As Oil Prices Go Up, Companies Struggle to Contain Their Costs

By Steven Mufson
Washington Post Staff Writer
Thursday, May 11, 2006; D01

When Hawaiian Electric Co. submitted a rate plan to regulators last fall, it included a worst-case scenario in which oil prices would start at $70 a barrel and escalate over time to $119 a barrel.

Today, the worst-case scenario has come true for current prices.

"When we did the scenario at the $70 range, it did seem high at the time," said Lynne Unemori, a spokesman for Hawaiian Electric, which unlike most utilities relies on oil for three-quarters of its fuel needs. Company planners thought prices were more likely to be "in the $40 to $50 a barrel range," she said. Now the company says that the rate increases it received last September aren't enough and that it will seek more from regulators.

In many U.S. corporate boardrooms, strategists are taking another look at their assumptions about oil prices and trying to figure out how they will affect business. The price of petroleum can make a significant difference in a company's profits.

Last fall, the jump in oil prices seemed more like a blip. Temporary factors, such as the hurricanes in the Gulf of Mexico, seemed to be the main culprits. But nine months later, persistently high prices are changing forecasts and assumptions about future prices.

"Most people have been disbelieving of this increase most of the way," said Stephen S. Roach, chief economist of Morgan Stanley & Co. "In the last six to nine months, there certainly has been some consensus on high energy prices. As people become convinced of this, they move to change their assumptions."

That could mean passing along price increases to consumers, changing capital spending plans and altering the way businesses are run.

American Airlines, which uses more oil every year than the Republic of Ireland, has asked employees for ideas about how to cut consumption. Courtney Wallace, spokesman for American Airlines' parent, AMR Corp., said a variety of innovations had saved the company $110 million over the past 18 months. Among the bigger ideas was using a single engine when a jet taxis, to save about $8 million a year. Now the company is installing "winglets" on the wings of its Boeing 737 jets that will reduce fuel consumption and help takeoff performance.

A lot is at stake for American Airlines. A 1-cent increase in the price of a gallon of jet fuel translates into an additional $33 million in annual costs, the company said.

"AMR paid $1.7 billion more for fuel in 2005 than it did in 2004, when it paid $1.1 billion more than it did in 2003," the company said. "Fuel now represents more than 28 percent of expenses, compared to 2002, when it constituted just 12 percent." This year promises even more increases. The company expects its tab for jet fuel to climb another 18 percent, to $6.5 billion.

Small companies are being hit, too. Ottenberg's Bakers Inc., which has 50 diesel delivery trucks and ovens that consume a lot of natural gas, plans to increase its prices. (Wheat and flour costs are also up.) Lee Ottenberg, the company's president, said that the District-based bakery will stop delivering to places like Front Royal in Virginia. "We're getting more selective about where we go to make deliveries," Ottenberg said. "Areas you might go when gas was at $1.50 a gallon might not make sense when gas is at $3 a gallon."

Companies such as FedEx Corp. have introduced fuel surcharges to cover higher oil prices. FedEx currently charges 13.5 percent extra for express service and 3.75 percent for ground services. The fee, which is adjusted monthly, will probably rise again next month.

But other firms have trouble getting customers to pay more. At Alcoa Inc., petroleum is used as a raw material in the manufacture of resins that go into plastic packaging and other products. "So far, we've been able to pass on a lot of those increases, but it's not easy," said Kevin Lowery, a spokesman for Alcoa.

"For energy intensive businesses, this is another input that's going to squeeze pricing margins," said Roach, the Morgan Stanley economist. "In the past we'd have seen oil price increases spill over into other prices, and an amazing thing about this energy shock is that we haven't seen that. A lot of that is because of globalization. But it has to come out of somewhere, so it has to come out of profit margins."

The Federal Reserve has also been watching to see whether oil prices might spark wider inflation or slow the economy and change consumer and corporate behavior. The impact has been hardest on motorists, who account for about half of the nation's oil consumption. The most energy-intensive industries -- such as steel, aluminum and glass manufacturers -- rely on coal or electricity. Those fuel prices are also rising, albeit more slowly, as oil becomes more expensive.

"To be sure, higher energy prices cut into households' purchasing power and the profits of non-energy firms," Federal Reserve Governor Mark W. Olson said in a speech last month. He noted that Federal Reserve Chairman Ben S. Bernanke had "recently noted that the surge in energy prices since late 2003 probably reduced the growth of real GDP between half a percent and 1 percent per year."

Among the companies whose plans are most closely linked to oil prices are oil companies themselves. They use oil as raw material in their refineries and for their petrochemical operations, and their capital spending for exploration and production hinges on the prices they believe they can obtain years later.

Royal Dutch/Shell Group last publicly mentioned its assumptions about oil prices in a strategy update on Sept. 22, 2004. "Shell sees an environment where oil prices have shifted structurally higher," it said then. "The Group screens projects around $20 per barrel and tests for upside at high prices." The company wouldn't say what figure it used at a strategy session this month.

Dow Chemical Co. is paying $20 billion for energy and petroleum feedstocks, about half the company's total costs. As recently as 2002, it was paying only $8 billion.

In 1996, the company set a goal of cutting its energy use for every unit of output by 20 percent by 2005. It slightly exceeded that target, saving $4 billion over that decade with investments totaling less than $1 billion, according to Peter Molinaro, Dow's director of government affairs.

Much of the savings came from cogeneration plants that harness waste heat and turned it into electricity and steam. The company is also tapping gas from a Georgia landfill and might substitute soy for some of its petroleum raw materials in making plastics.

Last month, the company's chief executive, Andrew N. Liveris, set a new target of improving the company's energy efficiency 25 percent more by 2015.

"Proposed energy efficiency projects go through the same analysis and prioritization process as all of Dow's capital projects," a Dow spokesman said. "Of course, as the cost of energy goes up, energy efficiency projects yield a higher return, moving them up on our list of investment priorities."

Molinaro said energy prices were a factor in the company's decisions to build projects in the Middle East, where until recently natural gas was mostly burned off as an unwanted byproduct of oil production. Dow Chemical is doubling the size of a chemical and plastics joint venture in Kuwait, where it will pay about $2 per thousand cubic feet for natural gas, much less the cost in the United States. The company is also working on a large project in Oman. In the past few years, Dow has closed 23 plants in North America.

"We have had to confront the steadily increasing prices of energy as a critical business issue," Molinaro said. "Our premise is that energy prices will remain high and volatile."

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