The Wall Street Journal: Rising Oil and Gas Prices Add to Energy Pressure On Broader Economy: Wednesday 31 August 2005

Hurricane Katrina sent oil and gasoline futures prices sharply higher, raising concerns about the mounting pressures on the U.S. economy from rising energy prices.

Katrina shut down eight major U.S. refineries in the Gulf Coast that produce gasoline, heating oil and other products for distribution across a broad swath of the Southeast and the East Coast. The wholesale price of gasoline surged by 41.39 cents a gallon yesterday, and retail prices, which already topped $2.80 a gallon in Chicago and $2.60 in Denver, are likely to rise as well.

AAA, formerly the American Automobile Association, expects retail gasoline prices to hit $3 a gallon soon if current wholesale prices hold.

October crude-oil futures settled at a new nominal record of $69.81 a barrel in trading on the New York Mercantile Exchange, up $2.61 for the day, or 3.9%. The inflation-adjusted record remains the $39.50 barrel price reached in April 1980, equivalent to $95.26 today.

Until now, energy prices have been rising largely because of robust demand in the U.S., China and other growing economies. But Katrina represents a supply-side shock, more akin to the oil shocks of the 1970s -- and one without the price controls in the 1970s that kept the cost at the gas pump from soaring. Now, if the supply disruption lasts several weeks while demand remains strong, gasoline prices will probably surge and gobble up the piles of money that consumers would normally be putting into the broader economy.

The storm has knocked out about 10% of U.S. refining capacity for what could be an extended period, underscoring how the Gulf Coast has become a potential chokepoint in U.S. energy markets. Even a minor disruption in the area sends ripples across the country and around the globe. A major disruption can quickly drive up the cost of everything from driving a car to heating a house for people from Chicago to Berlin.

The world's biggest energy chokepoint is the Straits of Hormuz, in the Persian Gulf, through which tankers every day carry some 15 million barrels of crude oil from the oil-rich Middle East to consumers all over the world. The U.S. has spent billions of dollars and much political capital to ensure that supplies from this region are uninterrupted.

But little attention was focused on the Gulf of Mexico, where platforms produce 1.5 million barrels and tankers offload a further one million barrels every day. This oversight changed last year, when Hurricane Ivan struck. The storm triggered underwater mudslides off Louisiana that turned orderly pipeline systems into a twisted mess. Large offshore production platforms were unable to send oil and gas into markets, pushing up oil prices for months.

As companies find more oil farther out in the Gulf of Mexico, they are investing billions in production facilities. These installations are vulnerable to hurricanes, and such storms typically are stronger over water. This expansion is adding to the region's concentration of infrastructure to transport and refine oil even as output from other parts of the U.S., including Alaska, is declining.

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Katrina has flooded the areas around several major refineries and possibly the refineries themselves. Even if crude-oil production in the Gulf of Mexico is quickly restored, turning that oil into gasoline requires refineries that probably aren't going to restart soon.

Fears of gasoline shortages are spreading. Florida Lt. Gov. Toni Jennings yesterday asked drivers to avoid unnecessary trips. Chevron Corp. began rationing gasoline it provides to wholesalers from its East Coast terminals. Drivers in Urbana, Ill., crowded gasoline stations, trying to fill up their tanks before prices went up. A deal for U.S. Gulf Coast gasoline scheduled for shipment on a pipeline to North Carolina traded at an unusually high $1 premium to the price of gasoline futures in Nymex trading.

"This is going to have a nationwide effect. [The Gulf Coast] is the entry point and refining center for most of the United States," said Geoff Sundstrom, a spokesman for AAA. "The pipeline systems there reach all the way up to New England, to Chicago and all the way out to Denver." Half the jet fuel produced in the U.S. is refined in the Gulf region.

Philip Verleger Jr., an oil economist and a senior fellow at the Institute for International Economics, a nonprofit, nonpartisan research institution in Washington, says his modeling suggests an unprecedented surge in gasoline prices. He says even a less-pronounced rise in gasoline and natural-gas prices could help tip the U.S. economy into recession.

"The risk is that households will have to spend so much of their consumption on energy that they will have to reduce expenditures on all other items," Mr. Verleger said, affecting numerous other sectors of the economy and potentially bursting the housing bubble. Scarcer and costlier energy would also hit retailers and manufacturers as well as the weakened airlines trying to get their jets off the ground as cheaply as possible.

"Depending on the next few days, this could turn out to be one of the biggest energy shocks since the 1970s -- perhaps even the biggest since then -- because it involves refineries and natural gas as well as oil production," said Daniel Yergin, oil historian and chairman of Cambridge Energy Research Associates.

Not everyone agrees with such dire scenarios. "Prices may stay at these [current] levels, or even go higher for a few weeks, then start to come down," said Mark Routt, an analyst at Wakefield, Mass.-based Energy Security Analysis Inc. "The system is going to work itself out in four or five days."

The storm-related squeeze on gasoline comes as drivers are already facing the highest pump prices, adjusted for inflation, since 1983. Yet the relentless rise in prices this year didn't scare off U.S. motorists, who pump 11% of the world's crude into their tanks in the form of gasoline. They snapped up growing numbers of gas-guzzling light trucks, including sport-utility vehicles, when manufacturers offered steep discounts this summer to move inventories.

The status of many New Orleans-area refineries is unknown. "We have not seen our refinery and we cannot talk to anybody in the area because the phones are out," says Mindy West, a spokeswoman for Murphy Oil Corp. Murphy's Meraux, La., refinery typically produces about 50,000 barrels of gasoline a day, or a little less than 1% of U.S. production. But its location, 10 miles southeast of New Orleans, is in an area with substantial flooding. Chevron has also been unable to reach its much-larger refinery in Pascagoula, Miss., and Exxon Mobil Corp. has been unable to get to its refinery in Chalmette, La.

Royal Dutch Shell PLC said its Mars platform, a floating production platform that typically produces 220,000 barrels of oil daily and 220 million cubic feet of natural gas, had sustained significant damage. An aerial photograph showed part of its above-water module had been turned over by the storm.

Operating and repair personnel who have reached other refineries are reporting manifold problems restarting the industrial complexes. Valero Energy Corp. said two key units at its St. Charles refinery were sitting in three feet of water and there was widespread electrical damage. It could take two weeks to restart it, once power is restored.

During the past few years, growing demand for gasoline has whittled down the spare refining cushion in the U.S. The effect of several refineries being out of operation could soon lower gasoline inventories to what the U.S. government says are minimum operating levels.

Typically, car tanks are about one-quarter full. If buyers start keeping car tanks three-quarters full, the added demand would quickly drain the entire system of gas supplies. Dan Pickering, president of Houston-based Pickering Energy Partners, says: "What you don't have in the system is the ability to run every car full of gas. If you get a hoarding mentality among the consumers, then it tightens the system even further. Fear of shortage begets the shortage. It becomes a vicious circle."

If the U.S. auto fleet of 220 million vehicles went up to three-quarters of a tank -- or, say, 10 gallons more -- it would be an additional 2.2 billion gallons of demand. Gasoline inventories were 195 million barrels on Aug. 19, and diesel an additional 77 million barrels, according to the latest government data, or a total of 8.19 billion gallons and 3.23 billion gallons, respectively.

The U.S. has few options for providing the market with surplus gasoline, because while it maintains an emergency stockpile of crude oil, called the Strategic Petroleum Reserve, it doesn't have a store of gasoline or other petroleum products. The Bush administration is considering tapping the SPR, as it did after Ivan, but hasn't made a decision yet.

While the refining woes are causing the most near-term pain, the loss of Gulf of Mexico oil production may also turn out to be problematic. Crude-oil prices eased from an earlier intraday high of $70.85 a barrel as the Louisiana Offshore Oil Port said Hurricane Katrina didn't result in any catastrophic damage. The facility, also known as Loop, imports about one million barrels a day of crude from tankers arriving from Venezuela, West Africa and elsewhere.

Before the storm, producers in the Gulf closed off wells that produce 1.4 million barrels a day. To put that in perspective, that's about the same as the spare pumping capacity held by members of the Organization of Petroleum Exporting Countries, excluding Iraq.

Because much of OPEC's spare capacity is in Saudi Arabia, which is four to six weeks of sailing time away, it can't immediately replace lost Gulf output. What's more, many refiners are unable to process the high-sulfur crudes remaining in Saudi Arabia.

Crude exporters close to the U.S., such as Venezuela and Mexico, have been operating flat out to meet world demand of 83.3 million barrels a day in the current quarter, according to International Energy Agency data and forecasts. The IEA expects that world-wide demand for oil will jump to 85.9 million barrels a day this winter. Since last spring, OPEC has been warning that it might not be able to meet that demand.

Natural gas could also become a problem, as nearly 88% of Gulf production was off-line after Katrina. On Monday and yesterday "we were very close to curtailing customers in Florida just to have enough flowing gas" in pipelines, said Paula Rosput Reynolds, chairman and chief executive of Atlanta-based AGL Resources Inc., a major U.S. natural-gas distributor.

Producers in the Gulf were scrambling to get personnel onto platforms to restart them. "It's utter chaos right now," says Carl Thornton, a supply manager for Cal Dive International Inc., a company that supplies divers and underwater-repair vehicles to the industry. Standing outside his Morgan City, La., offices because the backup electricity wasn't cooling the building, he marveled at the work ahead. "We're still doing Ivan work."

Write to Russell Gold at russell.gold@wsj.com, Bhushan Bahree at bhushan.bahree@wsj.com and Thaddeus Herrick at thaddeus.herrick@wsj.com