2007 energy outlook: costs up

Higher oil prices could come during a soft economy.

Remember this? Motorists complaining at the pump as the price of gasoline rises. Airlines bumping up airfares to cover expensive jet fuel. And delivery services tacking on surcharges, reflecting a record price for a barrel of oil.

But it's not just a description of this past spring. It's also the forecast for next year, probably just when school lets out for the summer and motorists are starting to put more miles on the odometer.

"We could see close to $85 a barrel on crude next year," says Phil Flynn of Alaron Trading in Chicago.

If the forecast comes true, energy could be a dominant factor in the economic outlook for 2007 because, unlike this year, the potential increases would come when the economy is expected to be struggling. It would thus be the wrong time for the equivalent of a tax increase, which is how economists describe a spike in consumer energy costs. And it could catch the Federal Reserve in the middle of an energy-fueled jump in the inflation rate: Usually, the Fed tries to counter inflation by raising interest rates, but in a soft economy, it would rather cut interest rates.

"If we get a surge in energy prices next year, then the probability of a recession increases dramatically," says Dennis Jacobe, chief economist for the Gallup Organization in Washington. "It depends on how fast the rise takes place."

Yes, some energy analysts are beginning to think 2007 will be a case of déjà vu for consumers and business. In this scenario, prices start to ratchet up in the spring, peak sometime in the summer at a new record, and then fall back to lower levels later in the year.

Right now, the weather is an important factor, especially for the price of oil. Tuesday, oil prices hovered around $62 a barrel, some $18 a barrel below the high for the year, as relatively warm weather affected the Northeast. "We have had a relatively mild winter so far, some 20 percent to 30 percent above average [temperatures]," says John Felmy, chief economist at the American Petroleum Institute in Washington.

Last week, the National Weather Service said the warm weather in the Northeast will continue into the first week of January. But Mr. Felmy worries that a return to "normal" temperatures in January could prevent refiners from switching to gasoline production, because they would have to produce more home heating oil. "To get back a normal winter, it has to be colder than normal the rest of the winter," he frets.

It's not just the weather that's keeping a lid on prices. US economic growth is slowing – down to about 2 percent growth in the gross domestic product. The slower growth means crude-oil demand is slack – up only 0.2 percent on a year-to-date basis.

Sluggish demand has already forced OPEC to reduce production by as much as 600,000 barrels per day. OPEC's reduction also means the cartel has the ability to ramp up production to keep prices in check.

In addition, non-OPEC sources are expected to increase next year, as new discoveries in Russia, Brazil, and the US Gulf of Mexico come onstream. The Department of Energy estimates this could add a few hundred thousand barrels of oil a day to the world supply.

Any new supplies, however, could quickly be absorbed by China. With its economy expected to expand by another 9 to 10 percent, its oil demand is expected to increase by about 7 percent, estimates Paul Ting of Paul Ting Energy Vision in Short Hills, N.J.

China currently imports between 3 million to 3.5 million barrels of oil per day, Mr. Ting estimates. This indicates it would need an additional 200,000 barrels each day to satisfy its larger appetite.

But as Ting points out, "it's never simple when it comes to the Chinese energy landscape." For example, with a significant amount of its oil coming from the Middle East, China is placing more importance on energy security. "The lack of a strategic petroleum reserve [in China] is a big issue," says Ting. "So in the next year or so, they will start to accumulate 100 million barrels of oil, which translates into an additional 100,000 barrels of oil per day."

While China grapples with surging demand, some analysts believe geopolitical concerns about energy may once again roil the energy markets.

In April, Nigeria, a key oil provider, will hold a presidential election. In the oil-rich delta area of Nigeria, dissidents are attacking oil platforms and kidnapping workers.

"Separatists are already attacking the infrastructure, and the unrest could climax in April," says John Kilduff, an energy trader at FIMAT USA, a commodities broker.

Tuesday, in an indication of the difficulties facing business operations in Nigeria, a gasoline pipeline there exploded, killing at least 200 people.

Energy markets will also be tuned in to the situation in Iraq, says Amy Myers Jaffe, professor of energy policy at Rice University in Houston. In one possible scenario, there might be some manipulation of the price of oil because of the ongoing sectarian strife in Iraq between the Shiites and the Sunnis, she says. She cites as an example the Iran-Iraq war in the 1980s, when Saudi Arabia, a mainly Sunni Muslim state, tried to keep oil prices down to hurt Iran, which is mainly Shiite.

"The fact the Saudis have not done it yet does not mean they would not do it," she says. "They have enough spare capacity to do this again if they see political facts they don't like."

If the strife in Iraq were to spread, that could pose a major risk. Most of the oil production in the region is in areas controlled by Shiites, even in Saudi Arabia, says Professor Jaffe. "There is the possibility this could become not just a crisis in Iraq but could spread to other populations. The reality is that if you commute to work, you have to care that there is no extended civil war in the Gulf."

Material from Associated Press was used in this report.

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