Riyadh terrorist attacks spawn new price risk premium

May 26, 2003
There is a new risk premium for oil prices: the threat of terrorist attacks in Saudi Arabia.

There is a new risk premium for oil prices: the threat of terrorist attacks in Saudi Arabia. Like the risk premium posed by the then-impending war in Iraq, this new one has little to do with actual physical shortages of oil. But the implicit, continuing threat to the kingdom's oil supply, coming in the wake of the May 12 terrorist bombings in Riyadh, will linger.

In the weeks and months to come, every rumor or report of possible or actual terrorist attacks in Saudi Arabia—especially those targeting oil export facilities—will add upward pressure to oil prices even as the physical market tightness is expected to ease.

And there are signs that oil supply actually will be less abundant than some analysts have been predicting of late.

Furthermore, threats to oil supply in other parts of the world aren't receding.

Saudi oil crucial

It could be argued that there is even greater risk to global oil supply today than at the time the US-led coalition attacked Iraq.

Iraq's oil supply outage had already been largely discounted before hostilities began. In fact, the rest of the Organization of Petroleum Exporting Countries—mainly Saudi Arabia—had already begun producing more oil early this year in anticipation of an Iraqi outage.

It was the speculated risk to other Persian Gulf oil supply, should the conflict spill over, that formed the bulk of that risk premium. That's why oil prices started falling in the days before the conflict began. The tough resolve of the Bush administration seemed to help overcome fears of a wider conflict—or even suggested to market-watchers that US military might would be brought into play to rein in other threats to gulf oil supply.

But, more importantly, it was Saudi Arabia's crucial role in world oil markets that prevented oil prices from spiking to intolerable levels during the runup to and prosecution of Gulf War II. As the kingdom is not only the owner of the world's biggest oil reserves, it also is the holder of the vast majority of the world's current spare oil productive capacity.

So a threat to Saudi oil supply is a threat to what is effectively the world's sole viable long-term oil supply cushion. While drawdowns of strategic oil stocks held by governments and companies would ameliorate any global oil supply crisis, that option has its limits: the volumes of inventory held. It was in fact Saudi Arabia's aggressive moves to boost its output by almost 2 million b/d that deflated any initiative to release strategic stocks at the war's outset.

There is no telling how long the kingdom could produce at that higher level, sustaining a cushion that could absorb most other outages. But the loss not only of the Saudi "swing cushion" but possibly all Saudi supplies for an indefinite period would expose the world's vulnerability following release of strategic stocks. At some point, the drawdown on strategic stocks would have to ease. That option would have to cede ground to the option of letting price destroy demand in order to preserve what little physical supply cushion remained. And while such a high price would stimulate immediate growth in production and later growth in productive capacity, it is inconceivable that any supply response could offset the loss of Saudi oil supply from the market.

Saudi response

The most critical market factor to watch in the coming weeks will be the Saudi response and follow-up to the terrorist attacks. The kingdom has come under criticism for its benign neglect in dealing with radical and even terrorist elements in its midst. US officials already have claimed that warnings of imminent attack in the kingdom and consequent pleas for stepped-up security were given short shrift by the Saudi leadership.

Now that it too has become a target, Saudi Arabia seems to be reassessing its attitude, if recent comments from Crown Prince Abdullah are any indication. Should the Saudis falter in their vigilance or willingness to deal with dangerous elements in their society because of a continuing involvement by the US in the kingdom's security, the price premium will grow.

Such concerns will linger even as some analysts' perceptions of excess supply on the horizon had already begun to evaporate before the Riyadh attacks. Next week's column will focus on those changing supply perceptions.

(Online May 16, 2003; author's e-mail: [email protected])