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Oil Prices May Already Be Fully Valued In Spite of Rumblings of War

By Marc Davis, Managing Editor
August, 2002

Recent unseasonal spikes in oil prices have proved a shot in the arm for energy stocks. At around $30 a barrel, oil is trading at its highest levels in 15 months. Just this year, alone, it has seen an increase in price of nearly 70 per cent since late January. But the trend may prove to be short-lived. Only the continued threat of war with Iraq will likely support these high spot prices.

However, recent U.S. polls show that only a little over 50 per cent of Americans now favor military action to oust Saddam Hussein, compared to close to 80 per cent last November. With the prospect of a financially draining war hurting the tentative U.S. economic recovery, many Americans are leery of taking such a gamble. After all, in tough economic times, U.S. citizens are always far more parochial in their thinking. Putting food on the table and making car payments and so forth will always take priority over geo-political considerations.

There is plenty of historical precedent for this viewpoint. At the outbreak of World War Two, the United States was at first reluctant to join the fray to support its close ally, Great Britain. This was at a time when Adolf Hitler's expansionist regime posed a much more serious threat to the U.S. than Saddam Hussein. But back then, many congressmen reflected their constituents' concern that nursing America back to a full economic recovery after the devastating Great Depression was more important than ousting Hitler. Of course, this all changed after Japan attached Pearl Harbour in December, 1941, thereby forcing an inevitable showdown between the U.S. and Japan's main ally, Nazi Germany.

Nonetheless, no-one expects Iraqi war planes to bomb Hawaii or commit any similar act of aggression. So sixty years later, President Bush faces an uphill struggle in convincing Congress and the American people that Hussein faces an immediate or near-term threat to U.S. national security. His cause is not even supported by some prominent former United Nations' weapons inspectors who argue that Hussein does not have any weapons of mass destruction and won't any time soon. Even retired General Norman Schwarzkopf, the man who led the allied forces into action during the Gulf War in 1991, is cautioning against hasty military action against Iraq. Furthermore, a messy, protracted war could seriously undermine the Republicans' prospects for reelection - a realization that is not lost on may GOP power brokers.

So where does this all leave oil prices if President Bush is talked into backing off? The fact is oil prices will likely stay within their OPEC-designated $24-$28 trading range. Since 1999, OPEC has shown discipline in maintaining its target price band by reigning-in the tendency of some of its members to overproduce. After all, global inventories right now are more or less at normal levels and a weak global economy is keeping demand flat at best. Furthermore, recent high oil prices will likely pressure OPEC to boost production quotas when it meets in Osaka, Japan later in September. Analysts expect the oil cartel to raise output for Nigeria, Venezuela and Algeria -- countries that have voiced a strong desire to increase their allotted quotas. All told, a production hike of 1.5 million to two million barrels a day is expected to be agreed upon in Osaka. This, in turn, will likely keep oil prices from heading even higher - a threatening scenario that could easily undermine the global economic recovery. So, think twice before leaping into oil stocks for the longer-term as the prospects of seeing oil spot prices hold firm at $30-plus a barrel are about as good as seeing Bush and Hussein settle their differences with a handshake.

However, on a brighter note in the energy sector, supply constraints are expected for natural gas after the summer months as U.S. production and inventories are down so far this year and are flat in Canada. This could set the stage for a natural gas shortage as a jump in demand is sure to spike prices higher during the coming winter months. Political considerations are equally at play. Palestinian-Israeli tensions in the Middle East and the threat of war with Iraq already caused spot gas prices to nearly double in the first half of this year. Hence, the upside for natural gas stocks can only improve if George Bush Junior does indeed decide to settle his father's unfinished business with Saddam Hussein.