Revenge Of The Old Economy

Oil shock 2000 shows that energy costs can still pack a wallop

Apparently, some Old Economy bogeymen can still reach out from the grave. High oil prices are hurting economies and angering consumers around the world. In Europe, protesters are seeking relief via a rollback of high fuel taxes. Truckers brought chaos to central London on Sept. 13. The same week, cabbies demonstrated in Germany and fishermen occupied ports in Italy. In the Pacific Rim, finance ministers from oil-dependent industrializing nations called on OPEC to hike production further. And in the U.S., where soaring prices of home heating oil are becoming a Campaign 2000 issue, President Clinton announced the creation of a heating-oil reserve.

What's behind all the sudden outrage? Impatience with the spreading impact of high oil prices--and a gnawing fear that they are here to stay. No one worried much last year when prices began rebounding from their low of less than $11 a barrel reached in December, 1998. Even when they hit $30 a barrel earlier this year, many thought the spike would be brief. But despite three production-boosting agreements by OPEC this year--the latest Sept. 10--oil is $34 a barrel, near its highest level since the eve of the Persian Gulf War in 1990. And natural gas prices are near record highs, too. In frigid Roseau, Minn., Schools Superindendent Herbert Benz worries that higher prices for diesel for buses and natural gas for heating may drain money from his instructional budget: "If it's more than just a spike, we've got some real problems."

For now, few are predicting the energy price rise will throw the world into a recession. But that's not to say that it won't exact a hefty toll as its effects roll through the economy: A prolonged price hike will measurably slow growth and raise inflation in oil-consuming nations, economists say. While rich countries are feeling the pain primarily in a handful of sectors, poorer countries such as India, Thailand, and South Korea that depend heavily on imported oil are getting walloped across the board.

So what's the outlook? Most oil experts believe that for the foreseeable future, prices are likely to remain volatile--and high--because of several factors. Oil inventories remain low. OPEC is approaching the limits of what it can produce without fresh investment, which has a long lead time. And Western oil companies, refusing to believe that higher prices are here to stay, are holding back on exploration and production spending. Goldman, Sachs & Co. analyst Stephen Strongin expects "a series of roving crises" over the next 12 to 18 months. He says there's even a 10% chance that oil could hit $50 a barrel.

Not everyone is that downbeat, however. In the futures market, which has admittedly been wrong before, traders expect the spike to reverse. For the world economy, the best-case scenario would be a drop in oil and gas prices to a more reasonable, sustainable level. That could happen through a combination of production increases and slowing growth in demand, resulting in lower prices in the spot oil market. But even the futures traders aren't expecting a big drop; they anticipate crude to be back under $27 a barrel by early 2002.

FED-PROOF. Until there's some relief, high oil prices will pose a nasty problem for central bankers. Such spikes don't just spawn inflation; they slow the economy by robbing consumers of spending potential. That's what the stagflation of the 1970s--when prices soared and growth slowed--was about. It's a crisis bankers can't easily fight by raising rates or by cutting them, either. If costly energy significantly slows the world economy, it's possible that consumers will retrench, businesses will cut back investment, and a downward spiral will take hold. Says DuPont Co. Chief Financial Officer Gary M. Pfeiffer: "I worry about what high energy prices will do to the growth of the world economy if they were sustained at these levels."

To see where energy bites, start with the U.S., the world's biggest energy consumer. Overall, the U.S. economy remains in excellent health, with growth expected to top 5% again this year and unemployment just over 4%. And though consumers paid 19% more for energy in July than they did a year earlier, contributing to a 3.5% annual rise in the Consumer Price Index, that hike has not significantly driven up the cost of other consumer goods. The core CPI, excluding food and energy, rose a modest 2.4% through July. The major reason: The New Economy has been so productive, it's overwhelmed the negative effects of costly energy, says John A. Tatom, a Chicago-based economic consultant.

But that could change as oil prices move. The U.S. forecast of Standard & Poor's DRI, a sister company of BUSINESS WEEK, is for continued healthy, noninflationary growth. DRI expects gross domestic product growth to slip to 3.6% next year, inflation to drop back to 2%, and unemployment to rise to 4.5%. That's assuming oil is around $30 a barrel the rest of this year and falls to $25 by the end of 2001.

If oil were at $20 throughout the period, things would have been a little better. DRI says 2001 growth would have been 3.8%, inflation 1.8%, and unemployment 4.4%. But if oil heads up to $40 throughout the period, the bite could be much stiffer. Then, 2001 growth would drop to 3.2%, inflation could hit 2.3%, and unemployment 4.7%.

For now, it's easy to find sectors where trouble is already popping up. Motorists remain frustrated by high prices at the pump, and businesses are starting to pass along higher fuel costs. Last month, United Parcel Service Inc. imposed its first fuel surcharge in 20 years, 1.25% on all packages. Starting with Continental Airlines Inc. on Sept. 7, airlines have doubled, to $40, their fuel surcharge on round-trip tickets. Truckers and railroads are howling about costly diesel.

With winter approaching, the political focus--and consumer outrage--in the U.S. is shifting from gasoline to home heating oil and natural gas. The price of natural gas--about $5 per thousand cubic feet--is more than twice what traders were forecasting last winter. And heating oil is up 80% since the start of the year, with inventories 37% below a year ago.

Those who feel oil shock most are the poor and working class. General Motors Corp.'s research indicates that sales of small pickups are more hurt by fuel hikes than sales of big sport-utility vehicles. "The upscale buyer is going to drive no matter what. This doesn't even faze them," says Van Bussman, chief economist of DaimlerChrysler Corp.

One reason the U.S. is in decent shape is that energy efficiency has risen steadily since the 1970s. Over the past five years, the economy's output is up 20% while oil consumption is up only 9%. That's in spite of the power drained by the flood of PCs, servers, and the like: Technology companies use less energy than heavy manufacturers. Even Intel Corp., a heavy user of electricity in its chipmaking plants, says energy represents a tiny percentage of its costs.

Elsewhere in the world, energy matters more. High prices have touched off gas-station boycotts and oil-refinery blockades in Europe. Bigger bills for imported oil have turned the euro zone's trade account from surplus to deficit. Already, higher oil costs could knock up to half a percent off Europe's growth next year, economists say. In Japan, Goldman Sachs estimates that more costly oil could cut 1.7% from corporate profits in the coming fiscal year.

Most vulnerable to higher oil prices are less-wealthy industrializing nations. To soften the blow, China is deferring planned new fuel taxes. Thai Airways and Malaysian Airline System have been hard-hit by jet fuel costs. Even OPEC member Indonesia has suffered. It's short on diesel fuel, which it imports.

In the U.S., high oil prices have helped Federal Reserve Chairman Alan Greenspan do his job of slowing the economy. But it's a dangerous way to chill consumer demand. A bigger bill for imported oil increases the need for the U.S. to import capital. Not surprisingly, the government reported Sept. 13 that the current account deficit widened in the second quarter to a record $106 billion.

Moreover, Greenspan worries that the oil price runup could cause unforeseen trouble. That's what happened in 1973, 1979, and 1990, when price jumps helped trigger recessions no one predicted. Even so, it's not clear what policy decision flows from that concern: As Greenspan knows from past tangles with rising oil and gas prices, you're damned if you raise rates, damned if you lower them. About all he can do is sit and worry. Like the rest of us.

Before it's here, it's on the Bloomberg Terminal.