Energy: The Big Squeeze

What's going on? Prices of gasoline and crude oil have been edging up for months, but in recent weeks they've hit the stratosphere. The national average price at the pump as of May 4 was the highest ever recorded, $1.84 a gallon for regular. In California, truckers have blocked traffic in Los Angeles and staged protests against the high price of diesel. Oil is nearly $40 a barrel -- the highest since just before the Gulf War in 1990. The combination is raising the possibility that high energy prices could hurt consumer spending, whack corporate profits, hike inflation, and hinder the recovery. Some even fear that gas stations could briefly run dry this summer. How worried should we be? Here's a look at what has gone wrong, how bad things could get, and what might be done.

Why are prices so high?

Much of the 50% rise in crude oil prices over the past year stems from strong demand in China and the U.S. OPEC's restraint on production has also boosted prices, even though actual cuts have been minimal. And more than ever, terrorism looms. Energy markets are jittery following a month of terrorist attacks in the Persian Gulf, including the murder of five Western oil workers in Saudi Arabia on May 1. Many are contemplating anew what would happen if Saudi oil supplies were interrupted, even temporarily.

Gasoline prices have risen even more sharply than can be explained by the rise in crude. That's because traders are worried that refiners won't be able to keep up with soaring demand over the summer. Thanks in part to record sales of gas-thirsty SUVs, consumption has in the past three months risen 4.6% over a year ago. That has left refineries stretched thin. Nervousness remains high even though gasoline stockpiles rose by 2% in April.

Will gas keep going up?

Probably. The recent increase in oil futures prices will likely be passed along at the pump. Mark A. Baxter, executive director of Maguire Energy Institute in Dallas, says gas prices could jump another 10 cents to 15 cents this summer.

Will this summer see a repeat of the 1970s, with shortages and long lines at gas pumps?

It's possible, but unlikely. U.S. gasoline inventories are 2.7% below their five-year average for the season. But refineries have some room to hike production. According to the Energy Dept., they are running at 93% of capacity, vs. a 10-year average of 94.4%. In the 1970s, government allocation controls prevented market forces from bringing supply and demand into balance, says John Felmy, chief economist of the American Petroleum Institute. Without such controls, he predicts, "We won't have gas lines."

That said, there's little margin for error. Bill Greehey, CEO of Valero Energy Corp. (VLO), the third-biggest U.S. refiner, says U.S. refineries will be unable to produce all the gas needed this summer, so imports will have to fill the gap. Indeed, imports now satisfy about 9% of U.S. demand, up from about 5% in 1998. But this year foreign refiners have had trouble meeting new U.S. formulation requirements. If problems hit, spot shortages could develop and prices could leap again.

Where is the greatest risk of shortages?

In California, because it is a gasoline "island." The state has to produce about 90% of the gasoline it needs because of its special gas formulation rules. Markets are so tight there that a relatively minor event, the Apr. 27 rupture of a refined-products pipeline in Northern California, triggered a low-level alert. Gasoline supplies in California through Apr. 30 were 9% lower than a year earlier, according to the California Energy Commission. One or two large refinery outages could cause major trouble.

How much damage are the higher energy prices doing to the economy?

The problem is twofold: High energy costs suppress consumer spending on other items, and they increase the rate of inflation. That's an unpleasant combination. David A. Wyss, chief economist at Standard & Poor's (MHP), estimates that each $10-a-barrel increase in the price of oil subtracts 0.25% from the economy's growth rate. Worldwide, the International Energy Agency recently estimated that economic growth would have been at least half a percentage point higher in the past two or three years if prices had remained at mid-2001 levels -- around $25 a barrel for New York Mercantile Exchange-traded crude. Still, the Federal Reserve remains optimistic that energy prices won't knock the recovery off track.

How are businesses coping?

Some better than others. High energy prices particularly hurt the petrochemical and transportation sectors. Dow Chemical Co. (DOW)Chief Financial Officer J. Pedro Reinhard says Dow's energy and feedstock costs rose 33%, to $11 billion, last year and are higher still in 2004, forcing Dow to raise prices an average of 8% in the first quarter. Elsewhere, the pain has been even sharper. John Heimlich, chief economist at the Air Transport Assn. trade group, says airlines are likely to lose $2 billion to $3 billion this year, but could have broken even if oil prices were $5 or $6 a barrel cheaper. To reduce weight and fuel costs, he says, airlines are lightening up on everything from magazines to seat-back phones.

What could trim prices?

An economic slowdown would do the trick, but nobody wants that. OPEC could help by producing more oil. It cut quotas by 1 million bbl. a day in April. Although members are cheating on their quotas, OPEC output did drop by 300,000 bbl. or 400,000 bbl. a day in April, contributing to the jump in prices. OPEC President Purnomo Yusgiantoro said on May 5 that the cartel might discuss raising quotas when it next meets in Beirut on June 3. But rather than reopen that can of worms, OPEC is more likely simply to tolerate a little more cheating, predicts Adam Sieminski, an oil analyst at Deutsche Bank in London.

Can the U.S. do anything for this summer?

Only stopgap measures are available. The Energy Dept. could stop adding oil to the Strategic Petroleum Reserve -- or even release supplies -- but the Bush Administration insists it won't. The Environmental Protection Agency could ease prices in California, New York, and Connecticut by letting those states sell gasoline without ethanol this summer. Another unlikely option: a cut in the federal gasoline tax.

What about the longer term?

The Bush Administration is trying to encourage the oil and gas industry to increase supply. It has, for instance, eased antipollution rules, which should increase incentives for refiners to add capacity, says Robert G. Slaughter, president of the National Petrochemical & Refiners Assn. The Administration also favors more drilling for oil, including in the Arctic National Wildlife Refuge.

What about efforts to encourage conservation or reduce consumption?

Environmentalists say the White House should promote conservation more aggressively. But there's little political support for a big increase in mileage standards or higher gasoline taxes. Meanwhile, Detroit is happily meeting the public's demand for pick-ups and SUVs. More palatable in Congress would be expanded tax incentives for fuel-efficient vehicles. For the long term, the Bush Administration advocates fuel-cell vehicles whose hydrogen fuel could be generated using alternatives to oil such as coal or solar power. But federal spending on energy research has fallen under both Bush and predecessor Bill Clinton. Bush's Democratic challenger, Senator John F. Kerry (D-Mass.), favors tougher mileage standards and more renewable energy.

What can consumers do?

If gasoline remains expensive for a long time -- or if shortages hit -- consumers will switch to more fuel-efficient vehicles, as they did in the 1970s. That may be starting to happen. While sales of big SUVs have been strong for the year as a whole, they took a beating in April. "At today's prices at the pump, you do see some impact at the margins," says Ford Motor Co. sales analyst George Pipas.

Fuel prices are still below their inflation-adjusted highs of the early 1980s. But that's cold comfort to a nation of gas-guzzling SUV drivers who are as close to a real energy crisis as they've been in years. By Peter Coy in New York and Stephanie Anderson Forest in Dallas, with Michael Arndt in Chicago, Christopher Palmeri in Los Angeles, Kathleen Kerwin in Detroit, and bureau reports

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