The human tragedy wrought by Hurricane Katrina, so visible in the anguished faces of her victims and shocking portraits of devastation dominating the national news media, is incalculable. The historic city of New Orleans, the cradle of important elements of American culture like jazz and its distinctive cuisine, has been laid waste, and given her precarious relationship with the sea, may never be the same. Rebuilding and recovery in the broader region likely will be costly, take years, and will require enormous sacrifice from its people and help from the nation.
In contrast, it is a little easier to begin assessing the national economic impact of Hurricane Katrina, at least conceptually. To do so quantitatively, it is first essential to gauge the several costs of this supply shock. The local loss of property and wealth, both insured and uninsured, is important, but is a one-time event. The metrics for gauging the ongoing impact on economic activity include the scope of lost refining, crude and natural gas production, electricity and pipeline outages, and disruptions to shipping, industry, and tourism. What follows is a first effort to calibrate those losses. Because the extent and especially the duration of the damage and the scale of eventual recovery are still far from clear, however, any such estimates are really educated guesses.
Despite that uncertainty, I believe that Katrina’s potential hit to the economy will far exceed that of Hurricane Ivan which hit the Gulf last September. The most important reason: while they both hit oil and gas production similarly (knocking out about 16% of national natural gas production and 26% of crude oil output as of September 1), Katrina also initially shut in as much as 20% of US petroleum refining capacity at a time when the global market for refined products is much tighter than last year. In addition, it appears that the damage in Katrina’s wake is more extensive than in Ivan’s, so recovery may take longer.
The stage for Katrina’s entrance was really set before she surfaced. The summer heat wave — a supply shock itself, because it resulted in scattered electricity outages that shut down refineries — depleted gasoline inventories to levels well below normal — 21 days’ supply, according to Morgan Stanley energy analyst Doug Terreson. As a result, when the shock hit, there was scant cushion to absorb the blow. In contrast, according to the Energy Information Administration, natural gas in storage appears normal for this time of year. But the dislocations in gas production and distribution have nonetheless pushed up quotes at the Henry Hub facility by 66% from their July levels.
But Katrina also weakened several links in the petroleum and natural gas production and delivery chain that may delay recovery from and complicate the analysis of the shock. The loss of electric power in the region shut down three major pipelines that deliver crude to Midwest refineries, and a variety of crude and products to the East Coast. As a result, 0.75 mbd of refinery capacity was operating with reduced runs, creating spot shortages of gasoline at some retail outlets. As of Thursday evening, operators were bringing those pipelines back on line with diesel generators, but the network was not operating at full capacity. Several Gulf refineries were flooded, and engineers cannot assess damage until the water recedes. Restoring electric power generation is essential to restarting unscathed refineries. Companies must construct facilities for workers who have lost their homes. Katrina probably also damaged Gulf production facilities, but to an unknown extent.
Duration matters for gauging the impact of shocks, and will determine how much refined prices will go up. To be sure, wholesale quotes have receded a few cents from their peaks as pipelines reopened. And some refinery operators may restart their operations within the next couple of weeks. But others probably will be down for up to several months. Rising demand will deplete inventories quickly, and it will take at least a week for imported gasoline to come from Europe. As for natural gas, the storm may have damaged four natural gas processing facilities on the Gulf Coast amounting to nearly 10 percent of total national production. Extended downtime would delay the recovery of natural gas production. This outage represents a bottleneck, because distributors often must treat natural gas before taking it to market. Recovery from Ivan’s dislocations took several weeks to initiate and months to complete, and the task today is far more daunting. It’s early days, but so far, it appears that recovery from Katrina is well off that pace.
The impact of this shock on consumers nationally will likely be significant and sharp, even if it is temporary. To illustrate, a move to $3/gallon for regular gasoline quotes in September with no change in volumes would likely boost gasoline outlays by $90 billion annualized over July’s level. Given the jump in wholesale quotes, prices at the pump could well rise further. Current quotes for heating oil, natural gas, and electricity might eventually add $50 billion to the energy bill, although the bulk won’t arrive until the fall brings cooler weather. The total would represent a short-term $140 billion (1.5%) annualized hit to discretionary spending power, and it will fall disproportionately on lower-income consumers. Inevitably, in my view, such a sharp hike will trigger much slower gains in non-energy spending.
There’s more. The Port of New Orleans is a major shipping gateway for the Midwest. Although it is overshadowed by other US ports measured by value of trade (accounting for 8.9% of exports and 3.6% of imports), flooding has snarled logistics for important bulk cargos comprising the majority of New Orleans’ trade, like grain, steel, forest products, coffee, rubber, copper, and agricultural chemicals. Maritime activities that are disrupted account for 107,000 jobs in the Port alone. Tourism won’t return to the Big Easy anytime soon; it netted local businesses up to $10 billion in revenues annually and employed 120,000 workers.
What are the financial market implications? Fixed income markets have rallied and could have further to go if the shock proves severe and protracted. That’s understandable: While monetary policy is still accommodative, core inflation is low, so this shock implies that the chances of a near-term pause in the Fed’s tightening cycle are small, but growing. The Fed’s work isn’t complete, however, so a pause now followed by renewed tightening, in our view, is far more likely than easing in 2006. But there’s a disconnect: Risky asset markets seem already to be looking past the shock towards the rebound in growth that could result from supportive policies and a resilient economy.
First, however, investors need to understand that the downside risks to the economic outlook have increased significantly, as has the uncertainty surrounding any forecast. For example, the surge in wholesale gasoline prices has yet to be felt fully at the pump, and thus in consumers’ discretionary purchasing power. The hurricane season isn’t over, although meteorologists say that another Category 4 storm is now less likely. Of course, we could all be overreacting to the headlines, as has often been the case with past disasters. And risky asset markets and analysts who cover them seem to be dismissing the short-term pain, looking through any growth shortfall. In contrast, investors seem to be ignoring the potential inflationary impact of this shock. Indeed, I keep hearing the inflation warnings of Bank of England Governor King ringing in my ears. And that could ultimately be the biggest risk of all to investors.
By Richard Berner, Morgan Stanley economist, as published on the Global Economic Foru