By Nordine Ait-Laoussine and John Gault

Nordine Ait-Laoussine is a former oil minister of Algeria and now president of Geneva-based NALCOSA. John Gault is an independent economist and an Associate Fellow at the Geneva Centre for Security Policy.

Global oil prices have shot up by nearly $20/B since the onset of unrest in Tunisia, Egypt, Libya and other countries in the Middle East and North Africa. Prices could well continue upward. This price jump is technically unjustified. It is also dangerous.

Past crises have, of course, provoked price surges. The closure of the Suez Canal due to the 1967 Six-Day War, the strikes which cut Iran’s oil exports in the run-up to the 1979 revolution, the halt of Kuwaiti oil exports in the wake of Saddam’s 1990 invasion, and the sharp reduction in Venezuelan exports due to an oil workers’ strike in early 2003 all caused oil prices to soar. In each of these cases, actual supply interruptions led to the price increases, and all of these events occurred when markets were tight and global idle oil production capacity was small.

The situation today is different. Prices began ratcheting upward weeks before the first reports, on 23 February, that Libyan crude oil exports were curtailed. And even a total interruption of Libyan exports would not pose a serious threat to world oil supplies.

Oil markets today are well supplied, with a comfortable cushion to spare. Global commercial petroleum inventories are at or near record levels. Saudi Arabia and several neighboring Gulf countries have ample idle crude oil production and export capacity, sufficient to compensate for interruptions of supply from larger exporters than Algeria, Egypt, Yemen or Libya. There is no refinery bottleneck, as there was several years ago. There is no shortage of tankers. And major oil importing countries hold substantial strategic reserves.

Moreover, nowhere have opposition protests been aimed at external powers or oil importing countries. Foreign embassies have not been targeted. There have been few reports of intentional damage to oil production or transportation facilities. On the contrary, the festering socio-economic problems underlying the protests – unemployment, stagnant growth, lack of opportunity – would only be exacerbated by an interruption of oil export revenue. Neither the existing regimes, on the defensive, nor the revolutionaries seeking reforms stand to benefit from supply interruptions.

So, why have prices risen?

Oil’s Larger Role

Over the past decade, oil has expanded from its basic role as a fuel for the world’s economies to encompass a much larger role as a financial asset.

Institutional investors and private individuals now include oil in their portfolios as a hedge against the (presumably uncorrelated) risks of owning equities, bonds, currencies or other assets. Holding physical quantities of oil is more difficult than holding paper assets, so investors have turned to oil derivatives. As a consequence, the daily volume of oil traded on futures exchanges is an order of magnitude larger than daily global oil consumption.

Even before the recent popular uprisings in Arab countries, demand from investors wishing to hold oil as a financial asset had pushed the price of North Sea Brent crude beyond $90/B, far above the level necessary to justify investment in additional supply. Projects to develop future liquid fuels production, even from such expensive sources as deepwater drilling, tar sands, and gas-to-liquids technologies, do not require more than $60/B to be commercially feasible.

Such a large gap between price and long term marginal cost is possible because projects take time to implement. The number of active drilling rigs, as recorded by Baker Hughes, currently is up 28% on year-earlier levels in the US and 11% outside North America. A recent survey by Barclays Bank revealed that oil industry exploration and production outlays should rise 11% in 2011. But such investment yields additional output only years in the future. In the short term, the only supply response reported to date is Saudi Arabia’s expansion of output to 9mn b/d.

Under such circumstances, and apart from substantial further output increases from OPEC, the only upper bound on oil prices is the point at which they begin to strangle economic growth. Until that point is reached, investors’ expectations concerning political unrest as well as rapid Asian economic growth may well propel a continued upward price spiral. But commodity price inflation in general, and oil prices in particular, could seriously damage such growth or even reverse the global economic recovery, as the chief economist of the International Energy Agency (IEA) warned in early January.

Under present rules, the IEA will not call upon members to release petroleum from strategic reserves unless a substantial physical shortage has already occurred. We are nowhere near this threshold today, but investors’ fears have already driven oil prices to dangerous levels. Perhaps the time has come for the IEA to reconsider its rules, written before oil’s role as a financial asset eclipsed that of oil as a source of energy.

Oil price bubbles eventually burst, as the world was reminded in the summer of 2008 when prices collapsed after nearly reaching $150/B. A renewal of the global recession, this time directly provoked by high oil prices, would be a catastrophe for everyone, including those seeking economic and political reform in the Middle East.

Drag On Economies

Meanwhile, oil prices at current levels already constitute a drag on the economies of oil importing countries. It is ironic that investors’ fears of an oil supply interruption have propelled already high oil prices to new heights, without that premium providing any sort of insurance against an actual shortage, however unlikely. The additional $20/B is nothing more than a tax paid by consumers because financial investors hold exaggerated anxieties.

While near term interruptions of supply would be manageable, and therefore do not technically justify recent price increases, the current turmoil could pose longer term problems for oil consumers. New regimes, yet to emerge following the departure of former rulers, may adopt populist policies that seek to reserve a larger share of oil and gas production for future domestic industrialization and other local uses. New leaders may eschew necessary foreign investment, viewing international oil companies or their home governments as having been too closely associated with the discredited former rulers.

Such possible trends have yet to emerge. Until they do, however, the irrational upswing of oil prices is nothing but trouble.