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Middle East again the key to oil price outlook

Oil prices are at their highest point since Operation Desert Shield, and once again, market watchers must look to the Middle East for clues as to why that has happened and as to what will happen next.

For the first time in 9 years, Nymex crude has topped $27/bbl, if briefly. The main culprit for that development, as in 1990, is Iraq. Saddam Hussein must chafe at being out of the spotlight for more than a few months, so Baghdad responded to the UN Security Council's 2-week extension of the latest 6-month oil-for-aid sales program with its usual combination of bluster and irrationality. The Security Council had voted to extend the sales extension for 2 weeks to give its members more time to debate the conditions under which sanctions against Iraq might be completely lifted. More specifically, it was the US and the UK pressuring France and Russia to decide on what those conditions should be-namely unfettered access to weapons sites for inspections. Claiming that the 2-week extension was an illegal further extension of the sanctions and a conspiracy led by the US to further cripple it (the words "act of war" were used), Iraq declared that it would refuse to export oil. That posed a worrisome situation for markets, as the loss of Iraq's 2 million b/d of crude for very long would force a rapid drawdown of stocks to a critically low level. Prices would certainly top $30/bbl by the end of the year, maybe $35, in the event of a protracted cold spell across the Northern Hemisphere.

Within a couple of days of making the announcement, Iraq backpedaled by saying it would accept the next 6-month rollover of the oil-for-aid sales program, and oil prices retreated. But only yesterday, Iraqi Oil Minister Amer Mohammed Rasheed said his country will not acknowledge the 2-week extension and will refuse to export oil during the 2-week period, which ends Dec. 4. Those exports already have been halted via the Iraq-Turkey export pipeline, as Turkish officials confirmed last week.

While other market factors are also at work (growing prospect of civil war in Nigeria, the surge in gasoline demand in the US over the Thanksgiving holiday), Iraq's troublemaking is the major market mover here, especially in light of the current market fundamentals. Taking 2 million b/d off the market even for just 2 weeks contributes to the ever-dwindling state of crude inventories. But it would not be surprising to see Baghdad throw another tantrum during the next 2 weeks, as the Security Council again debates sanctions, with the resulting dust-up keeping Iraqi oil off the market through the end of the year. The timing would be simply too irresistible for Saddam: the most lucrative of western holidays approaching amid a booming economy in the US, the likelihood of cold weather jacking up oil demand, the Millennium Crisis panic, etc. Then we are faced with the real market threat: losing Iraqi oil for a protracted period while OPEC refuses to fill the resulting supply gap when markets are already tightening. In what was almost an ominous portent of that scenario, Qatar's Prime Minister Sheikh Abdallah bin Khalifa al-Thani said there are no plans "for the moment" on the part of any OPEC member to increase oil production following the halt in Iraqi oil exports. And he said this in Paris after a meeting with French President Chirac. That was followed by comments made by the energy ministers of both Algeria and Venezuela that OPEC and non-OPEC exporters continue to implement the production cuts that have helped double oil prices this year, "in order to achieve sustained stability in the international oil market."

But another comment about stability came the same day from Saudi Crown Prince Abdullah bin Abdel Aziz, and what's telling is the how the context in which the term is used in his comment differs from the preceding quote. Prince Abdullah said, "The position of Saudi Arabia as a reliable source of oil supply and its importance in the global oil industry requires that the kingdom seek to secure stability in international oil markets, to preserve the interests of both oil producers and consumers."

Comments from Saudi officials about oil markets are to be read for what's between the lines. This quote suggests to western markets that Saudi Arabia won't sit back idly while oil prices shoot up out of control because of Iraqi mischief. Many analysts for the past few months have been predicting that higher oil prices will incite rampant quota cheating within OPEC, and that will moderate prices. Well, it just hasn't happened. While there was small bit of slippage in compliance with pledged production cuts in October, mainly from Iran, the actual volumes were pretty insignificant-especially in light of low stock levels.

Certainly the Saudis and the rest of OPEC are aware of what happens when stocks drop too low heading into winter and oil prices are already high; they really don't need analysts telling them that more OPEC oil is needed to bring prices down to a comfortable level for the global economic recovery to continue. What the Saudis want to see is actual, quantifiable evidence that stocks have dropped to the point where any increase in OPEC production won't spur another steep drop in oil prices before putting any slack back in the market. And that is happening. The American Petroleum Institute yesterday reported that crude stocks in the US fell by 2.072 million bbl last week, much more than the 1.23 million bbl decline that the market was anticipating. Refiners are drawing down lower-priced crude oil stocks in anticipation that oil prices will rise, and the act becomes-to some degree-a self-fulfilling prophecy.

Pretty serendipitous timing: the report of data showing oil stocks falling rapidly coinciding with the prospect of Iraq pulling its supplies off the market. Add to that US Energy Sec. Bill Richardson's response to queries about drawing down Strategic Petroleum Reserve stocks in a bid to dampen oil prices: Unless there is a genuine emergency, leave the market to take care of itself.

Was Prince Abdullah sending a subtle hint to markets (especially the US) that it would step in to act as a swing supplier should Iraqi supplies be withheld from the market this winter? Certainly, the Saudis are best-equipped to step up a sizeable volume of additional production quickly, but the kingdom would have to get at least tacit consent by Iran, Kuwait, and Venezuela (if not also Mexico) to undertake such a market rescue. This in turn could open the door for others in OPEC to loosen the reins a bit-but probably just enough to allow stocks to rebuild to a comfortable-but not price-plunging-level. Thus the long-predicted quotabreaking would finally occur, but accomplished on the "pretext" of an emergency (Iraqi troublemaking again). Oil prices would settle back down, perhaps to $18-22 by the spring, and the March OPEC meeting could be an opportunity for members to harden their resolve again, just in time for the seasonally slack second quarter.

Stranger things have happened. Oil is a funny business, isn't it?

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OGJ Hotline Market Pulse
Latest Prices as of November 26, 1999

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