What Happened to Cheap Postwar Oil?

Combine a creeping comeback for Iraqi crude with plenty of other supply and inventory troubles, and what you get is $30 a barrel

In the three anxious months leading up to the Iraq war, oil prices soared by 25%, to more than $37 a barrel. Despite the alarming rise, many energy experts were quick to argue that a fast and decisive victory would send oil tumbling below $25 for the rest of the year.

It hasn't worked out that way. True, prices dropped in the days and weeks after Saddam Hussein's regime fell. But since then, they've hovered around $30 a barrel, thanks to worries about low inventories, the slow resumption of Iraqi production, and continued supply disruptions from Venezuela and Nigeria. Worse yet, oil seems poised to remain stubbornly high for the rest of the year.

For now, the higher prices have had a relatively small effect on an economy revved-up by superlow interest rates and tax cuts. "The impact [of high oil prices] has been marginalized so that it's not as big of a drain," says Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson. "But the negative impact will be felt in the end."


  The U.S. Energy Information Administration estimates that oil will average $29 to $30 a barrel during the second half of 2003. Likewise, futures traders are betting that prices will remain firm. On the New York Mercantile Exchange, the September delivery closed Aug. 5 at $32.22 a barrel, while December delivery closed at $30.76.

What's behind the sustained strength in oil prices? The main culprit is post-war Iraq. After the U.S. military seized Saddam's oil fields largely intact, prices dropped briefly below $25 on expectations that Iraqi crude would soon begin flooding the market. But that never materialized because of widespread looting, sabotage of pipelines, and aging infrastructure.

Eventually, supplies from Iraq will come back, but progress has been maddeningly slow. Original forecasts from the Iraqi Oil Ministry called for output to reach 1 million barrels per day by mid-June and as much as 3 million barrels a day by yearend. Instead, it was late July before Iraq reached the million-barrel-a-day milestone.


  Industry consultant Cambridge Energy Research Associates (CERA) estimates it'll be the end of the year before Iraq comes anywhere near its pre-war level of 2 million barrels a day. "Production from Iraq has been delayed well beyond what people imagined," says John Browne, CEO of London-based BP (BP ).

And even if the Iraq situation improves, plenty of other trouble spots could continue to keep supplies low. Following the end of an oil workers' strike in February, Venezuela increased production faster than most observers had expected and is now producing about 2.7 million barrels a day. But analyst Frederick P. Leuffer of Bear Stearns figures daily output there is still some 500,000 to 600,000 barrels below pre-strike levels. And political instability has led to fresh concerns about potential oil-supply disruptions.

Ditto in Nigeria, which has recouped most of the 400,000 barrels a day disrupted during ethnic violence earlier this year. But in late July, a major Nigerian oil union threatened to go on strike on Aug. 19.


  The outages from Iraq, Venezuela, and Nigeria, which together produce about 10% of the world's supply, have helped push worldwide crude stocks down to their lowest levels in two decades. U.S. inventories, also depleted by severe winter weather in some areas, are at five-year lows for this time of year. Reduced levels are likely to persist as demand picks up in the second half for wintertime petroleum products, such as heating fuel.

OPEC, which has helped prop up oil prices by not overproducing, isn't expected to do much to ease the shortfall. When cartel ministers met July 31, the group stood pat on current quotas, declining to increase production. And many expect OPEC will continue to hold the line at its next meeting on Sept. 24. "That will make inventories tighter going into the third and fourth quarters," says Joseph A. Stanislaw, chief executive of CERA.

Mark M. Zandi, chief economist at Economy.com, figures if oil were to drop from its current $30 or so to around $25 per barrel over the course of a year, a quarter-percentage point would be added to gross domestic product growth. Instead of the 3.5% many are now predicting for the coming year, GDP growth would be lifted to around 3.75%. With the rebound struggling to gain momentum, that's additional growth the economy can ill afford to give up.

By Stephanie Anderson Forest in Dallas, with Stanley Reed in London

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