EDITORIAL Iraq and the oil market

Saddam Hussein's latest problems give the oil industry reason to assess its market's last half-decade and to wonder whether the future holds more of the same.

The Iraqi president this month suffered what may be his worst political setback since international military forces routed his troops from occupied Kuwait in early 1991. Two high-ranking Iraqi officials decamped to Jordan, taking with them an entourage of lesser officials and family members, including their wives, who happen to be Saddam's daughters.

Change in Baghdad

The dramatic defection and Jordan's uncharacteristic embrace of the exiles amount to a visible step toward political change in Baghdad. The threat to Saddam's regime certainly moves Iraq toward a resumption of oil trade. At the very least, it raises pressure on the Iraqi president to satisfy United Nations conditions for relaxation of the trade embargo.

Smitten with this suddenly improved prospect for additions to supply growing in time to 3 million b/d, the market yawned. Crude prices fell slightly but might well have done so anyway: Growth in world oil demand is weakening as economies slow in the key consuming countries.

So why doesn't the market react to this potentially major increase in crude supply?

As traders are fond of saying, the market long ago discounted Iraqi oil. The phenomenon is difficult to measure. To some extent, however, the presence of Iraqi potential has been suppressing prices for half a decade, which makes it difficult to draw enduring conclusions from recent market behavior.

For 5 years, no one has had to worry much about replacement supply, which used to play an important role in market psychology. For physical, economic, even strategic reasons, the oil market resists supply interruptions. This makes surplus the historic norm.

A manifestation of this inclination toward surplus is unused capacity to produce crude. The market demands such a buffer. For most of the 1970s and 1980s, it grew jittery and raised prices whenever production capacity utilization exceeded 80%. Yet for the past 5 years it has hummed along with capacity utilization at 90% or more -- as measured with most Iraqi capacity out of the equation. Crude prices in that period have mostly reacted to developments in product markets.

Such toleration for a thinning in the market's buffer of idle but ready production capacity reflects, to some extent, permanently reduced worry about replacement crude supply. Physical supply limits are receding thanks to technology. And delivery mechanisms are increasingly flexible thanks to computers and a proliferation of financial instruments that, in combination, enable companies to approach "just-in-time" inventory management with crude.

But industry officials and government energy regulators should not conclude from recent experience that replacement supply no longer has a role to play in market psychology. Since the Persian Gulf crisis, the market has been able to balance with supplies from non-Iraqi sources and be comfortable with a surplus no larger than 8-9% of available capacity. But during that period Iraqi production potential has hung over the market like a huge strategic reserve: off-limits for political reasons but physically present and, yes, politically available if the world really needed it. The surplus safety cushion was somewhat larger than 8-9%.

Maintaining the buffer

Recent trading innovations are very important. They provide flexibility and improve responsiveness, characteristics that will be crucial to the behavior of future markets.

But in those future markets, replacement supply will remain a vital -- if less volatile -- trading concern. And maintenance of a production capacity buffer will still be a vital necessity. This month's developments in Iraq provide a useful reminder that the market has had more buffer than may have been apparent -- and that it may reenter trade sometime soon.