Awash in an Ocean of Oil

By John Greenwald.

Once again, a stunning shift in the price of oil sent tremors around the globe. Yet unlike the jolts that staggered the world economy in the 1970s, last week's quake caused prices to crash rather than climb. On Tuesday oil dropped below $20 per bbl. for the first time in seven years. Said Charles Maxwell, an analyst with the Cyrus J. Lawrence brokerage house near Wall Street: "This is one of the most important days in the oil markets in a decade." Since November, the price of petroleum contracts has plunged about 40%, including an 18% drop last week. Said Peter Beutel of Rudolf Wolff Futures, a New York City investment firm: "A whole new era has begun."

Indeed, as mild, springlike weather temporarily warmed much of the U.S. and Europe, an all-out price war seemed to be getting under way. To boost their shares of the energy market, hard-pressed members of the Organization of Petroleum Exporting Countries and rival suppliers Britain, Norway and Mexico have been flooding the world with an ocean of oil. The battle reflects the aggressive new tactics of Saudi Arabia, the largest OPEC producer, which has doubled its output in recent months. "The Saudis shocked the market," said one U.S. oil expert. "It was like being hit over the head with a baseball bat."

Last week Sheik Ahmed Zaki Yamani, the Saudi oil minister, issued a stern warning. Without a new agreement to curb production, Yamani said, "there will be no limitation to the downward spiral that may bring crude prices to less than $15 per bbl., with adverse and dangerous consequences for the whole world economy." The threatening words pushed prices into a free fall. North Sea oil dropped to $17.70 per bbl. before recovering a bit to finish the week at $18.50.

Plummeting oil prices can do both grievous harm and enormous good. Less expensive oil means lower energy costs for consumers and companies, which can give a substantial boost to U.S. and worldwide growth. At the same time, however, a further fall in oil prices could deal a crippling blow to U.S. energy firms and debt-ridden oil producers, including Mexico, Nigeria and Venezuela. Their woes might then threaten banks and rock the international financial system. Says Edward Yardeni, chief economist for Prudential-Bache Securities: "The oil-price collapse suddenly woke people up to the fact that the financial crisis is still out there. We'd become so jaded that it didn't seem to worry anybody anymore."

Last week's declines stunned everyone, from commodities brokers to Texas oil barons. Panic swept the New York Mercantile Exchange, the nerve center of U.S. oil trading. "There was pure chaos on the floor," said Joel Faber, president of Faber's Futures and a governor of the exchange. As the price of crude fell, shipments of heating oil for February delivery plunged to 55.75 cents per gal., the lowest level since the late 1970s. Six blocks away, on the New York Stock Exchange, the Dow Jones industrial average dropped a total of 26 points on Tuesday and Wednesday before pulling out of its slump and finishing the week at 1529.93, down 6.77 points. Hardest hit were shares of energy firms, and banks with large loans to oil-producing countries. The stock of Chase Manhattan, for example, fell $7.125, a decline of nearly 10%, in two hectic days.

The fallout spread to foreign capitals and financial centers. Stocks traded on the Toronto Exchange last Wednesday lost about 2% of their value, to record the steepest slide in more than four years. "Even the bulls turned bearish," one moneyman said. As in the U.S., investors shunned shares of banks with substantial energy loans. In London, officials feared that the decline could sharply reduce tax revenues from Britain's North Sea wells. In Mexico, which desperately needs oil earnings to repay its $96.4 billion in foreign loans, the prospect of further price drops raised the specter of ! financial ruin. Elsewhere, leaders of oil-rich but otherwise poor nations, like Nigeria and Indonesia, were nervously eyeing prices.

In Washington, the Reagan Administration hailed the price slide as a victory. Said White House Spokesman Larry Speakes: "The effect of a drop in oil prices on the U.S. economy and particularly on U.S. consumers is favorable." Energy Secretary John Herrington was also ebullient. He called the tumble "good news for American consumers and outstanding news for American industries that are trying to compete worldwide." Still, President Reagan discussed the churning oil markets during the week in meetings with senior Administration officials. Said Herrington: "If there is to be price movement, we want it to be gradual."

Many economists stressed the positive aspects of the price collapse. Said Walter Heller, who served as chief economic adviser to Presidents Kennedy and Johnson: "This will be like a tonic for an economy, which, while it is not heading for a recession, has been showing only modest growth." The Commerce Department reported last week that the gross national product grew at a 2.4% annual rate during last year's fourth quarter, down sharply from an estimate of 3.2%. The economy expanded 2.3% for all of 1985, marking the weakest gain since the recession year of 1982. Data Resources, an economic-research firm based in Lexington, Mass., estimates that a permanent cut in the price of crude oil to $20 per bbl. would add 2 percentage points to GNP growth by 1988 and create 900,000 new jobs.

Lower oil prices would of course also help restrain inflation, which rose at an annual rate of 5.3% in December and at a moderate 3.8% pace for 1985 as a whole. Since the U.S. and the rest of the developed world run on oil, any price cut would ripple through the economy to hold down the cost of everything from jet fuel to the raw materials used in plastics. For example, each 1 cents decline in the price of aviation fuel saves the highly competitive airline industry $110 million annually and provides an incentive for lower fares. Energy also accounts for 10% of total costs in the trucking industry. In addition, depressed oil prices would hold down the cost of such competing fuels as coal and natural gas, and thus bring savings to an even wider range of industries.

The benefits hardly end there. Chase Econometrics estimates that every $5- per-bbl. drop in oil prices will cut $9 billion off the U.S. trade deficit, which reached an estimated $145 billion last year. That record shortfall helped slow U.S. growth by siphoning dollars to other countries. As the gap closes, says Lawrence Chimerine, Chase Econometrics' chairman, "consumers and business can spend that money on other things."

Consumers will have to wait, however, before seeing lower prices at the gas pump and on heating bills. If they are sustained, drops in the price of crude oil normally take from 45 days to 90 days to work their way through refineries and distribution channels. An industry rule of thumb holds that every $1 decline in the price of crude cuts 2 1/2 cents per gal. from the cost of heating oil and gasoline. Both now average about $1.15 per gal. If oil stays at about $20 per bbl., those product prices could fall as much as 25 cents per gal. within three months. A number of eager stations were unwilling to wait, and have already dropped the price of regular gas to below $1 per gal.

Some experts warn, though, that the cuts could prove smaller than expected. "In this environment, gasoline and heating-oil prices are living an economic life of their own," says Dan Lundberg, a Los Angeles petroleum analyst. "They're influenced much more by the economics of the marketplace than by signals sent by speculators from the futures market."

Oil-company officers naturally share that view. "You can't expect to see a lock-step movement between products and crude oil," said William Hermann, chief economist for Chevron USA. "You'll see a pretty close relationship over a long period of time, but extenuating circumstances keep product prices up after crude falls." Such forces include rising marketing costs, and federal regulations that require refiners to use costly methods to remove most of the lead from gasoline.

Europeans, meanwhile, are already paying less for gasoline and heating oil. Thanks partly to the falling value of the U.S. dollar, the currency in which crude prices are set, Continental consumers are enjoying their biggest energy bargains in years. While European gasoline costs remain almost twice as high as those in the U.S., Swiss drivers last week saw their fifth price cut at the filling station since September, and their second of 1986. At $2.13 per gal., premium gasoline now costs less in Switzerland than at any other time since 1982. The price of Swiss heating oil, now $1.03 per gal., is at its lowest level since 1979.

Still, falling crude prices could have negative consequences that might + rival or overwhelm the advantages they create. The greatest danger is the chance of a quake along the fault lines that run between banks on one side and oil producers and energy companies on the other. Said Alan Greenspan, a Manhattan-based economic consultant: "The situation is quite serious for Mexico. It will encounter considerable problems and may even create the impression that it could eventually walk away from its debt." Such a repudiation by the developing world's second largest debtor would be the realization of a nightmare that has haunted U.S. bankers for years.

Tumbling prices hurt Mexico because the Latin nation gets 70% of its export revenues from oil, which Mexicans have dubbed the economy's "fat cow." But that once ample creature is growing leaner by the day. So far, the drop in crude has cut $2.5 billion from Mexico's anticipated 1986 earnings, and the country may not be able to stand much more. "Falling oil prices will have an impact on a Mexican budget that is already stretched to the limit," says Economist Rogelio Ramirez de la O. He estimates that a sustained price of $20 per bbl. for oil would cause the Mexican economy, which is still suffering the financial effects of last year's earthquake, to show no growth in 1986.

Oil producers in the American Southwest face gusher-size troubles of their own. In Texas, the center of the U.S. oil industry, government analysts estimate that each $1-per-bbl. drop in prices will cost the state 25,000 jobs and $100 million in revenues. The declines make it less rewarding for companies to drill and develop wells. Local banks could suffer greatly if the fall continues. Says Frank Anderson, director of financial research for Weber, Hall, Sale & Associates, a Dallas brokerage: "The real problem will come if the contract price gets to $15 per bbl. and stays there for six months to a year. Then you'll see serious loan losses, a restructuring of bank portfolios and possibly even a reorganization of banks."

Experts in neighboring states issued similar warnings. In Oklahoma, officials said sliding prices could cut 10% from the state's already depressed oil production and could whack $50 million more out of a government budget that is now running a $197 million deficit. Oilmen fear that the declines could shut most of Oklahoma's 50,000 stripper wells, small units that individually produce no more than 10 bbl. per day but together account for the bulk of the state's petroleum output.

To forestall such developments, Congressmen from oil and gas states are seeking an oil import fee to raise the price of foreign crude and protect the U.S. energy industry. Says Democratic Senator David Boren of Oklahoma, who last week wrote Reagan urging him to support the plan: "If prices fall further, it will bring our exploration to a screeching halt." At Boren's request, Oregon Republican Bob Packwood, chairman of the Senate Finance Committee, agreed last week to hold hearings on the proposal.

Many economists support some form of energy tax as a conservation and revenue-raising measure. Heller called the drop in petroleum prices "a heaven-sent opportunity" to cut the federal budget deficit by taxing gasoline or oil. Martin Feldstein, who two years ago left his post as chairman of the Council of Economic Advisers to return to a teaching job at Harvard, has advocated a 20 cents-per-gal. levy on gasoline.

The Administration, however, is squarely against anything of the kind. Reagan has rejected such ideas in the past, and is unlikely to abandon his well-known opposition to tax increases. Said Herrington: "I do not believe an import fee is called for. It's a tax." Instead of taxing oil, the Energy Secretary wants to spur exploration by giving oil and gas firms new tax breaks.

The idea of an energy tax would have seemed absurd just six years ago, when the U.S. was still reeling from the OPEC oil shocks of the 1970s. Those blows, which drove the price of crude from about $2 per bbl. at the start of the decade to $34 in 1982, marked an economic turning point. The huge increases pushed the U.S. into double-digit inflation and helped trigger severe recessions in 1974 and 1981. They drained billions of dollars from rich and poor nations alike and transferred the money to OPEC countries, which suddenly became lands of fabulous wealth. Perhaps most damaging of all, the price hikes created an era of economic stagnation from which much of the world is still recovering.

OPEC's very success proved its undoing. Faced with towering prices, the U.S. and other industrial countries learned to live with less oil. Americans traded in their gas guzzlers for smaller, fuel-efficient cars, insulated their homes and workplaces more effectively and switched to natural gas and other less expensive fuels. Industries installed modern equipment that conserved energy.

Meanwhile, nations found and developed vast new sources of oil. Petroleum from such locations as Alaska, Mexico and the North Sea poured onto the market. As a result, OPEC's share of the world oil market has shrunk drastically. The cartel that accounted for 63% of global output in 1979 can now claim only about 38%. That decline has left many OPEC members unable to pay for the grandiose development projects they began in better times. Saudi Arabia, for example, is running about $12 billion in the red on its $55 billion annual budget.

By 1983 the combination of conservation and new oil supplies turned oil prices around, and they began a slow descent. The sharp break started last December, when OPEC dropped all pretense of discipline and its members frantically tried to raise revenues by increasing their market shares.

The final blow came from Saudi Arabia, by far the largest oil producer, which has boosted its daily output from a low of 2.2 million bbl. last summer to a current rate of about 5 million bbl. That increase, more than any other single factor, pushed prices into a free fall.

Many experts believe that the Saudis are playing a dangerous game of chicken. Yamani clearly hopes to force Britain and other non-OPEC producers to the bargaining table for talks aimed at cutting output to support prices. While the British have so far shown little interest in such sessions, last week's plunge in North Sea oil prices could help change their minds. Yamani also wants his fellow OPEC ministers to consider production cutbacks when a five-member special committee meets next week in Vienna. Says William Quandt, a Middle East specialist at the Brookings Institution: "The Saudis want the price to go down, but they don't want it to collapse."

Speculation swirled last week about where prices would eventually settle. For every observer who thought the decline would quickly end, others expected it to continue. "Prices could fall so much more that it's scary," said Philip Verleger Jr., a Washington-based energy analyst. "If it's left up to the Saudis alone, prices could drop to $5 to $10 per bbl. if they make no effort to keep their production in check." For Yamani, the crunch could come in the spring, when demand traditionally slackens. If no production agreement is reached by then, $20 per bbl. could seem like a high price.

Some experts looked further ahead to consider the implications of last week's frenzy. They feared that cheap oil might lead to a return of wasteful ways that would make a new oil shortage inevitable at some point in the future. But the trend toward conservation will not easily be reversed. Says Economist Heller: "It would take a long, long time to go back to our old oil-guzzling habits. This could be a trap, but only if we are dumb enough to fall into it."

With reporting by Raji Samghabadi/New York and Gregory H. Wierzynski/Washington