Iraq and the U.S. Economy by Scott Frahm, SCRC

The uncertainty concerning war in Iraq has recently left the U.S. economy stuck in neutral. Many economists have begun to paint a gloomy picture for the rest of the year due to the anticipation of the uncertainty surrounding the length of a potential war. Though the threat of conflict has been a major contributor to the pessimism across the U.S., there are still other factors at work. This evidence has been revealing itself recently through the following:

Oil Price spikes
The oil price spike of the past few months has been well documented throughout the popular press. According to the American Automobile Association’s Daily Fuel Gage website, the national average price of gasoline has jumped from $1.35 a gallon in December 2002 to $1.71 on March 20, 2003, a 26.7 percent increase (1). While some U.S. senators believe that this indicates that the oil companies are price gouging, the real reason is the uncertainty in the market about what will happen to the supply of oil currently produced by Iraq. Presently, Iraq pumps about 2.4 million barrels of oil per day or 2.6 percent of the 92 million barrels pumped globally per day (2)

While this represents a small percentage of oil production, the loss of this supply would dramatically increase the price of oil because other oil producers cannot immediately boost production if this supply is temporarily cut off. The uncertainty that this oil may be temporarily lost has already been factored into recent oil prices (2).

If Saddam Hussein pursues a scorched earth policy and proceeds to burn Iraqi oil wells, the supply would instantaneously be eliminated. This could be devastating because there is not enough worldwide spare capacity to immediately counter the effect of this lost supply (3). Hence, prices could climb further, reaching unprecedented heights.

Another factor is that Venezuelan and potential Iraqi / Middle East cutbacks have forced refineries to process oil varieties they were not designed to handle. This has the effect of reducing the yield at these refineries and driving up the price further. For example, a Houston refinery had to halve its production in December to 130,000 barrels per day because it did not have enough supply of a heavy grade of oil from Venezuela (3).

Additionally, because oil refineries operate on thin margins, they have been less inclined to stockpile oil supplies and instead have been operating on a just-in-time basis. Fears of oil prices dropping from the high prices of late will continue to pressure refiners to limit the inventory they keep on hand. If oil refiners purchase expensive oil and the market price has declined, the refiners will either have to warehouse the refined oil or sell it at a price that is possibly below what was initially paid for the crude oil.

Labor and economic indicators
The trends in recent labor and economic data provide a gloomy outlook. The Labor Department recently announced that U.S. businesses eliminated 308,000 jobs in February. Despite this bad news, Federal Reserve Chairman Alan Greenspan “is still betting that ‘geopolitical uncertainties’ (related to war concerns) are holding back demand” and that these uncertainties will be resolved when war concerns dissipate (4).

In light of Greenspan’s view, some economists believe that there are other factors contributing to our economic woes including: overcapacity, particularly in telecom; rising consumer and business debt; and the expectation that the housing market has run out of steam. Ed McKelvey, senior economist at Goldman Sachs & Co., says that if Saddam Hussein was ousted, there might be a huge relief rally, “but then after the visceral response, you would still be back facing the same problems” (4).

Overcapacity is a major issue impacting supply chain management. With capacity utilization at the end of the 1990s and in 2000 reaching upwards of 80 percent, many businesses believed there was plenty of room to expand. Capital spending was flush at that time, especially in 2000, and has dropped dramatically and leveled off since. Many believe that the consolidation process associated with the recent downturn is still ongoing. For example, John W. Rowe, CEO of Chicago-based electric company Exelon Corp., believes the consolidation is only half done and that this is “a classic case of what you have to do to work off the after-effects of a bubble” (4).

Cutbacks
The greatest fear of many economists may be the announcement of cutbacks in many kinds of business activity. Overcapacity and weak demand are the main contributors to these cutbacks. At its peak back in 2000, the securities industry employed 783,000 and now employs 708,000 people. Alan Johnson, compensation consultant at Johnson Associates, believes an additional 10 percent will lose their jobs (4). The total securities employment would then be down to about 640,000 people, nearly 20 percent off its 2000 peak.

Another front that could witness cutbacks is the airline industry. With the war in progress, the airlines are confronting another year of operating in the red. Passengers will be less inclined to fly during a war, much like the first time the U.S. faced off with Iraq in 1991. Even a short war could cost the industry $4 billion pushing more airlines to file for bankruptcy. According to Lehman Brothers, the impact to the estimated cash balance of airlines could be dramatic (5).

Another recent development may signal the weakness in the general economic state. Manufacturing activity in February signals that the anticipated rebound is tapering off. The Institute for Supply Management’s (ISM) index for manufacturing activity in February was 50.5, a decline from 53.9 in January and 55.2 in December. Manufacturing activity is considered to be expanding with a reading above 50 and is contracting when below 50. Still, many are concerned about the consecutive months of decline on the index. Norbert Ore, the ISM survey chairman, expressed that the February drop signals a “reversion to the slower manufacturing activity of last year, rather than just a temporary blip” (6).

Evidence of this outlook can be seen by the early March announcements of General Motors and Ford’s plans to slash output. General Motors plans to reduce its second quarter output by 11 percent (7). Ford will not release details of its planned cutbacks. This may only be the beginning of announcements of business activity cutbacks, at least until the war with Iraq has been resolved.

References

(1) Daily Fuel Gauge Report. (3/20/03) AAA's Media Site for Retail Gasoline Prices.

(2) Reed, S. (3/17/03). Oil & War. Business Week.

(3) Cummins, C., Bahree, B.,& Herrick, T. (3/11/03). Oil Markets Have Less Margin of Error Than in Last Iraq War. Wall Street Journal.

(4) Cooper, J. & Madigan, K. (3/24/03). Don’t Bank on a Bounce-Back. Business Week.

(5) Zellner, W. (3/17/03). The Airlines’ Unlikely Catalyst for Change. Business Week.

(6) Barta, P. (3/4/03). Manufacturing Lost Momentum During February. Wall Street Journal.

(7) Freeman, S. (3/4/03). GM and Ford Plan to Cut Output As Car Sales Sag on War Jitters. Wall Street Journal.


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