Oil Prices Threaten Recovery
As Saudis Try to Reassure U.S.

Oil prices hovering near $30 a barrel on fears of a U.S.-Iraq war are threatening to impede a U.S. economic recovery, even as Saudis and some other OPEC members said they would make up shortfalls if there's an attack.

Officials of the Organization of Petroleum Exporting Countries, concerned about avoiding a price collapse in the spring, raised doubts that the cartel would formally increase supply to reduce prices at its meeting Sept. 19 in Osaka, Japan. The high price of oil could squeeze both corporate profits and household incomes, and hurt the consumer spending that has been the economy's mainstay in the past year. It comes as growth forecasts already are being revised downward for the rest of the year.

With the price of a barrel peaking at $30.11 last week and Saudi ambassador Prince Bandar bin Sultan scheduled to meet President George W. Bush at his Texas ranch Tuesday, Saudi officials sought to reassure the markets and U.S. officials. They and other OPEC suppliers who see Iraq as a regional threat have indicated to the Bush administration that they will sell more oil and fill any shortfalls that might result from war. Because of its cuts in production, OPEC has spare capacity of about six million barrels a day that it could put into the market, most of it in Saudi Arabia.

At the same time, OPEC is signaling it is reluctant to raise its formal production quotas, even though demand rises as winter nears. Officials of the cartel don't think the high price is a result of fundamentals, but of fears about a U.S. invasion. "We would have to be very cautious about doing anything that would lead to a price collapse next year," says Adnan A. Shihab-Eldin, OPEC's chief economist.

The economic consequences of keeping the spigot turned down could be serious. Economists note that the last four U.S. recessions have coincided with -- or been preceded by -- $30-a-barrel oil. A return trip over that $30 threshold now wouldn't necessarily mean a renewed recession because the economy is less reliant on oil than in the past. But, says Jan Hatzius, an economist with Goldman Sachs, "it ranks as a big risk."

Oil prices broke the $30 mark several times early in 2001 as OPEC sought to keep supplies tight. Fears over an Iraq-related shortfall now are exacerbated because OPEC's production limits are keeping global inventories from being built up; they normally act as cushions against supply-and-demand shocks. OPEC's strategy "opens the market up to momentary spikes," says Larry Goldstein, president of the New York-based Petroleum Industry Research Foundation.

The impact of $30 oil prices hasn't yet been felt, but Mr. Hatzius says they could become significant if prices remain above $30 for several months. One reason for the muted impact so far: Gasoline prices have been more stable. While gasoline prices are up from their December lows, they remain 3.5 cents below a year ago, at $1.39 a gallon for regular gasoline, according to the Department of Energy's Energy Information Administration. The prices have been held down by increasing supplies of gasoline imports. But over time, they can be expected to rise, along with home heating bills, if oil prices stay up.

Bad Timing

Goldman Sachs estimates that every sustained dollar increase in oil prices amounts to a $5 billion transfer of income from American households to oil producers. Such a tax would come at a bad time for many household budgets, with the job market appearing to have stagnated and wage growth slowing.

Last year at this time, gasoline prices began falling substantially, dropping to a low of about $1.06 a gallon by December. Those sharp declines helped fuel consumer spending in the months after the shock of Sept. 11 and as holiday shopping approached.

OPEC is under a certain amount of pressure to increase oil production. OPEC members Nigeria, Algeria and Venezuela are chafing at their quotas, and non-OPEC countries such as Russia continue to gain market share by boosting output, while the cartel has slashed official quotas by five million barrels a day since early 2001.

OPEC itself projects global oil demand will increase in the fourth quarter to 77.8 million barrels a day, a rise of 1.8 million barrels a day from the third quarter. Some of that demand is seasonal. But demand is also higher than in the fourth quarter of a year ago, when it had fallen after the Sept. 11 terrorist attacks.

OPEC officials have in past months indicated that a fourth-quarter rise in demand of more than 1.5 million barrels a day would merit an official output boost, but it appears the cartel may prefer to drip-feed supplies into tightening markets. OPEC is already producing about 25 million barrels a day, more than 1.5 million barrels over its official quota.

Side of Caution

"OPEC prefers to err on the side of caution," says Leo Drollas, deputy director for the London-based Centre for Global Energy Studies, who predicts that OPEC will wait until January next year to officially raise its output.

Rising oil prices also have the potential to hurt corporate profit margins -- by increasing materials costs -- at a time when companies are trying to recover from last year's historic profit collapse. Airlines are especially vulnerable, with jet-fuel costs up about 1% from a year ago, and up 4% from their December lows.

Added together, this is likely to restrain an already limping economy. Macroeconomic Advisers, a St. Louis forecasting firm, revised its predictions for the second half of the year to 2.5% annual growth from 3.25%. But even the new forecast was built on the assumption that oil prices would average $26 to $27 a barrel. Higher-than-predicted oil prices darken the growth outlook even more. According to Joel Prakken, the firm's chairman, every $10 increase in the price of a barrel of oil shaves about 0.5% off growth.

The Energy Department says U.S. crude-oil stocks have been declining since March, while global inventories are falling at a rate of 600,000 barrels a day, according to the Centre for Global Energy Studies. The United Nations' retroactive pricing formula for Iraqi oil continues to discourage traders from buying Iraqi crude, further cutting global supplies by some 500,000 barrels a day.

Next year, OPEC estimates demand will rise by a modest 790,000 barrels a day to 76.95 million barrels a day, with non-OPEC supply up 920,000 barrels a day. The Paris-based International Energy Agency sees non-OPEC supply rising less, by 700,000 barrels a day next year, but OPEC officials stick to their forecast. "In the longer term, this doesn't appear to be a market in need of oil," said Mr. Shihab-Eldin, the OPEC economist. "There is plenty of supply."

The spiking oil prices have had less of an impact in Asia, where strengthening currencies have helped offset the price of oil, which is traded in dollars. Japan and Korea, Asia's two largest oil importers, have seen their currencies appreciate more than 8% against the dollar this year. And in Korea, an official from the Ministry of Finance and Economy told reporters that rising oil prices haven't affected the economy.

Perhaps the biggest worry for Asia is that high oil prices will slow spending by U.S. companies and consumers. That could threaten exports from Asia and likely stall the growth experienced in most Asian countries so far this year.

Write to Thaddeus Herrick at thaddeus.herrick@wsj.com, Jon E. Hilsenrath at jon.hilsenrath@wsj.com, Bhushan Bahree at bhushan.bahree@wsj.com and Phillip Day at phil.day@wsj.com

Updated August 26, 2002 10:05 a.m. EDT