Who's Afraid Of Pricey Oil?

Why the recent hikes at the pump don't worry Alan Greenspan--or those sport-ute-loving consumers

If you're looking for signs of inflation in the U.S. economy, look no farther than the nearest gas pump. Since hitting a 12-year low of $11 a barrel last December, oil prices have more than doubled to just above $25, the biggest hike in such a short time in modern history, except for times of major turmoil in the Middle East. What's worse, the increased prices come when the U.S. gets more of its oil from overseas than ever, and the U.S. trade deficit is hitting record highs. In an economy already running in high gear--in giant sport-utility vehicles, no less--the surge in petroleum prices certainly seems to spell trouble.

So far, though, hardly anybody seems to care. Consumers continue to buy gas-guzzlers at a record clip. The stock market has noticed the jump in oil, but nervous investors seem to be responding mostly to the dollar, gold, and the apprehension over what's ahead for the economy. Even at the Federal Reserve, where Chairman Alan Greenspan scans the horizon for signs of inflation, oil prices--at their highest level since the start of 1997--barely appear on the radar screen. Greenspan believes the diminishing role of oil in the economy reduces the inflation threat of rising prices. Now, economists and market watchers no longer expect the Fed's Open Market Committee to raise short-term interest rates on Oct. 5.

To be sure, oil remains crucial for everything from transportation and heating fuels to petrochemicals and plastics. And there's no way to avoid the effects of higher energy prices: Sooner or later, they show up in higher prices or smaller earnings or both. But there are good reasons not to panic. First, there's no guarantee that these high prices will stick, despite OPEC's impressive compliance with a production-restraint deal reached last March. Investors are betting that prices will fall: The New York Mercantile Exchange contract for oil to be delivered a year from now is just under $20 a barrel. Even oil company stocks are still well off their highs, despite strong indications of profitable third and fourth quarters.

Second, oil doesn't matter as much to the overall economy as it once did. As Greenspan puts it, America's economic output is getting lighter: more software, less steel. The result of that shift is that the amount of oil and natural gas required to produce goods and services has fallen by nearly half since the 1970s, from 14,600 British thermal units per inflation-adjusted dollar of gross domestic product in 1973 to 7,700 BTUs this year, according to the Energy Dept.'s Energy Information Administration (chart).

What's more, even if the Fed were worried about high oil prices being inflationary, it's not clear that raising interest rates would be the right response. After all, the purpose of a rate hike is to cool an overheated economy. But an oil-price rise alone tends to do just that. It chills the economy because it diverts consumption spending offshore, to foreign oil producers.

Even now, economists are factoring the effects of more expensive oil into their forecasts. Economic growth will be about 0.3 percentage points lower this year and next than it would have been if oil prices had simply drifted up slowly from last year's low point, according to Standard & Poor's DRI, a unit of The McGraw-Hill Companies, publisher of BUSINESS WEEK.

Raising rates would exacerbate the chilling effect of costly oil. "If anything, the Fed would say, `Oh, dear, oil prices are taking money out of consumers' pockets. We'd better loosen monetary policy,"' says Cynthia M. Latta, principal U.S. economist for DRI. Given what's going on in the rest of the economy, Latta doesn't actually think the Fed would cut rates; but then again, a hike may be just as unlikely. San Francisco Fed President Robert T. Parry almost said as much in a Sept. 27 speech: "With high uncertainty about the future, a somewhat delayed action could be preferable to running the risk of tightening when it's not warranted."

On a micro-economic level, rising energy prices are already crimping earnings expectations in some sectors--airlines, railroads, and truckers, in particular. Airline analyst Susan Donofrio of Deutsche Banc Alex. Brown is forecasting that higher fuel prices will reduce profits for the 10 major U.S. carriers by $116 million in the third quarter and $213 million in the fourth. In 1998, she figures, lower fuel prices added $1.2 billion to the majors' bottom line.

Now, that fuel has moved in the opposite direction, it's payback time. The carriers that do the least to lock in their fuel costs--Alaska, Southwest, TWA, and USAirways--are feeling the biggest impact from the 30% to 45% increase in jet-fuel prices over the past year, says analyst Brian D. Harris of Salomon Smith Barney. On the other hand, airlines that don't employ hedging strategies reap the biggest savings when jet-fuel prices fall. "Comparatively, it's painful," says Southwest Airlines Co. CFO Gary C. Kelly. "But we're still very profitable at these energy price levels. We just don't have the kind of windfall we had last year."

HURT. Among the first public victims of higher fuel prices was FDX Corp. The Memphis-based parent of Federal Express Corp. says higher fuel prices slashed $27 million from operating profits in its first fiscal quarter, ended Aug. 31, and could cut them by more than $150 million for the full fiscal year if current trends continue.

One unit of FDX, Viking Freight Inc., imposed a 1% fuel-adjustment surcharge on its customers starting in August, and CFO Alan B. Graf Jr. said in September that adding surcharges in other units is "a very hotly debated topic within our company." In practice, however, most shippers swallow most or all of their fuel-cost increases. Norfolk Southern Corp., based in Norfolk, Va., is looking for cost cuts in other areas to compensate, says Curt Steele, assistant vice-president for material management at the railroad. "It has hurt us all," he says.

Oil prices would start to do more serious damage if they reached $30 a barrel or more for an extended period, economists say. But that's unlikely in the absence of another Mideast conflict. In fact, if the price rises much beyond $25 a barrel and stays there, new supplies would almost certainly come onto the market and pull prices down.

So far, the major Western oil companies, such as Exxon, BP Amoco, and Royal Dutch/Shell, have not increased exploration and production spending above their 1999 budgets, which were set when oil was at its nadir. Memories of the 50% decline in oil prices from 1997 to 1998 are still vivid: "Once bitten, twice shy," says Fadel Gheit, an analyst for brokerage firm Fahnestock & Co. But new technology is making it cheaper than ever to find and produce oil, so profit margins on $25-a-barrel crude are enormous. The longer prices remain this high, the more E&P projects will be undertaken--and once they get under way, it's hard to stop them.

NO PROBLEM. That, in essence, is what your average American consumer is counting on. SUVs account for 18% of new-vehicle sales this year, up from under 10% in 1993, according to J.D. Power & Associates. And the fastest growth--35% this year--is in the fuel-hungry luxury segment, such as the Cadillac Escalade and Ford Excursion.

High oil prices? No problem, says Thomas N. Tyrrell, CEO of Republic Technologies International, an Akron company that makes steel bars for sport-utes and spent $1 billion to update steel plants for the purpose, is betting that high gas prices won't kill the SUV market. Jokes Tyrrell: "The car companies make so much money on SUVs, they might even pay you for the gas."

Plenty of forces--tight labor markets, a falling dollar--could spur inflation and kill America's long-lived economic expansion. But, for now, it's not oil--or anything else---that's fueling inflation.

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