PREPARE NOW FOR A SAUDI OIL PRICE SHOCK / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Prepare now for a Saudi oil price shock

By Michael Levi

Published: February 22 2011 21:22

Turmoil in Egypt spooked oil traders last month, threatening to close the Suez Canal. Now Libya, which accounts for about 2 per cent of global production, seems on the brink of civil war, creating further disquiet. With prices above $100 a barrel, the world must prepare for further oil price volatility – and the threat of a genuine crisis if production is disrupted in Saudi Arabia or elsewhere.


The situation has sent activists and politicians scrambling for their usual answers. Some call for more domestic production; others urge alternatives to oil. But neither will make much difference. Alternatives have potential, but will take decades to arrive at scale. Expanding domestic production is even less promising: new supplies don’t insulate consumers from big changes in world prices, and increase output only slowly. Both are worthy, but we need plans for short-term crisis management too.


Such plans must begin with a coherent approach to strategic petroleum reserves. These can be used as a buffer against global disruptions, meaning that if supply drops, or transit routes are disrupted, stocks are released to calm world markets. The problem is, it is unclear which circumstances justify their use. The current situation does not merit it, the head of the International Energy Agency (IEA) reassured markets they could be used, if needed. If unrest spread to Saudi Arabia a release would make sense, but policy is muddled on more moderate disruptions.


Curtailing Saudi production, in particular, would be a huge shock to markets. The probability of such contagion is very small, but even these limited odds matter when the consequences are grave. With neighbouring Bahrain still roiling, the chances of unrest spreading to the desert kingdom have increased. But what if a production shutdown in Libya was followed by Algeria, which produces about 2m barrels a day? The IEA must decide what its breaking point will be, to deter pre-emptive market panic.


Wealthier oil-consuming states must also redouble efforts to bring China and India into a new global system for co-ordinating releases. Any single country’s stockpile has limited power to respond to changes in price, so the west (via the Organisation for Economic Co-operation and Development) co-ordinates its release through the IEA. But as oil demand shifts to Asia, so responsibility for responding to shocks must also move with it. However no one really knows how the Chinese leadership, in particular, will respond to current dramas in the Middle East. How they would react to a significant price spike, rather than a physical disruption of shipments to China, is also unclear.


Efforts to co-opt China and India have so far been unsuccessful, in part because neither are members of the OECD. To participate both would also have to be more transparent about their own oil markets. Instead, a new co-ordination scheme should be developed, with broad agreement on the basic rules for accumulating and releasing stocks, possibly co-ordinated through the group of 20 leading nations. Stockpile management should also be separated from transparency demands, to which China is averse.


New approaches to oil market speculation are also needed. The G20 is currently overhauling rules in response to the 2008 oil price spike, which saw prices rise to $147 a barrel. However this was driven by economic factors – particularly surging Chinese demand – not a geopolitical shock. The responses have, understandably, focused on how to deal most effectively with similar circumstances in the future.


The type of speculation that would follow disruptions in Saudi Arabia or Iran, however, could be different. In such cases speculators would be responding to elusive political changes, rather than steady economic developments. Speculation is normally healthy, but their moves could add volatility as panicked traders hoard oil. It would be wise to consider and, if necessary, prepare for exceptional new restrictions on speculation during such moments of extraordinary geopolitical stress.


None of these measures replaces the need for a long-term transformation in the global energy economy. But such broader thinking must not crowd-out short-term measures to cope with present problems. We don’t know how our newly globalised economy will respond to a sharp geopolitical oil price shock. But we should prepare, before we find out the hard way.


The writer is a senior fellow at the Council on Foreign Relations


Copyright The Financial Times Limited 2011