Coping With Sky-High Oil Prices

Why are they surging -- and how will the economy fare? It's likely inflation will stay cool, but so will hiring

The signs are all there for a perfect storm. Global demand for oil is surging, supplies are tight, and geopolitical jitters are sending almost daily shock waves through the markets. As a result, oil prices have hit record highs. Economic growth and hiring already have shown signs of slowing in the U.S. And economists are increasingly concerned that both the global and U.S. recoveries could suffer a setback if prices remain at the $45 per barrel level -- or spike even higher because of a major terrorist attack or other cataclysmic event.

Here is a look at the powerful forces at play in the oil markets and the global economy:

What's behind today's high oil prices?

It starts with an unexpected hike in demand. Rapidly rising oil consumption has eaten away the margin of safety provided by the ample spare production capacity recently provided by OPEC. With little surplus capacity available, buyers are worried that potential disruptions in a number of producing countries including Russia, Iraq, Saudi Arabia, and Venezuela could lead to major shortages and further spikes in prices. In 2001, OPEC had almost 6 million barrels per day in extra capacity it could call on. Now it is pumping close to flat-out.

Not only are prices high, but day-to-day swings of $1 or more a barrel are increasingly common as traders react to such news as the temporary Aug. 9 shutdown of production in Iraq. "The impact of any event is greatly magnified," says Paul Horsnell, head of energy research at Barclays Capital in London.

Why has huge demand caught the world by surprise?

A synchronized global recovery is the key factor. For perhaps the first time, most of the planet is growing in tandem. Demand, according to the International Energy Agency, is likely to grow by a record 2.5 million barrels per day in 2004, a 3.2% increase from last year. Consumption growth in 2004 alone is likely to be close to the total reached between 1998 and 2002, even though many had been predicting relatively stagnant demand.

The hottest growth area has been China, which clocked sizzling year-on-year increases of more than 20% in April and May. This year China will suck up 830,000 barrels a day more oil than last year, the IEA estimates, accounting for a third of world demand growth. As their incomes boom, the Chinese are buying cars even as the government rushes to build more roads to accommodate all the new traffic. Switching manufacturing from the West and Japan to less efficient facilities in China just adds to the nation's thirst for oil.

The U.S., too, continues to defy predictions as the economic recovery chugs along and as Americans continue to buy gas-guzzling vehicles and energy-gobbling McMansions. In the second quarter, America's demand for oil grew by 3.5%, the biggest gain since 1999.

Why hasn't production capacity kept pace with demand?

Both the oil majors and the national oil companies that dominate OPEC production have underinvested in bringing new supplies to market. OPEC's foot-dragging developing the 76% of world oil reserves under its sands and swamps is the biggest problem. Incredible as it may seem, OPEC's production capacity has actually declined over the last quarter-century from about 34 million barrels per day in 1979 to about 30 million barrels now. With OPEC imposing production cuts on its members to prop up prices, governments have seen little point investing in new output. Political turmoil, wars, and nationalizations have led to production declines in major producers including Iraq, Iran, and Libya. And most Middle East producers have also severely limited oil companies' access to their reserves

In many respects, today's supply constraints stem from the late 1990s, when OPEC overproduction undermined the market. With prices approaching $10 per barrel back then, the oil majors became ultraconservative -- and they remain so today because they fear OPEC will once again pull the rug out from under them. As a result, they won't touch projects unless they promise at least 15% returns. What's more, pressure from profit-hungry investors has prompted the majors to chop exploration budgets and avoid taking big risks.

Has the oil merger boom of the late 1990s discouraged investment?

The jury is still out, but some analysts believe it may be having an impact. Since the consolidation, says Richard Gordon, executive vice-president at Norwalk (Conn.)-based oil consultants John S. Herold Inc., companies have tended to ax "aggressive new venture programs" in favor of concentrating capital on existing discoveries that were ready to develop. One result: There isn't a huge pool of newly discovered reserves for the companies to develop now.

Has American policy exacerbated the oil squeeze?

Yes. The Bush Administration has done little to encourage conservation. One glaring example: There's been scant pressure on auto makers to improve gas mileage, making supply shocks more probable. U.S. policy in the Middle East, moreover, has had unintended consequences. Economic sanctions against Iran, Iraq, and, until recently, Libya, may be justified. But they hurt the oil industries of these countries, probably reducing supplies. While the war in Iraq was intended to help stabilize the region over the long run, so far it has unleashed anarchy in the country that has the world's second-largest oil reserves. Iraqi production has yet to consistently recover to prewar levels.

Will geopolitical jitters continue?

Most likely. For starters, there isn't any quick resolution in sight to the struggle over Yukos, the Russian oil company that exports a hefty 1.3 million barrels per day. Christopher Weafer, chief strategist at Alfa Bank in Moscow, doubts that President Vladimir V. Putin would sever Yukos' exports for a lengthy period, since it would damage the international standing of his government and wipe out a major source of foreign exchange. But there are no guarantees that such worries will deter Putin's henchmen, who seem determined to bring the nation's most important industry back under greater state control. Disruption or not, the whole affair is bound to discourage and delay investment in the Russian oil industry, which has accounted for nearly all of non-OPEC production growth in recent years.

Iraq, obviously, is also a mess. Insurgents have demonstrated that they are capable of shutting down the country's exports for days at a time. There are two silver linings: The Iraqis are fairly adept at patching up pipelines after the insurgents blow them up. They also have a tough new leader in Prime Minister Ayad Allawi, a former Baathist who is trying to both co-opt and smash his opponents. Still, Iraq is likely to roil the markets for some months to come.

Huge outages in other producing regions seem less likely. While the continuing Islamist violence in Saudi Arabia is terrifying, especially to expatriates, it has yet to threaten oil supplies. Venezuela remains a wild card with simmering opposition to President Hugo Chávez always threatening to boil over.

Where do prices go from here?

Today's inventory levels, which are slightly below the five-year average, would, in a calmer international environment, be expected to produce prices in the low $30s per barrel. But as long as the international situation remains tense, prices will remain higher. Says Edward L. Morse, senior adviser at trading firm HETCO in New York: "Fifty dollars looks much more likely than $30, and even $100 cannot be ruled out."

Still, many analysts think it will take a major event to push prices up much higher than they are now. What's encouraging is that the markets are coping quite well. There have been no major shortages and buyers are able to secure plenty of oil -- albeit at a price. The situation could even ease somewhat in the coming months as Saudi Arabia, Iran, and Algeria add another 1 million barrels a day or more to capacity. That probably means that unless something happens to considerably worsen the supply situation, prices could peak at the mid-$40s. "The only thing that's going to drive prices much higher is some big disruption," says Michael Smith, the head of energy analysis at BP PLC (BP ) in London. Of course, it wasn't that long ago that analysts thought oil prices in the $30s couldn't last.

Do high oil prices have the same impact on the economy as in the past?

The answer seems to be yes -- and no. High oil prices still act like a tax that hits consumers and businesses on a material and psychological level. But the recent spike will not ignite inflation this time round. Indeed, with the job market weak, workers aren't able to negotiate wage increases that in the past have fueled rising prices. Costlier oil instead is having a cooling impact on hiring. That's partly because worries about further price spikes, as well as terrorism jitters, are prompting renewed caution and attention to costs in the executive suite. Says Cisco Systems CEO John T. Chambers: "Most of the CEOs I talk with are a little more cautious in their optimism than they were a quarter ago." Because companies are already struggling with rising health insurance and other costs, executives are looking first to their payrolls to find savings.

Why are higher oil prices less inflationary than in the past?

Oil-driven inflation -- which prevailed in the bad old days of the 1970s -- is far less likely now thanks partly to more astute monetary policy. During the oil shocks of the '70s, the Arthur F. Burns-led Federal Reserve chose growth over inflation-fighting, unleashing unusually generous stimulus. That "choice that enabled a round of inflation in other goods and services," says Jim Griffin, a portfolio strategist at ING Investment Management (ING ).

Equally important, "with energy costs rising and with competition intense, few businesses can afford to pass these cost increases on to their customers," says Peter S. Cohan, an investment and management consultant in Marlborough, Mass. True, many businesses now have more pricing power, but that's in comparison to more than two years of outright deflation in consumer goods when prices outside of services were actually falling. Although yearly inflation, measured by the consumer price index, rose to 3.2% in June, core inflation, which excludes energy and food, is still running at a modest 1.8%.

How do higher oil prices affect the employment picture?

The "oil tax" is increasingly becoming a tax on job growth. The sharp slowdown in the economy in the second quarter and in payroll jobs in June and July is easily the most surprising development in the economy this year. Even the Fed acknowledged the oil link, after its rate hike on Aug. 10. "This softness likely owes importantly to the substantial rise in energy prices," the Fed's Open Market Committee said in a statement.

The job and inflation effects of oil are closely related. Because labor now plays an increasing role in cost control, higher energy outlays only add more pressure to keep profits up by controlling labor costs. That means higher oil prices will be one more incentive for companies to stretch their productivity gains. "Given very limited pricing power and the rising costs of energy and health care, businesses continue to emphasize productivity first and hiring second," says Sung Won Sohn, chief economist at Wells Fargo Bank (WFC ). With labor's weakened bargaining position in recent years, Sohn says, "the higher price of oil should be viewed as a deflationary, not inflationary, factor."

How will businesses respond to costlier energy?

Energy is just one more cost for businesses to deal with at a time when shareholders are relentlessly demanding better profits. Moreover, it also comes as productivity is slowing. The Labor Dept. reported that productivity posted a healthy 2.9% advance in the second quarter, but that increase was slower than in recent quarters at a time when rising benefits costs are pushing up labor compensation.

As a result, unit labor costs last quarter rose at the fastest quarterly pace in two years. If prices fail to keep up, then margins will get squeezed and companies will be forced to find new efficiencies, most likely at the expense of jobs. One example: "The high level of oil and natural gas prices has become a new reality for the chemical industry, and it will continue to exert pressure on margins," says J. Pedro Reinhard, chief financial officer at Dow Chemical Co. (DOW ) Dow hopes its prices can keep pace with rising costs, but it also plans to unload 3,000 employees in 2004, in addition to 3,500 in 2003.

What is the impact on consumers?

The "tax" on household spending falls disproportionately on middle- and low-income folks -- and the companies that cater to them. That's because energy is a necessity that is a relatively larger portion of these families' budgets. In the first half, households coughed up an extra $44 billion on gasoline. That rise alone accounted for 26% of the overall increase in consumer spending. The additional dollars spent filling up the tank mean less for other things. "Any extra money we spend on gas, we used to spend on entertainment," says Robert Tanner, a music professor at Morehouse College in Atlanta.

Retail sales took a big hit in June and July, especially at the likes of Wal-Mart Stores Inc. (WMT ) and discount stores that attract lower- and middle-income shoppers. Same-store sales at Dollar Tree Stores Inc. (DLTR ), for example, declined 0.2% during the first half vs. the same period last year. Grouses Adam Bergman, director of investor relations at the Chesapeake (Va.)-based chain: "We are hurt by high oil prices because people are giving their extra dollars to Exxon (XOM )."

What about the impact of high oil prices on the auto industry?

So far gas-guzzling sport-utility vehicles continue to sell briskly -- but at growing costs to the Big Three. They are being forced to slap on increasingly outlandish incentives: Try up to $6,500 on a (XOM ) Chevrolet Tahoe. That's bad news because Detroit gets most of its vehicle profits from SUVs and trucks. Meanwhile, truck-based SUVs are losing favor as consumers trade them in for more fuel-efficient, car-based SUVs made mostly by foreign auto makers. Sales of entry-level, small cars could be hit, too, because such models are purchased by low-income drivers, the people hit hardest by higher oil prices. Detroit isn't asleep at the wheel, though. It's introducing fuel-saving technology on its bigger vehicles and rolling out car- based SUVs.

How is the runup in oil prices playing in the stock market?

Except for energy shares, not well. The market's view of oil prices has changed dramatically. "It wasn't long ago that everybody was betting that oil was going to go from $38 down to $32, at least, and now it is $45," says Henry J. Herrmann, chief investment officer of Overland Park (Kan.)-based Waddell & Reed Financial Inc. (WDR ). Herrmann says it's not so much the level of oil prices that is spooking investors, it's the upward trend.

As a result, there's growing concern that higher energy costs are slowing earnings growth. The spike has reminded investors of the need to be wary of the unexpected. "It is not that the market is saying the damage from current oil prices is systemic or irreversible," says Christine A. Callies, chief market strategist at Bessemer Trust. "It is the risk that oil might be $50 or $55 and that higher oil prices increase the probability of a spontaneous recession."

How will oil influence Fed policy?

Fed officials lean toward the belief that pricey oil disrupts economic growth more than it generates inflation. Still, when the Fed raised its target interest rate by a quarter-point, to 1.5%, on Aug. 10, it gave no sign that it was about to deviate from its planned series of interest-rate hikes during coming meetings. Although policymakers noted the impact of oil, they argued that the economic slowdown will prove short-lived. However, if oil prices stay high or go higher, and if the slowdown in the economy and employment persists, the Fed would undoubtedly back away from its "measured" pace of policy tightening.

So what does all this mean for the U.S. and global recovery?

Oil is still cheap by historical standards after taking inflation into account. And the U.S. is twice as energy efficient as it was in the 1970s. However, as recent jobs and growth data show, it is not immune -- even to oil at $40 per barrel. A supply disruption of only about 2 million barrels per day, slightly greater than the existing spare global capacity, could push oil to $65 per barrel, according to Waltham (Mass.) consulting firm Global Insight Inc. That would be enough for world growth to fall to 2.7% in 2005, down from about 4% this year. Even if oil prices hold at their current levels, U.S. expansion will suffer at a time when the nation's economy needs all the growth it can muster to boost hiring.

No doubt, high oil prices are taking a toll and will continue to do so. Indeed, every recession since 1970 has been preceded by a sharp runup in oil prices. So long as supplies aren't interrupted, the U.S. and global economies appear able to withstand $40 oil. But the price may be less growth and fewer jobs. And the higher prices go, the fewer new jobs there will be to go around.

By Stanley Reed in London and James C. Cooper in New York, with Stephanie Anderson Forest in Dallas, and bureau reports

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