Why oil prices may stay sky high

When Russia's largest oil exporter, Yukos, was apparently ordered last week to halt production in a dispute over paying back taxes, oil prices surged to an all-time high of almost $44 per barrel.

But analysts say the fact that Yukos could jolt the global oil market underscores how several factors are making the market vulnerable to shocks, and are likely to conspire to keep prices high for the next 12 to 18 months.

They point to the doubling of the pace of global demand in the past year, little spare production capacity, continuing terrorist attacks in the Middle East, and a controversial presidential referendum on Aug. 15 in Venezuela, the world's No. 5 oil producer.

"You can write a checklist of factors that are contributing to this very overheated and feverish market," says Peter Kemp, editor of the Petroleum Intelligence Weekly in London. "The [oil supply] cushion ... that can be used in an emergency is very, very thin."

In part because of higher gasoline prices, the US government said Friday that economic growth slowed sharply in the spring.

Adjusted for inflation, however, the cost of oil remains about half has high as the peaks reached in the late 1970s and early 1980s.

While some estimate a $10 per barrel "terror premium," Mr. Kemp figures that at least half the current price surge is "going to be a permanent feature until we see increases in supply, which are not imminent."

Yukos produces one-fifth of Russia's oil output - or about 2 percent of global production - and is locked in an ongoing tug-of-war with Russian authorities over a $3.4 billion tax bill, fraud charges, and the fate of its former CEO, the billionaire oligarch Mikhail Khodorkovsky, who is now in jail.

But even as Yukos warns that it is being forced into bankruptcy - though executives learned late last week that in fact they could keep producing - other factors shaping the oil market magnify its global impact, and that of any other potential threat to supply.

After several years of sluggish demand growth, the markets have been caught off guard by several factors: a very cold winter last year, nuclear power outages in Japan, surging natural gas prices in the US, and China's expanding economy "emerging as a driver of world demand," says David Fyfe, principal oil supply analyst at the International Energy Agency in Paris.

The global demand is growing at the fastest pace since the late 1970s, with one estimate putting the figure at 4.1 percent growth for the first half of this year.

To meet that demand, the supply side today is also pushed to the limit. The Organization of Petroleum Exporting Countries (OPEC) is already pumping at close to capacity. In late July, OPEC officials said they were producing 27.5 million b.p.d, two million b.p.d. above their quota. As of today, OPEC says it will boost production another 2 percent or 500,000 b.p.d.

While some of OPEC's 11 member nations are investing in new capacity, it will take 12 to 18 months for that investment to bear fruit.

And it will take more than a year before relief comes from increased production anticipated from some former Soviet Union nations with new pipelines, growth in Russia itself as well as in west Africa, and even "a bit extra" coming from Latin America, says Fyfe.

The equation is complicated by attacks in Saudi Arabia and Iraq - some of which have directly targeted the oil industry - political uncertainty in Venezuela, and unrest, strikes and pipeline outages in Nigeria.

"When you take concerns of supply disruptions - be it Iraq, Nigeria, Venezuela, Saudi Arabia, or Russia - together with the fact that there is very little spare capacity within OPEC, these keep markets rather nervous," says Fyfe.

How flat out is current production? Saudi Arabia - the world's biggest exporter, which has traditionally used its spare capacity to fill gaps and regulate prices during emergencies - has 1 million b.p.d. spare capacity, says Kemp. All other OPEC nations combined could cobble together just half a million b.p.d..

"That's not an awful lot of capacity in reserve" with global daily consumption running at 81 million b.p.d., says Kemp. "You've got a very, very finely balanced situation that, to people playing the markets, looks extremely dangerous and is pushing prices up to the levels we've seen."

Another variable overshadowing the market is the string of attacks against oil infrastructure in Iraq, and more recently oil personnel in Saudi Arabia.

"We estimate that the fear factor adds as much as $10 per barrel to the price of oil," says Jim Burkhard, director of Cambridge Energy Research Associates in Boston. "There has been no shortage of oil on the market, but as we eat away at that spare capacity, as we see so many potential sources of supply disruption emerge, this fosters anxiety ... that pushes prices high."

While the "terror premium" began to be a factor after Sept. 11, 2001, and more lately because of violence in Iraq, Mr. Burkhard says those events added just a few dollars per barrel.

It was the attack on May 1 at Yanbu, Saudi Arabia, that left five expatriate oil workers dead - along with subsequent attacks, he says, that pushed the per barrel premium up, but oil delivery has not been affected.

"The events in Saudi Arabia over the last few months do intensify the fear factor, because Saudi Arabia holds a position of unparalleled importance in the oil market," says Burkhard. "It's where the bulk of the world's spare production capacity is."

And next door, continuing violence in Iraq has a negative impact. "Certainly the fact [is] that Iraq wasn't a cake walk ... and the original optimistic pictures that were painted about what sort of future Iraq could expect after the invasion...now seem fanciful," says the Energy Intelligence Group's Kemp.

Still, the oil market has shown a surprising resilience.

"In normal times - if we can remember when they were - something like Yukos's difficulties would not have the ramifications that we've seen," adds Kemp. "We've had crisis after crisis after crisis, but...there have been no shortages, no lines at gas stations - all the worst scenarios have not materialized."