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Although most commentators concede that the free market does a decent job providing regular goods and services day in and day out, for some reason they believe that when it comes to unlikely but catastrophic events, government intervention is necessary.

An excellent example of this misguided mindset is the recent argument over what to do with the federally administered Strategic Petroleum Reserve. We'll see that government involvement only makes things worse, and that the free market — if only allowed to do its job — would solve the alleged problem.

FEARING OPEC: THE STRATEGIC PETROLEUM RESERVE

The Strategic Petroleum Reserve (SPR) was authorized in 1975 in response to the OPEC embargo. Its purpose is to provide an extra cushion in the event of another import disruption. The SPR currently contains about 700 million barrels, or two months' worth of net oil imports for the United States. The Bush Administration is currently buying about 50,000 barrels of oil per day to add to the stockpile, a move that has raised criticism from people such as Hillary Clinton, who argue that the government should be taking steps to lower oil prices rather than raise them.

In a recent op ed, I made a (necessarily brief) case for selling off the SPR entirely. The government would net some $56 billion which could be used for tax relief, and the valuable oil would be placed under private control. But what if there were another OPEC embargo? Isn't everyone telling us that we need to decrease our "dependence on foreign oil"?

Contrary to popular belief, the free market is particularly well suited to anticipate and prepare for future supply disruptions. After all, the whole purpose of insurance companies is to evaluate and prepare for unlikely but catastrophic events. In the case of oil, there are sophisticated markets not only for spot oil (i.e., oil traded in the present) of various grades and locations, but there is also a "futures market" for oil, in which buyers and sellers can lock in today their price and quantity for a transaction to take place on a specified future date. It gets even more complicated, for there are call and put options, at various strike prices and exercise dates, that one can buy on oil futures; see here and here for more details on these derivatives.

The crucial point to remember is that there is nothing magical about government officials. There is no intrinsic reason to expect them to better forecast future disruptions in oil imports. Just as Wall Street can look at futures contracts to back out "the market's" views on the likelihood of a Fed rate cut, so too does the complex web of various prices on financial contracts allow us to deduce the implied likelihood of various spot prices of oil in the future. The market price takes into account the "bets" made by all relevant participants; it pools the information, so to speak, of everyone all over the world who has a strong enough opinion to put money behind it.

To see how all this works, suppose there were no government-run SPR and that tensions with Iran suddenly escalated. Analysts would forecast huge spikes in the spot price of oil in the event of military strikes. Depending on the likelihood of this happening, prices on oil futures as well as more exotic derivatives would constantly adjust with every development in the standoff. Investment banks issuing call option contracts would hedge themselves by buying oil futures, raising the price on futures contracts for oil. Because of the possibility of arbitrage, the rising futures price of oil would in turn drive up the current spot price as well, even if the impending military confrontation wouldn't happen for months. The higher spot price of oil would raise gas prices and so forth, leading everyone to economize on oil consumption — exactly how we would want them to behave.

Here's an interesting wrinkle that I couldn't dwell on in my earlier piece because of space constraints. A clever critic might say, "Yes Dr. Ivory Tower, I agree with you that an impending war with Iran would scare the market, causing the futures price of oil to shoot up. As you say, this would lead domestic oil producers — who are purely trying to maximize profit, not become geopolitical analysts — to sell more futures contracts. And I also agree that arbitrage would make the rising futures price pull up the current spot price, too. But so what? The problem with oil is that our domestic producers have capacity constraints. The point of the SPR is to have a stockpile of already pumped oil, ready to go. In a purely free market, what incentive would there be for someone to accumulate such a stockpile?"

This is a subtle but important question. Whenever the defender of the free market gets momentarily stumped, I've found that the solution is to not try to "force it" but just calmly think through the incentives everyone faces. After all, the beauty of the Invisible Hand is that the individual actors don't have to understand the big picture.

To see under what circumstances private speculators would maintain their own stockpiles of oil, we need to review the relationship between spot and futures prices. In a mathematical finance textbook, they will teach you that the equilibrium futures price must be just high enough, relative to the spot price, to exactly offset storage costs and interest. If it were higher than this critical value, then an arbitrage opportunity would exist: someone could sell a futures contract (promising to deliver the item in the future), then buy the item on the spot market and store it, waiting for the delivery date specified in the futures contract. This possibility keeps the spot and futures prices of items such as shares of corporate stock in a tight relationship with each other.

But things are not so simple when it comes to oil. Here, there is not a fixed stockpile that is being allocated between present and future owners. On the contrary, what people are really buying and selling is oil that has already been extracted, and this is a quantity that can vary over time, depending on the actions of oil producers. If the futures price of oil goes through the roof, the spot price might not immediately jump up to the new level, as dictated by storage and interest on the invested capital. It might lag behind, precisely because of the pumping capacity of the various domestic oil fields.

Think of the situation from an individual oil producer's point of view. All of a sudden he has a huge increase in people wanting to buy futures contracts from him. But once he has promised to deliver a certain critical quantity during a future month, he knows that if he sells even more barrels for delivery in that month, his unit extraction costs will go up. In other words, if demand for "future oil" is sufficiently high, the oil producer has to insist on a markup for future oil that is higher than even the storage and interest costs require. The "arbitrage-free" relationship of the textbooks would not be satisfied, and people would have the incentive to buy spot oil while selling short oil futures.

Naturally, the oil producer himself might elect to do this, but he doesn't need to. There might be others who are more adept at stockpiling large quantities of oil above ground. The elegance of the market economy is that the division of labor allows people to specialize in very precise niches. In our example, one group of experts might forecast the impending military strike on Iran, and dabble in the financial markets accordingly, even though they never directly deal with a single barrel of oil. The oil producers respond to the change in demand, even though they might have no clue about the military situation. And finally, the most able warehousers see the unusual configuration in spot and futures prices, and stockpile oil accordingly, even though they may have no idea about the relative extraction costs facing the producer. Through it all, the profit-and-loss system weeds out those who do a poor job, and rewards those who perform their specific task.

SOCIALIZED OIL RESERVES

In contrast, what are the incentives for government officials to correctly calibrate the precisely optimal size of the Strategic Petroleum Reserve? Since it's not their money on the line, there really are none. This is an important point, so let's think it through. When it comes to a private speculator, if he thinks that the United States will bomb Iran next month — and that others haven't anticipated this possibility as he has — he stands to profit by buying what he believes to be underpriced oil futures contracts.

But what if he's wrong? To the extent that his forecast influenced others, he will lose money. For example, if he just bought one or two thousand barrels worth of oil, this wouldn't have done much. But if he controlled a large hedge fund, and bet very heavily on his hunch, then his very actions would have pushed up the price of oil futures, as we described in the section above. As time passed and everyone else realized the price was too high, it would move back down, and the speculator would lose accordingly. He would have that much less financial capital with which to mislead markets in the future.

There is no such feedback mechanism when it comes to government officials. Right now the Bush Administration is buying oil at some $90 per barrel to add to the SPR, and some analysts argue that this action itself is significantly propping up oil prices. Is this good or bad? It's impossible to say, since the government is not trying to turn a profit. We can't even use noneconomic criteria, because this is an economic issue. For example, one might say, "Well, if OPEC did put another embargo on us, during which the SPR ran dry, then we'd know the officials in charge miscalculated, and that they should be fired!"

Yet this apparently sensible rule is no help. If that rule were in place, the government officials running the SPR could simply slow the rate at which they emptied it, to ensure that it never ran dry during the embargo. If people complained at the slow drawdown, the officials could rightfully respond, "What are you complaining about? The embargo has no end in sight, so we need to conserve." Without resorting to a profit-and-loss test, there would be no way to argue with them.

There is one respect in which the government could be expected to do a better job administering the SPR, due to its privileged position in anticipating future supply disruptions. After all, government officials would presumably know if the United States were going to bomb Iran before private oil speculators would! And with all of its intelligence networks, it's possible that the United States would better anticipate foreign "surprises" as well.

There are several weaknesses with this justification for the government-run SPR. First, we still have the incentive problem; without their own money on the line, there would be a different set of rewards and punishments for the officials making the decision, and these criteria would not necessarily line up with the economically sensible ones. For example, they might not want to tip off foreign enemies that the United States was about to move, by entering the oil markets with massive buying.

A second problem is that "the government" is not a monolithic entity. The people making the military decisions are not the ones stockpiling the SPR. As anyone who has studied the government in practice knows, there is no reason to expect different agencies to communicate with each other, especially when it comes to something as sensitive as impending military strikes.

Finally, a third problem is that the "intelligence" gathered by government agencies is itself suspect. For the narrow task of anticipating future oil prices, I would trust the data and analyses gathered by private parties over that culled from government sources.

CONCLUSION

As we have seen, the free market has very sophisticated institutions to deal with potential supply disruptions, while the government has nothing analogous. Unfortunately, these private-sector mechanisms can only work effectively when speculators know that they will be able to reap the rewards for their farsighted behavior. If, instead, they know that during an "emergency" they would be slapped with "windfall profits taxes" or even have their oil seized outright, then the crippled market won't perform nearly as well. To prepare for another OPEC embargo, the federal government just needs to get out of the way.