Oil and troubled waters

Sep 6th 2005
From The Economist Global Agenda

The economic effects of Hurricane Katrina, like the human costs, are hard to predict. But the disaster is already putting upward pressure on oil prices at a time of strong demand, tight supply and refining bottlenecks

OVER the past week, a shaken nation has watched a Hobbesian nightmare unfold on its television sets. Americans have begun asking their officials pointed questions about who let this happen, but they are also questioning themselves, discarding their faith that the terrorist attacks of September 11th 2001 had finally taught Americans how to pull together in a crisis. Long after the looting has stopped and the refugees have been resettled, the reverberations of the Hurricane Katrina disaster will be felt in the American psyche.

But these are not the only effects that will reach beyond the flooded streets in time and space. Economists are already hard at work, rewriting their forecasts to account for the toll that Katrina may yet take on the nation’s economy. The affected area’s ports move a large fraction of America’s imports—including critical oil and gas supplies—as well as roughly half its grain exports. Action Economics, a market-analysis firm, has already nudged its forecast for GDP growth down to 4.4% from 4.6%, at an annualised rate, for the current (third) quarter.

While big hurricanes like Katrina destroy wealth, they sometimes lead to a temporary surge in GDP as the downturn immediately after the storm is made up for by the burst of economic activity that takes place when the rebuilding begins. In the case of Katrina, however, any output boost will be balanced by the effect on the area's energy infrastructure. In a research report from Merrill Lynch, David Rosenberg says that while rebuilding could add $40 billion to America's GDP, disruptions to energy supplies could raise prices enough to claw back $30 billion of that gain.

The Gulf of Mexico provides about a tenth of all the crude oil consumed in America; and almost half of the petrol produced in the country comes from refineries in the states along the Gulf's shores. Though some pipelines have begun operating again at reduced capacity, some three-quarters of the region's natural gas production, and over 90% of oil output, are still shut down, and the Department of Energy reported last Thursday that ten refineries, processing 1.9m barrels per day, were out of action. Twelve more refineries have been forced to cut production owing to supply shortages.

This is bad news considering that refineries had been running flat out in recent months to keep up with high demand. The government is doing what it can to ease the bottlenecks: oil has begun to flow from the national Strategic Petroleum Reserve to refiners caught short; the administration has lifted restrictions on foreign ships making deliveries between American ports; and the Environmental Protection Agency has temporarily relaxed some fuel regulations until September 15th, which will prevent differences in petroleum standards among American states from causing local shortages. Other countries have also responded: Europe has offered petrol from its reserves (America stockpiles only crude oil). Nonetheless, average petrol prices nationwide hit $3 for the first time on Monday September 5th, the Labour Day holiday. In southern states such as Georgia, some retailers have been charging more than $5 a gallon.

The real concern, however, is not how high prices will go, but how long they will remain there. After the American Petroleum Institute said last week that the effect of Katrina on oil and gas production would be “significant and protracted”, oil rose towards the record $70.85 it had hit earlier in the week; by Tuesday, it had fallen back again to just under $67. Though in real (inflation-adjusted) terms prices are still lower than in the wake of the Iranian hostage crisis in 1979, that reassuring mantra has worn thinner in recent months as real prices have edged closer to those historical highs. Furthermore, while much of the recent oil-price increase was demand-driven, and thus expected to have relatively benign economic effects, any sizeable outages owing to Katrina could cause a supply shock similar to those that repeatedly battered the world economy in the 1970s.

Those fears may be overdone. But $70 oil and petrol futures at double the level of a year ago raise the possibility of lingering economic effects, particularly if the region’s oil infrastructure takes months to get back online. Though America’s economy has recently posted enviable growth rates, these have been kept up by consumers who have run down savings and taken on debt in order to keep spending growing faster than their income. With consumers stretched thin and interest rates rising, a prolonged period of high petrol prices might well force households to retrench, at least temporarily. Mr Rosenberg calculates that every one-cent rise in the price of a gallon of petrol takes $1.3 billion out of consumers’ pockets, which could trim as much as a full percentage point off consumer spending this winter. Speculation is growing that the Federal Reserve will temporarily halt its steady tightening of the money supply at its next meeting, on September 20th.

Already there are calls for policy changes to fix the flaws in America’s energy infrastructure exposed by Katrina: its tight refining capacity, its dependence on offshore drilling in the hurricane-prone Gulf, its love affair with big, inefficient cars. The Senate committee on energy has scheduled a hearing for Tuesday to explore some of these issues.

But oil and gas are not the only industries to be affected. While construction companies and their suppliers are no doubt gearing up for a bumper season when the waters recede, agricultural exporters are busy looking for alternative shipping routes if Gulf ports do not re-open soon. Particularly hard-hit will be the corn harvest, which started last week, but all farmers will suffer from higher energy prices. Insurers, of course, will take a nasty hit to earnings from claims that may run as high as $25 billion. And the combination of cancelled flights and higher jet-fuel prices threatens to push more airlines into bankruptcy.

Innocents abroad

The ripples will spread even beyond America’s shores. Many other nations, particularly in Asia, are heavily dependent on robust American demand for their exports; and some are already feeling the pain of high oil prices. Indonesia's central bank was forced to raise interest rates sharply last week to stem a near-10% drop in the rupiah. Partly thanks to lavish fuel subsidies, Indonesia’s oil imports, financed in dollars, have touched off fears of a balance-of-payments crisis, driving the currency sharply downwards. While rich countries are much less dependent on oil than they used to be, thanks to increases in fuel efficiency and a shift from manufacturing to services, middle-income countries are still big energy guzzlers: India and South Korea use more oil per dollar of GDP today than they did in the 1970s.

Even in less-thirsty Europe, there are fears that economic recovery could be choked off in its infancy by the steady upward march of prices for petrol and heating oil. That would weaken another of Asian exporters’ main markets and leave the world economy looking vulnerable. If the damage Katrina has done to the Gulf's oil-pumping capacity forces Americans to shop abroad for more fuel to feed their appetites, it could be a long cold winter for everyone.

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