Mideast Risks High in Oil Market Despite UK-Iran Resolution

NEW YORK Apr 04, 2007 (Dow Jones Newswires)

Iran's plan to release 15 U.K. sailors and marines led to a selloff in oil prices Wednesday but it hardly lessens traders' worries about instability in the Middle East.

If anything, the 13-day standoff between Iran and the U.K., which led to a sharp spike in oil prices and a drag on other markets, has renewed the focus on political risk related to the Middle East and other oil-producing regions.

After initially slumping more than $1 on Iranian President Mahmoud Ahmadinejad's announcement that Iran would free the soldiers, oil prices recovered much of their losses. Although that was aided by a sharp rally in gasoline futures, analysts said the market's refocused attention to the Middle East remains a driving force behind higher prices.

As a result, analysts said, crude oil futures are unlikely to give back all of the risk premium that traders factored into prices when Iran seized the sailors and marines in disputed waters on March 23.

"There is no lessening of tensions in the Middle East," said Mike Fitzpatrick, vice president of risk management at brokerage Fimat Futures USA in New York. "People look and say, things remain terribly unsettled in that part of the world."

In early afternoon trading, the nearby May crude contract on the New York Mercantile Exchange was down 55 cents at $64.09 a barrel after dropping as low as $63.57 a barrel immediately following the Iranian announcement. The contract fell more than $1 Tuesday on anticipation of a deal between Iran and the U.K.

Other markets also reacted briefly, with U.S. equities rising slightly at the open and Treasury prices dipping. The dollar climbed modestly before giving up gains on weak U.S. service sector data.

Effect May Not Have Run Its Course

Oil prices have been the biggest gainer from the seizure of the U.K. naval personnel. While Iran claims the U.K. troops were illegally in its waters, analysts see the seizure as a retaliation for recently imposed U.N. sanctions or even as calculated move to draw the Western allies into a limited conflict.

In the 13 days since the incident started, prices jumped nearly 8%, at one point topping $68.00 a barrel, as rumors of a U.S.-Iran military confrontation roiled the market. The detention came at a time of already rising tensions between Iran and the U.S. over Iran's nuclear ambitions and its role in Iraq, leading traders to worry that the incident could escalate and potentially lead to a disruption in the region's oil supplies. The Mideast is home to two-thirds of the world's proven oil reserves and responsible for about 25% of daily crude oil production.

That sparked volatile and often rumor-driven trade, with speculation about instability in the region further fueled by the presence of two U.S. aircraft carrier groups in the Gulf, the largest naval force in the region since the start of the 2003 Iraq invasion. The navy says the presence of the carriers is a warning to "any country not to miscalculate our resolve to help provide security and stability in the region."

Tim Evans, an analyst at Citigroup in New York, said the oil market reaction to the announced release may not have fully run its course, adding that "it's a bit early to fully judge how much of a retreat gets attributed to this announcement."

However, if oil prices manage to retain some of their recent gains, it will confirm what many analysts have been saying in recent weeks: the oil market is tighter than a year ago.

U.S. petroleum inventories are below year-ago levels, the Organization of Petroleum Exporting Countries has cut production, the U.S. economy is chugging along at a healthy pace, demand is strong and the supply-demand surplus during the traditionally weak second quarter is smaller than usual.

"It's also possible that once we recognized the fragile nature of supply from the Persian Gulf region, it is hard to revert immediately to pretending that those supplies are fully secure," said Evans.

Bill O'Grady, chief global investment strategist at brokerage A. G. Edwards, said that much of the recent rally in crude prices had to do with the strength in gasoline futures ahead of the summer, rather than tensions with Iran. Gasoline, he said, has given: the market a lot of help, and it probably has more to give," O'Grady said.

"My hunch is that we're coming to the end of this," he added. "The Iranian tension issue will be with us but will become less of an issue over time, and I suspect the concern will be with a reconstituted al-Qaeda."

More Political Risks On Radar

While the speed with which the standoff ended took many by surprise, the incident underscored the volatility Iran exerts in oil markets, said Greg Priddy, an analyst at consultancy Eurasia Group in Washington, D.C.

Despite the resolution, the larger concern over Iran's nuclear program will remain a force in the market, he said, adding: "I expect that indications of an expansion of the number of centrifuges installed (by Iran) will eventually regain the market's attention."

Anthony Sabino, an oil industry expert at St. John's University in New York, agreed that the political risk related to Iran and the broader Middle East will remain a force in the market. By some analysts' estimates, $15 to $20 of the price of oil is a reflection of that risk.

"While (Wednesday's) drop in crude prices is all well and good, the market will still factor in remaining political tension about the U.S. in Iraq, the chance that this could happen again, but more so the coming of the summer driving season in the U.S., which will raise prices yet again," Sabino said.

Copyright (c) 2007 Dow Jones & Company, Inc.

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