Oil Prices Could Be Entering A Vicious Cycle Of Volatility

Paul Stevens, a fellow at the London-based think tank Chatham House, laid out his scenario in a new FT op-ed.

It goes like this:

The Arab Spring is forcing Middle Eastern governments to spend more on social policies.

This will prompt oil producing countries to seek higher prices, through production curbs.

That, in turn, will be met by demand destruction from the rest of the world. Plus, supplies are already increasing thanks to shale development.

So prices will begin to flag.

Normally, the Saudis would step in as the "swing producer" to keep prices stable.

But Stevens says the Saudis may not have enough of a financial cushion to do so. The last time the Saudis abandoned this role, in 1986, prices fell about 60%.

Meanwhile, the falling prices will only serve to further aggravate social unrest.

Unlike in 1986, Stevens notes, there are now huge volumes of futures trades in crude markets.

So more unrest could enable paper markets to push prices back up.

The market is thus ripe for large price swings, Stevens concludes:

The result would be much greater oil price volatility. In that case, security of supply concerns – based on fears of physical disruption – would be overtaken by concerns about the macroeconomic impact of oil price volatility.

Strap it down.