Fear itself carries a price, says CERI

Canadian research institute estimates “fear premium” at 45-50 percent of world oil price; sees no change through 2006

Gary Park

Petroleum News Canadian Correspondent

The price of fear will likely continue to pump an extra US$22 per barrel into world oil prices through 2006, says the Canadian Energy Research Institute.

Otherwise CERI estimates that the price of oil based solely on market fundamentals would be only $21.50-$25.50 per barrel.

The Calgary-based agency expects that rising geopolitical uncertainty will “act as an upward force” on what it describes as the “fear premium,” although improving supply flexibility should have an offsetting effect, barring any major and sustained disruptions.

CERI said the War on Terror, including the war in Iraq, have added to political instability in the Middle East, heightening concerns about security of supply, especially among major oil importing countries.

That has spawned a revival of geopolitical competition among major powers (the United States, Europe, China, Russia and Japan) and a scramble to secure access to foreign oil.

Civil unrest in Venezuela, Nigeria

The lack of supply flexibility shows up in several ways, including low levels of OPEC spare production capacity, a shortage of global facilities to process lower quality crude and low commercial inventories.

A surge in oil demand in 2004 caused OPEC spare capacity to dwindle to around 1 million bpd in the latter part of the year from 4 million bpd, 5.5 million and 3 million in 2001, 2002 and 2003, respectively, the study said.

Uncertainty regarding OPEC decline rates

Although there is uncertainty over both existing field decline rates and the timing of new additions, the International Energy Agency has projected an increase in OPEC production capacity of 1 million bpd in 2005 and 700,000 bpd in 2006, raising spare production capacity from 1.9 million bpd in 2004 to 2.6 million bpd this year and 3.6 million bpd in 2006.

CERI is also counting on two major advances to ease constraints on the global refining system – an improving crude slate, notably from Saudi Arabia and Nigeria, and additions of desulfurization capacity to refineries to take advantage of large price differentials between various crude qualities.

In the realm of geopolitical uncertainty, CERI believes Iraq and Nigeria are the “most likely to suffer a major supply disruption,” while Saudi Arabia and Venezuela have quelled local opposition to their regimes, making them less likely candidates.

Iran and nuclear weapons

“Unfortunately, Western options to discourage Iran from developing nuclear weapons are limited,” with an invasion by the U.S. unlikely, leaving “surgical” air strikes as the most likely choice, the institute said.

It said the “war drums might grow louder through 2006 … although the Iranian nuclear situation likely will not lead to a supply disruption until at least 2007, if at all.”

CERI excludes traders and speculators from its list of “fear premium” contributors.

It said speculators on the NYMEX futures exchange decreased their bets on higher prices for most of the year when the price of WTI closed at US$55.17 per barrel in October 2004.

Refiners concerned about the availability of crude oil to meet winter demands were responsible for driving up prices, CERI said.

In contrast, when WTI hit US$57.27 per barrel on April 1, speculators were moving into the market on the upside, despite expectations of lower spring and summer demand.

Herrera: $24 oil will increase the ‘fear factor’

The problem, he said, is that $24 for a barrel of oil is “not an incentive to explore for new oil anywhere else in the world. Despite great new technology, oil is proving more and more difficult to find and the cost of successful exploration is increasing.

“Therefore $24 oil will only increase our reliance on the Middle East and thereby inevitably increase the ‘fear factor.’

“When one looks carefully at the CERI logic,” Herrera said, “it is difficult not to conclude that world demand has been largely responsible for the increase in the price of oil.”

CERI figures, he said, show that world demand for oil has led to the “effective elimination of any spare OPEC capacity. However, it then goes on to say that the International Energy Agency forecasts that plenty of new oil will be found in the near future so everything will be hunky-dory. Such a forecast is obviously designed to eliminate fear, but the widespread lack of success in finding significant large new reserves of oil over the past decade or so would suggest that a logical concern about our future supplies of oil might be a healthy reaction.”

Herrera said it is “worth remembering that even if the world is close to its peak oil output (a theory CERI does not mention), it only indicates that about half the world’s oil has been used. That is hardly a fearful prognosis.” On the other hand the “various political misfortunes that CERI mentions as contributing to its ‘fear premium,’ are not unique to this time. World wars, cold wars, dictators etc have characterized the whole of the Oil Era. It would be naive not to expect similar influences during the second and final half of the oil era. We will undoubtedly have to pay for them even if we are not afraid of them,” Herrera said.

—Petroleum News