Middle East tensions have pushed up cost of oil and bellicose talk in the US ahead of a likely attack on Iraq has added a 'war premium' to prices,writes David Buchan
America's allies may be divided over whether President George W. Bush should try to topple President Saddam Hussein. But they all fear one inevitable consequence of a US attack on Iraq: higher oil prices. At the same time, some see a regime change in Iraq leading to an increase in supply.
The world turns on oil. This week's world summit on sustainable development in Johannesburg will preach about moving from hydrocarbons to cleaner energy. But oil still has a monopoly on the world's transport, and the cost of other fuels such as natural gas is often indexed to its price.
Oil price rises can be a leading indicator of recession. Not all economists blame the oil price jumps of 1973, 1979 and 1990 for the recessions that followed, but the International Monetary Fund's rule of thumb is a rise of $5 a barrel sustained over a year reduces world gross domestic product by 0.25 per cent.
Oil prices have been rising all year. The benchmark Brent crude moved up from a $19.50 average in the fourth quarter of 2001 to a $25.20 in the second quarter of 2002. It accelerated last week, topping $27.40, an 11-month high, while West Texas Intermediate, which trades at a premium in the key US market, briefly broke through the $30 threshold.
"There is at least a $2 war premium in the price," says Mr Leo Drollas of the London-based Centre for Global Energy Studies. Middle East tensions, arising from the Israel-Palestinian conflict as well as Iraq, have inflated the oil price all year. War talk in Washington has now pushed the forward curve of oil futures prices up, but with oil for delivery next month marked higher than oil for next year. The world oil market has moved into its typical pre-war mode, known as "backwardation". At first sight, this is curious: if the likelihood of a US onslaught on Iraq increases next year, so should that year's oil price. Yet backwardation illustrates the market's thoughts about Iraq.
"The market is convinced of the inevitability of an attack, only uncertain about the timing, so it is prepared to pay more for oil delivered today than for future production still in the ground," says Mr Drollas.
At the same time, some traders also believe that even if Iraq's oilfields took a hammering, it would emerge as a very different player in the world oil market.
Mr Peter Gignoux, chief oil trader with Salomon Schroder Smith Barney, says: "A successful US operation would produce a nice friendly government in Iraq, and it is doubtful that it would be an OPEC [Organisation of Petroleum Exporting Countries] member." Iraq is an OPEC member but does not have an export quota because its sales are governed by UN sanctions. Without UN sanctions and OPEC membership, Iraq could pump and sell far more oil.
Meanwhile, another reason for the current oil price rises is changing fundamentals. The International Energy Agency (IEA) says growth in world oil demand will be 200,000 barrels a day (b/d) this year, the lowest increase for more than a decade. While OPEC production may be 1.5 million b/d less in the first half of this year, because of quota cuts and lower Iraqi sales due to pricing rows with the UN, the IEA says this will be mostly offset by a 1.2 million b/d surge this year in non-OPEC output.
However, the IEA believes demand will start to rise from the fourth quarter of this year and grow by 1.1 million b/d in 2003, though the figure could be lower if oil prices soar. The IEA is on more solid ground in putting growth in non-OPEC supply at 670,000 b/d next year, or half this year's increase, since no new big fields are scheduled to come on stream next year. The big oil companies - ExxonMobil, Royal Dutch/Shell, BP - have increased capital expenditure this year, but are struggling to counter field declines and raise overall output. Only smaller companies - TotalFinaElf and Eni - seem able to make substantial increases from their smaller baseline production.
Assuming there is no war in Iraq in the short term, the big question is what OPEC will do at its next quota review meeting in mid-September. After last year's formal quota cuts by Iraq's 10 OPEC partners, OPEC has now idle producing capacity of six million b/d, half of it in Saudi Arabia. It would seem obvious that OPEC members would award themselves a quota increase, especially as they have recently lost revenue and market share and as the temptation to cheat on quotas rises with the oil price. Also, Algeria and Nigeria have sought a formal rise in their quotas relative to the rest, because their oil-pumping capacity has been much increased by western oil company investment.
But this would be the first significant quota revision since 1990-91 when Saudi Arabia took part of the Kuwaiti and Iraqi share. The politics may be so difficult that OPEC might take no action. It may also claim its "market mechanism" does not justify a quota increase. Its supposed trigger for a quota increase is $28 for the OPEC basket of crudes, which trades at a quality discount to Brent and WTI. Last Friday the OPEC basket price was $26.78. Even if it exceeded $28, OPEC might argue the $2 or so war premium in it is unreal.
Since the 1973 Arab oil boycott, Saudi Arabia has said it would use its spare capacity to fill any emergency gap in the market, regardless of OPEC quotas. It did so in the 1979 Iranian revolution and in the 1990-91 Gulf crisis, and would probably do so in the event of an attack on Iraq. With 80 years of reserves at current production rates, the Saudis have great interest in the long-term stability of the oil market.
But cooler US-Saudi relations during the past year have cast a small doubt over Riyadh's reliability as supplier of last resort in a crisis caused by a US attack on an Arab state. Oil-importing governments are checking and in some cases increasing their emergency oil stock arrangements.
The broadest of these is co-ordinated by the IEA whose 26 members - including the US, Europe, Japan and South Korea - keep a minimum 90 days worth of imports in government- or company-owned stocks. The biggest such stockpile is 580 million barrels in the Louisiana and Texas salt caverns of the US Strategic Petroleum Reserve. The Bush administration is topping it up at the rate of 100,000 b/d, roughly what a big refinery consumes daily. Few other IEA members appear to be increasing stocks in the way non-IEA members in import-dependent Asia are. China is starting a government stock, while the 10 members of the Association of South East Nations (Asean) have decided to revamp their 1986 oil security agreement by creating stockpiles.
The IEA's performance in 1990-91 casts doubt on how useful it might be now in providing emergency oil to the market speedily. In the 1980s an IEA statement recognised that "a stockdraw could be particularly effective in the initial disruption states, when the danger may be greatest of market over-reacting". Mr Vito Stagliano, who was a US energy department official in the Gulf crisis, says the IEA's European members and secretariat blocked US requests for an early oil release during late 1990. The oil price rose from $17 just before Iraq's invasion of Kuwait to $40 by October, and did not fall until the IEA agreed to release 2.5 million b/d in January 1991 to coincide with Operation Desert Storm.
Mr Stagliano says: "IEA opposition was based on the specious theory that there did not exist an actual shortage of oil. But the shortage which the IEA bureaucrats and European governments were seeking was of course reflected in the oil price."
Mr Robert Priddle, the IEA's executive director, bridles at claims of IEA "disunity" in 1990-91. He says his agency could release - just from its members' public stocks - up to 13 million b/d in the first month of a crisis. That raises the question of whether it would do so in the case of a US attack on Iraq. European governments might prove reluctantto help in a crisis that many of them felt Mr Bush had brought on himself. - (Financial Times Service)
