By James Deloach and David Johnson On Feb. 24, 2011, oil prices surged to 2-1/2-year highs of over $100 a barrel as the unrest in Libya continued with no end in sight and, on Feb. 25, oil was hovering around that threshold. It has been reported that the revolt in Libya has cut off up to 75 percent of the OPEC nation's 1.6 million barrels per day of production. Oil markets continued on edge as the unrest sweeps across Northern Africa with the looming specter of further spreading across the region to other oil-producing countries. Upward pressure on oil prices eased on news Saudi Arabia was in talks with European refiners affected by the disruption with hopes that other OPEC countries have started looking at ways to divert their crude to Europe. In other developments, Saudi King Abdullah announced on Feb. 23 that a $37 billion program to help alleviate a housing shortage with, and provide other benefits to, lower- and middle-income citizens to insulate the world's top oil exporter from the ongoing wave of uprisings. Meanwhile, foreigners are leaving dangerous regions in droves. For example, Turkey is in the process of evacuating some 25,000 of its citizens representing more than 200 Turkish companies involved in construction projects in Libya worth more than $15 billion. Some of the construction sites have come under attack by protesters. Some economists have stated that the turmoil in Libya isn't likely to drive up oil prices enough to shave more than a half percentage point off the world's economic growth this year. However, if the upheaval spreads, we have a different story. Because the upheaval began in Tunisia and spread to Egypt, it takes quite an optimist to assume it will end with Libya. Accordingly, what may be happening now is that markets may be betting that the instability spreads. Many questions arise as the protests proliferate across the Middle East. How far will the turmoil spread within the region? Will it spread outside the region? What will be the short- and long-term impact on energy costs? How high will the price of oil go? To $125 per barrel? To 150? Even higher? Will the pricing spike threaten the global economy and the current recovery? Continuing prices in triple digits are sure to tax a global economy that is already struggling to keep up with rising food prices. Higher energy costs will be especially tough on the emerging economies like India, China and Africa. And in the U.S., if oil prices remain high, the pace of growth in the U.S. economy is more likely to be too slow to lower unemployment, casting a cloud of uncertainty on the recovery. Pay Attention to the Fundamentals We see several primary issues that continue to drive up the price of oil. Factors driving the price of oil are primarily related to the fundamentals. For example: • America has slowed down its drilling programs, yet the country’s demand for crude oil remains high. • Growing affluence within China and India is causing a rapid demand for all resources, including oil. • Unrest in the Middle East threatens production capability and availability, creating uncertainty regarding future supply. This is even happening outside of the region. In Venezuela, for the better part of a decade, billions of dollars of oil revenue have been diverted for other purposes, so production has fallen. According to the U.S. Energy Information Administration, the average annual crude oil production in Venezuela peaked at 3.167 million barrels per day in 1998 before Hugo Chavez took office. Production has steadily declined since. In 2009 (the latest information available), Venezuela’s average production was 2.239 million barrels per day, a decline in production of nearly 30 percent. The regime change drove oil experts out of the country as oil money was diverted to social and political spending. • With the U.S. Dollar as the world currency for oil and the U.S. driving large deficits, printing money and devaluing the dollar, oil exporting nations keep raising the price of oil to offset the impact of the dollar’s devaluation. There is also the lingering concern around the potential spread of the turmoil to Saudi Arabia, the lynchpin of global oil production. The Saudi regime shares many of the attributes of neighboring governments that have sparked uprisings – rising food prices, autocratic rule, a large population of disenfranchised young people, as well as ethnic and religious divisions. Until recently, many western observers were of the view that the risk of unrest in Saudi Arabia was limited by the Saudi government’s ability to use its oil wealth to calm restive groups seeking its demise. Only the future will tell the story. Everyone knows the end game can mean regime change, but no one knows what a change in regime would mean in any of the oil producing nations. If regime change has implications similar to what has occurred in Venezuela, as discussed above, it will not bode well for the global economy. On the technical side, traders have traditionally exchanged information on matters such as exposures or stimulants to supply and bid oil up or down accordingly. This behavior is expected in the short run, and that has always been the case whenever new developments arise signaling fresh threats of supply disruptions. However, if these recent events truly take hold and have a lasting effect, they may sustain higher prices for a long time. Other Factors to Consider The above fundamentals do not provide the full picture. Other developments can reverse the upward pressure on prices. For example: • Stabilization in the Middle East, with protesters returning to their homes and a return to “business as usual” on the oil production side. • New technologies that even slightly decrease the demand for oil. • Significant new production from recent Brazilian discoveries in the Santos Basin. • New onshore U.S. shale oil production – and the willingness of America to renew off-shore drilling. • The willingness and capability of Saudi Arabia and other OPEC countries to step in to fill any supply shortfalls. • The offset of oil production slowdowns with strategic reserves held by a handful of western countries. Those reserves are estimated at around 1.6 billion barrels, about half of which are held in the U.S. In fact, there are reports that the White House might consider tapping the Strategic Petroleum Reserve to bring down prices in the short term. However, because the forces of supply and demand rule over the long term, the use of these reserves to tamp down oil price spikes has had only mixed success in the past. Unless oil producers support the effort by keeping up production, the effect of releasing reserves is temporary. Concluding Commentary With commodities, no one knows where prices will head. The last time oil prices surpassed the $100 threshold 2½ years ago, they didn’t stay there long and rapidly declined once they hit their peak. Market forces can lead one to assume that prices will continue to rise. When observers start thinking that way, it seems that something dramatic happens to reverse the trend. Irrespective of one’s individual point of view, the situation we face today is a formidable one because we can’t be certain how it will play out. Further, if oil stays above $100 for a protracted period of time, the global economy will face significant issues. Higher energy costs will hit everyone and every industry – hard. Every company that has assumed stable energy prices in their strategic horizon needs to revisit their strategy. It may make sense for each company to evaluate alternative scenarios involving higher than expected energy prices and their impact on the organization and its competitors, customers and suppliers. Such scenario assessments may drive some companies to consider taking initial steps to respond to the risk of higher costs of energy and fuel. By James Deloach, Managing Director, Protiviti, and David Johnson, Managing Director, Protiviti