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The Wall Street Journal: Cheaper Oil May Jolt Industries, Economies

EXTRACT: Major oil companies also are likely to see shrinking earnings from their oil-production operations, the largest source of income for integrated oil companies like Exxon Mobil Corp., BP PLC, Royal Dutch Shell PLC, Chevron Corp. and others.

THE ARTICLE

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By MARK WHITEHOUSE, ANN DAVIS and BHUSHAN BAHREE
January 15, 2007

Oil prices fell sharply last week and are hovering near the lowest levels since mid-2005, raising the prospect of significant changes in the outlook for corporate profits, consumer spending and the global economy.

Though crude oil rose $1.11, or 2.1%, to $52.99 a barrel Friday on the New York Mercantile Exchange, the price has plunged 13% in 2007 and is down 31% from its record finish of $77.03 on July 14.

The price of oil tends to be volatile, and it could bounce back quickly. If sustained, the decline would have a big impact on everything from the consumer to the profits of giant energy companies. It also could dent the revenue — and the political clout — of big oil-producing nations such as Russia, Iran and Venezuela.

In response to the recent fall in international oil prices, China said yesterday it would cut the price of domestic gasoline and jet fuel.

Gasoline prices were cut to 4,980 yuan ($639) a ton, down 220 yuan a ton, effective yesterday, the National Development and Reform Commission said. That is a reduction of about 4.2%.

The ex-factory price of jet fuel also dropped, by 90 yuan a ton, the NDRC said. The decision, which applies across seven different types of jet fuel, cuts per-ton prices by about 1% to 2%.

The widely expected announcement was the first cut to domestic oil-product prices since May 2005. China is trying to bring domestic oil prices more into line with international markets after decades of state-controlled pricing.

Meanwhile, Javad Yarjani, the head of OPEC affairs at the Iranian Oil Ministry, yesterday said the Organization of Petroleum Exporting Countries is considering whether to hold an emergency meeting to try to reverse the drop in oil prices. There has been no agreement yet, he said.

If lower oil prices lead to a reduction in what American consumers spend on gasoline, it would leave them with more money for discretionary purchases, such as restaurant meals, movies and vacations. That spending could provide a welcome cushion for the U.S. economy, which has been grappling with a sharp downturn in the housing sector. It also could boost airlines and auto makers, which have been hurt by high fuel prices.

As yet, the drop in oil prices hasn’t produced much relief at the gas pump. Regular-grade gasoline is selling in the U.S. at a nationwide average of $2.28 a gallon — down from more than $3 this summer in many parts of the country — but just a penny less than in December, according to auto club AAA.

Nonetheless, oil’s pullback “is coming at a great moment for the U.S. economy,” says Ethan Harris, chief U.S. economist at Lehman Brothers in New York, who estimates that each $10 reduction in oil prices adds about a half percentage point to annualized growth in inflation-adjusted gross domestic product — a broad measure of economic activity.

“You’re worried about this one-two punch from housing — first construction collapses, and then the consumer collapses. Lower energy prices are acting as a sort of smelling salt,” Mr. Harris said.

Indeed, many economists credit the retreat of energy prices from the summer peak for a recent bout of stronger-than-expected U.S. economic performance. Nonfarm payrolls in the U.S. rose by a seasonally adjusted 167,000 jobs in December, and economists expect inflation-adjusted consumer spending to have increased more than 4% in the fourth quarter of 2006. That has led some to raise their estimates of inflation-adjusted GDP growth for the fourth quarter to an annual rate of more than 3%, compared with forecasts of about 2% just a month ago.

The added impetus for the U.S. economy could change the picture for the Federal Reserve, which is trying to keep short-term interest rates high enough to control inflation, but not so high as to cripple the economy. In recent months, prices in bond and futures markets have suggested that investors expect a slower-growing economy and receding inflation pressures to allow the central bank to lower interest rates in 2007. As oil prices have fallen, those expectations have changed.

“If this acts like a tax cut and consumers spend a lot of it, then it just makes the Fed more and more likely to stay on hold and to watch carefully what happens to inflation,” said Richard Berner, chief U.S. economist at Morgan Stanley in New York.

The strength of the U.S. and global economies is one reason many doubt oil prices will remain weak for long. “I would expect to see the market bounce back,” said Nariman Behravesh, chief economist at consulting firm Global Insight. “The fundamental in terms of the oil market is demand growth, which comes from economic growth. From that perspective, we don’t see any further weakening.”

Analysts attribute lower oil prices in part to the fact that, with the start of the new year, many large institutional investors, such as pension funds, have been pulling back from energy investments. Also, unseasonably warm weather in many parts of the U.S. spilled into January, temporarily reducing oil demand.

If it continues, the current drop in oil prices would create a number of winners and losers.

Lower oil prices are “a plus for us,” said Paul Ballew, top sales analyst at Detroit auto maker General Motors Corp., noting that higher oil prices significantly crimped demand last year. GM is a top producer of gas-guzzling sport-utility vehicles and pickup trucks and is counting on big sales of its new Chevrolet Silverado; the auto maker has blitzed the airwaves with ads for the pickup truck during U.S. football games.

Even lower prices at the pump, however, wouldn’t be a panacea for GM, Ford Motor Co. or DaimlerChrysler AG’s Chrysler Group. GM and Ford, which have reported billion-dollar losses, are in the midst of restructuring plans that include worker buyouts. Chrysler, which reported a $1.5 billion loss in last year’s third quarter, is set to announce a restructuring plan next month.

Rising oil prices over the past several years caused jet fuel to displace labor costs as the U.S. airline industry’s No. 1 expense. For every penny decrease in the price of a gallon of jet fuel, the U.S. airline industry saves as much as $195 million in costs annually. At AMR Corp.’s American Airlines, the world’s largest carrier by passenger traffic, that amounts to savings of $30 million a year, or $80 million each time crude oil prices drop by $1 a barrel.

On Thursday, British Airways PLC said it will reduce fuel surcharges on flights between Britain and the U.S. that last less than nine hours.

Cheaper oil would sharply reduce earnings of big oil-producing nations, including those in OPEC. Leo Drollas, deputy director of London’s International Centre for Global Energy Studies, estimates OPEC’s 11 members earned $518 billion in 2006, up from $437 billion in 2005.

Assuming a fall of about $4 a barrel in oil prices on average this year, and lower output to shore up prices, Mr. Drollas estimates OPEC export revenue would fall to $488 billion this year. But if prices average about what they are now for all of 2007, the export earnings of OPEC countries — leaving out Angola, which just joined Jan. 1 — would fall to 2005 levels, or less if the exporters group slashed output further to support prices.

Major oil companies also are likely to see shrinking earnings from their oil-production operations, the largest source of income for integrated oil companies like Exxon Mobil Corp., BP PLC, Royal Dutch Shell PLC, Chevron Corp. and others.

The pain is spreading to the hedge-fund sector, say some on Wall Street. Rumors have swept trading floors of a hedge fund in distress, though no new announcements have been made. Among other potential losers are small investors who came late to the oil party this year and bought new investment vehicles that allowed them to buy shares in funds that traded like a stock but tracked the price of oil futures. Pension funds and other institutions banned by mission from making futures-markets trades also flocked to such vehicles.

Other losers may be a variety of companies that raised huge sums from private-equity firms and the public markets assuming that, even if oil traded lower, the days of sub-$50 oil were largely gone.

Oil’s fall, along with a more than 7% fall in copper this year, has helped to trigger some dire predictions. “In our view, we are witnessing the definitive end of the commodity price boom that began late in 2001,” wrote ABN Amro analysts in a piece Tuesday.

–Mike Spector, Melanie Trottman and Siobhain Ryan contributed to this article.

Write to Mark Whitehouse at [email protected], Ann Davis at [email protected] and Bhushan Bahree at [email protected]

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