OIL UPDATE: Tough Day In Iraq May Test Market's Optimism

Update Monday March 24, 7:41 AM By Stephen Parker Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Oil prices slid nearly 30% in the past seven trading days as the market bet on a best-case resolution of the war in Iraq, but fierce resistance Sunday slowed coalition forces' push toward Baghdad and could provide the first real test of the market's optimism, analysts said.

U.S. Central Command said Iraqis using ruses, including faked surrenders followed by ambushes, killed some coalition soldiers in the Al-Nasiriya area of southern Iraq. Other difficulties included Iraq's capture of a handful of U.S. soldiers, the accidental downing of a U.K. aircraft by a U.S. missile, and a grenade attack on forces in Kuwait blamed on a Muslim U.S. soldier.

U.S. President George W. Bush and U.S. military officials said the Iraqi regime ultimately will fall, but warned of tougher fighting to come as U.S.-led forces advance on Baghdad.

Day-to-day developments in the war aside, the long-term trend for oil prices is still seen as down. But heavy selling in recent sessions has left the market vulnerable to spikes, analysts said.

"Any setbacks at this point could generate a rally in an oversold market," Cameron Hanover analyst Peter Beutel said Sunday. "I don't see the price going back over $40, but these rallies will be sharp - they won't be timid affairs."

Another potentially bullish development emerged in Nigeria Sunday, when ChevronTexaco Corp. (CVX) shut down 440,000 barrels a day of oil production in the western Niger Delta due to ethnic violence. Royal Dutch/Shell (RD) and TotalFinaElf (TOT) have also shut in some production there, leaving 28% of the country's 2.2 million barrels a day in output off line.

Light, sweet crude futures closest to expiration fell below $27 a barrel Friday on the New York Mercantile Exchange after hitting a Feb. 27 peak near $40.

U.S. government and oil-industry analysts said that major oil producers' increased exports would fill any supply gap created by the loss of Iraqi oil production and that a short war would lead to a relatively quick resumption of Iraqi oil exports. Until the weekend, developments hadn't challenged that view.

Hoping For The Best

Last week, Merrill Lynch analysts summed up the market's optimistic sentiment, saying, "The general retracement we're seeing in oil prices reflects the hope for a 'perfect storm' of sorts where Iraq's infrastructure goes largely unscathed and no other supply dislocations develop from a war."

A key concern for the oil market is not only whether the coalition takes Baghdad, but whether Iraq's roughly 2,000 oil wells are quickly secured with minimal damage. Iraq's oil-export operations have shut down since U.N. officials left the country and buyers dried up as war ensued.

Only a handful of Iraqi oil wells were known to be damaged Sunday, and southern fields were under U.S. and British military control, but coalition forces still hadn't secured the country's rich oil fields in the north.

For now, the oil market appears adequately supplied. The Organization of Petroleum Exporting Countries has increased its oil output to 26.5 million barrels a day - just 400,000 barrels a day below the level that preceded Venezuela's two-month general strike, according to the U.S. Department of Energy's statistical arm. The increase comes despite the loss of Iraqi oil production and some lost output in Venezuela and Nigeria, the Energy Information Administration said Friday.

Barring a major disruption in the Middle East beyond the lost Iraqi production, some industry analysts expect oil prices to end the year around $25 a barrel in New York.

"There's definitely still potential for upside risk, but in my view that thought process has been overblown," Jacques Rousseau, senior analyst at Friedman, Billings, Ramsey & Co. Inc., an institutional brokerage, research and investment banking company, said Friday. "Any time the world has enough time to see something like this coming, they get prepared."

Rousseau projected the U.S. oil price will drop from about $35 a barrel in the first quarter to $26 in the second, ending the year around $23.

Nigeria A Wild Card

Erik Kreil, the EIA oil analyst who updated the agency's OPEC supply report Friday, said oil prices are now at the bottom of the range justified by supply and demand fundamentals.

"When we look at what the fundamental price should be based on inventories, $27 would be a fair number," Kreil said. "A price of $28 to $30 is what we would have said, based on inventories and other market fundamentals."

U.S. commercial inventories of crude oil remain near a 27-year low at 270.2 million barrels, just above the level at which the EIA said refiners could experience supply or production difficulties.

Commercial crude stocks remain low primarily because U.S. oil prices above $30 a gallon this year were too high to risk holding inventories, not because oil isn't available to store, analysts said.

A seasonal decline of about 2 million barrels a day in world oil demand is expected in spring, allowing U.S. refiners to begin restocking ahead of the summer driving season, Rousseau said.

Venezuela, a key OPEC producer, has already restored its oil output to at least 2.4 million barrels a day, nearing the level that preceded its strike that began in December. The recovery occurred faster than most had anticipated, easing concern that war in Iraq would mean the simultaneous loss of two major OPEC members' oil.

But with U.S. oil inventories stretched tight and producers nearing the limits of their capacity, there is little margin for error in the event of further disruptions, like those in Nigeria, the fifth-largest source of U.S. oil imports in 2002.

Nigeria's low-sulfur, or "sweet," crude is valued for the high quantities of gasoline it yields. A prolonged disruption of Nigeria's output could drive up U.S. gasoline prices, which reached a record high of $1.728 a gallon on March 17, Kreil said.

"There isn't a large source of light, sweet crude substitute waiting to come on for Nigeria," Kreil said. "If it continues to worsen, that's definitely going to be a concern for gasoline."

Beyond the war uncertainties and Nigerian disruption, Rousseau said the pace of economic recovery will reclaim its prominence in oil-market psychology. If U.S. economic growth this year is below normal as forecasts indicate, demand for oil and refined products will follow suit and apply downward pressure on prices, Rousseau said.

-By Stephen Parker, Dow Jones Newswires; 201-938-4426; stephen.parker@dowjones.com