Are We Over A Barrel?

By Adam Zagorin/Washington

Will spiraling energy costs doom the longest economic boom in American history? With petroleum selling in the past few weeks for nearly $35, close to a 10-year high, talk of a possible oil shock--a threat unseen since the 1990 Gulf War--is suddenly gaining respectability. And prices could go higher still if dictator Saddam Hussein suddenly shuts off Iraq's flow of crude, which the victorious West has allowed to flow into Western markets since 1996. Or if the Organization of Petroleum Exporting Countries makes good on threats to rein in crude-oil supplies in 2001. The Clinton Administration's decision last September to release some 30 million bbl. of oil from the U.S. Strategic Petroleum Reserve (SPR) did little to cool the crude market, and since then Middle East turmoil and strong global demand have kept traders on edge. At the same time, global refining capacity is strained to the limit. "When you have a market this tight, it's vulnerable to disruption," warns Daniel Yergin, chairman of Cambridge Energy Research Associates. "It could be a political event. It might involve a logistical problem with refineries or even the weather."

Scare talk about oil prices will probably reach a peak this winter. Colder than usual temperatures are forecast for North America, and inventories of home heating oil and natural gas are at what the U.S. Energy Department calls "alarmingly low levels." That's the classic formula for a price spike that could quickly drive the cost of oil above $40 per bbl., a level that, if sustained for any significant length of time, could inflict considerable damage on the U.S. and global economies. O.K., that's the scare-your-pants-off scenario. At the moment, though, most experts are more optimistic. Despite the capacity strains, they don't think the oil pinch will get anywhere near so bad. Indeed, in the absence of a Middle East war or some other unforeseen calamity, the price of crude is expected to drift down after the winter peak-demand period, perhaps to less than $30 per bbl. by spring and even into the low-$20 range by the end of 2001. Says Yergin, one of the country's foremost experts on the energy supply: "We should see the fundamentals of supply and demand reassert themselves over the tension that has been driving the market for much of this year."

For all the scare stories to pass, though, cooperation from OPEC is essential. The only problem with this notion is that many countries in the 11-member organization feel short of cash, a hangover from the time, only two years ago, when oil was selling at close to $10 per bbl. That cost such major producer countries as Saudi Arabia, Indonesia and Venezuela tens of billions of dollars in revenue and has left OPEC wary of increasing supplies beyond the 3.7 million bbl. a day it has released onto the world market so far this year.

OPEC's latest woes began after a sharp downturn in global demand for oil brought on by the 1997 Asian financial crisis, which laid waste the economies of the Far East. The lower prices that followed made it less profitable to explore for new reserves or to produce from deep-water wells in the North Sea, the Gulf of Mexico and other high-cost areas. Then OPEC decided to cut back production in an effort to drive prices back up again. That successful strategy caused supplies to contract further, just as Asia's economies began to rebound smartly. By 1999, crude prices were skyrocketing, and the bust had become a boom for producers and oil companies.

The turnaround has been so rapid that supply and demand are still badly out of synch. Today market conditions are so tight that there is just 2.5 million bbl. a day worth of spare production capacity. That is equivalent to less than the total daily output of Iraq--but only about a seventh of the amount of oil the U.S. consumes in a day. Energy Secretary Bill Richardson, who has spent much of this year pleading with OPEC oil ministers to raise their production to the limit, is still repeating that mantra. Just in case, Richardson has made it clear that if prices spike too dramatically this winter, the Clinton Administration will once again release oil from the SPR. Any release from the 570 million bbl. reserve would provoke controversy, because it was created by Congress for use only in national emergencies.

For all the maneuvering on the supply side, the big surprise is how little damage rising energy prices have done to the U.S. economy and its sensational boom. The oil-price hikes are far from cheap. Americans will pay at least $50 billion more for oil products this year. But the extra outlays have reduced economic growth a mere 0.5%. One reason is that while the price hikes are fearsome on paper, they are less so in reality, especially when measured against historical heights. While there has been plenty of grumbling about high gasoline prices, the inflation-adjusted price at the pump remains less than half what it was 20 years ago. The pinch for drivers is measurable, but largely because 1 in every 2 vehicles sold in the U.S. market is a gas-guzzling SUV or light truck.

Off the freeway, the story is different. The accelerating shift away from energy-hungry heavy manufacturing toward more fuel-efficient high-tech and services has made America's New Economy less vulnerable to oil-price spikes. Indeed, according to Martin Baily, chairman of President Clinton's Council of Economic Advisers, "the U.S. is currently about half as dependent on oil as it was in the early 1970s."

In just the past five years, for example, U.S. output of goods and services has shot up 20%, but petroleum consumption has risen only about 9%. And while oil is more expensive, the extra cost has been partly offset for the economy as a whole by depressed prices for other commodities like gold, wheat and lumber. Some industries, of course, feel the hikes more than others. Airlines and shippers, for example, have begun to demand fuel surcharges from customers. But even so, the overall impact of higher energy prices on inflation has been negligible.

"America has become a more efficient society," points out Edward Maran, an oil analyst with the A.G. Edwards investment firm. "It covers everything from higher average gas mileage on our cars to refrigerators, dryers and air conditioners that all use less energy."

There is an exception, as those who use natural gas as an energy source will almost certainly be acknowledging this winter. Cleaner to burn than coal or oil, natural gas has become the heating fuel of choice for millions of Americans over the past decade; electrical-generation plants have also turned increasingly to gas as a source of energy. As a result, natural gas accounts for about 25% of the nation's overall energy needs. The same economics that governed crude oil, however, distorted the gas market. Even as demand grew, comparatively cheap prices over the past decade made investment in reserve stocks and new drilling less profitable. As a result, U.S. production capacity is 6% less today than it was three years ago. And the price curve has changed dramatically. Consumer prices for natural gas are already more than twice last year's levels and are virtually certain to rise an additional 40% this winter. Some estimates put the increases as high as 80% in the event of severely cold weather or supply disruption.

The U.S., however, still has it good, compared with many countries hard hit by high energy costs. Britain, France and other members of the 15-nation European Union were rocked in September by occasionally violent protests in response to soaring gasoline prices made higher still by hefty taxes levied at the pump. To make matters worse, the E.U.'s new single currency, the euro, has lost close to 20% of its value this year, pushing up the cost of petroleum, which is priced worldwide in U.S. dollars. Altogether, Europe's big oil bill is expected to cut growth 0.5% in 2001, about the same as in the U.S. The difference is that Europe has not really enjoyed the long-term expansion experienced by the U.S., and every bit of lost growth has a more serious consequence in terms of forgone opportunities for employment. The bite is even bigger in Japan, where oil-price hikes will slice nearly 1.5% off corporate profits. Japan is heavily dependent on expensive imported petroleum. Its economy is still stagnant, and the price increases are no help in escaping that painful condition.

But even in the U.S., there is no reason for complacency. If oil and gas are in short supply now, the long-term global outlook appears worse. Foreign oil, much of it from the unstable Middle East, is expected to make up 64% of U.S. consumption by 2020, up from 51% in 1999, according to the latest projection of the Energy Information Agency. Domestic production over the same period will decline about 1% annually in the years ahead. Meanwhile, petroleum demand outside the U.S. will probably keep heading for the skies. China alone is expected to put something like 170 million additional cars on its rapidly improving roads by 2020. By that year, oil consumption in parts of the industrializing Third World should push global demand to 115 million bbl. a day from current levels of around 76 million bbl.

Both Al Gore and George W. Bush tried in their campaigns to address the threat of rising energy prices, albeit in characteristically different ways. Vice President Gore pushed a variety of conservation measures, including boosting automobile-fuel efficiency and developing alternative resources like wind and solar power. Bush and running mate Dick Cheney, both former oil executives, would like to ease U.S. dependence on foreign oil by boosting domestic production.

But any of these approaches would take years to produce a serious decline in consumption or to spill enough new oil onto the market to lower the price appreciably. And even though prices are high, the political will to take either the supply or the demand route to a new energy equilibrium is weak in the badly divided new Congress. As Senator Max Baucus, the senior Democrat on the Senate Finance Committee, put it, "I don't see any significant changes in U.S. energy policy unless there is a huge crisis." And for all the sighs about energy costs, the crisis is not at hand.

--With reporting by Carole Buia/New York, Abi Daruvalla/Brussels and Steven Frank/Toronto

With reporting by Carole Buia/New York, Abi Daruvalla/Brussels and Steven Frank/Toronto