Oil loses power to drive boom off course

SUNDAY TIMES (LONDON)

January 23, 2000

Observers are having a hard time figuring out what to make of it all. The American economy continues to power ahead, with the latest survey by the Federal Reserve showing strong growth in almost every region of the country. Yet inflation remains at unthreatening levels, despite a leap in oil prices of a magnitude that it was once thought would wreak havoc with the country's economy.

The price of crude oil has more than doubled since last March and this has, of course, had its effects. As petrol prices have risen, trucking companies have had to raise transport charges, and airlines are complaining that the rise in jet fuel prices from about 50 cents a gallon last year to about 65 cents now is eating into profits or, in the case of Continental Airlines, driving it into the red. And a cold snap in the northeast of the country has made it expensive for New Englanders to keep their homes toasty warm.

More important, rising oil prices are starting to affect the headline rate of inflation. Not to worry, say some: the key indicator is the core inflation rate, which excludes so-called volatile items such as oil. But if oil is likely to remain at the present price of $ 26, or move to the $ 30-$ 40 range, as some are predicting, it cannot be excluded from central bankers' considerations when they sit down to decide by how much to raise interest rates. Wage escalators in labor contracts are geared to the headline inflation rate, not the core rate. So rising oil prices will feed through into wage increases in some industries.

But Americans are unworried. In the past, rapid increases in oil prices had a shattering effect on the stock market and produced the dreaded stagflation that stalled the economy for years on end. Now, there is hardly even a grumble - and with some reason.

For one thing, a gallon of petrol is still 10 cents cheaper (in real terms) than it was in 1973. For another, oil has become far less important to the economy. In the 1970s, when the Arabs unsheathed the oil weapon, spending on oil products accounted for almost 9% of gross domestic product; now it accounts for about 3%. More efficient car engines are one explanation. Another is the steady shift of the American economy from being oil-driven to being IQ-driven. Then, too, an increasing number of manufacturers have the ability to switch from oil to natural gas when the cost of oil soars.

Policymakers have a more important reason for not being overly concerned about the price increases: they have learnt from past mistakes. In the 1970s they attempted to offset the drag effect of higher oil prices by loosening monetary policy. The result was a spate of inflation. Today, with the economy growing at more than 4% and unemployment virtually non-existent, the Fed would not feel any need to loosen the monetary reins, even if oil prices rise further, and may well tighten to offset any inflationary effect of the higher fuel prices. Such tightening, estimates the Organization for Economic Co-operation and Development, would reduce the effect of a $ 10 per barrel increase in oil prices on the general level of consumer prices from 1.2% to a less significant 0.5%.

Indeed, some energy policy experts are hoping that OPEC's recent production restraints will remain in place. They argue that America's interests are not served by low oil prices. Amy Myers Jaffe and Robert A Manning, energy analysts at Rice University and the Council on Foreign Relations, respectively, warn in the recent issue of Foreign Affairs that "long-term trends point to low oil prices over the next two decades. Paradoxically, this ... could destabilize oil-producing states, especially those in the ellipse stretching from the Persian Gulf to Russia", causing a "backfire" that could "imperil U.S. interests".

Jaffe and Manning are surely right that in the long run there will be a glut of oil. It will take more cohesion than OPEC has shown in the past for it to stick to the production restraints that are currently driving up prices. It is not at all clear that cash-strapped Saudi Arabia will cut back even more on its production to make room for Iraq, Iran and Libya, when those states again are in a position to become important suppliers to the world's consumers. Indeed, Iraq has let it be known that when the embargo ends it intends eventually to lift output to 6m barrels a day, which amounts to 25% of OPEC's current production.

Nor is it clear that the markets on which oil producers have historically relied will be theirs in the future. Concern over the impact of fossil-fuel use on the environment is putting pressure on carmakers to come up with alternatives to petrol. Toyota and Honda will soon roll out cars that combine batteries or electric motors with petrol engines - and use half as much petrol as existing models. And by the beginning of the next decade we are likely to see the introduction of fuel cells that combine hydrogen and oxygen to produce electricity. Paul Portney, president of Resources for the Future, a prestigious non-partisan Washington think-tank, says that "fuel cells are the likely fuel-propulsion mechanism in the future". In the manufacturing sector, the shift to cleaner-burning natural gas is likely to continue. It may even accelerate as the cost of transporting natural gas to consumers continues to fall.

So, looking down the road into the middle of this new century, we are more likely to see the oil age coming to a close because we have less need for it, than because we run out of the stuff. After all, the stone age did not end because we ran out of stones.