Asiaweek.com | Crude Awakening

SEPTEMBER 29 , 2000 VOL. 26 NO. 38 | SEARCH ASIAWEEK

Lucas Oleniuk and Wei Leng Tay for Asiaweek.

Crude Awakening
Now at their highest since the Gulf War, petroleum prices are roiling markets, worrying businesses and igniting angry protests. Here's how dearer oil could hurt Asia's fledgling recovery — and what the region needs to do to weather black gold's steep ascent
By ASSIF SHAMEEN and RICARDO SALUDO

ALSO:
• All You Need to Know: Nervous about oil prices? Here your worries are addressed, your questions answered
• Blackout Alert: Expensive oil threatens the region's best-recovering economy

There's no reason to panic. Many Asians nervously repeated those words to themselves the past week. No prizes for guessing why: oil. Thanks to that three-letter word, it did seem like the region's economies could again get seriously hobbled — and even before they had fully recovered from their last brush with catastrophe in 1997-1998. The danger signs came from half a dozen time zones away. Gas stations ran dry in Europe, their supplies blocked by protesters fuming over rising fuel costs. In London the benchmark crude price hit $37 a barrel, the highest in a decade. Pledges by the Organization of Petroleum Exporting Countries to boost output did little to allay fears of worsening shortages and escalating prices. Eight of the 10 OPEC members under its quota system (Iraq isn't) are already pumping at full throttle, with very little room to lift production.

Amid spreading talk of another global oil shock, Asian stocks slid sharply on Sept. 18. It wasn't just moody markets fretting about the region's economies slipping on an oil slick. That same Monday, the Asian Development Bank's chief economist, Iwasaki Yoshihiro, warned of "a double whammy." In an interview with Agence France Presse, Iwasaki said that over the past year, developing economies in Asia have suffered from both depreciating currencies and surging petroleum prices. Inflation is heating up, while trade balances are deteriorating — both of which could hit exchange rates and growth. In a worst-case scenario of oil prices averaging $35 a barrel for a year, Iwasaki sees the world economy slowing by 0.2-0.25 percentage points — and Asia by twice that decline.

You don't say, Iwasaki-san. Maybe the ADB chief economist should share some sushi with Tim Condon, his counterpart at ING Barings in Hong Kong. Condon believes "the worst is behind us on oil. We are looking at average prices of $28 [a barrel] this year and much lower next year." The ING economist adds that the more vulnerable Asian oil importers, like South Korea, Thailand and the Philippines, "have already taken the hit" from costlier crude in their exchange rates, inflation rates and trade balances. "By and large, they are now at a stage where they might surprise the pessimists on the upside." His bottom line: "While the oil shock of the last few months has reduced consumption spending and GDP in some Asian economies, the recovery, however fragile it might seem, is still on track. We are not about to see Asia plunge into a recession because of oil prices any time soon."

Feeling better? Well, don't get carried away in your relief. The world does have an oil supply problem. OPEC secretary general Rilwanu Lukman said in Jakarta that the cartel had boosted output by more than 3.2 million bpd since March. Yet crude stocks are tight; the U.S.'s own inventories are 8% less than they normally are at this time of year. Upward pressure on prices won't let up, what with demand for winter heating kicking in from November until at least February. OPEC's agreed 800,000-barrel-per-day (bpd) increase in its export quota isn't much, since a lot of the gain is already accounted for by excess output of producers cheating on their previous limits. The actual additional crude is only 365,000 bpd, which will take two months before impacting on supplies of gasoline and other refined products.

The cartel said it would consider further hikes in production if prices stay above $28 for four weeks or more, with 500,000 bpd automatically triggered from December. But OPEC's spare capacity is less than 2 million bpd, mostly in Saudi Arabia. And don't even ask about a possible threat by Iraq to slash its 2.3-million-bpd output in an effort to get decade-old U.N. sanctions on the country lifted. No wonder most petroleum analysts and traders see more than half a chance of oil hitting $40 or even $50. Still, many forecast $19-$28 for the first quarter of 2001. Merrill Lynch expects an average of $25 a barrel through 2002, while Goldman Sachs oil and chemicals analyst Paul Bernard sees less than $20 in the medium to long term. "The high-price environment will be over by January, at the very latest," Bernard says. "We might have a couple of dollars of upside from here on, but prices won't stay at those levels for too long."

But what if they do? Sean Darby, a strategist with Dresdner Kleinwort Benson Securities in Hong Kong, anticipates downward revisions of forecasts for Asia in 2001 "if oil remains at around $30 until Christmas." One reason: As Western consumers and companies spend more on fuel, transport and other oil-dependent goods and services, they won't buy as many TVs, DVDs and PCs made in Asia and crucial to its export-driven recovery. The other big worry is how the U.S. Federal Reserve and other central banks react to oil-fired inflation. If they raise interest rates, that could hit asset values and business and consumer spending in the industrial world. Hardly anyone is saying recession yet, but neither is the prospect totally dismissed.

Friedrich Wu of Singapore's DBS Bank estimates that this year's $30 average price has added half a percentage point to inflation in the Philippines and cut its GDP 0.2%. Korea's consumer prices are up by an additional 0.4% on oil, and Thailand's up 0.6%. Even Singapore, Asia's premier refining center, has lost 0.2% of its GDP due to more expensive crude. A Chase Manhattan study estimates the impact of every $10-a-barrel rise in price at 0.3-2.2 percentage points in added inflation and reduced output, depending on the country.

All these worries make it imperative for Asian economies and enterprises to get serious with restructuring, which would generate business growth and investor confidence — both threatened by the oil shock. To countries slow to reform Salomon Smith Barney economist Don Hanna advises: "Korea has shown that when you get restructuring right, you get a bigger overall positive impact than what temporary oil shocks take away." Kleinwort Benson's Darby expects big tests for fragile economies like the Philippines and Thailand. "As oil prices are rising, the strength or fragility of the recovery is tested all across Asia — in what areas economies are able to perform and where they need to undergo restructuring," he explains.

Even oil exporters will face trying times. Malaysia benefits; Southeast Asian crude is the low-sulfur "sweet" kind very much in demand. But petroleum makes up a mere 5% or so of Malaysian exports, so any gains there could be more than offset by declines in shipments of manufactured goods like appliances and electronics, which may be hit by rising oil prices in industrial-world markets.

Indonesia gains from higher crude revenues, which are about double the initial budget projections. But the country needs to spend more to keep local gasoline and kerosene at their hugely subsidized prices of 12 and three cents a liter, respectively. The IMF has been pushing Jakarta to eliminate the subsidy, most of which goes to motorists and industries, not the poor. Indeed, the fuel subsidy of more than $5 billion is 10 times social welfare spending. Moreover, 30% of the cheap refined products are smuggled into neighboring countries. Authorities are set to begin a three-year phase-out of the subsidy, but few expect the plan to be implemented as agreed with the Fund. The last time it was tried, people rioted and overthrew the Suharto regime. To prevent a repeat of the unrest, Jakarta will provide a small monthly allowance to compensate low-income groups for the lost subsidy.

Turning to industries and companies, oil producers are tipped to do well, of course. Both Merrill Lynch and Goldman Sachs' Bernard forecast gains for PetroChina, the country's largest listed oil company; Thailand's PTT EP and Gulf Indonesia Resources. Barmada, a Malaysian venture servicing exploration and production enterprises, will also do well. But refiners and distributors, especially those unable to raise prices due to state controls or consumer resistance, would see margins squeezed. That's what stock data service Surf88 predicts for Petronas Dagangan, which operates filling stations in Malaysia.

China's Sinopec pumps crude and makes refined products; the latter operation used to suffer from controlled domestic prices until they were liberalized in June. Now, says UBS Warburg analyst Cheng Khol, "margins are quite high." Rachel Tsang of Vickers Ballas puts the refinery margin at about $36 a ton. Selling refined products at unrestricted international prices is also a winning proposition. Barclays Capital's Dominique Dwor-Frecaut, a former World Bank economist for East Asia, notes that Korean refiners are boosting output, "hoping to become swing producers of oil products like Singapore."

Transport companies normally suffer from higher fuel prices, as Malaysia International Shipping Corp. does. But seafaring giants NOL of Singapore and Taiwan's Evergreen and Yangming Marine can pass on higher costs to customers through inflation-hedging contract mechanisms. "Some also hedge some of their oil purchases," Darby adds. The refining and petrochemicals sectors can also hedge, while still charging customers more, if the market can bear it. On the other hand, where there is a glut in capacity, profits shrink. "My bet," says Bernard, "is that almost every petrochemical or chemical company in Asia is experiencing a bit of a margin squeeze at the moment."

Jean-Louis Morisot, aviation analyst at Goldman Sachs, frets over higher jet-fuel prices: "A move from $20 to $35 a barrel can put a reasonably profitable airline into the red." But he notes that "some [airlines] are hit harder than others." Top carriers like Cathay Pacific, Qantas and Singapore Airlines have sophisticated mechanisms to hedge usually half of their fuel expenses, which normally make up 15%-30% of total operating costs. Qantas is covered for almost all its fuel needs until 2002. But not so Malaysia Airlines, Philippine Airlines, Garuda Indonesia or Thai Airways, says Morisot, though MAS insiders contend that up to half its oil needs are hedged until April. The silver lining, however, is strong travel demand, which is enabling carriers to pass on fuel cost increases. "If jet-fuel prices remain at current levels we will see very selective fare increases," predicts Morisot. "My guess is the market can easily absorb these fare hikes."

As hard-nosed analysis takes over from the oil-shock scenarios and protest headlines of the past week, the smart money is beginning to look beyond current market volatility and seek buying opportunities. Says Manu Bhaskaran, a director with SG Securities Asia in Singapore: "Oil price hikes have already been priced in Asian markets." Rather than gloom, he sees brighter prospects: "Restructuring is likely to accelerate. Inflation is low; the next [interest-rate] move by the U.S. Federal Reserve is likely to be down. Asian markets are ready for a rebound."

Christopher Wood, a strategist for ABN Amro Asia in Hong Kong, gives more reason for calm: "Remember, oil prices in real terms even at these high levels are just half of what they were in 1973. Oil really isn't as important as it used to be. But the psychological impact of $40-oil headlines is there because 1973 wasn't that long ago." Wood expects prices to fall from here on, and financial markets in Asia and elsewhere to rally. "Higher-than-anticipated oil prices in the third quarter of this year will slow down the U.S. economy and probably open the way for the Federal Reserve to cut rates early next year," he predicts. "Once markets start pricing that in, we will see them rally."

Is such optimism warranted? Well, it may just be what Asia needs now. If its crude awakening leads to drastic spending cuts all around, recovery would stall, whatever the oil price. Even worse, crude worries may distract the region from facing more crucial issues. "Weak economies are using oil as an excuse," says Wood. "The problem in the Philippines is political. In Thailand it's [bad] loans and restructuring. Indonesia has bombs going off all over the place." Plainly, Asia has bigger things to worry about than oil.

With reporting by Yulanda Chung/Hong Kong, Warren Caragata/Jakarta and Arjuna Ranawana Kuala Lumpur

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