Terror premium for world oil prices

As the price of oil remains stubbornly high, the global economy, companies and ultimately consumers themselves are reeling under its consequences, and bracing themselves for its long-lasting ripple effects. But is the current oil price actually reflecting real market facts?

The United States and China have recently led world markets in the quest for and subsequent surge in demand for oil to a particularly worrisome level. This higher than expected oil demand, among industrialised nations, is mainly caused by continued economic improvement. This increases their reliance on global trade, which in turn results in a higher fuel demand needed to move around the goods produced.

Even though they are only transitory factors, one also has to mention the persistent cold weather in the winter months, and the driving season, which peaks in summer, also takes a heavy toll on oil demand.

A prominent issue reigning within the global oil markets is the current premium to the price of crude derived from the ever-present political instability in key oil regions of the world, particularly the Middle East. Concerns have been raised over the reliability of supplies from the world's largest oil producer, Saudi Arabia, following recent deadly terrorist attacks.

Even though the attacks have focused on the workers themselves, analysts believe that the actual facilities will be the next target. There is also a growing unrest in Nigeria, where a powerful umbrella union has called for a general strike in protest against a rise in fuel prices. As a consequence, this could easily disrupt oil shipments from Nigeria. Any disruptions in oil output, particularly in Saudi Arabia, would certainly have a huge impact on global oil markets.

This robust global oil demand which is poised to continue growing, coupled with the political uncertainty present in the Middle East, have created an oil price rally. Crude oil prices behave very much like other similar commodity prices; however, in this case, the question the world is asking is whether the fear of an oil disruption is justified.

According to Saudi Arabian leaders, a disruption of supply from the oil kingdom is relatively unlikely since the infrastructure is well protected. Speculation as to whether political instability in the Middle East could actually affect supplies, has clearly created a "terror premium" in world oil prices.

Looking back, market commentators always provided us with good explanations for the movement in oil prices, but more often than not there is a disconnection between such explanations and real market facts. Various studies concluded that over-time market fundamentals always prevail and dictate the real price of all commodities.

To cool down prices and meet rising oil demand, Saudi Arabia, made it clear that it will be increasing its oil output for June by about 500,000 barrels a day (bpd), to 9.1 million bpd. Saudi Arabia was also backed by the United Arab Emirates, which together promised to deliver one million barrels a day of real extra oil in June, while the other members of the Organisation of Petroleum Exporting Countries (OPEC), including Venezuela and Iran, opposed these proposals.

Saudi Arabia and the United Arab Emirates, the only two OPEC members with extra oil capacity, put further pressure on OPEC to raise output quotas to ease crude oil prices that had by then risen to 21-year highs following recent terrorist attacks.

OPEC's long-awaited formal meeting on June 3 in Beirut raised formal output limits by two million bpd from July and another 500,000 bpd from August. Following OPEC's final agreement, prices began to fall slightly, probably reflecting the relief to global oil markets and the clear message that co-operation from OPEC is present.

However, there is a notable uncertainty regarding the immediate effects, if any, of such decisions. Many believe that the effect of a decline in oil prices will be slow, since there is at least a two-month delay for oil to reach the markets.

Despite OPEC's decision to raise production quotas and increase US inventories, the prices of major Russian exports, particularly for all energy resources, are expected to remain at high levels during this year and at the early next year.

Volatility in crude oil prices can have various repercussions in the economy. It can result in lower profits for corporations, translated from wrong energy forecasts. Surely, high-energy prices would add to inflationary pressures, which in turn would choke most of the rapid recovery the world economy is currently experiencing.

At the end of the day, oil is a natural and thereby limited resource, which will one day run dry. If you add to this the fear of any major oil disruption, which is currently haunting the markets, one has to expect that the 'terror' premium for world oil prices and a certain level of volatility is here to stay.

Paula Grech, B.Com. (Hons) Banking & Finance, is a fund operations administrator with Globe Fund Advisors Ltd, who are licensed to provide advice to collective schemes by the Malta Financial Services Authority.

E-mail: pgrech@globe.com.mt.