War's effect on oil prices
IRAQ: Business Online Special March 25, 2003
Graham Searjeant, Finance Editor of The Times, explains the strange peaks and troughs in the cost of petrol during the war on Iraq.
Q. We are at war with a major oil producing nation in Iraq, yet the price of a litre of petrol has been cut on some foreecourts this week. How can that happen?
A. The price of crude oil went up by 50 per cent between early November and early March, taking North Sea Brent crude nearly one-quarter over the top of the $22-$28 per barrel range that Opec, the producers’ cartel, has been trying to maintain.
That was partly because of real demand and supply factors. Petrol refiners and armies were stocking up in advance in case of a war shortage or disruption to supplies. There was also a prolonged strike in Venezuela, which normally supplies three million barrels per day, more than Iraq, and is a key supplier to the United States.
At the same time, short-term traders, speculators and trend-following hedge funds joined in on financial markets such as London's International Petroleum Exchange and the New York Mercantile Exchange, using contracts for future delivery. They reckoned that buying and driving up the price was a safe, one-way bet.
But trends never last for ever and trend-following speculators are always looking for the moment when the momentum is spent to take their profits and perhaps move the other way. Since uncertainty was blamed for the turmoil on markets, the obvious trigger was the breakdown of any talks that might have delayed or even avoided war. This finally came two weeks ago. Brent crude then fell by one-quarter to less than $25 per barrel, until that trend went too far. The weekend revelation that the war was not a pushover in turn provided the opportunity for prices to turn up again, so far to $26.50 per barrel.
The sense in the oil price movements is therefore speculative rather than real.
Petrol prices should react to changes in crude oil prices several weeks earlier, since the crude has to be shipped to refineries, turned into petrol and then distributed to forecourts. But retailers often jump the gun, reckoning that rising oil prices make customers more likely to accept a price rise and, as now, that they might as well cut prices a bit early and win some business off competitors.
In this case, competition has brought quick benefits for motorists, but they might not last long if the war drags on.
Q. How does the price of oil affect world stock markets?
A. In such a volatile atmosphere as we have now, all markets can move instantly on the same news. On Monday morning, for instance, after hope was lost that force would dislodge the Iraqi regime in a few days, the oil price went up, the dollar fell, shares dropped sharply and Government bonds rallied simultaneously.
The logic, strictly limited, was that economic recovery might be put off, only in part because of oil prices. For the previous eight trading days, it had been the other way round, with oil prices tumbling, bonds edging down, the dollar recovering and shares staging their most rapid advance since early in the Second World War
Over the longer term too, there are clear links between oil prices and share prices. Big movements in oil prices have often been associated with turning points in stock markets, albeit in the opposite direction.
Oil is the most important single commodity in the world economy. It affects business costs across the globe and also affects people's spending power through the cost of fuel for cooking, heating and transport.
Historically, the impact has often been exaggerated because oil prices tend to change suddenly and violently. In 1973, for instance, a trebling of oil prices caused a world recession. In that case, however, the economy had been overheating and running into inflation and high interest rates anyway. Much the same was happening when the first Gulf War caused a spike in oil prices above $40 per barrel in 1991.
The collapse in oil prices in 1986 produced an economic boom. In that case, however, share prices started booming only many months later, in line with company profits rather than the oil price itself. In retrospect, historians will surely judge that the oil price was ultimately the trigger of the collapse of the dotcom bubble in 2000. Oil costs had remained remarkably subdued during the boom years of the late 1990s, but doubled during 1999, ensuring an end to easy economic growth. Shares then collapsed.
Q. How is the conduct of the war in Iraq likely to affect the oil price in the short to medium term?
A. On a day-to-day basis, oil will follow the mood of how the war is going. If coalition forces are progressing fast, it will fall. If they are suffering setbacks, it will rise. If the Iraqi regime fell, there should be a short, sharp drop.
The longer military action lasts, however, the more likely it is that genuine supply shortages will arise.
To make up for Iraqi oil and for the loss of nearly one million barrels per day from the world markets due to tribal conflict in Nigeria, other Middle East producers are pumping at near to full capacity. Any further disruptions could cause a genuine shortage.
If and when the war is over, oil prices will first fall but they may later recover. Some analysts, including Goldman Sachs, the investment bank, claim that there would soon be a tight market if the United States and the rest of the world economy were growing at a reasonable pace and that oil might settle at $28 to $30 per barrel.
Iraq, which has been under-producing for the past 12 years or more, has potential to boost supplies greatly once its industry has modernised and invested. But that could take years.
Q. Are there any other important factors that may help to keep the price of oil down during the war?
A. Venezuelan oil is coming back into the market. The country's oil minister claims it is almost back to normal, though outsiders think it could take a long time to recover the final one-third of previous output. Strife in the Niger Delta seems to be linked to upcoming federal elections, so it could fade away quickly there, but problems there have proved intractable in the past.
Saudi Arabia and other Gulf producers will produce as much as they can to replace missing supplies. An unusually large amount of oil is on ships plying their way from the Gulf.
When this arrives in the West, it should ease the market for refined products such as petrol at the pump, whatever happens to the price of crude oil on financial markets.