Talk of oil price 'soft landing' premature?

March 31, 2003
Is it premature to talk of a postwar "soft landing" for oil prices?

Is it premature to talk of a postwar "soft landing" for oil prices?

The stunning plunge in oil prices in the days just before the Mar. 19 launch of military action against Iraq by US-led forces inspires a lot of head-scratching.

For several months now, traders have kept oil prices buoyed well above $30/bbl out of concern over loss of oil supplies resulting from a war in Iraq. The concern was not so much over the immediate loss of Iraqi supplies; the presumption was that the Organization of Petroleum Exporting Countries would readily take up that slack. The greater concern was over the possibility of additional Persian Gulf supplies lost from a broader conflict at a time when Venezuelan crude supplies were still limited.

Another concern was that Iraqi supplies might be lost for a long time as a result of sabotage, as with Desert Storm in 1991. This concern was exacerbated by the extremely tight situation for global crude and refined product stocks.

During this time, there were repeated assurances from OPEC, especially the Saudis, that the organization could accommodate any shortfall. The litany of assurances even evolved into strenuous jawboning by OPEC ministers to head off possible releases of strategic oil stocks by the US unilaterally or by the International Energy Agency, for fear of glutting markets. Most scenario analyses took in various projections for such releases.

But continued uncertainty kept oil prices propped up at a time when there were ample signals that OPEC and strategic stocks could accommodate any shortfall. That's understandable, especially given the confusion over what OPEC's spare capacity actually is and under what circumstances stock releases could occur.

A number of analysts disputed the notion that markets would see a repeat of the launch of Desert Storm, accompanied as it was by history's biggest 1 day drop in oil prices, given the much greater difficulty in ousting Saddam Hussein's regime vs. just ousting Iraqi forces from Kuwait.

Puzzling market reaction

Given all that, why did oil prices plummet $9/bbl in the week prior to the launch of Operation Iraqi Freedom? What had changed in traders' outlooks? Stocks were still tight, hovering near minimum operating levels in the US. While Venezuelan production was on the rise, there remained confusion over the actual volumes. There was nothing tangible to point to the lack of likelihood of sabotage to Iraqi oil fields or to other Persian Gulf oil infrastructure; in fact, concerns were growing of an Al-Qaeda terrorist attack on gulf facilities or shipping. At the same time, declarations of force majeure were coming out of Nigeria as growing civil unrest there shut in sizable volumes of crude oil by Royal Dutch/Shell Group and ChevronTexaco Corp.

And yet the "war premium" began to evaporate almost immediately in lockstep with the ratcheting up of war certainty. Somehow, in the span of a few days, traders' uncertainty over the threat to oil supply had been transformed into the presumption that a war would be swift, decisive, and result in minimal supply disruptions. At this writing, that outcome was still far from certain. A number of oil wells were ablaze at presstime, albeit not involving large volumes. And in the days following the onset of military action, both IEA and the US said there was no need to release strategic stocks.

Commercial stocks remain uncomfortably low, and minimal inventories of gasoline and natural gas (limiting fuel-switching as winter winds down) ensure, one would think, some upward pressure on crude prices.

But OPEC sources said Mar. 20 the group would call for an emergency meeting to decide on output cuts if oil prices slip to the low end of its $22-28/bbl target for the OPEC crude basket price. This ostensibly was the first step toward ensuring a soft landing for oil prices this quarter. And yet uncertainty about the repercussions from the military strikes on Iraq lingered.

Could it have simply been that traders finally took to heart OPEC's assurances? Or did they perceive the relentless determination of the Bush administration to oust Saddam as indicative of the US's prospects for military success with minimal supply disruptions—after all these months of overheating oil prices?

The market adage is: "Buy the rumor, sell the fact."

Maybe it should be: "Buy the rumor, sell the presumption."

(Online Mar. 21, 2003; author's e-mail: [email protected])