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Oil and Iraq
War or no war, prices will fall.


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As the U.S. and Great Britain prepare for war with Iraq, there are strong similarities to the events of 1990-1991. We now face the same enemy at the same time of year. Price movements in oil, oil stocks, and the broader stock markets in the past six months are nearly identical to those in 1990. Even the president has the same last name.

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As military forces build near Iraqi borders, a “war premium” on oil — ranging from $5 to $8 a barrel — has propped up oil prices above $30 a barrel. The case was the same in late 1990. In 1991, oil prices declined sharply, the stock market soared, and oil stocks underperformed.

In 2003, oil prices and oil stocks should follow the same path as in 1991. War with Iraq is now likely, and timing of the war points to the first quarter. The war should end quickly with minimal casualties.

Differences between today and 1991 suggest that oil prices are unlikely to match the highs seen in 1990 — but that the correction is apt to be as severe. Here are the variables:

Iraq is a less important supplier of oil today. In the past year, it has supplied about 25% less oil than it did in 1990. Meanwhile, Kuwait’s oil production, which ceased in August 1990 through late 1991, is flowing at about 2 million barrels a day and is capable of producing about 2.4 million barrels a day. Finally, strategic reserves of crude oil and refined products in OECD countries (Organization for Economic Cooperation and Development), at 1.25 billion barrels, are 50% higher than in 1991, and the ability to release oil is vastly better today.

A quick military victory could remove a major uncertainty facing world oil supplies. In 1991, within minutes of the first bomb being dropped on Iraq, oil prices fell from $34 a barrel to less than $20 a barrel. Under U.S. military occupation, oil exports would be expected to hold steady, as opposed to Saddam’s use of oil as a political weapon. Iraq stopped all oil exports last April in protest of the Israeli-Palestinian conflict. Exports were a million barrels a day below plan in the third quarter of 2002, owing to illegal surcharges imposed by Iraq on its oil exports. The U.S. military will oversee oil production operations to secure volumes near Iraq’s current capacity of 3 million barrels a day or more, versus production of 2 million barrels a day in 2002.

Even if war is averted, oil prices should fall this year. The “no-war” scenario would likely come about if Saddam Hussein’s government complies with UN sanctions and cooperates with UN weapons inspectors. This scenario assumes a steadier flow of oil from Iraq in 2003 of, say, 2.8 million barrels a day, or 800,000 more barrels a day than in 2002.

And higher production from Iraq would consume all, or more than all, of the increased call on OPEC oil projected for 2003, leaving no room for higher output by the other ten OPEC members — for the third year in a row — unless oil prices fall. The persistent erosion in OPEC’s market share and need for revenues is apt to push members to cheat further on production quotas.

A drop in oil prices to a more normal level, of $18 to $20 barrels a day, would stimulate economic growth and likely would be beneficial to many industries, just as it was in 1991. However, oil stocks will likely come under pressure. In 1991, the S&P 500 advanced 26.3% while the S&P Oil Composite rose only 4.3%.

The longer term outlook for Iraq and its oil production is uncertain. The country could expand output capacity to 5 million or 6 million barrels a day within three years of operating under a stable government. To be sure, a new government will seek to rebuild the country’s economy, and it must do so by resurrecting its oil industry. This could put oil prices under pressure for many years.

Major oil companies, with their expertise in exploration and development and access to modern technology and capital, will need to assist Iraq in this massive undertaking if it is to realize its potential. However, Iraq’s factious population may render stability illusive — and a prolonged occupation could delay expansion of the country’s oil production capacity.

— Mr. Leuffer, CFA, is senior managing director and senior energy analyst for Bear Stearns & Co. Inc.



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