Cold Comfort in Winter Oil Prices

Possible U.S. action against Iraq, uncertain winter demand, and OPEC's upcoming summit add up to little hope of lower prices anytime soon

By Peter Luxton

With crude-oil prices up around 40% so far in 2002, the Sept. 19 meeting of the OPEC could represent a crucial juncture for the direction of the global economic recovery and financial markets. Ministers from the cartel's 11 member countries will decide whether to keep production at current levels or raise output against the backdrop of the most restrictive production quotas in more than a decade.

Some cartel members, as usual, have been quietly overstepping their stated production limits. Excess production by OPEC members has been creeping up to exceed 2 million barrels per day, as of August, 2002. The compliance rate slipped to 90%. Sure, that's the worst performance since the current quota system was introduced in 1999, but it remains an exceptional figure by historical standards. And while non-OPEC oil output also is increasing, it's risen only by a relatively marginal amount.

So the cartel members' relative discipline, and the lack of significant additional production from other sources, should help to provide a fundamental underpinning for higher crude prices over and above the immediate political concerns -- mainly, the prospect of a U.S-led military action against Iraq -- that are generating short-term price volatility. Certainly, OPEC members appear to be at odds over policy in the runup to the meeting. But unless production rises significantly, higher prices may be here to stay, whatever takes place on the geopolitical stage.

WIDER RISKS.

  That would be bad news for economies worldwide. To the extent that lofty crude prices don't reflect the increasingly negative world economic outlook, they represent a potential tax on consumers -- and a further weight on an already struggling global recovery, particularly on manufacturers.

In part, the latest price rise reflects the uncertainties of Mideast politics and the prospect of military action against Iraq. The market isn't just worried about disruptions Iraqi oil output, which, in any case, has dropped below 500,000 barrels per day in the last week of August, according to U.N. data. The real fear stems from the wider risks to the region as a whole from the political backlash arising from any potential conflict.

These worries persist despite regional producers having the capacity to make up any war-related shortfall and committing to do so. But things have changed since the 1990-91 Gulf war episode, when prices for the benchmark Brent crude peaked at $38 per barrel after Iraq's invasion of Kuwait in the summer of 1990, only to subside even before the U.S.-led invasion of Iraq took place in early January. This time around, the added wild card of the U.S. effort to combat terrorism adds an extra dimension to a risk premium that's unlikely to fade quickly.

HISTORICAL PATTERNS.

  Just how much is all this uncertainty tacking on to the price of a barrel of crude? We at Standard & Poor's MMS estimate that the war-risk premium is up to $7 per barrel, which could lead to a sharp pullback when and if the situation calms.

However, looking at the somewhat longer-term picture, oil prices have effectively returned to the levels of a year ago. The price drop witnessed late in 2001 and early 2002, along with oil's subsequent recovery, could be seen as a one-off event related to the exceptional events of September 11 and the U.S. foray into Afghanistan. This suggests that oil prices have returned to the more normal pattern that has followed past spikes.

In the couple of years following previous increases, the erosion in oil prices has been relatively limited. Following the jump sparked by the Iranian revolution in 1979, oil prices averaged over $30 per barrel in 1980-83, despite a global recession that crimped demand. In the early 1990s, oil traded in annual average terms only $4 per barrel below the 1990 average peak.

RESTOCKING SEASON.

 With the late-2000 peak for the current cycle, oil-price behavior hasn't been dissimilar from these past patterns and would point to average prices around the $25-per-barrel mark for the rest of 2002 and 2003. This is down on current prices of around $30 per barrel but still high compared to historical norms.

Seasonal patterns also favor some continuing strength to oil demand as the winter restocking season approaches. In 2001, consumption was depressed by a relatively warm Northern Hemisphere winter. If a more typical season is in the offing, supplies could remain tight, even though demand for oil didn't pick up as fast as expected in the first part of 2002.

Oil stocks stand at roughly the same level as a year ago. However, the increase in oil supplies by member countries of the Organization for Economic Cooperation & Development has been less than the average of the past five years, suggesting that make-up demand could appear at some point. This winter, with the prospect of conflict with Iraq and already-tight supplies, the global economy might just feel the chill.

Luxton is director of global foreign exchange research for Standard & Poor's/MMS International

Edited by William Andrews

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