IE 11 is not supported. For an optimal experience visit our site on another browser.

Oil prices include a growing 'risk premium'

An Iraqi man covers his face as he watches a burning oil pipeline near the southern city of Basra on Monday. A sabotage attack on the southern pipeline has hurt exports and fueled fears of future attacks on oil facilities.Zohra Bensemra / Reuters file
/ Source:

As oil prices remain stubbornly above $40, strong demand and tight supplies continue to push the cost of crude to record levels. But a part of the increased price is the result of fears that terror attacks could severely crimp the world’s oil pipeline — what traders call the “terror risk premium.”

That premium — a kind of terror surcharge — changes daily depending on the latest headlines. But it represents a big portion of the $8 increase in the price of oil since the start of the year — a gain of roughly 25 percent.

Traders currently peg the risk premium at between $4 and $8 a barrel, but some estimates are higher. Last week, A.G. Edwards analyst Bruce Lanni calculated that, based on the levels of oil stockpiles, the “fair value” of oil was about $27 a barrel. At current prices, that translates to roughly an added $13 due to terrorism fears. That's the highest level in 10 years, Lanni wrote in a research report.

And though difficult to assess precisely, the added risk represents a real cost, according to Phil Flynn at Alaron Trading in Chicago.

“It’s not just an arbitrary number we pull out of the air,” he said. “Upstream and downstream, you have to pay more for insurance; you have to pay more for security, to insure ships. People want more protection for their dollar’s worth of oil.”

The threat to Middle East oil supplies has existed for as long as there has been violence in the region. The last time oil prices spiked above $40 a barrel was just before the Gulf War began in 1990 — on fears that the conflict, and resulting damage, could restrict supplies. As the war’s outcome became clearer, prices backed off again.

'Choke points'
More recently, Energy Department analysts have identified key “choke points” around the world where the flow of oil by ships or pipelines is especially vulnerable to attack. The list includes the Strait of Hormuz at the entrance to the Persian Gulf and the Strait of Malacca linking the Indian and Pacific Oceans. Security has been stepped up to protect those vulnerable locations.

But attacks in the past few weeks have demonstrated that the threat extends to virtually any major oil installation. Three weeks ago, suicide bombers in three boats blew themselves up in and around a major Iraqi oil terminal in Basra, one of the most heavily guarded facilities of its kind in the world. A week later terrorists attacked and killed six workers at a Saudi Arabia’s Yanbu oil complex — bringing the threat of terror attack on oil facilities into sharp focus.

“Yanbu is quite isolated with a small population and not many facilities,” CIBC analyst Allen Brooks wrote in a research note last week. “But May 1’s event demonstrates that possibly no place is Saudi Arabia is safe.”

Securing Saudi Arabian oil production is critical because it represents about half the world’s excess production capacity. But that excess supply is just a drop in the bucket compared to global demand. The International Energy Agency estimates that even if OPEC decide to increase production, it could only pump another 2.5 million barrels per day before maxxing out. That’s just a three percent cushion for global demand that now tops 80 million barrel per day.

“You have less excess in OPEC than you’ve had at any other time,” said Raymond James oil analyst Marshall Adkins. “Our buffer in the system is smaller that we’ve ever seen.”  

And while Saudi Arabia remains the biggest concern, it’s just one of five “high risk” countries producing more than 2 million barrels a day – including Iran, Iraq, Nigeria and Venezuela, according to Adkins.

“If anyone one of those five guys goes offline, you’ve got not just $40 oil but north of $50 oil,” Adkins said.

The fear of a terror attack interrupting oil supplies comes as a rapidly expanding global economy continues to create record demand, even as most oil producing countries are pumping as fast as they can. In its monthly report, the IEA said Wednesday that it was boosting its forecast for demand for 2004 — the biggest increase in demand since 1988.

Demand is especially strong in rapidly developing countries like China — where second-quarter consumption is expected to rise at a 21 percent annual rate, up from 18.5 percent in the first quarter, according to the IEA.

The surge in demand comes at a typically slack time of year for the oil markets, when demand for winter fuels like heating oil taper off and gasoline consumption has yet to reach peak demand for summer driving.

The IEA says world consumption will rise by 3.8 million barrels per day from the second quarter's 78.7 million barrels per day to 82.5 million barrels per day in the fourth quarter — an increase that could send oil prices even higher.