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In this week’s Grumpy Economist Weekly Rant, John Cochrane examines how oil markets would respond if the Strait of Hormuz were closed for an extended period. While the short-run effects would depend on the duration of the disruption and the quality of policy responses, Cochrane warns that governments can make the shock worse by subsidizing demand when supply is already constrained.
Cochrane argues that the long-run story is different. Energy markets adapt through two forces policymakers often underestimate: supply elasticity and demand substitution. Over time, producers build pipelines, drill new wells, bring additional capacity online, and consumers shift toward alternative fuels, more efficient transportation, nuclear power, renewables where they make economic sense, and lower-energy shipping. The longer the disruption appears likely to last, the stronger the market response becomes—making Iran’s threat initially powerful but much harder to use repeatedly.
Transcript
Hi, I’m John Cochrane, and welcome to the Grumpy Economist Weekly Rant.
We’re going to talk again today about oil, the Strait of Hormuz, energy prices, and what that will do to the US economy in the long run.
First, for the short run, the question, of course, is: how long is the Strait of Hormuz closed? How long is the energy supply shock going to last?
That’s a matter for foreign policy that really isn’t my expertise. I hate to think that the US will allow such a thing to happen, that the Strait stays closed for a long time, but they might.
It also depends on how bad the policy response is around the world. Many governments are already subsidizing people to use oil in the place of the oil price rise. Hmm. If supply is constrained and you subsidize demand, what happens to the price? It gets worse and worse.
But let’s hope all of that passes. What happens in the long run? In the long run, which isn’t too long—a couple of years—economics has two principles that most people ignore: elasticity of supply and substitution in demand.
If the Strait is closed for any amount of time and looks like it’ll stay closed, what do people do? They build pipelines. The Saudis are already building and rebuilding and doubling up the pipelines that they have to ship oil not through the Persian Gulf.
They drill. Anybody sitting on oil is drilling like crazy, opening up new wells. There are a lot of oil wells that are able to produce more at a slightly higher price. Bring them online.
Fracking. Lots of Europe is sitting on an enormous reserve of natural gas, more than since Germany invented sauerkraut. But they don’t allow themselves to frack it. Well, maybe they will allow that and bring more online.
People will shift from oil to other fuels. In fact, oil is, in many senses, too precious to burn. It’s so useful for petrochemicals and other things.
Even coal. Natural gas. There are many other fuels. Renewables, yes, renewables. Windmills, solar panels? Where they make economic sense, people will turn to them. People will learn to use energy in a more time-dependent way so that the renewables can be effective.
Nuclear. Let’s bring nuclear power back. Smaller cars, carpools.
Even in the US, the Jones Act. This is one of the ones that economists love to bemoan. We don’t allow shipment from US state to US state except on US ships manned by the US Merchant Marine, which means tremendously more expensive.
President Trump waived it briefly. Let’s get rid of the Jones Act, and all of those things that go on trucks can go on ships, using much less energy.
In the short run, energy is inelastic. We’ve committed to some ways of doing things, and we only have so much production. But in the long run, there’s nothing more elastic than the supply and the demand for energy.
Paradoxically, the longer it looks like the supply will be constricted in the Strait, the more the response.
If you’re an oil well producer and you need to put some few millions of dollars into getting your oil wells going, you want to know that the demand for it is going to be there six months to a year from now.
What will the world look like with a permanently closed Strait of Hormuz? Actually, not that much different. This is a threat that Iran used once, but it can’t use it again and again because there are so many alternatives.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.