June 22, 2004,
Oil prices, at almost $38 a barrel, reflect a speculative premium for a potentially major supply interruption of $10 a barrel or more. What kind of interruption? A terrorist attack, for one.
Inventories typically dictate commodity prices. If inventory levels are low, prices are high; if inventories rise, prices fall. The correlation between movements in U.S. crude-oil inventories held by oil companies (which are reported by the Department of Energy weekly) and the price of oil is particularly strong. However, this relationship appears to have broken down beginning in January this year.
U.S. crude-oil inventories held by the industry have built by nearly 34 million barrels year to date, one of the largest increases ever for this time of year. In addition, the U.S. Strategic Petroleum Reserve (SPR) has increased its holdings by 24.9 million barrels so far in 2004. Clearly, with inventories building and building rapidly oil supply exceeds demand. It may be hard to believe, but even with strong petroleum demand and oil prices at today’s high level, the world is actually oversupplied with oil.
Industry inventories of 303 million barrels, as of June 11, are consistent with oil prices of $24 to $28 a barrel. The difference between this price range and current prices represents a terrorist premium.
Although the risk that oil supplies may be interrupted by terrorist acts certainly appears higher today than in many years, overall the odds of a major prolonged stoppage of oil flows caused by terrorism are low perhaps one in twenty. While oil output fluctuates daily and is influenced by political issues, labor strikes, war, and unrest in developing countries, there has not been a significant interruption in oil supplies owing to terrorism since before the September 11 attacks.
Major oil production and transportation facilities around the world are considered to be terrorist targets and, accordingly, are fortified. Although security at facilities might be penetrated, heavy fortification, at least so far, may have led terrorist groups to go after “softer” targets such as western workers in Muslim countries.
Recent terrorist acts in Saudi Arabia are especially concerning. Oil prices have risen with each report of a terrorist act within the kingdom and following reports of Saudi police action against terrorist suspects despite the fact that not a single drop of oil production has been affected.
As for the Strategic Petroleum Reserve, President Bush appears committed to building the SPR to its authorized capacity of 700 million barrels (currently the reserve holds about 661 million barrels). If the Bush administration will not use the SPR to manipulate oil prices and will only release oil in the event of a supply disruption, then there is little danger of the SPR “depressing” prices ahead of a terrorist event.
The key question is: What will take the terrorist premium out of oil prices? Even OPEC’s decision to relax quota restrictions has not pushed oil prices down as much as one might expect.
It is likely that the lack of an event will make oil prices fall. In another three months we could be awash in oil. Consider the following: If supply exceeds demand by 2 million barrels a day through September (current oversupply is closer to 3 million barrels a day, with Saudi Arabia, Kuwait, Nigeria, and the UAE having pledged to increase production in the next few months), and 25 percent of this comes to the U.S. (as would be typical), and the U.S. government continues to build the SPR at one million barrels per week, then industry stockpiles could reach 340 million barrels by the end of September. The last time inventories were this high was in March 1999, when oil prices were $11 a barrel.
Frederick P. Leuffer, CFA, is senior managing director and senior energy analyst for Bear Stearns & Co. Inc.