Hitting the Economy

By Robert J. Samuelson

Newsweek Sept. 12, 2005 issue - We're getting a painful lesson in economic geography. What Wall Street is to money, or Hollywood is to entertainment, the Gulf Coast is to energy. It's a vast assemblage of refineries, production platforms, storage tanks and pipelines—and the petroleum engineers, energy consultants and roustabouts who make them run. Consider the concentration of energy activity. Oil production in the Gulf of Mexico accounts for nearly 30 percent of the U.S. total. Natural-gas production is roughly 20 percent. About 60 percent of the nation's oil imports arrive at Gulf ports. Nearly half of all U.S. oil refineries are there. Katrina hit this immense system hard. The shock wave to the U.S. and world economies—which could vary from a temporary run-up in prices to a full-blown global recession—depends on how quickly America's energy-industrial complex repairs itself.

No one knows the answer to that, because damage assessments of closed refineries and crippled production platforms and pipelines are still spotty. In 2004, Hurricane Ivan dislodged undersea pipelines connecting production platforms with the coast. "Some pipelines moved half a mile," says Jim Osten of Global Insight. "It was as much as six months before the most damaged got back into production." Nor is it clear how quickly the Port of New Orleans will resume anything like normal operations. "I'm getting reports of weeks or longer," says Aaron Ellis of the American Association of Port Authorities. Port officials haven't been able to inspect fully shipping channels and docks, because "they've been involved with search and rescue."

As Katrina approached, hundreds of the Gulf's production platforms were evacuated, shutting down 95 percent of its oil production and 88 percent of its natural-gas output. Refineries representing an eighth of the U.S. total either halted or cut their runs. Energy prices jumped immediately, and most economists expect them to stay up. In parts of the South, gasoline rose to nearly $6 a gallon. Nationally, gasoline prices "have to be over $3 a gallon for the rest of the year to bring supply and demand into balance" by slowing consumption, says Lawrence Goldstein of the Petroleum Industry Research Foundation. He thinks that some refineries won't come back for months. President Bush decided to release crude oil from the Strategic Petroleum Reserve, the nation's 700 million-barrel stockpile; but the immediate problem was the refinery outages and the resulting gasoline shortages.

At a minimum, this will hit consumers' pocketbooks—and perhaps their confidence. Before Katrina, Goldstein estimated that consumers' annual fuel bills this year would average about $250 more for gasoline and $400 more for home heating oil and natural gas than in 2004. Now he reckons those amounts will go up 30 percent to 75 percent. Costlier energy could adversely affect consumer spending, corporate profits and inflation—or all three. "We could be reaching a tipping point on consumer psychology, especially when people get their home heating bills," says Mark Zandi of Economy.com. "Those will be big."

Still, few economists are predicting a recession. Zandi says he's tentatively shaved his forecast for second-half growth from 4 percent to 3.5 percent. On the whole, the U.S. economy has stood up well to shocks. In the three months following September 11, it actually pulled out of a brief recession. The housing boom remains strong; the government reported last week that home prices rose 13.4 percent in the past year, the largest increase in more than 25 years. The 4.9 percent unemployment rate is the lowest since August 2001. The Federal Reserve, which has been raising overnight interest rates since June 2004, might decide to call a halt later this year. "The run-up in energy prices, in terms of the negative effect on the economy, can be a substitute for rate hikes," says economist Stuart Hoffman of PNC Financial Services.

Even the direct effects of Katrina aren't entirely clear. Airlines will inevitably suffer from higher jet-fuel prices, and tourism to the Gulf Coast will plummet. But the impact on agriculture, aside from higher fuel prices, may be slight. In 2004, Gulf ports handled 22 percent of U.S. wheat exports, 71 percent of corn exports and 65 percent of soybean exports, according to the Agriculture Department. By themselves, the figures imply a nasty bottleneck for U.S. exports and global food supplies. The good news is that the big grain movements don't occur until late fall, after the harvests, and, by that time, Gulf ports may be working again. Finally, the rebuilding of devastated areas could actually boost the economy in late 2005 and 2006.

What clouds all forecasts is the precarious state of the world oil market. Even before Katrina, it was operating on a razor's edge. In the 1990s, global oil demand increased sluggishly, with annual increases averaging about 1.4 million barrels a day (mbd), according to economist Mary Novak of Global Insight. Then in 2003 and 2004, global demand—led by China—exploded, adding about 5mbd over two years. This exhausted most spare worldwide crude production capacity, she says. The resulting pressures pushed world prices from about $25 a barrel in 2002 to near $40 in 2004 and now to almost $70. Global refining capacity likewise failed to keep pace; it's increased only 700,000 barrels a day over the same period, says Goldstein.

Something similar has happened in natural gas. "American production has been pretty much flat," says Jonathan Cogan of the Energy Information Administration. Demand is rising, and imports (from Canada or as liquefied natural gas) haven't filled the gap. Price pressures have intensified. In 2002, wholesale natural-gas prices averaged about $3.50 per thousand cubic feet. Just before Katrina, they were $9.86; last week they rose to more than $12.50.

These developments have profoundly altered global energy markets. "You have always had problems of pipelines going out, refinery explosions or weather-related disruptions," says Goldstein. But the system had ample spare capacity to produce more crude oil, refine more finished fuels or store them both. A supply shortfall in one part of the system could be made up in another. The resulting price changes were typically small, a couple of cents a gallon or less.

"Today when things go wrong, you don't have these cushions," he says. It's possible to balance supply and demand only through price changes. Because fuels are so essential to most people and companies, the needed increases must be steep. Buyers don't quickly cut their consumption. Indeed, the fear of shortages could make things worse by inspiring people to fill up more often, says Goldstein.

It is this remorseless logic—the old law of supply and demand—that poses the greatest peril for the American and world economies. The most obvious danger is that there will be other disruptions that compound today's scarcities: another damaging hurricane; a terrorist act in the Middle East; a politically inspired production cut (from, say, Iran); political unrest in a major supplier (say, Nigeria); an unplanned pipeline or refinery outage.

One way or another, the effects will ripple around the world. High prices and tight supplies are already expected to attract fuel to the United States from the rest of the world. If oil prices reach $100 a barrel, the United States would come close to a recession, according to a projection by Global Insight. The same depressing influences would also be felt in Europe, Japan and China, which are all major oil importers. Katrina might then perversely become the instrument by which oil prices collapse, because—being too high—they overwhelmed the world economy.

© 2005 Newsweek, Inc.