A Fragile Reprieve on Energy

Easing gasoline, crude, and natural gas prices could rev the recovery -- if they last

As recently as August, high energy prices looked as if they might become a serious obstacle to economic recovery in the U.S. and abroad. Oil was more than $30 a barrel, natural gas remained in short supply, and gasoline had hit an all-time high. Federal Reserve Chairman Alan Greenspan captured the concern in congressional testimony in July, when he warned of "debilitating spikes" in the price of natural gas. The big worry: If energy prices were high when the economy was slack, how much higher would they go when it was firing on all cylinders?

Then a funny thing happened: Growth began to accelerate, but rising inventories allowed energy prices to drop rather than rise. From late August through Sept. 23, crude oil fell 14%, to about $27 a barrel, and natural gas dropped 15%, to $4.50, in futures trading on the New York Mercantile Exchange. Even stubbornly expensive gasoline began to fall: The average retail price for self-serve regular unleaded has fallen for four weeks in a row, dropping a dime from its peak, to $1.64 on Sept. 22.

Energy consumers may have rejoiced, but producers certainly didn't: Increasingly worried about the slide in crude prices, OPEC oil ministers meeting in Geneva on Sept. 23 agreed to cut production by 3.5%, rolling back a June 1 hike. The move surprised the markets -- which had expected OPEC to hold production steady -- and sent crude prices back up $1.11, to $28.24, in Nymex trading by the end of the day. Analysts quickly concluded that the cartel isn't trying to force prices up, but it does want to stem any further slide. "They are showing they're ready to defend the price," says George Beranek, manager for market analysis at consultant PFC Energy in Washington.


Hitting that balance JUST right is a tricky business given the intensely volatile energy markets. A major disruption -- say, a cutoff of Iraqi production or a harsher-than-expected winter -- would send prices back up. And if current cuts don't work, there are likely to be more.

Beranek thinks OPEC could announce further cuts of 1 million to 2 million barrels a day when it meets in December. OPEC's move also roiled stock markets, sending the Standard & Poor's (MHP ) 500-stock index down 1.9% as investors worried that a jump in oil prices could boost costs and cut into the nascent earnings revival. But some see the fears as overblown. Bear, Stearns & Co. oil analyst Frederick P. Leuffer says OPEC's cut didn't change his prediction that prices will average $18 a barrel next year, vs. $30 this year. Says Leuffer: "So far this quarter, every OPEC member except Venezuela and Indonesia have cheated on quotas."

The moderation in energy prices, if sustained, will help the economy by boosting consumer spending, helping to keep the expansion alive as business investment starts to kick in. David A. Wyss, chief economist at Standard & Poor's, figures the price drop will lower inflation by about a quarter of a percentage point and raise economic growth by a tenth of a percentage point or so. And cheaper energy has helped revive consumer confidence, notes Bruce C. Kasman, head of economic research for J.P. Morgan Chase & Co.

If economic growth stays strong into the fourth quarter, will energy prices rebound? It's possible. But there's reason to believe that won't happen. For one thing, stronger growth doesn't trigger as much increased energy consumption as it once did because of improved efficiency. In the U.S., output per unit of energy, adjusted for inflation, is up 77% since 1973, the year of the first Arab oil embargo. For another, global growth isn't exactly torrid.


More important, supplies are growing along with demand. Fighting saboteurs, Iraq has managed to raise its oil output to 1.3 million barrels a day -- about half the 2.5 million barrels it produced daily before the U.S. invasion. Venezuela, too, has bounced back after a crippling strike: It's producing about 2.6 million barrels a day, vs. 3 million pre-strike. Russian oil production this year, moreover, will average 8.2 million barrels a day, up 7% from last year.

The outlook for natural gas has brightened as well. The Nymex price spiked to $9.58 in late February on shortages caused by severe weather. As recently as May, the price was above $6 per million BTUs on fears that producers couldn't rebuild depleted reserves in time for winter. But the summer was mild in much of the nation, dampening demand for natural gas from electric utilities to run air conditioners. High prices also scared off some customers. So buyers were able to rebuild inventories to almost normal levels.


Even gasoline is finally coming down. For much of the spring and summer, prices rose far more than the runup in crude oil could explain, hitting a national average of nearly $1.75 a gallon just before Labor Day -- the highest ever before inflation. Because refiners underestimated demand, they cut back on production. Then, when summer driving came in above expectations, prices shot up, allowing refiners' profit margins to triple or more. Gradually, though, competition among refiners and retailers is raising supply and forcing margins back down. Tom A. Kloza, chief oil analyst at OPIS Energy Group in Lakewood, N.J., thinks gas will fall 15 cents to 30 cents by Thanksgiving.

Energy markets are volatile, but in the long run, there's plenty of flexibility to tame prices. High prices spark more supply, sending prices down. That has been the case lately for oil. Western and other non-OPEC oil producers, including Russia, are stepping up exploration. When demand spikes, imports flood in.

The natural gas market is more vulnerable because it lacks the safety valve of imports. Just 1% of natural gas used in the U.S. comes from outside North America. Only four ship terminals capable of handling imports of supercooled liquid natural gas exist in the U.S., and they're at full capacity. That's one reason Mark G. Papa, chairman and CEO of Houston oil-and-gas producer EOG Resources (EOG ) Inc., warns that "we're not out of the woods yet" on natural gas supply.

That said, the betting is that energy prices will fall in the coming year. One help: The Energy Dept. is forecasting a normal winter, in contrast to the frigid one of 2002-03. On the Nymex on Sept. 24, natural gas for January delivery was $5.21 -- not too far above the $4.59 of the October contract. Crude was $27.60, down from $28.24 now. And January wholesale unleaded gasoline goes for 75 cents, vs. 87 cents today. For now, the markets remain convinced that energy prices will help, rather than hinder, the recovery.

By Peter Coy in New York, with Stephanie Anderson Forest in Dallas, Stanley Reed in London, and Christopher Palmeri in Los Angeles

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