Jumping at shadows

12 April 2002

Uncertainty is now the prevailing theme across OPEC's world, from an Iraq fearful of US military action to Middle Eastern producers absorbed by the violent drama unfolding in the occupied territories. There is even volatility in non-Arab OPEC countries, with Venezuelan President Hugo Chavez facing a groundswell of political opposition. The consequent jitters of oil traders have helped push energy prices well above the level suggested by market fundamentals, but there is a growing divergence of opinions over whether serious price spikes are in store, or whether the market will ride out the political storm with quiet assurance.

In the short term, there is little doubt that the price will continue to climb. The market is tightening, with OPEC showing strict quota discipline and non-OPEC producers maintaining their restrictions on supply. Even the fears over low demand growth have receded as the US economy starts to recover.

The tight market has amplified the effects of political tension on the oil price, with recent weeks providing two particular areas of market concern. Initially, the expectation of US military action against Iraq led to fears that Gulf oil supply would be disrupted. Throughout the first quarter, the US talked up its intention to topple Iraqi President Saddam Hussein by force. The price kept rising as the talk grew bolder.

By early April, the military threat facing Iraq had been overshadowed by the worsening violence between Israel and the Palestinians. In response, Iraq called for a repeat of the 1973 oil embargo to put pressure on Israel and the US. In the context of a rapid and steep escalation of the conflict, the call was cautiously echoed by Iran and was much reported in the press, prompting a leap of $2 a barrel in the oil price. On 8 April, Iraq confirmed its stance, announcing the immediate cessation of oil exports for 30 days. Iraqi exports so far this year have averaged about 2 million barrels a day (b/d).

But neither event is likely to occur in the short-mid term. For any sustained military action against Iraq, the US needs Arab political and logistic support; support that it has been vehemently denied. Almost all Arab states have publicly voiced their opposition to military action, and at the Beirut summit in late March, they effected a rapprochement between Iraq and Kuwait to present an unexpected united front. The position will not waver so long as the US fails to reduce the violence in the Palestinian territories. Once support is secured, a military campaign against Baghdad would need months of preparation.

For all the posturing, fears of a wider oil embargo are unfounded. Even the level of Iraq's own unilateral export moratorium remains in doubt, with oil flowing to Syria and Jordan after the embargo began. Baghdad suspended its oil exports for the whole of last June, but other OPEC countries filled the supply gap then and they could easily do so again. Saudi Arabia alone has sufficient spare capacity to cover Iraqi exports, which have been low throughout 2002 due to the retroactive pricing formula enforced by the UN. It would take two-three months to bring the new capacity on stream, but global strategic reserves can easily cover the interim period of lower supply.

Iranian statements of support for an embargo can be discounted too: it would only undertake an export moratorium in concert with the rest of OPEC, which is highly unlikely to endorse it. Libya, another vocal supporter of an embargo, is in a similar position. Critically, all the Arab Gulf states, as well as other producers like Algeria, have dismissed the threat.

Fundamentally, an all-out embargo would have to be supported by Saudi Arabia. The kingdom's Foreign Affairs Minister, Prince Saud al-Faisal, has emphatically ruled out such action, injecting some much-needed realism to the debate. 'Oil is not a weapon. Oil is a resource,' he said in an interview published on 3 April. 'Oil is what makes our economies run. Conditions then [during the 1973 embargo] were one thing and now are another thing. An enemy, if he were fighting us, would destroy our capacity to produce oil. Why would I do the same thing to myself? This would weaken me more than anybody else. The oil is needed for our development, and for every action that we take we have to rely on the resources that oil brings. So anybody who called for an embargo would have to be somebody who does not understand the reality of the international economy or harboured objectives inimical to the Arab countries.'

Nevertheless a de facto embargo can be implemented without incurring many of the risks of a full embargo. Oil producers will have the opportunity to send a sharp signal of their displeasure when they review production quotas at the next OPEC meeting on 25 June. 'The market needs between 1 million and 1.5 million b/d of OPEC oil in the coming months,' says Geoff Pyne, analyst at Sempra Energy Trading. 'The market will continue to tighten if OPEC doesn't change its quotas in June. In a sense, forgoing a quota increase is a way of getting round a formal embargo. OPEC is notorious for doing nothing when things are difficult.'

However, even such muted action is problematic. Producers know they are far more vulnerable than oil consumers to high price volatility, and would only countenance any political moves in the oil market if the violence in the Middle East were to worsen markedly. President Bush has attempted to deflect the perception of uncritical US support for Israel with a stern, albeit double-edged, demand for an Israeli withdrawal.

Outside the Middle East, Venezuela is contributing to the air of concern. Since late March, oil workers at state producer Petroleos de Venezuela have been protesting at the appointment by Chavez's government of new senior staff, which they see as political interference running against the company's interests. Production and exports have been affected, although the full scale of the reduction will not be known for some time. If Chavez's government falls, a shift in oil policy could be expected in favour of higher production.

Political tension is hardly new to the Middle East, so it seems surprising the price has risen so sharply. The message is that a tight market will jump at shadows. 'Traders react to one source of information at a time,' says one analyst. 'They seize upon rumour or the expectation of trouble, but as soon as real action does start, they factor it into the price and the market eases.' Consequently, future points of tension over the coming months can be expected to push up the price provided OPEC and non-OPEC countries maintain their current production levels.

There lies the nub. 'The market has been getting tighter slowly and inevitably since the last OPEC cut took place,' says Leo Drollas, head analyst at the London-based Centre for Global Energy Studies (CGES). 'The effects have been felt on the market since mid March and demand is proving stronger than some people had thought. Even a cooling in the political tension would only be temporary because the Iraq issue is still there and won't go away. So the price will be on the high side this summer - and rising.' CGES forecasts the oil price to average $26.50 a barrel for Brent in the third quarter and $25.30 a barrel for 2002 as a whole.

True to form, OPEC has attributed the price increase to market sentiment, rather than fundamentals. 'The jump in prices is the result of speculation but not the result of a shortage of supply,' said OPEC Secretary-General Ali Rodriguez on 4 April. 'We have to wait and see because if we increase production now and the situation returns to normality maybe we will face a collapse of the prices.'

It is clear that no change in output levels can be expected before the June OPEC meeting. By its own arguments, the organisation has good reason to keep production low. With prices inflated by $4-6 a barrel by the political situation, the value of oil based on fundamentals is close to the bottom of the organisation's preferred price band of $22-28 a barrel. Furthermore, following its decision in late 2001 to take 1.5 million b/d out of the market, OPEC output is now at its lowest level for a decade.

Non-OPEC producers are also playing their part. They have reaffirmed their commitment to keep output levels unchanged until the end of June after participating in the latest round of OPEC production restrictions. 'We do not at the moment have any convincing arguments that current prices are stable,' said Russian Energy Minister Igor Yusufov on 4 April. 'We are, of course, monitoring oil prices but I see no reason to take hasty decisions.' The expectation is that if the price stays high, both Russia and Norway are likely to quietly increase their export levels.

Political unrest, coupled with curtailed supply, is masking the true picture of oil demand. 'We see that demand has improved,' says Vera de Ladoucette, analyst at the US' Cambridge Energy Research Associates (CERA). 'We've upgraded our estimates for demand growth from 200,000 b/d to 500,000 b/d for the year as a whole. We think demand will get progressively stronger throughout the year, although increased prices could put a break on the US economic recovery.' Drollas agrees: 'Stocks are beginning to fall,' he says. 'In the second quarter we could, amazingly, have a stocks draw. That is not right and is a real worry.'

The overall picture, though uncertain, is good for Gulf economies. Forecast budget deficits across the region could now be significantly reduced, easing the need for stringent expenditure. But governments will not be too hasty. If the fundamentals seem deceptively strong, the US economy sinks again and the political tension is alleviated, the price could easily fall back below $20 a barrel. For now, caution remains the watchword, but there is a chance that the political premium on the oil price will earn the Gulf a strong financial dividend.

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