Oil shock. That's the worry of executives, consumers, and world political leaders alike as the Bush Administration prepares to launch a military campaign to depose Iraqi President Saddam Hussein. For the moment, the energy markets show every sign of giving in to such dread. With global inventories reaching dangerously low levels, crude oil approached the feared $40-per-barrel mark in the trading week of Feb. 24-28, while futures markets gyrated in some of the wildest action traders had ever seen. Heating oil, gasoline, and natural gas prices in the U.S. also hit near-record highs before falling back a bit. "There has been genuine chaos," says Peter A. Gignoux, head of the oil desk at Citigroup (C ) in London.
Is the chaos justified? Not if you believe this optimistic scenario: After the U.S. delivers a quick knockout blow to Saddam, prices decline swiftly and uncertainty evaporates. A U.S. victory in Iraq would instantly wipe away a war premium of at least $5 per barrel, analysts figure, and prices would drift down further not long after that. "I personally feel that the price is going to fall," says Leo P. Drollas, deputy executive director and chief economist of the Center for Global Energy Studies, a London think tank. "The war is going to be short and won't have much impact in terms of the oil market unless Saddam goes for some outrageously bizarre self-sacrificial act."
But there's more roiling the oil markets and driving up prices than the prospect of war, which is why the outcome may not unfold quite as smoothly or swiftly as the optimists hope. Supplies are tight, and may get tighter still, for a host of reasons investors may only be dimly aware of. Claude Mandil, director of the International Energy Agency in Paris, which is responsible for making sure consuming countries have adequate energy supplies, ticks them off: Venezuela. After a devastating strike, it's still producing far below its previous output, and it may not come back for months or years, if ever. Nigeria. It's facing turbulent elections, and violence could spread to the oil fields. Japan. The country has shut down some reactors for safety checks and may soon need a lot more oil. "There are a lot of ifs," says Mandil.
O.K., but what about the Saudis and Russians? Aren't they pumping as fast as they can? They are -- but the OPEC countries in particular have only been at full speed for about two months, and it's going to take a while for the crude to work its way through the system. That's especially true in the U.S., because inventories of crude oil as well as refined products such as heating oil and gasoline are near historic lows. A devastating two-month strike by oil workers in Venezuela and a fiercely cold winter in the U.S. have drained American crude stocks to 270 million bbl. -- the lowest level since 1975. Refineries in the U.S. are operating at just 89% of capacity, below seasonal averages.
Even in the best circumstances, with the world's big producers in high gear, it will take months to replenish stocks. And in less-than-ideal circumstances? Well, the global system can't take too many more shocks. If the war lasts more than a few days, Iraq's current 2.4 million bbl. per day in oil production is likely to evaporate. "There is spare capacity but not much more than Iraqi production," says Mandil. Edward L. Morse, executive adviser at Hess Energy Trading Co. LLC, a New York-based energy-trading firm, is more pessimistic. He estimates that the OPEC cartel can only produce 1.1 million bbl. more per day than it is already, outside of Iraq and Venezuela. In contrast, OPEC's spare capacity in July, 1990, before the Iraqis invaded Kuwait, was 5.2 million bbl. per day. "Systems with limited capacity have reduced levels of cushion in case of emergency," says Morse. Because of the tight supply conditions, prices are unlikely to fall as precipitously as they did in January, 1991, when they sank to $18 shortly after the U.S. attacked Iraq. If the war takes unexpected turns, prices could rocket.
No wonder the recent market gyrations have commanded attention from Washington to Riyadh. On Feb. 25, Energy Secretary Spencer Abraham announced that the U.S. "can act quickly" to use the Strategic Petroleum Reserve (SPR) of 599 million bbl. "to offset any severe disruptions if it's needed." Some analysts expect President Bush to tap the SPR in the early days of a war. "My guess is that when the order comes for the tanks to move, the order will also come to start the oil flowing," says W. David Montgomery, an energy expert at Charles River Associates Inc. in Washington. But even that may not happen if the war is over quickly and there's no major supply disruption. Abraham has refused to speculate on the timing of any release.
The Saudis are doing practically all they can to boost supply. They have long railed about the dangers of an attack on Iraq but are now resigned to Saddam's removal. They are positioning themselves to limit the political damage of a war: That includes a big shift in their approach to oil. For three years, Saudi Petroleum & Minerals Minister Ali Al Naimi cajoled producers inside and outside OPEC to stick to production discipline to keep prices at $25 per barrel. No longer. "We are contributing a lot, and this is not just propaganda," says a senior OPEC official in the gulf. "We are using our production capacity, and we are pushing OPEC to increase."
Industry sources say the Saudis are producing from 9 to 9.5 million bbl. per day -- the highest level since the Gulf War. Engineers for Saudi Aramco, the world's largest oil producer, are busily opening up mothballed wells and testing out Saudi oil fields so that the kingdom will be able to sustain output of 10.5 million bbl. per day in the event of a war. Oil company executives say that while the Saudis are trying to preserve a bit of ammunition for later emergencies, they are willing to sell almost all the oil their customers want. "Anybody who goes and asks for extra barrels will get it," says one crude buyer. All the big producers welcome the opportunity to fill their coffers. The Saudis are raking in $250 million in oil revenues a day.
The Saudis are also loading an estimated 30 million bbl. of crude onto their own fleet of tankers and steaming toward Asia and the Caribbean as a buffer against disruption in their fields. Across the rest of the oil world, from Russia to Norway to Mexico, production is also humming. Outside the kingdom, only a few countries -- chiefly Kuwait and the United Arab Emirates -- have any spare capacity left. Russia could pump more, but a lack of pipelines and other facilities is limiting its exports to just 4 million bbl. per day out of total current production of 7.75 million. "It's important to build new infrastructure -- the more the better," says Eugene Shvidler, president of Russian oil major Sibneft.
Venezuela remains a wild card. State-owned oil company Petróleos de Venezuela (PDVSA) is still reeling from the effects of the recent national strike aimed at forcing Venezuelan President Hugo Chávez to resign. PDVSA managers supported the strike, as did many of the company's 38,000 workers. Chávez recently fired over a third of them and split the company into two parts to weaken its clout. Some analysts say the outfit has permanently lost some 400,000 bbl. per day in capacity because of damage to facilities and mature wells. It's now pumping an estimated 1.55 million bbl. per day, vs. 2.66 million before the work stoppage -- and Venezuela's turmoil may not be over. As a result, Caracas might not be able to supply the U.S. with oil in an emergency. "Venezuela is going from being a part of the solution to being a part of the problem," says José Toro Hardy, an ex-director of PDVSA who is now an independent oil analyst in Caracas.
How the markets play out in the short-to-medium term may depend on the release of oil from the Strategic Petroleum Reserve in the U.S. and similar stocks in Japan, South Korea, and Germany. Oil industry sources say the U.S. and other countries could tap worldwide reserves to the tune of 8 million bbl. a day -- close to all U.S. imports -- for three months. But there may be delays in actually marketing the SPR oil, and refineries may have difficulty matching substituted crude to what it is replacing. Lee R. Raymond, chairman and CEO of Exxon Mobil Corp. (XOM ), told analysts on Mar. 5 that he expects a period of extended confusion in the oil markets after fighting starts, no matter what happens with the SPR. "I wouldn't suspect there will be clarity on this at all," he says. "There'll be a lot of what-ifs and whens."
Then there's the danger that war poses to the fields of the Persian Gulf. Alarmists say Kuwait and Saudi Arabia are exposed to an attack from Saddam. Not likely. Anthony H. Cordesman, a gulf military analyst at the Center for Strategic & International Studies in Washington, notes that there are built-in redundancies in the oil installations of the gulf countries.
If the Iraqis or Osama bin Laden sympathizers, for instance, managed to damage the Saudi Gulf terminal of Ras Tanura, the Kingdom could shift oil exports to the safer Red Sea. "Unless Iraq tried a concerted terror attack using virtually all of its remaining missiles and advanced attack aircraft plus large amounts of persistent nerve gas or biological weapons, and had great success, it could not produce a serious cut in oil exports in another gulf state," he says.
But smaller disruptions are possible. Some tankers may steer clear of the gulf, creating bottlenecks. Or a hit in Kuwait and Saudi Arabia might panic the markets even though no oil is affected. And there's the chance that Saddam could destroy the Iraqi oil patch himself. If so, it could take years and billions in investment to bring the fields back to what they were. The effects of war may linger for a long time.
By Stanley Reed in London, with Anthony Bianco in New York, John Carey in Washington, Christopher Palmeri in Los Angeles, and bureau reports