Curtis, Tracy L. Foertsch,
Acosta Fraser, Ben
Lieberman, and James
From December 2006 to March 2007, Heritage Foundation scholars
conducted a computer simulation and gaming exercise that
examined the likely economic and policy consequences of a major oil
disruption in the Persian Gulf. The exercise utilized a realistic
scenario, state-of-the-art macroeconomic modeling, and a
knowledgeable team of subject-matter experts from government,
business, academia, and research institutes from around
This project was a proof-of-principle investigation that
combined computer modeling and gaming to capture how U.S. decisions
during a crisis might affect how global energy markets and the U.S.
economy adjust to sudden and significant disruptions of oil
supplies. In this scenario, the United States responded to a crisis
precipitated by an attempted Iranian blockade of the Strait of
The game began with a series of economic results based on a
scenario in which Iran began blockading the Strait of Hormuz in
January 2007. The assumption was that Iran may succeed in
fully blockading the strait for up to one week, but after that,
some oil shipping would slowly resume.
The Heritage Foundation economics team, supported by
analysts at Global Insight, then modeled the blockade's likely
economic effects on world oil prices and the U.S. economy. They
found that under worst-case circumstances:
- The price of West Texas Intermediate (WTI) crude would
peak in the third quarter of 2007 at $150 per barrel, an increase
of $85 per barrel;
- Real (inflation-adjusted) gross domestic product (GDP)
would fall by over $161 billion in the fourth quarter of 2007;
- Private non-farm employment would decline by over 1 million
jobs by the middle of 2008; and
- Real disposable personal income would be more than $260 billion
lower by the fourth quarter of 2007.
With this set of economic forecasts, the game participants
devised policy responses to mitigate the oil price shock and
subsequent economic harm. They recommended a number of policy
moves, which are described later in this report. The economics team
ran new economic simulations based on these policy responses
and found that:
- The price of WTI crude would peak in the first quarter of 2007
at $75 per barrel, an increase of less than $12 per barrel;
- Real GDP would remain at roughly non-crisis levels during
- Employment would expand by 109,000 in 2007; and
- Real disposable personal income would grow at non-crisis rates
The project demonstrated the feasibility of modeling the
economic consequences of crisis decision making and responses
during an oil price shock induced by a hostile foreign government.
At the same time, the game emphasizes how much more work is needed
to explore how various combinations of political, military,
diplomatic, and economic initiatives might affect the course
of a global energy crisis. The Heritage Foundation plans to
expand and refine its simulation and modeling tools to
evaluate international responses, environmental consequences, and
private-sector and public responses to other foreign policy
The results of the game also suggest that an official
response to an actual crisis based on an Iran blockade of the
strait might be effective. The experts who played the roles of the
U.S. government officials opted for a focused but restrained
use of military power oriented toward objectives that directly
addressed vital national interests and that were clear, relevant,
and obtainable. This use of force demonstrated the U.S.
determination to uphold freedom of navigation in the Strait of
Hormuz. The American response did much to calm global markets and
reassure American consumers.
In addition, the experts chose to take a minimalist approach to
interfering in U.S. domestic markets. They focused primarily on
liberalizing domestic energy policies and rolling back regulatory
restrictions. They also strove to propose policy changes that
would minimize fears over shortages beyond the immediate crisis. In
this exercise, the combination of a determined but limited
military response and minimal government intervention ameliorated
the economic consequences of the crisis.
As global energy demand grows-especially among China, India, and
other developing countries-competition for access to oil is
escalating. The Persian Gulf is becoming the most important
bottleneck, making freedom of navigation through the strait a vital
American and global interest.
However, the U.S. has a poor track record in responding to real
energy crises. The most notable incidents in recent history were
the two great oil shocks sparked by the Arab oil embargo in 1973-
1974 and the Iranian revolution in 1978-1979. They led to fuel
shortages, long gas lines, gasoline rationing, high inflation, and
energy-related damage to the overall economy. The energy
crises of the 1970s are among the most unpleasant memories from
Yet despite the serious global turmoil during the 1970s,
America's energy ills were not entirely the result of these
external forces. At almost every turn, Washington policymakers
exacerbated the already challenging energy situation with their own
policy blunders. The federal government's newly created maze of
economic and environmental regulations and implementing agencies
greatly hampered domestic energy supplies and limited the private
sector's ability to respond to events.
In retrospect, the U.S. government probably caused at least as
much harm as any foreign entity did. Much of the energy crisis was
self-inflicted by bad decisions made in Washington. The errors of
the 1970s should serve as a cautionary tale as America again
faces similar energy challenges.
America's leaders tend to act decisively in time of crisis-to
"do something." However, the lessons from the 1970s are clear: Bad
decisions can make things much worse. Thus, developing tools to
evaluate the character of decisions and explore the options
and consequences of potential choices before a crisis occurs is
critical for policymaking in this uncertain century.
Indeed, serious thinking about policy decision making during an
energy crisis is needed more than ever before. Global energy
markets have never been more integrated or more competitive. U.S.
decisions during a crisis will affect not just every American
consumer, but the worldwide economy. In turn, the global energy
supplies will affect global markets and, consequently, America's
ability to trade with the rest of the world. Thus, few skills are
arguably more important than making the right decisions during an
energy crisis, and the tools to evaluate these potential decisions
are more crucial than ever.
Organizing for Crisis
The purpose of this exercise was to gain data on how the United
States would respond to an oil crisis resulting from an attempted
blockade of oil flowing from the Persian Gulf. From these data
emerge insights into policy decisions that should or should not be
made during an energy crisis. Additionally, the exercise proved the
validity of the economic model used to simulate market responses to
policy decisions made during an energy crisis.
Led by Ariel Cohen and James Phillips, Heritage Foundation
experts developed the scenario used in the simulation. The crisis
was designed to be plausible, to make the results as realistic
as possible, and to prevent players from "fighting the scenario." Game
participants were presented with the following "facts" as game
Day 1 After one month of debate (which
gives markets time to factor action into oil prices), the United
Nations Security Council imposes significant sanctions on Iran over
its suspicious nuclear program.
Day 2 Iran withdraws from the
Non-Proliferation Treaty and tests a nuclear weapon.
Day 3 The U.S. bombs Iranian nuclear
sites, air bases, and air defense targets but spares Iran's oil
infrastructure to minimize disruption of the world oil market.
Day 4 Iran announces that it will deny
its oil exports to any country that does not condemn the U.S.
action, but it continues to produce oil at the same levels. Most
countries that refuse to condemn the U.S. action either are oil
exporters (e.g., the United Kingdom and Canada) or do not
import Iranian oil anyway.
Day 5 Pro-Iranian Shiite militias in
Iraq stage an uprising, attack coalition forces, and shut down
Iraqi oil production in the southern oil fields. This takes roughly
60 percent of Iraq's oil exports off the world market for an
indefinite period. Venezuelan President Hugo Chávez
announces an oil embargo against the U.S. in support of Iran. Most
other members of the Organization of Petroleum Exporting Countries
condemn the U.S. "aggression" but ignore Iran's call for an
embargo. Sudan and Libya embargo oil exports to the U.S., but this
has little effect because the U.S. imports very little oil from
them. China, Japan, and the European Union condemn the U.S. and
escape Iranian oil threats. Russia condemns the U.S. and continues
oil production at maximum capacity to exploit higher oil
Day 6 An oil tanker is sunk by a mine
in the shipping channel in the Strait of Hormuz. Iran is believed
to be responsible but does not claim responsibility. U.S.
intelligence believes that the mine was laid by Iranian
Revolutionary Guards in civilian clothes operating from a fishing
vessel or an Iranian Kilo-class submarine. Saudi Arabia
announces that it will divert as much oil as possible to Red Sea
ports through secure pipelines.
Based on this scenario, Heritage Foundation analysts estimated
the losses in oil shipping out of the Persian Gulf and their
effects on world oil spot prices. These estimates also became a
central parameter of the game. Participants were presented with two
levels of oil price spikes associated with a short interruption of
oil supplies and a more protracted disruption.
Scenario 1. The moderate-case scenario is the loss of 2.5
million barrels per day (mbd). This amount is insufficient to
trigger International Energy Agency (IEA) emergency
mechanisms. Demand is reduced, but not enough to drive prices much
higher than they were in the summer of 2006. Provided the U.S.
government makes the appropriate decisions, the Strategic Petroleum
Reserve (SPR) is utilized at a rate of 15 percent of the total
decrease in supply.
Scenario 2. In the worst-case scenario, oil shipping
drops by 6 mbd or more and supplies are disrupted
significantly for the first two calendar quarters of 2007. This is
sufficient to trigger IEA mechanisms, which start at a loss of 7
percent to IEA members in total or to an individual member. IEA
Integrated Energy Policy calls for a 7 percent cut in demand when
the policy is triggered, but analysts at Global Insight who
assisted Heritage Foundation scholars in estimating the economic
effects of the oil disruption assumed that the cuts were less than
this. If demand is cut too much and the SPR is released, there are
no real problems with supply, stocks rise too much, and there is no
justification for a high price. SPR is utilized as in the
Heritage Foundation experts also facilitated the actual game.
The game began with a briefing on the scenario, including the
trigger that disrupts oil production and the reactions of key world
players. Then the group broke up into three teams:
policymakers (National Security Council); government agencies
that implement the policy (federal agencies); and industry
that meets the technical needs of implementing policy
(industry). Teams consisted of experts in foreign policy, including
regional experts; experts from the Departments of State, Homeland
Security, Energy, and Defense; and congressional staff members. The
policymakers directed policy; the federal agencies and industry
members determined the best way to implement and meet the
technical needs of the policy.
The teams reconvened after the exercise to conduct an
after-action report that outlined lessons learned from the game.
Lessons included considering ways to improve
methodologies and conduct of the game, as well as emerging
insights for national energy policy.
The simulation of the energy market responses to the crisis and
policy decisions was based on the Global Insight Short-Term U.S.
Macroeconomic Model. (See Appendix A.) The energy simulations to
produce data results were conducted in three steps that are
detailed in Appendix B. The two scenarios were run to see the
different effects on the market. These scenarios were then compared
to a third scenario that accounted for the policy
recommendations from the players.
Chart 1 shows the changes in crude oil prices in the scenarios.
In the moderate-case and worst-case scenarios, prices increased
significantly, but the worst-case scenario clearly delineates the
policy challenge. As a prudent measure, the participants quickly
decided to address the worst-case outcome, in which the price of
WTI crude rose to $150 per barrel by the third quarter of 2007,
compared to $65 per barrel if no crisis had occurred.
This significant jump in crude prices caused a substantial
economic response. For example, real GDP fell by more than $150
billion in both the fourth quarter of 2007 and the first quarter of
2008. (See Chart 2.) In fact, the simulation forecasted that the
two-quarter crisis could depress GDP for 10 quarters, or two and a
This fall in real GDP is mirrored by reductions in private
non-farm employment and real disposable income. (See Chart 3 and
Chart 4.) The simulation forecasted that the worst-case scenario
would result in roughly 1 million fewer jobs one year after the
strait was blocked. Changes in employment commonly lag behind
shocks to the economy, and that lag is apparent in the forecasts.
If Iran's blockade of the strait produced an $85-per-barrel
increase in crude oil prices, employment would not recover for
almost three years.
In addition, households would have slower income growth. The
oil-induced economic slowdown would reduce real disposable
personal income by nearly $260 billion by the fourth quarter of
2007, and real disposable income would average roughly $100 billion
lower during 2008. It would not recover until the first quarter of
In the exercise, the game managers assumed that the crisis
started on January 1, 2007, and tasked players with finding
practical policy responses to the crisis that would have the likely
effect of reducing the spike in oil prices and mitigating the
economic harm that inaction would likely produce.
At the end of the game, the participants recommended
- The U.S. and its allies deploy sufficient military forces to
protect freedom of navigation in the Strait of Hormuz. The
participants assumed that the military response would be
extensive, swift, and effective. They further assumed that the U.S.
and allied military response to the blockade of the Strait of
Hormuz would reduce Iran's obstruction of tanker traffic by 50
percent by January 31, 75 percent by March 31, and 100 percent by
October 1, 2007.
- The U.S. government employ the Strategic Petroleum Reserve
according to the rules laid out in international treaties. The
participants assumed that every country with SPR inventories would
respond according to these rules beginning on January 1, 2007.
(Full compliance in sharing, much less in reducing
demand, is highly unlikely. Global Insight optimistically
assumed 50 percent compliance.)
- Congress pass a one-time emergency supplemental defense
appropriation of $30 billion. Not only would the appropriation
fund military operations in the Persian Gulf, but the game
participants believed that it would stimulate the U.S.
economy, mitigating some of the immediate economic
- Congress and the Administration agree to increase
funding for the Low-Income Home Energy Assistance Program.
The participants assumed that funding increases, passed by Congress
in February 2007, would be proportional to the national
average increase in home energy prices (oil, natural gas,
electricity, and other distillates).
- Congress and the Administration temporarily reduce
regulatory burdens that would otherwise cause energy prices to
increase. The participants assumed that, in March 2007,
Congress would delay implementation of fuel economy standards and
relax compliance with the Jones Act and clean air regulations
regarding power plant improvements.
- The U.S. government end tariffs on ethanol as of
January 1, 2007. This would encourage ethanol imports and
reduce retail biofuel prices.
- The Administration make no change in retail gasoline and
diesel taxes. This recommendation supports federal revenue
growth at a time of extra spending.
- The Administration request permission to permit petroleum
recovery in the Arctic National Wildlife Refuge (ANWR) and the
off-shore reserves immediately west of Florida. The
participants assumed that Congress would pass this legislation in
late January 2007. The game participants further assumed that
this policy change would apply downward pressure on petroleum
and gasoline prices in the futures markets.
Weathering the Crisis
To determine whether these policy recommendations would
offset some of the economic harm produced by the oil blockade,
Heritage Foundation analysts implemented these recommendations in
the same economic model that was used to estimate the original
economic effects in order to allow accurate comparisons.
The results were impressive. The policy recommendations
eliminated virtually all of the negative outcomes from the
blockade. Charts 1 through 4 show the simulation results for the
price of crude oil, real GDP, employment, and personal income under
the three scenarios: moderate case, worst case, and the
participants' policy responses. In virtually every economic
indicator, incorporating policy responses neutralized the negative
effects of the crisis.
Overall, the military response had the greatest effect, because
it shortened the length and severity of the crisis. However,
supplemental budgetary appropriations increased defense spending,
which helped to keep GDP from falling significantly even with
increased oil prices.
Additionally, the lack of government response (or limited
influence on the market through regulations) helped by
allowing market forces to adjust to the crisis without artificial
constraints, keeping the overall price shock from being too
Most important, the exercise demonstrated that the model can
account reliably for the effects of policy decisions on market
forces, making it a viable model for future simulations.
The Way Forward
As is often the case with first-time modeling, several
changes have been identified that would improve the overall
effectiveness of the exercise:
- Broadening the number of countries covered by the model so that
their reactions are taken into consideration.
- Making more energy and defense policy experts available during
the exercise to provide guidance on policy decisions. For example,
such experts could help to determine an appropriate amount for an
emergency defense supplemental bill.
- Directing participating groups to clearly indicate the
desired outcomes of their policy recommendations. Measuring
desired outcomes against actual outcomes would offer a better
assessment of the effectiveness and unintended consequences of
individual policy decisions.
The analysis also suggests that the right blueprint for an
American response to any attempt by a hostile state to use
armed force to disrupt global energy supplies is that the United
States must lead. An American-led military response focused on
objectives that are clear, relevant, and obtainable would
demonstrate U.S. determination to uphold freedom of navigation,
which would be essential to calming global energy markets and
reassuring producers and consumers. At the same time, minimizing
disruptions and focusing on measures that liberalize energy
policies and roll back regulatory restrictions would allow the
marketplace to find the best market-based solutions to meet
global energy needs.
James Jay Carafano,
Ph.D., is Assistant Director of the Kathryn and Shelby Cullom
Davis Institute for International Studies and Senior Research
Fellow for National Security and Homeland Security in the
Douglas and Sarah Allison Center for Foreign Policy Studies at
The Heritage Foundation. William W. Beach is
Director of the Center for Data Analysis at The Heritage
Ariel Cohen, Ph.D., is
Senior Research Fellow in Russian and Eurasian Studies and
International Energy Security in the Allison Center, Lisa Curtis is Senior
Research Fellow for South Asia in the Asian Studies Center, Tracy L. Foertsch, Ph.D.,
is a Senior Policy Analyst in the Center for Data Analysis, Alison Acosta Fraser is
Director of the Thomas A. Roe Institute for Economic Policy
Studies, Ben Lieberman
is Senior Policy Analyst in Energy and the Environment in the Roe
Institute, and James
Phillips is Research Fellow for Middle Eastern Affairs in the
Allison Center at The Heritage Foundation.
Preparation of the war game, its execution, and the
writing of this report were collaborative efforts. Carafano and
Beach shared the overall direction of the project and the writing
of this report. Cohen, Philips, and Curtis constructed the war game
scenario. Foertsch used the Global Insight U.S. Short-Term
Macroeconomic Model to simulate the economic effects of a major oil
disruption in the Persian Gulf. She also simulated the extent
to which the participants' policy responses neutralized the
negative effects of the crisis. Fraser and Lieberman interpreted
the participants' policy recommendations and advised the economics
team on how to implement them in the economic model. Marietta
Sanders, a Heritage Foundation intern, assisted in writing
Description of the Global Insight
Short-Term U.S. Macroeconomic Model
The Global Insight Short-Term U.S. Macroeconomic Model is a
large-scale 10-year (40-quarter) macroeconomic model of the U.S.
economy. It is used primarily for commercial forecasting.
Over the years, analysts in The Heritage Foundation's
Center for Data Analysis (CDA) have worked with GI economists to
adapt the GI model for policy analysis. In simulations, CDA
analysts use the GI model to evaluate the effects of policy changes
not just on disposable income and consumption in the short run, but
also on the economy's long-run potential. They can do so because
the Global Insight model imposes the long-run structure of a
neoclassical growth model and makes short-run
fluctuations in aggregate demand a focus of analysis.
The Global Insight model can be used to forecast over 1,400
macroeconomic aggregates that describe final demand, aggregate
supply, incomes, industry production, interest rates, and financial
flows in the U.S. economy. The model includes such a wealth of
information about the effects of important changes in the economic
and policy environment because it encompasses detailed modeling of
consumer spending; residential and non-residential investment;
government spending; personal and corporate incomes; federal,
state, and local tax revenues; trade flows; financial markets;
inflation; and potential GDP.
Consistent with the rational expectations hypothesis,
economic decision making in the Global Insight model is generally
forward-looking. However, in some cases, Global Insight
assumes that expectations are largely a function of past
experience and recent changes in the economy. Such a
retroactive approach is taken in the model because GI believes
that expectations change little in advance of actual changes in the
economic and policy variables about which economic decision
makers form expectations.
The energy simulations were done in three separate steps.
Step 1. To simulate the effects of the oil price shock,
the Heritage Foundation economics team introduced the change in oil
prices and the contribution to domestic oil supply from the
Strategic Petroleum Reserve into the Global Insight model. They
then directly changed three separate oil prices in the model: the
weighted average price of imported crude, the weighted average
price of domestic crude, and the average price of West Texas
Intermediate crude. All three were assumed to deviate from
baseline levels by the same amount; namely, the change in WTI crude
oil prices forecast by Global Insight.
The contributions to the domestic oil supply from the SPR were
also calculated by Global Insight. They were converted to
quadrillion BTU before they were input into the GI model.
In Step 1, the team assumed that the Federal Reserve would
adjust the effective federal funds rate in response to changes in
the civilian unemployment rate and the rate of Consumer Price
Index (CPI) inflation. They next imposed the model's monetary
reaction function that mimics the actions of the Federal Reserve.
Heritage economists excluded the GI model's exchange rate
variables, solved the model, and saved the new forecast before
continuing to Step 2. This new forecast was used as the starting
point for Step 2.
Step 2. The team adjusted the response of real
non-residential investment in mines and wells on the advice of
economists at Global Insight. Global Insight recommended this move
because this variable in the current version of the GI model
is very responsive to oil price shocks. As a result of these
discussions, the team halved the change in the mines and wells
variable from the baseline forecast. They then ran the model
again with these adjustments before continuing to the next step.
This new forecast was used as starting point for Step 3.
Step 3. The team next neutralized the relative price
effects of oil-related energy products and adjusted the world GDP.
U.S. trading partners would likely face the same price changes as
the U.S. and take similar hits to their GDP from an oil price
shock. Neutralizing the relative price effects and adjusting world
GDP helped to ensure that the final simulation results reflect
these shared effects.
The team neutralized the relative price effects by adjusting the
baseline. They made adjustments, first, by calculating the
deviation from baseline in the GI model's variable for the U.S.
producer price index excluding energy and, second, by applying that
deviation to the model's two variables for foreign producer
They adjusted foreign GDP inside the model by modifying key
indices of the real trade-weighted GDP of U.S. trading partners.
The team then solved the model and saved the forecast. This new
forecast was used to generate the summary results spreadsheets.
 The price of WTI crude is one of many
benchmark spot market prices for petroleum.
 Players "fight the scenario" when they
become sidetracked on discussing or fixing supposed flaws in a
scenario rather than conducting the wargaming and planning that the
scenario was intended to facilitate.
 If Venezuela actually followed through,
this could lead to short-term disruptions and higher world oil
prices. The U.S. would be forced to find substitutes for Venezuelan
oil, which would be difficult in the short run because U.S.
refineries are configured for the heavier and sourer Venezuelan
 Global Insight provides the most
comprehensive economic, financial, and political coverage of
countries, regions, and industries available from any source,
covering over 200 countries and spanning more than 170 industries
and using a unique combination of expertise, models, data, and
software within a common analytical framework to support planning
and decision making. Recognized as the most consistently accurate
forecasting company in the world, Global Insight has over 3,800
clients in industry, finance, and government, with revenues in
excess of $95 million, 600 employees, and 23 offices in 13
countries covering North and South America, Europe, Africa, the
Middle East, and Asia. The Heritage Foundation worked with
Global Insight to determine some of the results outlined in this
report. For more complete information on the methodology and
macroeconomic model used, see the appendices.
 Global Insight noted that power plant
improvements (adding pollution-abatement equipment) are far too
advanced to have any impact in the short or medium term. Utility
companies have ordered equipment that is scheduled to be installed
through 2012. They have already paid money that they cannot recover
through rates unless the equipment is installed. There may be some
ability to waive NOx emission standards for a few months, but this
would have minimal impact. Oil consumption by power generators is
extremely small and is limited to a few East Coast states that have
little capacity to turn to coal. To the extent that oil consumption
could be reduced further, it would require increased reliance on
natural gas-a fuel already in short supply.
 The U.S. is already at capacity for the
most part, so this would not have any real short-term effects.
 Opening ANWR would have no short-term
impact because production could not begin for several years.
Therefore, it is not relevant in a short-term simulation.
 Additional information on the Global
Insight model is available from the authors upon request.
 The methodologies, assumptions,
conclusions, and opinions presented here have not been endorsed by
and do not necessarily reflect the views of the owners of the
Global Insight model or their employees. Fortune 500
companies and numerous government agencies use Global
Insight's Short-Term Macroeconomic Model to forecast how changes in
the economy and public policy will likely affect major economic
indicators. Additional information on the simulation methodology is
available upon request.
 The Federal Reserve Board is assumed to
follow historic patterns of behavior when reacting to the oil price
shock. Heritage Foundation economists implemented this assumption
in the Global Insight model using an econometrically estimated
function that adjusts the effective interest rate on federal funds
in response to changes in the unemployment rate and the rate of CPI