Rising prices and uncertainty over Iraq have prompted claims that oil prices are somehow ‘unreal’and are being inflated by a large ‘war premium’. If this is correct, how does such a premium come about and how can it be measured? Does it affect short-term prices, longer- term prices or the shape of the entire forward price curve? The answers to these questions are important because they help to clarify how OPEC and consumer governments should respond to the price signals emitted by the oil market.
This new study by the CGES examines the behaviour of the forward price curve and concludes that there is no evidence that oil prices are being artificially inflated. Although the threat of war against Iraq has certainly added to the general level of uncertainty about future supply, there is nothing unusual about the level of prompt oil prices,the shape of the forward curve or longer-term price expectations. If oil prices were to be adjusted by subtracting a $3-8/bbl ‘war premium’, the result would be very much out of line with the behaviour of the market in recent years.
Earlier work by the CGES has demonstrated that there is a strong correlation between forward price spreads and the level of stocks held by the industry. If the ‘war premium’ is as large as OPEC maintains,there should be a significant change in the relationship between forward spreads and stocks since the US first threatened Iraq, but this does not appear to be the case. Although the crude market moved from a modest contango in February 2002 to a steep backwardation by September 2002, US crude stocks have also fallen to very low levels over the same period.
Nor is there any evidence of a ‘war premium’ in longer-term prices.In fact,the five-year-ahead WTI price appears to be remarkably stable for long periods of time,fluctuating around $21/bbl since the middle of 2000. After examining the behaviour of the forward curve under a wide variety of market conditions, the CGES study suggests that changing perceptions of uncertainty determine the overall shape of the forward curve. If the market is seriously worried about future supplies - as it was, for example, during 2000 - high prices extend much further out along the forward curve before reverting to long-term expectations.
Using the exponential decline rate of the forward curve as a proxy for the prevailing level of uncertainty, the CGES study argues that prompt oil prices would have been much higher than they are at present had the market expected a sustained interruption in oil supplies following action against Iraq. The evidence suggests instead that, for the time being, oil prices do not contain a discernible ‘war premium’. It is much more likely that the US threats against Iraq have acted as a catalyst, encouraging the market to think once again about potential supply side problems and the overall balance of the market after a short post 9/11 period during which the market was considered oversupplied.