The Energy Crisis: Dark Days Ahead?

Costly gasoline, tight supplies, rolling blackouts--this crisis could imperil the economy

Vice-President Dick Cheney tapped into the nation's black mood on Apr. 30 when he declared that the U.S. faces a "present crisis" in energy. Heads nodded all around: There's a nasty feeling that the bad old 1970s are back. Gasoline prices have zoomed to record highs as overstretched refiners struggle to cope. In hard-hit Chicago, gasoline prices rose 25 cents in April alone--and full-service premium goes for $2.46 a gallon downtown. Natural-gas inventories remain tight, raising concerns about another price spike like the one that skewered consumers last winter. The U.S. electricity market is in an uproar, a combination of California's bungled deregulation and nationwide growth in consumption that has outpaced additions to generating capacity. California is bracing for more rolling blackouts this summer, and there's a chance the lights could go out in metro New York as well if it gets hot enough. Even coal, usually plentiful and the main fuel for electricity, is causing trouble, with prices up in some cases nearly 130% since 1998.

Add it all up, and the bill for energy of all kinds keeps rising. Power expenditures zoomed 39% from 1998 through 2000, and are likely to rise another 9% this year in spite of the economy's sluggish growth, estimates Standard & Poor's DRI. That represents a huge drag on the economy. In fact, the increase in energy prices since 1998--close to $200 billion--swamps the $100 billion that might be injected into the economy this year by the Bush Administration's proposed tax cut.

What's more, the drain is socking the U.S. at a time when it is more vulnerable to the stagflationary impact of high energy prices than it was a year ago. Economic growth slowed to 2% annually in the first quarter, down from 5% last year, and the inflation measure in the gross domestic product report accelerated to a 3.2% annual rate. The biggest factor behind the surge in inflation was a 34% annual increase in electricity and natural-gas prices in the first quarter. David A. Wyss, chief economist of Standard & Poor's, says the economy will probably grow a half-percent less this year than it would have if energy prices had stayed at their 1998 low.

Corporate profits, too, have been hit hard. In the first quarter, according to a preliminary tally of more than 800 companies in the BusinessWeek Corporate Scoreboard, rising energy prices contributed to a 26% decline in overall earnings, the biggest drop in nearly 10 years. The only ones profiting from the crisis are the energy companies and their investment bankers.

Amid the gloom, however, there is one bright spot: Once the U.S. gets through this year, the outlook could brighten considerably as market forces help add supply. Just as in the past, sustained high energy prices are garnering a strong response, encouraging producers to bring new supply online and prompting conservation efforts by energy users.

Last winter's high natural-gas prices have set off a rush of gas exploration, for example, with more domestic drilling rigs now in operation than since 1986. Oil prospecting is up as well. Lehman Brothers Inc. says U.S. oil and gas companies plan to increase worldwide exploration and production budgets 19% this year. As for electricity, the North American Electric Reliability Council predicts a surge in energy-generating capacity. Last year, it projected 100,000 to nearly 200,000 megawatts of capacity would be added by 2004, vs. just 60,000 megawatts of added demand.

FUTURE SHOCKS. Financial markets, moreover, are signaling that prices should fall over the next year as new supplies emerge. Hedgers can purchase natural gas at $5 per million BTUs for December delivery, vs. more than $10 last December. Wholesale gasoline can be had at 79 cents for November, vs. $1.03 now. Wholesale contracts for summer electricity in the Midwest have also plummeted 20% in the past two months, while West Coast summer contracts are down 30% since Apr. 10, according to surveys by Platts Energy Trader.

The Administration's energy plan, based on the preview from Cheney, would encourage this long-term private-sector response by focusing on supply. Key elements of the plan include removing regulatory obstacles to the construction of new refineries and power plants--including nuclear plants--and spurring oil and gas exploration in the Arctic National Wildlife Refuge. The Democrats have countered mainly by advocating more stringent energy conservation laws.

But in both cases, the proposed measures offer primarily long-term solutions. Neither party has much to say about short-term fixes--largely because few government actions would help much in the short term. Emergency interventions, such as siphoning oil from the Strategic Petroleum Reserve or slapping controls on wholesale electricity prices, tend to be ineffective or counterproductive.

This doesn't mean the short-term dangers to the economy aren't real. Over the past three decades, energy price spikes have been a key contributor to economic downturns. One concern now is that the Federal Reserve will hold off on needed rate cuts because of fears of energy-induced inflation. Indeed, the Fed warned in its Beige Book report on May 2 that "upward wage pressures have generally abated, only to be replaced with energy costs that have risen sharply." At the same time, soaring energy prices and potential blackouts in some areas could add to consumer anxiety, already fragile due to rising unemployment and the tumultuous stock market. That would be dangerous, because consumer spending accounts for two-thirds of the economy.

Although an energy-crisis-induced recession is still unlikely, it isn't out of the question. Standard & Poor's Wyss believes the deciding factor is California, which accounts for 14% of U.S. output. If there's an energy-induced recession in California, says Wyss, "the rest of the country would be hard-pressed to keep growing." State officials warn that there could be 34 days of rolling blackouts this summer if usage isn't curtailed. The state's biggest utility is in Chapter 11, and some independent power producers have shut down because they haven't been paid by utilities. Sung Won Sohn, chief economist for Wells Fargo & Co., has cut his projections for the state's real growth from 3% to 1% for 2001.

Many California manufacturers say that if something isn't done soon, they'll leave or close. Universal Plastic Mold of Baldwin Park, Calif., has a contract with Southern California Edison that gives it a discount in return for agreeing to allow its power to be cut off in an emergency. For 9 1/2 years, it was never shut down. This January, power was cut 16 times. Now, prices are going up 46%. "We're not immune to being put completely out of business," says Co-owner Don Ashleigh. And FeRx Inc., a San Diego biotech company is building a factory out of state, near Denver, to save money. Says CEO Jacqueline Johnson: "I can't imagine, with the current energy situation, ever putting a facility like this in California. It would simply be too expensive."

It's not just California residents and businesses who are feeling the ill effects of costly energy. UAL Corp. President Rono J. Dutta blames the airline's $305 million first-quarter loss in part on a 27% increase in fuel prices from a year earlier. UAL stopped hedging fuel prices at the end of 2000, thinking that they were bound to fall as the economy slowed. But the reverse occurred. "It's unusual for fuel costs to go up like this into a recession," says Dutta.

For Dow Chemical Co., the killer is raw material costs. Dow paid $600 million more in the first quarter for energy and hydrocarbons--oil derivatives used to make chemicals--than in 2000's first quarter. It managed only $80 million worth of offsetting price hikes. The company called it "one of the most challenging quarters for the North American chemical industry, and also for Dow."

Meanwhile, aluminum smelters that located in the Pacific Northwest to take advantage of cheap hydropower are being asked by the Bonneville Power Administration to shut down for up to two years to free up electricity for other customers. Residents worry that if they do, the jobs may never come back. "It is sad when small rural economies are destroyed so people in larger metropolitan areas can continue their lifestyle unaffected," Robert Abernathy of Blaine (Wash.) wrote in a recent letter to BusinessWeek. Rural America is also being hurt by a 73% surge in nitrogen-based fertilizer prices since January, according to DRI.

"COVER MY EYES." Consumers everywhere are facing a second summer of costly gas. The average national price for regular gas, $1.63 as of Apr. 30, is the highest ever, before adjusting for inflation. Price increases are steepest in the Midwest, where refiners are once again having trouble meeting regional pollution rules. But drivers in every state are feeling the pinch. "I just cover my eyes when I swipe my card" at the pump, says Jim Rowe, who works for an information-services company in Atlanta.

Inevitably, paying energy bills requires trimming back elsewhere. Brian Kiefer, 36, a father of four in Newton, Pa., says that when his family drives to the shore on weekends now, they pack a lunch and return in time to have dinner at home, to make up for increased gas expenses. And Amanda Huffman, a student at Agnes Scott College, a private all-girls school in Decatur, Ga., has also cut back: "We used to go out and just drive around and go to random places because it was fun," she says. "But now we carpool or don't go out." Multiply their stories by the millions, and it's easy to see how the current energy crisis looms large over the lives of most Americans--and how it may yet bring down the U.S. economy.

By Peter Coy in New York, with Stephanie Anderson Forest in Dallas, Michael Arndt in Chicago, Ushma Patel in Atlanta, and bureau reports

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