Depleting oil reserves worrying in the face of rising us-iran tensions

Between the time Opec was formed in 1960 and 1971 the US had more than enough oil available for domestic purposes and in fact "managed" oil prices by permitting increases and decreases in domestic oil production. From 1960 through February of 1971, the US imported on average 1.2 million barrels a day.

But in March of 1971, the regulator, the Texas Railroad Commission allowed full domestic production due to surging demand. Opec, eager to have the revenue from oil sales did not want to rock the boat. It was in these early days, unsure of the power it wielded and accepting the terms dictated by the West that oil imports surged to more than 6 million barrels a day by 1977. Also during this period, in 1973 with the occurrence of the Yom Kippur war between Israel and Egypt/Syria and the resulting Arab oil embargo, Opec learned for the first time that it and not the United States had the ability to control oil prices.

It should be pointed out that in the oil price spike of 1973-1974, the price of oil more than quadrupled rising more than 400 per cent in just six months in response to a mere 7 per cent cut in production by Arab producers. Keep in mind we did not have intense competition from energy-hungry places like China and India to bid for the limited supplies that were still available. Consider where prices would have gone if that were the case. Also keep in mind that there were no futures contracts or hedge funds to point a finger at; everyone accepted the law of supply and demand as the determining factor of price. One result of the shock of the Arab oil embargo was the initiative to establish the Strategic Petroleum Reserve (SPR) in 1975 to make up for any emergency shortfall of supplies. The intent of the SPR, coupled with the existing industry stocks, was to provide several months to a year of supply should there be an import shortfall.

Since that time, however, the effect of increased demand for imports and the reduction of industry stocks have led to a steady and significant decline in the number of reserve days available in case of emergency. Although the target SPR reserve capacity was raised, reliance on imported oil has also increased to well over 10 million barrels a day reducing the number of days imports it could cover. The current SPR level at 705 million barrels is estimated to be the equivalent of approximately 59 days of imports and at the same time industry stocks of crude has declined to only about 300 million barrels or about 25 days. So combined, we have gone from a 300 day reserve in 1985 to the current reserve of just 85 days.

These "days' supply" figures can be misleading from both a positive and negative viewpoint. While in 1975 virtually all our imported oil came from Opec, today we have a diversified source including secure suppliers such as Canada's 2 million and Mexico's 1.3 million barrels a day. As the 59-day SPR supply relates to total oil imports, only about half of that is seriously at risk of being cut off.

Even at the SPR's full daily draw-down capacity there would still be a shortfall of 600,000 barrels a day to be made up by industry stocks. In fact the 4.4 million barrel a day SPR draw-down can only be sustained for 90 days after which it would drop to 3.8 million for 30 days and then drop further to 3.6 million for an additional 30 days and then drop way down to 2.2 million barrels a day. Using these numbers, at the end of approximately 200 days both industry stocks and the SPR would be empty. This potential scenario of a confrontation with Iran and the bidding war for the very limited supply of oil that would be available is what valuing oil at US$140 (Bt4,690) and above today is.

Some of Iran's oil dollars, $80 Billion this past year alone have been used to bolster their military defences and over the next several months they will take delivery of new This appears to be pushing up the timetable for a decision on striking at the nuclear sites and the current price spike reflects this.

Prior to what I call the current "Iran Spike" in oil prices to $140, another less ominous factor had been driving oil prices higher in the past year. This is not a US problem but a world problem. We hear almost daily about pressure being put on Opec to increase production to bring down prices and generally it is Saudi Arabia, the world's largest producer who steps up production by 200 or 300 thousand barrels a day to balance supply demand pricing. But where does this additional supply come from? It comes from reserve capacity, the difference between current production and maximum pumping capacity. This too has decreased dramatically over the past few years from 5.6 million barrels a day in 2002 to the current spread of 1.3 to 1.6 million barrels a day. Under this scenario, the loss of production from any one of the top 20 oil producers would for the first time create a shortfall that Saudi Arabia alone could not fill.

Meanwhile, the United States is facing an economic "Perfect Storm". The Iran clock ticking, the dollar dropping, the Fed trying to rescue the banking, mortgage and investment industries at the cost of driving up inflation, the "sub-prime" mess driving tighter credit, rising unemployment, soaring fuel prices as well as increases in everything made with petroleum and even rising food prices brought on in part by the shift to biofuels.

In the short term, prices are likely to continue to rise and fall sharply as the market balances the risks of the events described above. If there's talk of the Iranian crisis being resolved without a need for military action we should see a rapid and dramatic drop in crude prices. In essence the futures prices we are watching climb to $140 and above represent a risk factor or risk premium over and above the current supply demand valuation.

With all the talk about speculators driving up prices, the fact remains that the price discovery and risk-transfer function of the futures market is the result of anticipated market conditions and events and not merely today's supply/demand relationship. A premium must be built into the price for the risks of possible events.

Even with exceptional efforts by West-friendly producers such as Saudi Arabia to put more than enough oil in the marketplace, they cannot control the future risk premium of growing tensions from being factored into the market price. All of the possible outcomes of this scenario are however not bleak. We have been to the edge of conflicts before that have resolved themselves and surely in any conflict no one truly wins.