DAVID BLACKMON: Oil Price Fear Premium Returns With A Vengeance

The “fear premium” has returned to oil prices over the last two weeks after a long absence. It’s all related to the Iran conflict, and unfortunately no end seems to be in sight.

Back in the early years of this century, when I was conducting government policy work in Austin, I had a conversation about oil prices with a member of the Texas House of Representatives. This was amid a spiking of crude oil prices during those up-and-down years in the aftermath of 9/11.

He asked me why the price had shot up by something like $15 following that awful event since the market at the time was probably over-supplied according to all available data.

“Simple,” I told him, “It’s the fear premium.” That is the phenomenon in oil markets in which crude prices rise due to fear among traders that a conflict in the Middle East region could impact oil flows through the Strait of Hormuz. The market fundamentals don’t really matter much during such times.

When he asked what portion of the price at the time was due to nothing but fear among traders, I told him it was probably in the $15-$20 range, which translated to an additional 30-40 cents per gallon at the pump. We then spent half an hour talking through the fundamental details of how crude prices are determined on the global market, impacting everyone on earth.

That conversation still sticks in my mind because this fellow was one of the handful of members in the Texas House at the time who had a strong understanding of oil and gas, yet that was apparently the first time he’d heard of the fear premium concept. And to be fair, that was and still is typical of most Americans, 98% of whom seldom have any reason in their lives to learn the details of what goes into the price of oil on the open market each day and how those factors translate to the price of gas when they fill up their cars.

Most Americans don’t really even notice the price of gas until it rises significantly and causes them pain in the pocketbook. Even then, the only thing most people know about it is that they’re angry because they have no choice but to buy it, and whichever person who happens to be President at the time is to blame because the media told them so.