As the price of crude oil spiked in recent months, economists and energy pundits were stumped. The data on global economic growth, supply, and demand didn’t seem to warrant the action in the markets. There had to be an alternative explanation.
Thus was born the “terror premium.” In May, when crude topped $40 per barrel, economists and oil analysts began to argue that prices were being pushed up by fear of terrorism and political instability in major oil production centers—Nigeria, Venezuela, Russia, and particularly Iraq and Saudi Arabia. What’s more, several big events slated for the summer—the Euro 2004 soccer tournament, the Athens Olympics, the U.S. political conventions—would provide targets for attacks. George Worthington, Asia Pacific chief economist for Thomson IFR, quantified the terror premium as $8 a barrel. The same month, the Economist likewise settled on $8, and the Kerry campaign noted that “Economists estimate that Americans are now paying a ‘terror premium’ of $10 to $15 per barrel for oil.” In August, HSBC economist John Butler suggested the premium was somewhere between $10 and $15.
As evidence for the terror premium, analysts tended to cite the difference between the price of a barrel of crude oil to be delivered in the next month and the price of a barrel to be delivered much later. In March 2003, for example, just before the Iraq war started, light sweet crude traded at about $35 per barrel in the spot market while the price for a June 2004 contract was only about $25.In May, when oil hit $40, the price for a barrel of oil to be delivered in July 2005 was about $35. In other words, the market assumed that oil prices would return to historical means in the future once the temporary instability responsible for today’s elevated prices dissipated.
But what if the theory of the temporary terrorism premium is wrong? After all, terror and instability are likely to be with us for the foreseeable future. And the absence of terrorist incidents at major events this summer didn’t calm the oil market down. Quite the contrary: Oil prices are climbing and topped $50 a barrel this week. Could it be that the rise of oil prices is caused by global economic forces that are more powerful than terrorism?
As Barry Ritholtz points out, there may never have been much of a terror/instability premium in oil prices to begin with. After 9/11, when the world suddenly became aware of the ravages of terrorism, oil prices plummeted briefly. Why? Investors feared the global economy would contract, thus tamping down demand. Further, between April 2002 and January 2004, oil prices were relatively stable. (The price spiked sharply before the outbreak of hostilities in Iraq in early 2003 but quickly settled back down to prewar levels.) It’s only in the past year that prices have taken off.
What’s changed, then? Global economic growth, continued increases in demand from all corners of the globe, and concerns about capacity. Three years ago, Japan, the United States, and Europe were in a rare period of synchronous recession. Today, all three are growing, and China’s appetite for industrial commodities is suddenly omnivorous. Perhaps the price of oil is rising because the long-term equation of supply, demand, and capacity has changed in the past few years.
The first reaction to such an assertion—by investors and by analysts—is denial. Analysts tend to forecast by analogy: Under generally similar macroeconomic circumstances in the past, oil prices behaved a certain way, so that’s how they should behave next year. But perhaps we are at the beginning of a new era in which the old rules have been thrown out the window. The International Energy Agency noted that second-quarter oil demand grew by a whopping 5 percent, despite the higher oil prices. Meanwhile, the United States, the world’s largest consumer of oil, produces less and less of its own oil and imports more and more each year; car sales are growing in China; and the huge economies of Latin America—Argentina and Brazil—seem to be recovering. If demand continues to grow rapidly, concerns over production capacity will likely increase, not lessen.
