Oil: The X Factor - Spikes in the price of oil are the wild card putting pressure on our fragile economy.
<a href=www.business2.com>Business 2.0 By Cybele Weisser, March 2003 Issue
The U.S. economy runs on oil. No other commodity exerts as much leverage over the nation's financial health. Petroleum pervades everything from the obvious--gasoline, heating oil, jet fuel--to crayons, toothpaste and DVDs, not to mention working its way into the cost of transporting all the food and goods we produce and consume. No surprise then that spikes in the price of oil have preceded the past four recessions.
In normal times, the current slowdown in world economies would mean less demand for oil and thus lower prices. But these are far from normal times. As worries about a war with Iraq have mounted over the past year, the price of oil has jumped 65%, from $20 to $33 a barrel. Then in December a massive strike crippled the oil industry in Venezuela, the third-largest U.S. supplier. Throw in an unusually cold winter in the Northeast, and U.S. inventories of crude oil are now 44% below where they stood a year ago.
The situation could change quickly with a U.S. victory over Iraq. But don't start celebrating yet. It's true that oil prices plunged quickly after the Gulf War, but world oil markets and the supply equation are very different today. To help you make sense of the volatile energy markets, here's a look at how rising oil prices are affecting our economy and where prices may be headed in the months to come. Plus, in the box below, we discuss four energy stocks that are well positioned to thrive in the coming year.
The economic punch
Despite the fact that the U.S. economy is more energy-efficient than it was 20 years ago, we consume 26% of the world's oil--about 20 million barrels a day, up from 15 million two decades ago. Just 43% of that oil is produced domestically, down from 77% in the early '70s, according to the American Petroleum Institute.
The most visible evidence of higher oil prices is at the gas pump. Over the past year the price of gasoline has risen more than 37%, from $1.12 to $1.53 a gallon. Factor in the 33% spike in home heating oil prices over the past year, and Americans are collectively spending $50 billion more on gasoline and heating oil than they were a year ago, says Economy.com's Mark Zandi.
This acts like a major tax increase, cutting into consumer spending. And "if people see high oil prices as a symbol of bad times, they stop spending," says Lehman Brothers' chief economist Ethan Harris. Our struggling economy, which has been buoyed by continued consumer spending, can ill afford such a hit. "If we get to $40 a barrel and stay there for a couple of months, we'll be back in recession," predicts Zandi.
Higher oil prices also take a bite out of profits in energy-intensive industries. Airlines, which have little ability to pass on higher jet fuel prices, are hardest hit. But trucking, shipping and manufacturing industries such as chemicals, paper and steel take blows too. For example, chemical giant DuPont said recently that every 10% increase in the price of oil and gas decreases its net income by $165 million. And finally, there's the impact of oil prices outside the U.S. Countries such as Japan, Germany and France import all of their oil, so they are highly vulnerable to price increases. This hits the U.S. economy indirectly via lower revenue from exports. Overall, economists calculate that every $10-a-barrel oil price increase that sticks for a year reduces economic growth by 0.5%.
Best-and worst-case scenarios
What's the best-case scenario for oil prices today? Ideally, the conflict in Iraq will be short and successful, as it was in 1991, and prices will again fall dramatically. If a friendly regime is installed, there could be an even more significant effect in the long run, since Iraq is sitting on the second-largest reserve of oil after Saudi Arabia. Worst-case scenario? A war drags on and the conflict spreads across the Middle East, pushing the price of oil as high as $50 a barrel or more. "An ugly playing out of events in Iraq--a long, drawn-out war--could put the entire global economy in recession," warns Lehman Brothers' Harris.
But even if a war is resolved quickly, oil prices might not react as they did after the Gulf War. Then, "the market was swimming in oil," and the price of oil fell back to $20 within days, says Sarah Emerson, an economist with the Energy Security Analysis Institute (ESAI). But now, whatever excess supply other members of the Organization of Petroleum Exporting Countries (OPEC) bring to the market is only compensating for the loss of supply from Venezuela. Furthermore, when Venezuela's crisis is over, its operations could take up to six months to completely restart, says Charles Ober, manager of T. Rowe Price's New Era fund. Increased production in Iraq isn't likely to flood the market either, he adds, since Iraq doesn't have the infrastructure to ramp up production to levels that would add a huge amount of oil quickly.
Taking all of this into account, ESAI predicts that oil will average $29 a barrel in the year's first half, 34% above the normal range of $18 to $20, and that it will stay above $25 for the rest of '03. What does that mean for companies in the sector? For giants like ExxonMobil, probably not much: Higher prices help some divisions while hurting others, so the impact is mildly positive overall. But higher prices almost always encourage the Big Oil companies to spend more on exploration and production, which is a boon to pure-play oil and gas drillers and oil service companies. And while oil is in the spotlight now, investors shouldn't forget about the opportunity in natural gas. With North American gas reserves depleting at the rate of 30% a year, domestic gas drillers should receive "extensive capital investment," says Standard & Poor's analyst Tina Vital. In the Spotlight The Middle East The world's richest source of oil is also a hotbed of political instability. Will a victory for coalition troops bring peace to the Middle East and some measure of calm to the global economy? That's no easy question to answer, but knowing more about the region will help you decide for yourself. The Web Guide contains essential research on 19 Middle Eastern countries -- from Bahrain to Iraq to Israel to Yemen. Plus, we've gathered business information on the area, including the latest tech news and the top Web markets and incubators.