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By Rana Foroohar
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How big is the fear factor? On June 1, the first day of trading after the deadly terrorist shooting spree on oil expats in Khobar, Saudi Arabia, the price of a barrel of oil spiked more than $2 to a record $42, or roughly double the amount that most oil companies consider the natural price in normal market conditions. This capped an 18-month price surge, propelled by what economists say is a witch's brew of abnormalities, from supply disruptions in Iraq and Venezuela to rising demand in China, but one factor seemed to stand out. As oil reached $42, estimates of the oil risk premium--a subjective surcharge that roughly reflects the market's fear of future shocks--reached as high as $12. By this analysis, the fear factor outweighed all others.
Three weeks later the price of oil remains well above its long-term trend, closing at about $39 last week, and concern remains high over how long this shock will last. Each $10 rise in the price of oil takes an estimated 0.5 percent off world GDP growth, so the stakes are huge. According to the International Energy Agency, world oil supply is more than meeting demand, so many analysts believe the main driver of current prices is psychology: the market is inflated by fear.
To get a handle on this phenomenon is not easy. The risk premium is a slippery measure, not hard information stored in a database somewhere. Though it's widely accepted and now hotly discussed in oil markets, many serious economists think the premium is a fiction, invented by lazy analysts to explain why their price predictions often fall so far off the mark. But let's assume, for the sake of understanding how terror hits markets, that it is possible to strip out and measure its influence. To help psychoanalyze the current market, NEWSWEEK asked the World Markets Research Centre in London to estimate how much geopolitical risk contributed to the decision to buy oil for each year going back to 1970 (chart). The results suggest that the market has been at least as, if not more, driven by fear in the past--and that the future is bleak.
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The oil shocks triggered by the Yom Kippur war in 1973, the Iranian revolution in 1979, the 1986 Iran-Iraq tanker wars and the gulf war in 1991 all produced price spikes in excess of what could be explained by the disruptions of supply. In each case, according to the WMRC, the risk premium spiked and accounted for at least 30 percent of the total price. The WMRC believes it was back up to 25 percent at the $42-a-barrel peak.
Yet the nature of the risk has changed. There is nothing markets hate more than uncertainty, and Mohammed Ali-Zainy, a senior energy analyst at the Centre for Global Energy Studies in London, notes that earlier Middle East shocks "were centered around governments, rather than the more unpredictable threat of terrorists." True, the Yom Kippur war led to the creation of a cartel that wrest-ed control of the global market from Western oil companies and quadrupled prices in one hot summer. But OPEC would evolve into a force for price moderation and global stability--a trajectory Al Qaeda seems unlikely to follow.
Since no one can say when the war on terror will end, the fear factor now has a permanence that is entirely new. Even the obliteration of a major national oil industry in the Iranian revolution, which led to a record high of $75 a barrel (in today's dollars), "was a singular, quantifiable event, not a nebulous threat," says John Felmy, chief economist for the American Petroleum Institute. The same is true of the shocks of '86 and '91; they were passing events.
The first U.S. war with Iraq may have been the leading example of a largely psychological oil shock. When Iraq invaded Kuwait in August 1990, and the West embargoed all 4.6 million barrels per day of Iraqi and Kuwaiti oil, there was more than enough spare capacity in the world to cover the shortfall. Yet, blindsided by the invasion, and fearful of the Iraqi troops massing at the Saudi border, companies started stockpiling oil, bidding prices up from $20 to a peak of $41 by October--even though the net oil-supply disruption was zero. "At that point, most of it was fear factor," says Lowell Feld, an analyst at the Energy Information Administration, an independent research arm of the U.S. Energy Department.
The legacy of earlier oil shocks has heightened the fear factor this time. In the past, the oil producers responded to price booms by investing in new facilities, creating excess capacity that magnified the ensuing price drops. Eventually producers became extremely wary of building new capacity. Since 1981 the world's spare production capacity has fallen from 12 percent of total global consumption to just 2 percent. Virtually all of that spare capacity is in Saudi Arabia, the target of five major terrorist attacks in the past 12 months. "Psychology is extremely important right now, more so than normal," says Ed Silliere, risk-management chief for Energy Merchant Corp., a New York trading firm.
If markets hate uncertainty, speculators like nothing better. Since 1983, when the oil-futures market was created, speculators have flooded into the game. The number of futures contracts held by hedge funds--which seek high returns for high-income investors--has doubled in the past two years. "Hedge funds are adding a level of volatility in the market that wasn't seen during crises in the 1970s," says Citibank analyst Peter Lynch. Yet those who blame this year's run-up on hedge funds and other speculators are mistaken: according to the New York futures exchange, speculators were net sellers of oil from January until June 8, which would tend to drive the price down.
The notion of a risk premium itself is very controversial. The believers calculate the premium using models that factor in the components of oil prices--the balance of supply and demand, inventory levels--to produce an "equilibrium level price." Anything above that is assumed to be the risk premium. MIT economics professor Robert Pindyck dismisses that definition as "nonsense." The price of oil on the futures market can be moved only by adjustments in supply and demand for the underlying commodity. "The only way to translate 'worry' into a price in the oil market is to buy and hold more oil," says Pindyck.
That worry was abated when Saudi Arabia pledged more oil production June 3. Then last week, when attacks on Iraqi facilities knocked out some 1.5 million barrels a day in capacity, prices barely budged, suggesting that markets had already priced in the possibility of attacks on this scale in the war zone. Silliere says if the attacks had happened in Saudi Arabia, oil prices would have been "blown away." William Ramsay of the International Energy Agency says the markets aren't likely to send prices skyward again unless there is a "step change" in the level of terror attacks on oil facilities. And until the war on terror subsides, no one knows when or if that day will come.
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