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Terror not economics rules price of oil

From anecdotal evidence, it seems clear that Islamic militancy in Saudi Arabia is more widespread than initially believed. As long as this understanding prevails in world markets, oil prices will continue to command a risk premium.

Ghalib Chaudhuri
Historically, higher oil prices had always led to blaming Organisation of Petroleum Exporting Countries (OPEC), unless of course the disruption in the supply was caused by external factors, like war. Under normal circumstances when prices shoot up, OPEC, who holds the pricing power through control of substantial supply and spare capacity, becomes the whipping boy for the rest of the world. It is usually blamed for not using its flexible spare capacity to increase supply and match the growth in world demand, thereby helping release pressure on prices. This time however with prices of the liquid gold hovering at US$40 a barrel, OPEC is hardly the culprit. In fact it is bending over backward to bring the extra supply into the market and ease pressure on prices, but curiously to no avail.
The three principal factors that are purported to be driving the prices are global growth, supply chain bottlenecks, and, perhaps the most intractable of all, terrorism.
Sudden spurt in global growth has led to a higher demand for oil. This, according to a recent report by the International Energy Agency (IEA), has led to oil consumption rising to a sixteen-year high, adding an additional requirement of 3.6 million barrels per day (b/d) between the period 2002 and 2004. The bulk of this higher demand is generated by China, accounting for 36 per cent, with North America responsible for 24 per cent, the rest of developing Asia and Europe at 16 per cent and 11 percent respectively. Given this rise in demand, it would not be surprising to see prices go up. But with the supply of oil also rising in tandem with demand, the current oil price is a paradox, defying the fundamental
rules of economics. IEA estimates that there is in the first quarter of 2004 an excess of oil supply, including inventory, of 1.2 million b/d. So it is not lack of supply that is causing the price hike. Also, the recent OPEC decision to further increase supply has hardly dented its market price, which proves that excess demand is not the real cause.
Another reason that has being cited for higher prices is the bottleneck in the supply chain created in the US. The refining capacity of North America is unable to keep up with the surge in demand for oil in the American economy, which has, since the third quarter of last year, shown spectacular reversal in
growth. However as stated earlier the North American market is only answerable for 24 percent of increased demand for oil, making it less of a reason for the price hike
So if higher demand for oil and supply chain bottlenecks don't fully explain higher prices, than what does? The futures market for oil perhaps provides the clue. At the New York Mercantile Exchange (NYMX), the largest commodity exchange in the world, the net long position of speculators in future contracts on oil have risen sharply since April this year, causing prices to move up. Uncertainty caused by terrorism is the principal reason behind the speculators driving the
future price of oil higher. The fear that a random act of terrorism could severely disrupt the supply, which is already tight as it is, must be a constant concern for the market.
The recent acts of terrorism in Saudi Arabia have greatly increased the fear factor. It is not inconceivable that important oil installations in Saudi Arabia may fall prey to terrorism, resulting in reduced or even cessation of supply from the Kingdom, which accounts for 10 percent of current global production. And if that were to happen, unfortunately, there is no other existing capacity anywhere globally to fill this shortfall,
at least in the short term. The terror premium on oil prices today is estimated to be in the region of 4-8 per cent and is not likely to disappear overnight. This overhang of terror will persist for some time, however the risk premium may fluctuate within a range, depending on the frequency, intensity, and target of the unfolding acts of terror.
Assuming that higher oil prices are here to stay, should the world be worried by its effect on growth? Evidently not, according to the joint findings of IEA and OECD. Higher prices by an average of US$10 from abase price of US$25-35 will effect global growth by 0.5
per cent. Nothing significant or dramatic, to panic about. Sadly and understandably, higher prices have a disproportionately greater effect on developing Asia and more so in poor highly indebted countries than the Western economies. Whilst in its manufacturing frenzy, Asia is busy guzzling up fuel, US and other Western economies have over the years learnt to be more fuel-efficient. Unfortunately Asia needs twice as much oil to produce one unit of output compared to the US. Nevertheless, if prices stay at current levels, the overall effect is not that devastating.
With terrorism taking the centre stage as a cause for higher oil prices, the future of price stability for oil remains murky. The reason lies more in the realm of geopolitics than economics, the latter being relatively easier to predict. Terrorism is a social phenomenon that evolves out of complicated and deep-rooted resentment that
cannot be eradicated overnight, even if one tries through force or by correcting the wrong. One has to just look at the relentless suicide brigades in Palestine to understand what deep-rooted resentment and bitterness can do.
From anecdotal evidence it seems clear that Islamic militancy in Saudi Arabia is more widespread than initially believed. As long as this understanding prevails in world markets, oil prices will continue to command a risk premium. Unfortunately, despite a rumoured pact between the House of Bush and the House of Saud for lower oil prices during the election year, events have already shown that honouring the agreement may turn out to be difficult if not impossible.
Ghalib Chaudhuri is managing partnerof Octavian Associates.