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|  | AUGUST 12, 2004
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 and consumer spending 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's 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, 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.
BW MALL
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