There has been a lot of rumbling of late on the trading floors of the world’s commodity exchanges. Oil prices have been on the rise, a happening that always brings frantic hand-waving and screaming to the market even in the era of high-tech everything. As the cost per barrel of crude topped $30, alarm bells went off in the heads of consumers all around the globe (and warm smiles lit the faces in several parts of Texas).
As has been the case for several years now, the basics of supply and demand support a price in the mid-$20s. While volatile forces on all sides frequently pull prices above or below this level (often for extended periods), they always manage to return. In my opinion, the reason has to do with game theory, the complex mathematical examination of how we react to (and with) one another in competitive situations (a field notably impacted by the work of a youthful John Nash of A Beautiful Mind fame). In essence, lower prices drive the folks in and out of the cartel to actually cooperate in lowering production (the dynamics and inherently unstable nature of cartels is another fascinating mathematical process worth a non-technical look at some point). At higher prices, consumers start buying less and suppliers start cheating on their quotas.
In any case, the present frenzy is driven almost exclusively by the threat of war in the Middle East, to some extent because of ongoing conflicts but mostly because of the current discussions of an invasion of Iraq. Demand is down to some extent due to a relatively weak international economy and reduced consumption of jet fuel. Nonetheless, the prospect creates uncertainty about the future oil supply situation, and markets react to uncertainty by pricing it. At present, it is evidently worth about $3-$4 per barrel.
Assuming that the war speculation ends soon, oil prices will settle back into the mid-$20s. That’s the easy one. The more difficult question is, of course, what happens if we indeed go to war? Market analysts and media pundits alike consistently remind us that prices went above $40 per barrel during the Gulf War in the early 1990s. They always forget to mention that they only stayed there for a day or so. Once it was recognized that there would be ample supplies, the invasion actually lessened the uncertainty.
The situation is certainly different now, but this little history lesson is instructive. Given the facts that (1) there are many more players in the market now who want nothing more than to expand their share, (2) it is highly improbable (though not impossible) that a group of significant producers would shut off the spigot in support of Iraq (or opposition to us), and (3) we are extremely adept at not bombing oil production or the mechanisms to get it to market. I strongly suspect that a war would not keep oil prices up very long. On the other hand, the greater number of factors at work in this instance could well keep the spike in place for more than a day.
This issue is very important to the economy. While some Texans certainly obtain enormous windfalls from sustained price increases, they really do have notable affects on overall business conditions. While we tend to focus on the price at the pump, oil also heats, cools, flies, paints, clothes, cures, packages, and does a thousand other things in our daily lives. A sustained price hike or heightened instability will definitely impact our domestic recovery and that of other nations whom we depend upon to buy the things we make.
All of this to say that a lingering period of abnormally high oil prices is by no means the most probable outcome to the current market environment irrespective of whether we invade Iraq. On the other hand, it is clearly a scenario that is too critical to be ignored.