Analyst: Iraqi war poses less threat to E&P stocks this time

Sam Fletcher
OGJ Senior Writer

HOUSTON, Aug. 29 -- If the US takes military action against Iraq, oil prices probably will quickly tumble as other members of the Organization of Petroleum Exporting Countries again increase production to offset the shortfall of Iraqi exports, as they did in 1991, said Robert Morris at Salomon Smith Barney Inc.

But the stock values of publicly traded exploration and production companies are much less likely to follow oil prices down this time like they did 11 years ago, said Morris. Such a retreat "will be partly mitigated, particularly for natural gas weighted companies, by the expected strength of natural gas prices in 2003," he said.

Concerns over Middle East hostilities—of which anticipation of an imminent US-Iraqi conflict is the latest manifestation—have lifted oil prices more than 60% from a low of $18/bbl in mid-January. "During this same time period, E&P shares have gained nearly 20%, concurrent with a roughly 30% increase in natural gas prices while the S&P 500 has declined about 15%," Morris said. "The question on most people's minds is how E&P shares might react should the US ultimately invade Iraq."

Market reactions
The potential response of E&P investors "is highly dependent on the actual timing, duration, and outcome of the operation," Morris acknowledged. "If the US attacks Iraq before yearend, E&P stocks are more likely to decline if oil prices drop sharply than if the attack occurs next year."

That's because of "the increasing tightness in the North American natural gas supply-demand balance, particularly heading into this winter and through 2003 (and beyond)," said Morris.

"The supply-demand fundamentals for natural gas are currently much tighter than in 1990-91 and, consequently, E&P stocks have recently traded more in response to natural gas than crude oil prices, apart from recent volatility in the overall market," he explained.

"We believe the impact of a potential conflict with Iraq on our 2003 natural gas price outlook would be minimal, primarily because the supply-demand balance will continue to tighten regardless of oil prices."

Salomon Smith Barney is projecting a composite spot natural gas price of $3.50/MMbtu for 2003, based on assumptions that benchmark West Texas Intermediate crude will average $20/bbl for the year and that gas demand will lose about 4 bcfd to cheaper fuel oil and distillates.

"However, if the situation between the US and Iraq is not resolved or the military engagement becomes extended, and oil prices retain their current 'war premium,' remaining in the high-$20/bbl range, then we would not expect any significant natural gas demand to be lost," Morris said. "Under this scenario, our $3.50/MMbtu composite spot natural gas forecast, assuming normal winter conditions, could prove conservative."
1990-91 crisis

During the 1990-91 crisis, said Morris, oil prices increased roughly 20% from around $18/bbl in May 1990 when Saddam Hussein declared Kuwait's overproduction to be 'economic warfare' against Iraq to more than $21/bbl when Iraq invaded Kuwait 3 months later. During that same time, E&P shares posted a much more modest 4% gain.

Following that invasion, oil prices surged 85% to nearly $40/bbl in early October as some 5 million b/d of Iraqi and Kuwaiti production—nearly 8% of the world's oil supply—was taken off the market. E&P shares on average gained 9% during that period, "although they peaked 2 weeks earlier than oil prices," Morris said.

But then oil prices began to fall as world leaders gave near-unanimous support to a military liberation of Kuwait and an Iraqi invasion of Saudi Arabia proved less likely.

"Oil prices declined nearly 30% from their peak in early October to the start of operation Desert Storm on Jan. 17, 1991," said Morris. "Interestingly, E&P shares also declined roughly 30% from their peak in late September to the start of Desert Storm, ending up roughly20% below their pre-conflict levels."

During Desert Storm's active military phase in Jan. 17-Feb.27, 1991, oil prices fell another 30% while E&P shares gained about 9%, "concurrent with an 18% rise in the broader markets. Thus, E&P shares wound up about 14% below their pre-conflict levels at the end of the (Persian) Gulf War vs. a 4% gain by the S&P 500," Morris said.

Contact Sam Fletcher at samf@ogjonline.com