions

  1. Explain the prisoners’ dilemma game and explain what is meant by the Nash equilibrium in the game.
  2. What is the Nash equilibrium of a game of chicken?
  3. Explain the asymmetries in the ‘game’ being ‘played’ by the USA, Israel and Iran?
  4. What other actors are there in the ‘game’ and do they play any significant role?
  5. How important is information and understanding held by the USA, Israeli and Iran about the likely consequences of their actions?
  6. What can mediators, such as Pakistan, do to de-escalate the situation?
  7. What are the likely long-term costs to the global economy if the blocking of the Strait of Hormuz persists for a number of months?
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Crude oil – a volatile market

The market for crude oil is usually a volatile one. Indeed, in the last few months, the market has seen prices rise and fall due to various supply and demand influences. Crude oil is coined the ‘King of Commodities’ due to the impact it has on consumers, producers and both the micro and macro economy. The price of crude oil affects everything from the cost of producing plastics, transportation, and food at the supermarket.

This makes the market for crude oil an economic powerhouse which is closely watched by businesses, traders, and governments. To gain a full understanding of the movements in this market, it is important to identify how demand and supply affect the price of crude oil.

What influences the demand and supply of crude oil?

The law of demand and supply states that if demand increases, prices will rise, and if supply increases, prices will fall. This is exactly what happens in the market for crude oil. The consumer side of the market consists of various companies and hundreds of millions of people. The producer side of the market is made up of oil-producing countries. Collectively, both consumers and producers influence the market price.

However, the demand and supply of crude oil, and therefore the price, is also affected by global economic conditions and geopolitical tensions. What happens in the world impacts the price of oil, especially since a large proportion of the world’s biggest oil producers are in politically unstable areas.

Over the past five years, global events have had a major impact on the price of oil. The economic conditions created by the impact of the COVID pandemic saw prices plummet from around $55 per barrel just before the pandemic in February 2020 to around $15 per barrel in April 2020. By mid-2021 they had recovered to around $75 per barrel. Then, in the aftermath of Russia’s invasion of Ukraine in February 2022, the price surged to reach $133 in June 2022. More recently, geopolitical tensions in the Middle East and concerns about China’s economic outlook have intensified concerns about the future direction of the market. (Click here for a PowerPoint of the chart.)

Geopolitical tensions

In the first week of October 2024, the price of crude oil rose by almost 10% to around $78 per barrel as the conflict in the Middle East intensified. It unfortunately comes at a time when many countries are starting to recover from the rise in oil prices caused by the pandemic and the war in Ukraine. Any increase in prices will affect the price that consumers pay to fill up their vehicles with fuel, just when prices of diesel and petrol had reached their lowest level for three years.

The Governor of the Bank of England, Andrew Bailey, has said that the Bank is monitoring developments in the Middle East ‘extremely closely’, as the conflict has the potential to have serious impacts in the UK. The Bank of England will therefore be watching for any movement in oil prices that could fuel inflation.

The main concerns stem from further escalation in the conflict between Israel and the Iran-backed armed group, Hezbollah, in Lebanon. If Israel decides to attack Iran’s oil sector, this is likely to cause a sharp rise in the price of oil. Iran is the world’s seventh largest oil exporter and exports over half of its production to China. If the oilfields of a medium-sized supplier, like Iran, were attacked, this could threaten general inflation in the UK, which could in turn influence any decision by the Bank of England to lower interest rates next month.

Supply deficits

This week (2nd week of October 2024) saw the price of crude oil surge above $81 per barrel to hit its highest level since August. This rise means that prices increased by 12% in a week. However, this surge in price also means that prices rose by almost 21% between the start September and the start of October alone. Yet it was only in early September when crude oil hit a year-to-date low, highlighting the volatility in the market.

As the Middle-East war enters a new and more energy-related phase, the loss of Iranian oil would leave the market in a supply deficit. The law of supply implies that such a deficit would lead to an increase in prices. This also comes at a time when the US Strategic Petroleum Reserve has also been depleted, causing further concerns about global oil supply.

However, the biggest and most significant impact would be a disruption to flows through the Strait of Hormuz. This is a relatively narrow channel at the east end of the Persian Gulf through which a huge amount of oil tanker traffic passes – about a third of total seaborne-traded oil. It is therefore known as the world’s most important oil transit chokepoint. The risk that escalation could block the Strait of Hormuz could technically see a halt in about a fifth of the world’s oil supply. This would include exports from big Gulf producers, including Saudi Arabia, UAE, Kuwait and Iraq. In a worst-case scenario of a full closure of the Strait, a barrel of oil could very quickly rise to well above $100.

Disruption to shipments would also lead to higher gas prices and therefore lead to a rise in household gas and electricity bills. As with oil, gas prices filter down supply chains, affecting the cost of virtually all goods, resulting in a further rise in the cost of living. With energy bills in the UK having already risen by 10% for this winter, an escalation to the conflict could see prices rise further still.

China’s economic outlook


Despite the concern for the future supply of oil, there is also a need to consider how the demand for oil could impact price changes in the market. The price of oil declined on 14 October 2024 in light of concerns over China’s struggling economy. As China is the world’s largest importer of crude oil, there are emerging fears about the potential limits on fuel demand. This fall in price reversed increases made the previous week as investors become concerned about worsening deflationary pressures in China.

Any reduced demand from China could indicate an oversupply of crude oil and therefore potential price declines. Official data from China reveal a sharp year-on-year drop in the producer price index of 2.8% – the fastest decline in six months. These disappointing results have stirred uncertainty about the Chinese government’s economic stimulus plans. Prices could fall further if there are continuing doubts about the government’s ability to implement effective fiscal measures to promote consumer spending and, in turn, economic growth.

As a result of the 2% price fall in oil prices on 14 October, OPEC (the Organization of the Petroleum Exporting Countries) has lowered its 2024 and 2025 global oil demand growth. This negative news outweighed market concerns over the possibility that an Israeli response to Iran’s missile attack could disrupt oil production.

What is the future for oil prices?

It is expected that the market for oil will remain a volatile one. Indeed, the current uncertainties around the globe only highlight this. It is never a simple task to predict what will happen in a market that is influenced by so many global factors, and the current global landscape only adds to the complexity.

There’s a wide spectrum of predictions about what could come next in the market for crude oil. Given the changes in the first two weeks of October alone, supply and demand factors from separate parts of the globe have made the future of oil prices particularly uncertain. Callum Macpherson, head of commodities at Investec, stated in early October that ‘there is really no way of telling where we will be this time next week’ (see the first BBC News article linked below).

Despite the predominately negative outlook, this is all based on potential scenarios. Caroline Bain, chief commodities economist at Capital Economics suggests that if the ‘worst-case scenario’ of further escalation in the Middle East conflict does not materialise, oil prices are likely to ‘ease back quite quickly’. Even if Iran’s supplies were disrupted, China could turn to Russia for its oil. Bain says that there is ‘more than enough capacity’ globally to cover the gap if Iranian production is lost. However, this does then raise the question of where the loyalty of Saudi Arabia, the world’s second largest oil producer, lies and whether it will increase or restrict further production.

What is certain is that the market for crude oil will continue to be a market that is closely observed. It doesn’t take much change in global activity for prices to move. Therefore, in the current political and macroeconomic environment, the coming weeks and months will be critical in determining oil prices and, in turn, their economic effects.

Articles

Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices in the main two scenarios:
    (a) Conflict in the Middle East;
    (b) Concerns about China’s economic performance.
  2. How are the price elasticities of demand and supply relevant to the size of any oil price change?
  3. What policy options do the governments have to deal with the potential of increasing energy prices?
  4. What are oil futures? What determines oil future prices?
  5. How does speculation affect oil prices?
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Oil prices fall below $100

One of the key prices in any economy is that of oil. Whenever oil prices change, it can have a knock-on effect on a range of other markets, as oil, or some variation, is used as an input into the production of countless products. The main products that consumers will see affected are energy prices and petrol prices..

Although on the supply-side, we see a large cartel in the form of OPEC, it is still the case that the forces of demand and supply directly affect the market price. Key things such as the demand for heating, economic growth, fears of war and disruption will change the demand and supply of oil. The possibility of militant strikes in oil producers, such as Syria, would normally reduce supply and push up the market price. However, we have actually seen oil prices drop much faster than we have in two years, dropping below $100 per barrel since September 5th. The slowdown of economic growth in Asia, together with the return of Libyan production at a level greater than expected have helped to push prices down and have offset the fears of global production.

The market forces pushing prices down, while good for consumers and firms that use crude oil or one of its by-products, are clearly bad for oil producers. (Click here for a PowerPoint of the chart.) Countries are urging OPEC to halt its production and thereby shift supply upwards to the left putting a stop to the downward oil price trend. Several countries are concerned about the impact of lower prices, and one country that may be significantly affected is Russia. Some are suggesting that the impact could be as big as 4% of Russia’s GDP, taking into account the ongoing political crisis with Ukraine.

The market for oil is highly susceptible to changes in both demand and supply-side factors. Microeconomic changes will have an impact, but at the same time any global macroeconomic factors can have significant effects on the global price. Expectations are crucial and as countries release information about the size of the oil stocks and inventories, it is adding to the downward pressure on prices. Some oil experts have predicted that prices could get as low as $80 per barrel before OPEC takes significant action, influenced heavily by countries like Saudi Arabia. The following articles consider this global market.

Articles

Iran urges OPEC to halt oil price slide Financial Times, Anjli Raval (26/9/14)
Oil overflow: as prices slump, producers grapple with a new reality The Globe and Mail, Shawn McCarthy and Jeff Lewis (27/9/14)
Weak demand, plentiful supply drive decline in oil prices International Distribution (26/9/14)
Oil prices plunging despite ISIS CNN Money, Paul R La Monica (25/9/14)
Oil prices fall on EIA report of big U.S. crude stocks build Reuters, Robert Gibbons (17/9/14)
Sanctions and weaker oil prices could cost Russia 4% of GDP – official RT (25/9/14)

Data

Spot oil prices Energy Information Administration
Weekly European Brent Spot Price Energy Information Administration (Note: you can also select daily, monthly or annual.)
Annual Statistical Bulletin OPEC

Questions

  1. What are the key factors on the microeconomic side that affect (a) demand and (b) supply of oil?
  2. Explain the key macroeconomic factors that are likely to have an impact on global demand and supply of oil.
  3. Militant action in some key oil producing countries has caused fears of oil disruption. Why is that oil prices don’t reflect these very big concerns?
  4. Use a demand and supply diagram to explain the answer you gave to question 3.
  5. What type of intervention could OPEC take to stabilise oil prices?
  6. Why is the Russian economy likely to be adversely affected by the trend in oil prices?
  7. Changes in the global macroeconomy will directly affect oil prices. Is there a way that changes in oil prices can also affect the state of the global economy?