The Ripple Effect of High Oil Prices

The global economy depends on a superinfrastructure of air, land, and sea transportation networks to move basic goods, primary energy, and people across borders. The global manufacturing industry, particularly in Asia, has thrived due to the massive profits gleaned from items with a high price to weight ratio, such as food, clothing and information technology, that were transported cheaply all over the world. However, the volatile nature of oil prices has shaken the foundation of the transportation-oriented global economy, and sent ripple effects throughout numerous sectors.

COLLAPSING JUST-IN-TIME SUPPLY CHAINS

Today's economy relies on the constant transport of inventory between processing and delivery points across the globe. Relying on traditionally low transportation costs, companies were able to avoid maintaining storage facilities by keeping inventory moving and having it arrive “just-in-time.” The resulting high-profit margins for producers and cheaper prices for consumers propelled globalization.

Unfortunately, this “just-in-time” production approach has not scaled with oil prices. Rapid and volatile movements in the price of oil have placed a significant amount of stress on the world's superinfrastructure, shrinking those large profits and increasing the cost for consumers. As a result, Stephen Jen, a strategist at Morgan Stanley in London, argues high oil prices will “…stress-test the entire Asian model, which has been built in a time of low energy costs and low shipping costs.” For example, over the last decade, the American steel sector has declined primarily due to China's cheap labor costs. For a short time, it was actually more cost-effective to ship raw iron ore from the United States to China for processing and then return it in final form for consumption than it was to complete the process domestically. However, Jeff Rubin, chief economist at the Canadian Imperial Bank of Commerce (CIBC), estimates that phenomenon is now nearing its end due to rising transportation costs which have eroded China's labor cost advantage almost entirely. As a result, “US domestic steel production has risen by almost 10%,” while China's steel exports are “now falling by more than 20% on a year-over-year basis.”

It is important to note that Japan, Korea, Singapore, and Taiwan are likely to fail this “stress test” as well. “Just-in-time” supply chains are designed to avoid the requirement of costly reserves, or margins, for times when supply is disrupted. Given this key design principle, these countries are unable to absorb the shock of increased oil prices without reducing production. Already, Japan has seen its industrial production decline by 3.5%, a full 50% more than was expected by economists, at the same time unemployment reached a four year high.

THE FALTERING AIRLINE SECTOR

The airline industry is perhaps the most affected by high fuel costs as prices have skyrocketed in a short amount of time. According to the Air Transport Association, fuel expenses are expected to total $61.2 billion this year, an almost 50 percent increase over last year's $41.2 billion. American Airlines, spending about 30% of its operating costs on fuel, has begun charging additional fees for food, drink, and luggage to compensate for their higher overhead costs. Others, like U.S. Airways, are “retiring jets, cutting domestic seating capacity by as much as 8 percent by the end of this year, and eliminating 1,700 jobs to lower operating costs and reduce fuel use.” The situation is extremely dire. A report by the Business Travel Coalition warns, “already-depleted cash reserves are dwindling fast, and unless the fuel crisis lessens, airlines face not the now-familiar protracted restructuring in bankruptcy, but outright and immediate extinction.”

Cutting edge aircrafts, like the Boeing 787 Dreamliner, have only been able to decrease fuel consumption by 20%. Even with more efficient operating procedures, the decline in consumption is minimal. Southwest Airlines, for example, saved 8% of fuel costs by slowing flights down by 1-3 minutes. However, these gains pale in comparison to the increase in costs caused by aviation fuel prices tripling since 2000. Tim Wagner, an American Airlines spokesman, states succinctly, “The airlines are simply not designed to handle oil at this price.”

The record proves it, as Bradford Plumer of The New Republic reports, “Twenty-five airlines have gone belly-up this year – three to four times the usual yearly rate.” Still functioning airlines have been forced to eliminate less traveled routes and less accessed hubs in order to survive. The problem is not localized to the United States, Ryanair deputy CEO Howard Millar predicts that of the roughly sixty European airlines that exist, only five will survive existing conditions.

The full impact of the decline of global air transportation, Plumer argues, “could mean major shifts in the economy, changes in immigration patterns across the world, and perhaps even a remapping of the planet as we know it.”

THE IMPACT ON MICRO-STATES

Micro-states are developing nations with small populations densely packed on small tracts of land. All too often, these states are unable to develop a successful agricultural or industrial base as a result of their land and population constraints. In the last two decades, many of these states were able to circumvent their constraints by leveraging the cheap supply chains to rapidly modernize their primarily insular economies. By essentially outsourcing their agricultural and industrial capacity, these states achieved economic status similar to larger states in a dramatically shorter time, and exploded onto the global stage as service-based economies.

In leapfrogging agricultural and industrial development however, numerous micro-states became heavily dependent on foreign wealth from tourism. In Palau and Macao, tourism constitutes 70% of GDP. In the Cook Islands and the Maldives, tourism makes up almost half of total GDP. Non-tropical nations, like the UAE are also dependent on tourism for 30% of GDP. Now, with the tethers of the tightly coupled global economy coming apart, micro-states will be facing troubled futures. Many have been able to move up-market, offering premium services to appeal to fewer but wealthier customers better suited to absorb the economic shocks from higher energy prices. At $100 oil, luxury services like chauffeured cars, top hotels, and extended cruises are still viable. However, the tight link between transportation and the global transportation network, the recent jump from ~$100 oil to $150 has had a much greater detrimental effect. The Cayman Islands have experienced a drop off of almost $50 million in tourism revenue last year alone; 71% of Bahamas' hotels are projected not to earn net profit in 2008.

Moreover, due to the outsourcing of the fundamental planks of a modern economy, the rapid increase in transportation costs has caused a budgetary shock that stands to destroy many of these economies. The Bahamas, for example, currently imports 90% of what it consumes. The high cost of energy has expanded its deficit and is rapidly depleting the nation's reserves. From May to June of 2008, the reserve levels dropped by a significant 3.5 percent. The International Monetary Fund (IMF) estimates that if reserve levels drop below three months worth of imports, the Bahamas would be left economically crippled. The effect could be widespread, as indicated in the IMF report:

Because oil imports are 2.5 times larger than food imports for low-income countries…the oil price increase would have a larger balance of payments impact… Indeed, the oil price increase would severely weaken the external position of 81 countries…

Without a concentrated effort to shore up reserve levels, these micro-states, including Tonga, Togo, Sierra Leone, Eritrea, Jamaica, Fiji, Jordan and the Dominican Republic, will essentially have to undo the progress made at the time of low energy prices.

THE DECLINE OF RURAL AMERICA

In America, rural regions stand to suffer significantly from the effects of high oil prices and may face substantial challenges in the years ahead. Rural areas generally lack public transportation, forcing people to spend record amounts of their income on energy. Up from 1.9 % in 1998, Americans on average now spend about 4 percent of their after-tax income on transportation fuels, according to Brian A. Bethune, an economist at the forecasting firm Global Insight. The number is worse for rural residents who are seeing as much as 13% of their paychecks spent on transportation. At the same time, the total amount of miles traveled on U.S. roads has dropped by some 2.8% this year. The increase in cost and decline in demand has resulted in rural interstate travel decreasing five times more than urban interstate travel.

At current or higher price levels, life in rural America is simply unsustainable. For example, Holmes County, Mississippi with a median income of around $20,000 is currently spending 16% ($3,200) of that on transportation. Should this continue, rural residents would be forced to migrate from rural areas to urban centers in search of greater economic opportunity, affordable living, and to take advantage of publicly subsidized transit systems. Christopher B. Leinberger of the Brookings Institute argues that in the long term other core governance functions like “schooling and safety are likely to improve in urban areas” as the tax base increases with a population influx.

However, some analysts believe that the effects will not be permanent and that rural America will adapt to these new economic realities. Michael Hicks, a professor of economics at Ball State University, explains, “Rural retail centers are likely to see a lot more traffic as consumers are not willing to make the long commute to the big city.”

CONCLUSION

Corporations are looking at the long term while fighting short run implications. While business travelers are increasingly relying on teleconferencing and telecommuting, airlines are seeking out alternative fuels to insulate themselves from volatile oil prices. Sébastien Remy, head of Airbus' Alternative Fuel Research Program, predicts that 25% of jet fuel will be derived from non-petroleum sources by 2025.

In true form, average Americans are adapting. Public transit usage is at a fifty year high. New York and Boston, cities with strong public transit systems, have noticed small increases in use. However, “the biggest surges – of 10 to 15 percent or more over last year – are occurring in many metropolitan areas in the South and West where the driving culture is strongest and bus and rail lines are more limited.” Alternative transportation system leaders are ecstatic. “Vacation travel on Amtrak is up 28 percent over the same period last year,” according to Cliff Black, Amtrak's chief of corporate communications.

Still, analysts warn of limited capacity. Ross Capon, executive director of the National Association of Railroad Passenger, says that rail travel “is going to be held back because so many trains are sold out.” This is a problem plaguing most public transit systems because of our long term reliance on cheap oil: our alternatives simply cannot cope with a massive increase in demand.