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SEPTEMBER 13, 2004

NEWS ANALYSIS
By Amey Stone

$50 Oil: A Spreading Slick of Pain

Prices will most likely head back up -- and if that happens, growth and the economy will be going down

In recent weeks, Americans have enjoyed some respite from oil's seemingly relentless march to $50 a barrel. After peaking at $49.40 in mid-August, the benchmark light-sweet crude trading on the New York Mercantile Exchange had fallen to $42.50 by the first week of September. But prices lately have started to climb again, on reports of lower inventories and worries about the possible impact of Hurricane Ivan on Gulf of Mexico production. On Sept. 10, crude nearly hit $45 a barrel before slipping back again.

Brace yourself. Even if oil doesn't hit $50 a barrel in the next week or so, high-priced crude isn't going away. Moreover, the pain in your pocketbook may be just starting. The problem isn't just higher gasoline prices -- although that's where consumers have felt the impact first. In many ways, that's just the most readily visible effect.

As Federal Reserve Chairman Alan Greenspan explained in a Sept. 8 briefing on Capitol Hill, the oil-price jump affects the entire U.S. economy and has already contributed to a summer slowdown in growth. While Greenspan emphasized that the country is riding out of its "soft patch," many economists aren't so sure.

When you take a broad view of the effects of higher oil prices, you see the many ways it can eat into your income -- even if you haven't yet been affected by higher prices at the gas pump. Here's how $50-per-barrel crude could shrink your income:

Higher Gasoline Prices. Let's start with the obvious. Of course, as the last few months have shown, gasoline prices don't always move in lockstep with crude. Thankfully, that meant pump prices didn't keep zooming upward in July and August as crude peaked. Instead, gasoline peaked in May at a national average of $2.05 a gallon for regular unleaded, according to the American Automobile Assn.'s Fuel Gauge Report. As gasoline inventories rose during the summer, the national average price fell back, and it's now at $1.84 a gallon.

In a Sept. 8 report, the Energy Information Administration (EIA) predicted that gas prices would continue to fall, perhaps touching down at $1.80 by yearend, thanks to high inventories. Some experts are skeptical, however. Mark Baxter, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business, expects gasoline to head back to $2 a gallon. That compares with a 2003 average price of $1.57 and a 2002 average of $1.40.

"I don't believe the price at the pump reflects the price of crude oil," Baxter says. With crude oil in the $40 to $45 range, he says, "I think we should be seeing $2 a gallon."

For a family that drives two cars approximately 15,000 miles a year, that would amount to an extra $650 or so in gasoline costs in 2004, vs. those for 2003. Many families are hit much harder, for example, if they drive long distances for work or have old or gas-guzzling vehicles, points out Susan Fulton, a principal of investment-management firm WealthTrust in Bethesda, Md. She believes lower-income families are disproportionately hurt while upper-income Americans may hardly feel the pinch. "That is the terrible truth of it," Fulton says.

Costlier Home-Heating Oil. Gasoline isn't the only oil derivative purchased by many Americans. The EIA forecasts that the average price for a gallon of home-heating oil will rise to $1.50 from $1.36, for a total average expenditure of $1,048 annually, up from $991 last year. An extra $57 might not seem like much of a hardship in a given year, but if the winter is particularly cold or you have a large, drafty house, expect a much steeper price hit.

More Expensive Transportation. Transportation companies are often the first to try to pass along higher fuel costs to customers. Consider that jet-fuel and diesel-fuel (used by truckers) prices have gone up sharply this year. Not only will it cost more for airlines more to fly their planes but all businesses will pay more to move their products to stores, too.

The good news for consumers: So far, companies haven't been able to pass along too much of the cost increase to customers yet. For example, even though jet fuel is up 40% in the past year, the average airline ticket is down 3.5%, says David Kelly, Putnam Investment's economic adviser. But airlines have recently imposed surcharges on customers who fail to buy tickets online. This is one way they're already trying to pass along increased costs, says Baxter.

Broad-Based Inflation? Rising transportation costs can trigger an upward inflation spiral. It hasn't started yet -- as reflected in the Sept. 10 report showing a slight dip in August wholesale prices. Economic history has a knack of repeating itself fairly reliably, however. And higher energy prices back in the 1970s certainly set off higher inflation. Kelly reasons that when oil prices rose in the 1970s, workers were able to exert greater pressure on employers to raise wages than they can now, and that led to steep price inflation.

This year, however, hourly wage increases remain below the level of inflation, which means companies can't push through consumer-price increases or they risk losing business. Asked if he thinks oil is contributing to inflation, Kelly's answer: "I've got a pretty emphatic no on that."

But Baxter points out that many companies will pass along higher costs when they see an opportunity, and he cites other areas that can be affected. Along with transportation costs, he points out that everything plastic is made from petrochemicals. "There we're talking just about anything not made of wood or steel," adds Baxter.

A Weaker Job Market. In the '70s, energy costs contributed to pressures on wages. Ironically, this time around they're constraining the labor market. Higher oil prices were a key factor the Fed cited in the economy's summer slowdown. Weak retail sales were one of its clearest manifestations. A slower economy means fewer jobs created as well as fewer opportunities for workers to trade up to higher-paying positions. "I don't think oil is particularly inflationary, but it is a drag on growth," says Kelly.

Lower Stock Prices. Even though wealthy Americans aren't suffering too much from higher gasoline prices, they've already felt the blow of lower equity values due to costly oil. The shocks of crude veering upward contributed to some major stock market swings this summer. Also, if companies can't pass higher costs onto consumers, this influences profits and ultimately affects valuations.

Plus, due to lower summer sales, the share prices of consumer-product companies and discount retailers are already suffering. "I don't see a lot of real retail opportunity right now," says Fulton. "The reality is the vast majority of Americans are middle- or lower-income, and they consume most of the stuff -- and they're really being creamed by higher gas prices."

Another possible market impact to consider: If higher crude prices eventually spark inflation, that, too, would crimp share prices since the Fed would likely raise interest rates further to keep inflation at bay. Thus begins what economists like to call a vicious cycle. More expensive oil is already hitting Americans, rich or poor, in the pocketbook -- whether it's directly or indirectly -- and it may well continue to do so in the months to come, in ways that go well beyond the gas pump.




Stone is a senior writer for BusinessWeek Online in New York
Edited by Beth Belton

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