Geopolitics and tight supply to keep oil prices high (page 2 of 2)

Geopolitical concerns have become more acute generally, and particularly in Iraq and Saudi Arabia. How serious are the terrorist attacks in Saudi Arabia? The local market reaction is telling. Domestic equity and currency markets shrugged off the earlier attacks in Riyadh (April 21) and Yanbu (May 1), preferring to concentrate on the positive economic impact from higher oil prices. This time, by contrast, the Tadawul stock index fell back by over 3% and despite a subsequent bounce is now 10% below its mid May peak, despite record high oil prices. In the fx market, the saudi riyal forward points hit a four-month high and the market had its largest one-day rise for 18 months.

For the first time, long term resident expatriates and Saudis are expressing concern. The reason is the increasing frequency and targeted nature of attacks. Khobar was the fourth terrorist attack in less than six weeks and marks a significant step up in the scale and severity of militant insurgency in the Kingdom. Hostage taking and targeting of oil companies and oil related personnel were new developments.

So how serious is this for the oil market? While the loss of Saudi oil production is a risk, it may be less likely than the market currently assumes. Inflicting damage on the country's oil infrastructure, rather than attacking softer human targets, is difficult. Saudi's oil facilities are heavily guarded. There are an estimated 30,000 dedicated security personnel. The fact that the oil facilities have never been successfully attacked in the Gulf, except when Iraq invaded Kuwait, is testament to how hard it is. Moreover there is a large amount of redundancy in the Saudi oil network. Oil supply can be re-routed and alternative ports used. While we would agree that the loss of Saudi oil is a risk, and a growing one, it can be overstated.

Speculators have played a part in pushing prices to recent highs, with the net open position on the NYMEX, a proxy for speculative activity, rising sharply since the beginning of April. But the dominant drivers of oil prices are geopolitical concerns and the tight supply situation. We see no early resolution of these concerns and expect the OPEC basket price to average USD 35 per barrel this year. We anticipate a slowdown in the US in 2005 (to 3% growth from 5+% this year), which together with slower growth in China should ease demand growth and bring prices lower. However, they are unlikely to fall much below USD 30 pb until geopolitical concerns ease.

Helen Henton, Chief Economist India and Head of Global Commodities
Daniel Hanna, Regional Economist Middle East