U.S. Resilience Tested

Ken Silverstein EnergyBiz Insider Editor-in-Chief

High demand and short supply have pushed the prices of oil and natural gas into record territories. Oil, as high as $70 a barrel, is the most fungible, pervasive and transportable commodity and the price of all other fuel sources are tied inextricably to it. In other words, high oil prices help push up the cost of natural gas and coal, which are also in high demand.

Indeed, NYMEX natural gas futures for December now sit at more than $12 per million BTUs while coal spot market prices have risen from $30 a ton to $60 a ton. But that type of gyration is worrisome to a lot of analysts who fear that businesses that use lots of energy such as the airline and car companies or chemical and fertilizer makers will get badly hurt. They are also concerned that consumers will spend more of their incomes on energy and less on other essential products and services.

"A jump above $100 oil could well trigger a recession," says David Wyss, chief economist at Standard & Poor's Rating Services.

Commodity prices are underscored by quality, location and form, says John Tobin, with the Energy Literacy Project in Colorado. And while it all may sound esoteric, the bottom line is that commodities will usually move up and down with each other--but that relationship can vary. In other words, prices can differ for oil and gas based on whether it is light or heavy or on the level of sulfur content. At the same time, the market has to factor in transportation costs. Oil and natural gas prices tend to follow each other within 10 percentage points.

When natural gas prices were low in the 1980s and stood at about $2 per million BTUs, supplies were relatively plentiful. But, when the Clean Air Act of 1990 passed and tougher emission limits were put into effect, the demand for natural gas soared and supplies tightened. Prices shot up in 2001 to $6 per million BTUs as more gas-fired generators came on line. Today, in the wake of Hurricane Katrina, natural gas costs $10 per million BTUs many places around the country.

In the case of West Virginia consumers, they paid a little more than $100 a month for heating in January 2002 but are expecting to pay $200 for such heating in January 2006. In fact, local distribution companies in the state have already asked for 50 percent rates increases to be implemented over a couple years. Now, they are asking for another 20 percent increase over three years. While such "downstream" entities can typically pass along the higher costs, the industrials that pay for it oftentimes cannot absorb the added costs and they therefore turn to other alternatives, hurting the local gas companies.

Price Sensitivity

Not only are natural gas prices skyrocketing but they are also becoming more volatile. No one really knows where prices will settle. Even if the prices re-adjust at $5-$7 per million BTUs, all bets are off when it comes to predicting long-term natural gas usage.

In its "Accelerated Depletion: Impacts on Domestic Oil and Natural Gas" study released in 2001, the Energy Information Administration said that if the original 30 trillion cubic feet demand projection is to reach fruition by 2025, then the price of gas would have to remain less than $3.25 per million BTUs. It also said that producers would need to maintain high levels of drilling and have access to basins off the Florida coast and in the Rocky Mountains -- something that doesn't appear will happen anytime soon.

"Many forecasts, with respect to future natural gas demand, fail to take into account price sensitivity," says Billy Jack Gregg, head of the consumer division for the West Virginia Public Service Commission. "Consumers, industry in particular, will not use a commodity ad infinitum. They will employ the technologies to increase efficiency and decrease consumption. They will switch fuel sources. It will take some time to make the adjustments. If we begin to conserve, prices will fall, again."

The economy, in part, has absorbed the price increases in oil and natural gas because it takes less energy now to produce one unit of gross domestic product. Put simply, in the 1970s, the economy was more energy intensive than it is now, but energy was relatively cheap back then. Today, energy costs are higher but new technologies along with tougher environmental regulations have increased efficiencies. Chemical plants, for instance, no longer flare off steam waste. They recycle it to create even more energy.

The added efficiency, however, is still not enough to offset short supplies in oil and natural gas. And the crunch is unlikely to ease anytime soon. By knocking out about 20 percent of all U.S. oil and gas production, Hurricane Katrina has made an indelible mark on the economy here. And while most analysts say that such production will ultimately resume, it could take up to a year to repair platforms, pipelines and equipment.

Economic Cycles

Natural gas futures for January on the NYMEX are now more than $12.50 per million BTUs. But at least one analyst says that such prices could hit $15 per million BTUs by the beginning of the New Year. Philip Verleger, a visiting fellow at the Institute for International Economics, wrote in a paper that the United States could see price hikes of 60 percent between August and year end. That, in turn, will cause utilities to dispatch more oil-fired generation and the upward price spiral will continue.

"Rising prices are going to require consumers to double expenditures on gasoline, electricity, and heating fuels," says Verleger, in some measure because of Hurricane Katrina. "Other spending will be cut and recession will follow." Rising energy prices, meantime, are affecting many American companies that include the airlines and automotive sectors -- something that S&P says could impact the creditworthiness of industries that use lots of energy or sell products that use a lot of energy.

The pliability of U.S. consumers and industry is being assessed. At some point, energy prices may rise high enough to where it might create an economic downturn and then subsequently spawn initiatives to use alternative fuel sources. Such cycles take time to play out but they are natural off-shoots of a free economy. In the end, oil and natural gas prices will settle but at levels higher than they have historically been.

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