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Risk Factor: Higher Energy Prices
June 27, 2005

The seemingly permanent move of oil prices above $50 per barrel holds some significant implications for the US economy and for professionals who ponder the world of risk. These changes will approach gradually, but could also be unsettling, even frightening, and generate financial instability in the process.

Economies, like the markets which comprise them, generally go from periods of relative stability to periods of rapid change - also known as "adjustments" in the language of the multilateral bureaucrat. Author Jim Grant illustrates this concept of latency by reminding us that interest rates as much reflect the daily habits of traders as supply and demand or Fed policy gyrations.

Likewise, the reaction by consumers to sharply higher energy prices is gradual and grudging, but even at a glacial pace such changes are of enormous magnitude. Higher energy prices have put in motion structural changes to the US economy, good and bad, which are going to have a big impact on US markets and individual consumers.

For example, the rise in oil prices has already hurt the Big Two US automakers, stifling demand for larger SUVs as consumers migrate towards smaller, more efficient crossover vehicles and even electric-powered hybrids. But the shift in consumer preferences that already handed Ford Motor Co and General Motors 12 months of consecutive market share losses has just begun. Even more than markets currently anticipate, accelerating erosion of market share could hurt the financial stability of the Big Two, which are still among the largest employers in the US, both directly and indirectly through thousands of vendors, dealers and suppliers.

Higher oil prices could also speed the well-deserved demise of several legacy airlines, which will be forced to liquidate because fuel costs make operations impossible - even under court administration. Top of the list is United Airlines, which has been attempting for three years to emerge from Chapter 11 and is dumping its pension obligations on Washington in a last ditch effort to survive. Delta and Northwest are said to be waiting in the wings to follow United's example and file bankruptcy. Our sources in the industry say that none of these companies can survive in a world of $60 per barrel oil.

Sharply higher oil prices will ripple through the economies of Europe, Asia and North America, affecting every product or passenger that goes in a car or on a truck or a train to get from the point A to point B. The shock wave of significant increases in the cost of energy will force a new round of conservation and technological innovation, including a long overdue transition to hydrogen for fueling vehicles, but getting the US economy and the financial markets to that next island of stability could be difficult and messy.

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