Oil, Guns, and Iran

A flare-up with Iran has oil prices rising and traders jittery. There may be more turmoil ahead

by Moira Herbst

It's been a dizzying week for the oil markets. Crude prices at the New York Mercantile Exchange have been on an accelerated rise since Iran captured 15 British sailors and marines last week, fueling fears of a disruption in supply from the Middle East. After settling just shy of $64 on Mar. 27, crude futures shot up more than $5 that night to trade above $68 a barrel in electronic trading after rumors of an attack by Iran on U.S. warships. The U.S. military quickly denied the speculation, slicing a few dollars off prices.

"I was getting motion sickness watching the numbers jump across the screen," says Craig Pirrong, professor of finance and energy markets at the Bauer College of Business at the University of Houston. "We're in an unbelievably volatile period."

Oil prices, of course, are determined by a wide range of factors, from the weather to rising demand from China. But now geopolitics is moving to center stage. And perhaps nothing can spook traders like the unpredictable mix of politics, money, and guns. The U.N. is in a diplomatic standoff with Iran, the world's fourth-largest oil producer, and speculation over what the U.S., Britain, and Iran might do is rampant. Against this backdrop, traders react first and ask questions later. "The market cannot afford to not take anything in this part of the world seriously," says Fadel Gheit, a senior energy analyst at Oppenheimer & Co. (OPY). "If supply is threatened, there's no replacement for it. For traders holding positions, every second counts."

On Mar. 28, crude oil futures for May rose $1.15, to settle at $64.08 a barrel. Prices have surged 26% since the low of Jan. 18 and are at their highest level since Sept. 11 last year.

Paying a "Fear Premium"

Analysts estimate that a staggering $15 to $20 of the current crude price is a "risk premium," or "fear premium" as others put it, relating to geopolitics and other factors. In January the issue was weather; now all eyes are on Iran (see BusinessWeek.com, 1/10/07, "The Oil Market's Weather Obsession"). The concern is that if the current tensions escalate into armed conflict, a major hub of oil production will be cut off, reducing supply as global demand continues to rise. "Unfortunately we don't know the truth of what's happening behind the scenes," says Gheit.

Of course, the tensions with Iran could blow over. If that happens, the risk premium could shrink to a more moderate $10 per barrel. Stephen Schork, editor of the online Schork Report, a daily newsletter on oil and gas, says he sees prices remaining range-bound between $55 and $65 in the near-to-medium term. "Crude prices are comfortable there, and the markets like that range," says Schork. "The global economy can't handle oil over $65 a barrel."

Supply and demand could also bring prices down. An economic slowdown in China or the U.S. could cut into consumption and shave several dollars off oil prices. The scenario is not far-fetched: There are ongoing concerns about the health of the U.S. economy, especially in the housing sector, and speculation that Chinese growth cannot continue at current levels (see BusinessWeek.com, 3/6/07, "Stocks' Swoon Finally Hits Oil"). As for supply, China's state media said on Mar. 28 that its national oil company, PetroChina (PTR) had found an offshore field that could become China's biggest new domestic petroleum source in a decade, with reserves of 2.2 billion barrels.

For now tensions in the Middle East remain high. British Prime Minister Tony Blair said that London would move to a "new phase" if Iran does not soon provide access to the sailors and release them. Blair says the British naval ship on which the sailors were traveling was in Iraqi and not Iranian waters.