Oil's 'war premium' as Russia-Ukraine tangle

Russia-Ukraine crisis could vault oil to $100 a barrel: Energy expert

The Price Futures Group Senior Energy Analyst Phil Flynn and Sarge 986 President Stephen Guilfoyle discuss the energy market and inflation on ‘The Claman Countdown.’

The oil war drums are beating, and speculation over Russia's intention of invading Ukraine has caused a lot of movement in oil and U.S. stocks. Yet, mainly what we have seen in recent weeks has been the building of the "risk premium" in oil and calls predicting crude could hit $100 if the event occurs. 

"Risk premium" or, in this case, "war premium," is buying in crude ahead of a major potential event. In many cases, it is not well understood by the general public. You hear comments that oil companies or speculators take advantage of these situations to drive up prices, but in reality, the function of this is extremely important when there is a risk to supply.

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First, you have physical buying of crude by users who need to stock up on supply just in case a war cuts off supply. You also have the use of the futures market to lock in prices to avoid paying sharply higher prices and to make sure you can get your hands on supply. 

You have to have speculators step in to ensure those prices in the event of a worst-case scenario. Speculators use their capital and assume the risk similarly to an insurance company that assumes the risk for fire or disaster coverage.   

Also remember that when prices rise in anticipation of a potential oil dispute event, it also cools off demand a bit, increasing the odds of some type of supply in the event something bad happens.

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On the flip side, after a run-up in price, if the event does not happen it will drive prices lower than they would have been if there were not that fear in the first place. Hence, you should get lower prices for a while that should make up for the short-term higher spike in prices. 

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Yet sometimes it is hard to understand just how much of the price increase is risk premium and how much is being caused by good old-fashioned supply and demand. That could be key to know, especially if we get a retreat by Russia from the borders of Ukraine. Market talk seems to estimate that the risk premium surrounding oil could be anywhere from $5 a barrel to $20 a barrel depending on whom you talk to. 

I believe that the number is probably somewhere in the middle of those guesses. But make sure you don't assume that all the recent oil price hikes were all about war fears. The main contributor to today's price of oil is that global supply has been outstripping demand.

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In other words, if we get a peace premium sell-off on oil, I will not expect it to last. The global lack of oil investment and surging oil demand has led to what the Energy Information Administration (EIA) describes as one of the largest global oil supply drops in history. And even if war is avoided the trend of falling inventories should continue. 

The EIA put commercial inventories in the OECD ended the month at 2.68 billion barrels, which is the lowest level since mid-2014. And with the summer driving season right around the corner and global demand bouncing on a peace dividend supply should fall even further. In other words, if you get a break at the pump if war is avoided, enjoy it because it probably won't last.   

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Phil Flynn is senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. He is one of the world's leading market analysts, providing individual investors, professional traders and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline and energy markets. His precise and timely forecasts have come to be in great demand by industry and media worldwide, and his impressive career goes back almost three decades, gaining attention with his market calls and energetic personality as writer of The Energy Report. You can contact Phil by phone at (888) 264-5665 or by email at [email protected].

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