Estimating the Economic Benefits Derived From Forward-

engaged Naval ForcesDr. Robert LooneyDr. David Schrady

National Security Affairs and Operations Research DepartmentsNaval Postgraduate School

Research Undertaken for N8C - N81 - N3/N5

CSIS Conference on Naval Forward PresenceWashington, DC May 5-6, 1997

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Outline

• The Approach Used

• Assumptions in the Economic Analysis

• The Three Cases Studied

– Gulf War

– 1994 Iraq-Kuwait Border Incident

– 1987 Iranian Attacks on Gulf Shipping

• Conclusions

• Areas for Further Research--Force Structure

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Approach Used

• Analysis examines the economic impact of the differential in oil futures prices resulting from U.S. Naval forward engagement and crisis response

– impact on the United States and countries comprising the Organization for Economic Development and Cooperation (OECD)

– oil is essential commodity» price movements produce greatest economic

impact

– futures prices reflect market expectations based on available economic, political, military information

» best unbiased estimate of likely daily prices when contracted delivery date arrives

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Economic Analysis

• Naval forward engagement and crisis response affects market outlook

– futures prices decrease following naval crisis response

– differential in oil futures prices before and after naval crisis response allows the economic benefits of naval forward engagement and crisis response to be estimated

• Measurable economic benefits include increases in Gross Domestic Product (GDP), reduced unemployment and inflation, expanded industrial production, construction, etc.

– this briefing concentrates on GDP

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Notional Relationship Between Naval Crisis Response and Oil Futures Markets

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Linkages

Oil Futures Price

Profile Before

Crisis Occurred

Oil Futures Price

Profile

Immediately After

Naval Crisis

Response

Oil Futures Price

Profile After

Equilibration in Oil

Futures Markets

Medium-Term OIl

Price Effects

Associated with

Naval Crisis

Response

Short Run Oil

Price Effects

Associated with

Naval Crisis

Response

Initial Conditions

Calculation of Oil

Price Differential

Associated with

Naval Crisis

Response

Impact of Naval

Crisis Response

Vector

Autoregression

Econometric

Model

Calculation of

Economic Impact

of Naval Crisis

Response

Economic

Impacts

Associated with

Naval Crisis

Response

Increases in

Gross Domestic

Product (GDP)

Reduction in

Unemployment

Declines in Rate

of Inflation

Expansion in

Industrial

Production

Expanded

Construction,

Automotive, Steel,

etc.

Oil Market

Conditions-

-Inventories,

Demand

Position in

Business Cycle

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The Three Cases• The Gulf War

– August, 1990

• The Iraq-Kuwait Border Confrontation

– October, 1994

• The Gulf Shipping Crisis

– January, 1987

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The Gulf War

• Occurred at a time of excess inventory and production capacity

– mitigated oil price increases resulting from invasion of Kuwait

– OPEC incapable of establishing firm production quotas

– prices fell throughout the year up to latter part of July

• Oil prices increase after August 2 invasion of Kuwait

– decline in prices following naval crisis response August 7

– stabilization in prices around August 9

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The Gulf War

• Occurred at a time of excess inventory and production capacity

– mitigated oil price increases resulting from invasion of Kuwait

2-Jul 2-Aug 2-Sep

Iraq threatensover-producers

OPEC agrees toreduce output -

target price $21/bbl

1727

Iraq invadesKuwait

U.S. commitsto defend

Saudi Arabia

6

8

Eisenhower CVBG

in Red Sea

USMC troops& equipmentin theatre

15

Independence CVBGin Gulf of Oman

5

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The Gulf War

NYMEX Futures Prices (TY$)

20

21

22

23

24

25

26

27

28

29

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Months Until Contracted Delivery Date

$/ bbl

(1) Pre-invasion price profile, 8/1/90

(2) Post-invasion price profile, 8/6/90

(3) Peak in post-invasion prices, 8/7/90

(4) Onset of market equilibrium, 8/8/90

market response to crisis: prices increase, slope becomes negative indicating a premium is paid for immediate possession of oil

market reaction to naval crisis response

(1)

(4)

(3)

(2)

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The Gulf War

-3

-2

-1

0

1

2

3

4

8/1/90 8/8/90 8/15/90 8/22/90 8/29/90 Date

$/bbl

First Futures Contract Minus Second Futures Contract

Spot Price Minus First Futures Contract

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The Gulf War

• Three measures of the naval crisis response effect:

– August 9th futures profile - August 7th futures profile

» Direct impact

– August 9th futures profile - August 24th futures profile

» pattern produced by no naval crisis response, assuming oil prices would increase to $30 at this time

– August 9th futures profile - Tight oil market profile

» pattern produced by no naval crisis response with oil shortages producing an additional $5 per barrel price increase

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The Gulf War• Complexity of this case led to development of three

measures of the economic impact of naval crisis response

NYMEX Futures Prices (TY$)

18

20

22

24

26

28

30

32

34

36

8/ 2/ 90 9/ 2/ 90 10/ 2/ 90 11/ 2/ 90 12/ 2/ 90 1/ 2/ 91 2/ 2/ 91 Date

$/ bbl

(1) No Crisis (2) P re-Crisis Response (Aug 7)(3) With Crisis Response (Aug 9) (4) Hypthetical, No Crisis Response, Aug 24 P rice P attern(5) Hypothetical, Low Inventory Environment

(1)

(3)

(2)

(4)

(5)Effect # 3 (high estimate)assumes low inventories/capacities

Effect # 2 (medium estimate)

Effect # 1 (low estimate)

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The Gulf War• Three measures of the naval crisis response effect:

Effect #1 (Aug 7th profile - Aug 9th profile):

– U.S. Oil Import Bills: Potential savings of $3.2B

– U.S. GDP: Potential losses of $55.2B were averted

– OECD GDP: $69.5B World GDP: $83.6B

Effect #2 (Aug 24th profile - Aug 9th profile):

– Oil Import Bills: Potential savings of $5.4B

– U.S. GDP: Potential losses of $94.0B were averted

– OECD GDP: $119.6B World GDP: $143.9B

Effect #3 (Tight oil market profile - Aug 9th profile):

– Oil Import Bills: Potential savings of $10.0B

– U.S. GDP: Potential losses of $182.7B were averted

– OECD GDP: $231.4B World GDP: $278.4B

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Iraq-Kuwait Border Confrontation• Oct 7: Iraqi troop movements

• Oct 8: George Washington CVBG/Tripoli ARG respond

• Oct 10: Prices fall when markets open on Monday

• Oct 13: Medium term equilibrium in oil markets

• Oct 17: Slight rise in oil prices from final adjustment in oil markets

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The Iraq-Kuwait Border Confrontation

• Three measures of the naval crisis response effect:

Short Run Impact– October 10th futures profile - October 7th futures

profile

Medium Term Impact– October 13th futures profile - October 7th futures

profile

Final Adjustment– October 17th futures profile - October 7th futures

profile

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The Iraq-Kuwait Border Confrontation

NYMEX Futures Prices (TY$)

16.8

17.0

17.2

17.4

17.6

17.8

18.0

18.2

18.4

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Months Until Contracted Delivery Date

$/ bbl

(1) Profile after Iraqi troop movements, 10/7/94

(2) Initial reaction to naval crisis response, 10/10/94

(3) Medium term market equilibrium, 10/13/94

(4) Final adjustment, 10/17/94(3)

(4)

(2)

(1)

medium termimpact

long term impact

short term impact

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The Iraq-Kuwait Border Confrontation• Three measures of the naval crisis response effect:

Short Term (Oct 7th profile - Oct 10th profile):

– U.S. Oil Import Bills: Potential savings of $1.1B

– U.S. GDP: Potential losses of $7.1B were averted

– OECD GDP: $5.7B World GDP: $6.9B

Medium Term (Oct 7th profile - Oct 13th profile):

– Oil Import Bills: Potential savings of $3.5B

– U.S. GDP: Potential losses of $11.1B were averted

– OECD GDP: $17.9B World GDP: $21.5B

Final Adjustment (Oct 7th profile - Oct 17th profile):

– U.S. Oil Import Bills: Potential savings of $2.9B

– U.S. GDP: Potential losses of $11.7B were averted

– OECD GDP: $15.1B World GDP: $18.2B

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The Gulf Shipping Crisis• Occurs well into the Iran-Iraq war

• Excess production led to depressed oil prices

• Crisis evolves over time as part of larger conflict

– 9-21 Jan: Iranian offensive

– 19 Jan: Iranian use of Sea Killer missiles in night attacks on Gulf Shipping

– 27 Jan: Crisis response in form of U.S. announcement of stepped-up presence

– 27 Jan: Immediate impact/equilibration in oil markets

– 12 Feb: Medium term equilibration in oil markets

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The Gulf Shipping Crisis

• Two measures of the naval crisis response effect:

Initial Impact– January 27th futures profile - January 26th futures

profile

Medium Term Impact– February 12th futures profile - January 26th futures

profile

• A potential final adjustment (23 Feb - 26 Jan) was not calculated because it was more conjectural

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Lower

Raise

Likely Raise

May Raise

Likely Raise

NYMEX Spot Crude Oil Price

Event 3BNaval Actions Destabilize or Increase Oil Prices. Other Events May

Stabilize

Event 3Naval Actions

Stabilize/Lower Oil Prices. Non-Navy

Events May Increase Prices

(-)

Event 3CNaval Actions and

Other Events Destabilize Oil Markets and or Increase Prices

Variables Maintaining Long Run Pattern with

NYMEX Crude Oil

Statistically Significant

Short-Run Events

Movements in Brent Crude Oil

Markets(+)

Event 3Most Statistically Significant Event

Statistically Insignificant

Long-Run Adjustment

Increased Naval Activity

Increased Non-Naval Activity

Event 3ASome Naval

Actions Lower Oil Prices, Others and Non-Navy May Increase

Price (+)

Brent Crude Oil Markets

Increases in Brent Crude Oil Prices

Event 3ALess Statistically Significant Event

Increased Naval Activity

Increased Non-Naval Activity

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The Gulf Shipping Crisis

NYMEX Futures Prices (TY$)

17.5

17.7

17.9

18.1

18.3

18.5

18.7

1 2 3 4 5 6 7Months Until Contracted Delivery Date

$/ bbl

(1) Pre-crisis futures profile, 12/31/86

(2) Price profile at height of conflict, 1/26/87

(3) Prices after U.S. announces increased naval presence, 1/27/87

(4) Post-Crisis Response Equilibrium, 2/12/87

Market responseto intensifying

conflict Short term impact

Medium term impact

(4)

(1)

(3)

(2)

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The Gulf Shipping Crisis

• Two measures of the naval crisis response effect:

Short Term Impact (Jan 26th profile - Jan 27th profile):

– U.S. Oil Import Bills: Potential savings of $0.4B

– U.S. GDP: Potential losses of $5.7B were averted

– OECD GDP: $6.9B World GDP: $8.3B

Medium Term Impact (Jan 26th profile - Feb 12th profile):

– Oil Import Bills: Potential savings of $0.8B

– U.S. GDP: Potential losses of $11.2B were averted

– OECD GDP: $16.4B World GDP: $23.3B

OECD: Organization for Economic Development and CooperationOil import and GDP savings are in CB$97

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Conclusions

• Linkage between oil prices and naval forward engagement and crisis response has been established

– oil prices decline a day or so after naval crisis response and the declines spread rapidly through the futures markets

– linkage occurred in three different economic/political settings

• Spot price movements by themselves may seem small yet produce significant positive economic impacts when they ripple through the economy

• These patterns are consistent for the United States as well as the other major world economies

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Areas of Further Research: Links to Force Structure• Smaller force structure may cause slower response times

and a less robust response

– Effect on futures prices is expected to be a larger price shock and slower reaction to naval crisis response

Months Until Contracted Delivery Date

Pre-Crisis Price Pattern

Post-Crisis Response Price Patternwith Smaller Force Structure

Crisis Effect

$/bbl

Post-Crisis Response Price Patternwith Baseline Force Structure

}

Notional Relationship Between Force Structure and Oil Futures Markets

“Cost” of SmallerForce Structure

Equilibrium Price Pattern