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1 Benjamin Zycher, World Oil Prices: Market Expectations, the House of Saud, and the Transient Effect of Supply Disruptions 1 (June 2016)

handle is hein.amenin/aeiacuo0001 and id is 1 raw text is: KEY POINTS Ti hecommon mywnment that the sharp decline in oil prices during 2m14--5 inevitabig will lead to another steep increase is lurgely unsupported by the data on current and jiutures prices. T he Hiouse of Saud may perceive an increased need to buy internal political support, aind even a rising theat of overthrow from opponents internal or external, which would increase incentives for lower prices and increased/ output in the near term. 7'he recent moderate upturn in prices is consistent with the data showing increuses in supply disruptions, but both economic analysis anid the historicu! evidence suggest that the price effects of important supply disrup- tions tend to dissipate quick3. Several observers have argued that the recent sharp decline in oil prices is unlikely to last, largely because pricing strategy by Saudi Arabia can be described as dynamic profit maximization designed to drive overseas competitors out of business in the short run, and to erode investment in new competitive production capacity over the longer term. Punishment of overseas competitors unquestionably is a component of Saudi strategy, but the ensuing conclusion that sharp price increases are to be expected does not follow. That model falls short as economic analysis because it asks the wrong question: Will future oil prices remain low? The correct question is much more difficult: Why are current prices not far higher already? A sensible model of oil price patterns over time pre- dicts that expectations of higher future prices should be reflected in current prices. Current prices do not suggest sharply higher price trends, and recent data on futures prices and consumption and production paths are consistent with that inference. Although recent movements in crude-oil inventories support an infer- ence of prospective price increases, a simple analysis of spot prices and rates of return to arbitrage activities does not support that conclusion. Observed Saudi production and pricing strategy is consistent with a different hypothesis: the House of Saud's increased fears of internal and external threats to its rule, and an increased possibility of some sort of overthrow. In addition, the more recent partial recov- ery of international oil prices is consistent with an observed increase in global supply disruptions, so that a longer-term price recovery might reflect that factor rather than the effects of dynamic profit maximization by the Saudis. At the same time, a simple simulation of a severe supply disruption suggests that market prices would decline quickly from an initial sharp increase, an inference supported by the long-run history of move- ments in oil prices. Some common dimensions of conventional wisdom on international oil markets--- in particular, the description of OPEC as a cartel and the assumed effects of the 197'3 Arab OPEC oil embargo----are incorrect. But the optimi.- zation problem faced by the House of Saud is complex AMERICAN ENTERPRISE INSTITUTE 1

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