Could Oil Prices Stay High?

The jump in oil prices over the past month or so has clearly been driven by what’s going on in the Middle East and North Africa. That’s why most analysts assume that when things (presumably) calm down, oil prices will drop back to previous levels too. And so long as oil prices don’t stay high for a prolonged period, the economic impact should be relatively small.

But what if the geopolitical stress abates, yet oil prices remain relatively high? The standard answer is that this isn’t possible. If supply returns to previous levels, the market clearing price should too.

That seems reasonable, but I’d throw out a caution, because oil prices are funny things. Producers with substantial market power (think Saudi Arabia and maybe OPEC as a collective) target certain prices (currently believed to be between $60 and $80 a barrel) based on, among other things, their judgment as to what the global economy can tolerate. (If high oil prices tank the economy, oil demand collapses, prices follow, and producers’ revenues dry up.) They aren’t always successful, but they do try, and it often works. Producers are deterred from pushing prices too high in part because of fear of the unknown. But if a freak set of events, like we’re seeing now, push prices past previous thresholds, and if the global economy seems to handle things ok, pivotal producers might decide that targeting higher prices makes sense. They would thus cut back on supplies in order to realize the new target. The temporary price hike would become self-reinforcing.

This tendency could be compounded by a sense among producers that inflation, whether already realized or still on the way, was undercutting existing OPEC price targets – after all, that was part of the rationale for the original OPEC price hikes back in the early 1970s. To the extent cash poor (and hence price-hawkish) Iran has made relative gains in regional politics over the past month, that could also weigh on decision-making.

This is all, of course, quite speculative. But stranger things have happened. Part of the recent price hike could thus stick.