The Oil Factor Wanes
Every recession of the last three decades has been triggered in part by a big run-up in oil prices. But many economists and industry experts are betting that the latest surge will be different.
To understand why, take a look at Florida Power & Light Co.
At the time of the 1973 Arab oil embargo, the big Florida utility relied on fuel oil to make more than half the electricity it generated. Stung by high oil costs, the company started diversifying into natural gas and nuclear, coal and purchased power. Now, oil accounts for only 14% of its power generation.
And so it has gone throughout the U.S. economy.
Because of a variety of changes, some born of the economic pain of past price shocks, Americans are less dependent on oil. Together, these changes mean the economy is likely to survive this round of rising prices with less trauma than suffered in the past.
The changes include tougher vehicle mileage standards and switches by homeowners to newer, more efficient heating equipment. Broader economic shifts, such as the rise of the high-technology sector and the exodus of energy-intensive manufacturing to other countries, also have made the United States less oil-hungry.
And many industrial consumers of energy have become more efficient and started using a variety of energy sources, as did Florida Power & Light. This allows them to switch to whatever fuel is cheapest at any moment.
“We found ourselves in a situation where we were going before the Public Services Commission asking for a rate increase every couple of months,” said Bill Swank, spokesman for the Florida electric company, recalling the oil crisis of the 1970s. “We realized it wasn’t good to have all of our generation eggs in the same fuel basket.”
So the U.S. economy will be singed, not burned, by the recent oil price jump, which saw the spot price of crude hit a record $42.33 a barrel in early June before retreating to the high $30s.
If that price level is sustained, analysts and industry experts say, inflation might inch up and economic growth will slow -- though many predict a drag of about 0.5 percentage point, not much in an economy expected to expand at least 4% this year.
The Inflation Factor
“It’s clearly a negative,” said Stephen Friedman, director of President Bush’s National Economic Council, about high oil prices. “But you have to put this in the context of all the other things that are going on in the economy. While it’s a negative, we have no remote sense that it’s going to derail this recovery.”
Others agree that an oil- induced recession is a long shot, unless prices rise much higher and stay there for a while.
One reason the effect of oil prices will be muted, analysts say, is that prices in fact are not that high when inflation is taken into account. Although recent prices have set records, oil would have to soar to about $70 a barrel to match the highs reached in 1980, after adjusting for inflation.
But equally important are the broader economic changes that have made the United States less sensitive to oil price fluctuations. It takes about half as much oil as it did 30 years ago to generate $1 of gross domestic product, and energy expenditures take a smaller bite out of household budgets.
“The nature of the economy has changed,” said Bush economic advisor N. Gregory Mankiw, who joined Friedman in a recent briefing for reporters. “We’re more technology-based, more service-based. That’s one reason ... oil prices may have a smaller impact on the macro economy today than was true a generation ago.”
Philip K. Verleger Jr., an energy economist at the Institute for International Economics in Washington, said globalization also was a factor: “A lot of energy-intensive businesses have moved offshore. Businesses are much more efficient in the way they use energy. As a result, most manufacturers operating in the United States today are less influenced by energy prices.”
It isn’t only oil-dependent manufacturers that have sought efficiencies or moved to lower-cost countries. Persistently high natural gas prices also have prompted some companies to move. Because natural gas cannot be transported readily from one part of the world to another, its price can vary widely in different geographic regions.
Last year, Dow Chemical Co. closed chemical plants in Louisiana and Texas that used gas as a feedstock, shifting production to newer facilities in Germany and other overseas locations.
“As the price of the feedstock and fuel goes up, it makes it less advantageous to upgrade the technology at the old plants,” Dow spokesman Doug Brinklow said. “So we decided not to.”
Conservation has played a role too in reducing American sensitivity to oil price swings. Many factories have installed more efficient power plants, motors and machines. Businesses have replaced incandescent lighting with fluorescent tubes. Homeowners have installed storm windows and attic insulation. The use of fuel oil for residential heating has declined by more than half in the last 30 years as more homes have been equipped with electrical heat pumps or gas furnaces and as old oil-burning units have been upgraded.
Fuel Efficiency Rises
One monumental change was congressional approval of mandatory vehicle fuel-efficiency standards after the price spikes and gas shortages of the 1970s. Since then, the average efficiency of new passenger cars has climbed to nearly 25 miles per gallon from about 13 mpg. (If sport utility vehicles and other light trucks are included in the calculation, average fuel efficiency has declined slightly since the late 1980s, to about 21 mpg.)
“The single biggest thing the United States has ever done in terms of conservation was doubling the fuel efficiency of new cars,” said Daniel Yergin, oil industry historian and chairman of Cambridge Energy Research Associates.
The net effect of all these changes is a nation that is less susceptible to energy-induced downturns, particularly during times of robust economic growth, analysts say.
In fact, there appears to be increasing confidence that the current recovery has enough momentum to withstand the drag of oil prices in the range of $30 to $40 a barrel.
“We’re not at the grievous damage point yet,” said James Williams, president of WTRG Economics in London, Ark. “That number is probably $10 away. I’d say the tipping point is somewhere around $50 a barrel.”
Other economists place the danger zone even higher, at $70 a barrel or more. Given the uncertainties raised by Middle East tensions, a price increase to that level is not out of the question.
One factor that makes the outlook hard to evaluate is the “fear premium” in the price of crude. Economists say as much as $10 of the recent run-up reflects growing concern about the possibility of a successful terrorist strike on a major pipeline or distribution terminal in the Middle East. Those fears were fanned by recent attacks at an office and housing compound used by foreign oil executives in Saudi Arabia, in which 22 people were killed, as well as the recent sabotage of Iraq’s principal oil export pipelines.
“One can envision an increase that would be large enough and sudden enough to sabotage even a sustainable recovery like this one,” said Peter Kretzmer, senior economist with Banc of America Securities.
Absent a supply shock of that nature, some industry experts expect oil prices to subside gradually as the peak summer driving season passes, refiners rebuild inventories, China’s torrid economy begins to cool and members of the Organization of the Petroleum Exporting Countries make good on promises to boost production.
That does not mean that prices will fall back to the mid-$20s level of a year ago, however. Several analysts say they believe that the natural settling point is somewhere in the low $30s, with occasional fluctuations in either direction as market conditions change.
The country consumes about 20 million barrels of petroleum every day -- about 1 of every 4 used around the world. Domestic production has declined to about 8 million barrels a day; imports provide about 12 million.
Higher prices paid for domestic oil represent a huge transfer of wealth from U.S. consumers to producers. The effect on the overall economy is minimal, but the shift produces big losses and gains at the consumer and business level.
U.S. motorists top the losers’ list in sheer numbers. Two-thirds of the petroleum consumed in this country is refined into motor fuel. Gasoline prices have risen proportionately more than crude prices because of a shortage of refining capacity and fuel-blend requirements that make it difficult to move gas from one market to another.
Airlines also have been hard hit, along with truckers and farmers. Industries that use petroleum as a primary feedstock, such as chemicals and plastics, will be hurt by higher prices unless they can pass the added costs along to customers.
At the same time, the additional revenue is increasing the profits of oil companies, enriching investors and royalty owners and providing an economic boost to states and regions with significant oil production.
“There’s been such a focus on gasoline prices,” oil expert Yergin said. “But oil flows into every nook and cranny of our economy in many ways that people don’t see, from the cost of the plastic they use to bag fruit at the supermarket to the dismal financial plight of the airlines.”
The higher prices paid to foreign oil producers have a more debilitating effect on the economy, analysts say.
Because that money is extracted from the United States, it is the equivalent of a huge tax that generates no compensating benefits -- unless the foreign countries use their oil revenues to buy American products or investments. Inflation rises as businesses incur higher energy and transportation costs and try to pass those costs to customers. Economic growth slows because consumers are left with less money to spend on everything else.
Still, some analysts see opportunity amid adversity. Energy economist Williams said higher oil prices could help overcome the political inertia that has stymied efforts to expand domestic production on the one hand and promote conservation and alternative energy sources on the other.
“It’s hard for people to see an advantage in high oil prices,” Williams said. “But at these prices, a lot of alternatives start looking better.”
