--------------------------------------------------------------------------------

September 13, 2004

Let a Thousand Ideas Flower: China Is a New Hotbed

of Research
By CHRIS BUCKLEY

EIJING - Harry Shum's office may be one of the best places to witness the next stage of
China's rise as an economic powerhouse.

Set in the heart of the Haidian District in Beijing, with its canyons of universities, labs
and high-tech ventures, his office occupies a corner of Microsoft Research Asia, the
software giant's ambitious effort to tap scientific brainpower in China.

Dr. Shum oversees 170 scientists who huddle around computers in gray cubicles to
brainstorm and tinker with ideas that may one day drive Microsoft's technological empire
to even greater heights.
"Microsoft began to realize we can't find all the talented people in the U.S.," he said.
Pointing outside, he added: "Nowhere in this universe has a higher concentration of I.Q.
power."

Microsoft is not the only multinational company to use China as a base for research and
development. In recent years hundreds of them have set up laboratories here, and Chinese
officials claim the number is growing by 200 a year.

The labs vary in size and ambition, but as they multiply and expand they may help China
grow from mostly a user and copier of advanced technologies developed elsewhere into a
powerful incubator of its own, industry executives and experts say. And the shift may
eventually reshape applied research, jobs and policies in the United States and other
developed countries.

"The Chinese are going to become sources of innovation,'' said Denis Fred Simon, a
specialist in Chinese science and technology who is provost of the new graduate-level
Levin Institute of the State University of New York. "They will find themselves
enmeshed in global R.& D. more and more.''

But it is far from certain that China will reap the full rewards of this flowering. Planting
and nurturing corporate labs is a delicate business, and in China they are buffeted by
concerns about protecting patents, retaining and training researchers, and managing the
distances - physical and cultural - between here and headquarters.

When Microsoft opened its Beijing lab in late 1998, it was among the first multinationals
to establish a large research center in China. It hoped investing in research here would
help pry open the door to two dazzling prizes: China's large reservoir of skilled but
inexpensive scientists, and its consumers, still relatively poor but growing richer and
eager for new technology.

After considering several sites in Asia, Microsoft settled on the Haidian District, home to
some 40 universities, 138 scientific institutes and many of China's 810,000 research
scientists and engineers.

"China was really the No. 1 target from the beginning,'' Richard F. Rashid, the senior vice
president of Microsoft Research, said in a telephone interview from corporate
headquarters in Redmond, Wash. "We felt there was a tremendously deep pool of talent
there.''

Microsoft, like other companies setting up research facilities here, was able to lure
scientists from government-run labs, which do not pay as well and often are not working
on cutting-edge developments.

"There are a lot of really good scientists and engineers coming from Chinese
universities,'' said Maximilian von Zedtwitz, who teaches management at Qinghua
University here. "Their first choice is to go abroad, but their second choice is to work in
China for foreign companies."

When the Microsoft lab first announced openings for 50 positions, it was deluged with
tens of thousands of applications, said Zhang Ya-Qin, the former managing director of
the lab who is now a company vice president in charge of Microsoft's mobile technology.

It is no surprise that Microsoft Research Asia has such popular appeal. It is one of the few
labs here spared the pressure of developing products for direct application; its
researchers, like those in Microsoft's labs in Redmond, San Francisco and Cambridge in
Britain, are given leeway to explore ideas with no immediate commercial payoff.

But Microsoft researchers here also said they were conscious of their untested "outsider"
status, which makes them especially eager to find product applications for their
theoretical findings. Among other things, researchers are working on computer graphics,
speech recognition and text translation.

"We're a young lab and an experiment of having a lab in a developing country in Asia, so
there was a need to prove ourselves," said Zhang Hongjiang, who runs a new division
devoted to shepherding research findings into applications. He and many other
researchers in the lab said it felt more like an adrenaline-fueled start-up than an academic
institute.

If Microsoft ever overtakes Google in online search, for example, some credit may
belong to Ma Wei-Ying. His group, now up to 10 researchers, is working on new ways to
drill deep into the Internet and select and organize the information found there.

"We've progressed fast because we have a lot of really smart people and we discuss and
brainstorm a lot," Dr. Ma said. "In the U.S., the research is much more individual and
each researcher is more like a professor. Here it's more a team."

The expansion of foreign labs in China is bound to spark further debate, similar to the
controversy over outsourcing of technology services, about the implications of the
increasing globalization of corporate research.

Executives at Microsoft and other companies argue that their Chinese labs are not taking
jobs away from the United States or elsewhere. "There's an internationalization of
research going on," Dr. Rashid said. "That's a good thing. The more smart people, the
more innovation, and the more benefits for companies like Microsoft."

The starting point for this research boom is China's growing importance and
sophistication as a market for technology, especially telecommunications and the
Internet, industry executives said.

"People realize that with the expansion of China's market they need to tailor products to
the China market," said Martin Hirt, who works for McKinsey & Company, the
consulting firm, and has advised companies on technology development in China. "A 50-
year-old Finnish or American engineer is not going to understand the needs of an 18-
year-old Chinese youth."

Recently, Oracle opened a lab in Beijing to tailor its Linux operating software to suit its
Asian customers, and companies like Motorola, Siemens, I.B.M. and Intel are going even
further, running full-scale labs that work on their companies' most advanced products.

Last year, General Electric opened a large research center in Shanghai, where it plans to
employ 1,200 researchers by next year. And Nokia, the Finnish mobile telephone maker,
has moved its software code writing to China. Chinese officials in charge of the sector
say no one knows exactly how many international companies have research labs in
China, but an official from China's Ministry of Commerce recently stated publicly that
the country had as many as 600 and was adding 200 a year.

Dr. von Zedtwitz was more conservative, estimating that China had as many as 300
foreign research centers, most of them founded over the last three years. But he said that
within five years China could overtake Britain, Germany and Japan as a base for
corporate research, leaving it second only to the United States.

Although experts say that China's growth as an international research base will continue,
many also said that growth could be slowed or ultimately endangered by the growing
pains and legal uncertainties.

The most immediate threat is China's laxity in safeguarding intellectual property rights,
which makes it too easy for innovations and industrial secrets to leak out, only to
reappear in a Chinese competitor's product catalogue. Multinationals' growing resentment
of theft of patents and trade secrets is leading some to threaten to quit China for India, Dr.
von Zedtwitz said.

The other serious challenge is retaining and managing researchers who are young and
relatively inexperienced, but also eager for rapid promotions and raises. "You can get all
the smart people you want,'' said Dr. Simon of SUNY, who has studied many labs run by
multinationals in China, "but they'll run around like a herd of cats without leadership."

The recent rise of China as a base for multinationals to conduct research has not yet
seriously affected their advanced operations elsewhere. Indeed, it may be helping them.
But Mr. Hirt, the McKinsey consultant, cited examples suggesting that at the lower end
of applied research, some jobs were indeed shifting from the United States, Japan and
other developed countries to China.

Some Chinese officials have a converse worry - that the foreign labs may become
isolated enclaves, siphoning off China's best talent but creating few beneficial spillovers.
But a growing number of Chinese officials and experts seem to believe that the main
threat to China's future in innovation does not come from foreign aggression but from the
inertia of Chinese industry.
China has more than doubled what it spends on scientific research to 1.3 percent of
national economic output, compared with 0.6 percent in 1992. But little of that money
was invested by local businesses.

"The development trend is good, but the problem is our businesses,'' said Zhou Jizhong, a
specialist in applied research at the Chinese Academy of Sciences."They're the key, and
they're quite weak."

Copyright 2004 The New York Times Company | Home | Privacy Policy | Search |
Corrections | RSS | Help | Back to Top

May 29, 2004

Allen-Edmonds Keeps Its Shoes on an American

Factory Floor
By AARON NATHANS

PORT WASHINGTON, Wis. - The rumble, hum and clack of the Allen-Edmonds shoe
factory went quiet in late December. Many of the machines that helped workers pack
insoles, trim the leather and buff the finished men's dress shoes were gone by New Year's
Day.

But John Stollenwerk, the president of the company, was not preparing to send his
operations overseas. Instead, Mr. Stollenwerk gambled on staying put and reconfiguring
his factory floor, which reopened on Jan. 5, with a new manufacturing method that could
increase production and cut down on mistakes. The moves required an investment of $1
million, or 1.1 percent of the company's 2003 sales.

Mr. Stollenwerk is resisting a tide that has decimated the American shoe manufacturing
industry: About 98.5 percent of shoes sold in the United States are now made abroad,
according to the American Apparel and Footwear Association, which is based in
Arlington, Va.

But the numbers behind Mr. Stollenwerk's decision to stay show the stark economic
choices facing manufacturers. He hopes the million-dollar refitting will save the company
5 percent on each shoe. He could save 60 percent tomorrow, he acknowledged, if he
moved his manufacturing to China.

"It's costly to stay here because of the wages we're paying, the benefits, the rules and
regulations of the government for having a safe workplace, for having a clean workplace,
the emissions permit, taxes, health care," Mr. Stollenwerk said. "They're all good things,
don't get me wrong."
Allen-Edmonds, founded in 1922, gained much of its following by providing the Army
and Navy with shoes during World War II. Many men continued to wear the shoes for the
rest of their lives. The company, which makes small batches of men's dress shoes in a
variety of widths that sell for upwards of $200, claims both presidents named Bush as
customers.

But patriotism will get a shoe manufacturer only so far these days. In 1968, just before
worldwide tariffs on footwear were reduced, 642 million pairs of shoes were
manufactured domestically. In 2003, that number was down to just 60 million, mostly
specialty products made in the Upper Midwest, Southwest and North Carolina, according
to the association.

Most shoe retailers need quantity, said Fawn Evenson, president of the association's
footwear division. The rise of chain stores like Sears, Roebuck and J. C. Penney, and later
Wal-Mart Stores and Target, increased the demand for mass production, she said.

"You just can't beat it," Ms. Evenson said of Chinese shoe factories, where she said
workers make as little as $100 a week and put in 10-hour days. "These plants are modern,
clean, they are unbelievably efficient, and they get a very good price."

New Balance once made all its shoes in the United States, but as they became more
popular, the company added plants in China, said the chief executive, Jim Davis. Today,
New Balance makes 25 percent of its shoes domestically, he said. Allen-Edmonds may
have to make the same hard decisions if the shoes prove popular enough, Mr. Davis said.

"It might be hard for them to increase sales over time unless they change," he said.
"They'll make more shoes, but they might not make enough."

Another company with domestic manufacturing, the Minnesota-based Red Wing Shoe
Company, makes work boots, typically for union laborers who would not stand in
anything imported, said Peter Engel, the director of marketing.

Michael Atmore, editorial director of the trade publication Footwear News, said
patriotism did not often extend to buying shoes.

"Consumers today are less concerned about where something's made than ever before,"
he said "In part, they've been conditioned to accept that products come from all over the
world."

The most obvious competitive disadvantage at Allen-Edmonds is that it pays its workers
well, even by domestic standards. The average worker in the Port Washington plant
makes about $15 an hour before benefits, Mr. Stollenwerk said.

Ms. Evenson said the company's loyal following flowed from its unique manufacturing
process. The company stitches a strip of leather, known as a welt, to the sole, negating the
need for a rigid metal shank. The company says that makes for a more comfortable fit, as
well as more ease in getting through airport security screeners.

The company takes special orders, which it can turn around fast, said Jim Kass, director
of operations. A customer can send his shoes to be resoled and get them back in three or
four weeks, Mr. Kass said. That speed would be impossible if the shoes were sent abroad,
he said.

Mr. Stollenwerk, who works in a cubicle alongside his employees, said his company
made a nice profit, but declined to discuss specific earnings figures. Sales reached their
highest point in 1999 at $95 million. Sales in 2003 are estimated to reach about $88
million, up 10 percent from 2002, according to previously published figures confirmed by
the company. The company has cut about 10 percent of its work force through attrition
over the last five years, but turnover dried up recently as workers realized they did not
have many options left in the manufacturing sector, Mr. Stollenwerk said.

To keep things in the black, Mr. Stollenwerk is making big changes at his main factory.
He is shutting down one of four Allen-Edmonds plants and consolidating it with the Port
Washington site. The company will maintain plants in Milwaukee and Lewiston, Me.

The old assembly line in Port Washington is being replaced by a system of employees
working in groups, with each person doing several jobs, each trained to do the other's
tasks. The new method will cut down on time wasted on picking up and putting down
shoes, as well as mostly eliminating overtime, Mr. Kass said.

Under the new system, the worker who flattens the welt will then fill in the shoe's bottom
with a layer of hot cork, before sending it on. That should cut down on spoiled shoes,
allow workers to fill in for sick colleagues with more ease, and lessen repetitive strain,
said Tim Goetsch, lead worker at the factory.

The changes will also include installing computerized machinery left behind by the
Dexter Shoe Company, which left Maine for China in 2001.

Mr. Stollenwerk said the women in Maine who performed the fancy, detailed side
stitching on Allen-Edmonds penny loafers were nearing retirement age, with no one to
replace them. That work may someday have to be sent to the Dominican Republic, he
said.

Mr. Stollenwerk acknowledged that he has felt tempted to move operations to China, but
said that could lead to a decline in quality. If his company ever went to China, he said, it
would have to open its own factory there.

He said it was sadly amusing to see university students marching against low wages,
factory closings and other social problems brought on by globalization. "Those very
people are walking around with shoes made in China with 64-cent-an-hour labor and no
benefits," Mr. Stollenwerk said. "The very thing they're marching against, they're
supporting."

But do they have a choice?

"No," he said. "It's more and more difficult. Therein lies the problem."

Copyright 2004 The New York Times Company | Home | Privacy Policy | Search |
Corrections | Help | Back to Top

Jubak Journal
Eight Ways China Affects Our Lives Now
By Jim Jubak
MSN Money Markets Editor
5/12/2004 7:08 AM EDT
URL: http://www.thestreet.com/funds/jubak/10159684.html

Editor's note: Last week, Jim Jubak examined the Chinese economy's impact on world
financial markets. In this week's column, he takes a closer look at the role China plays,
and will continue to play, in the everyday lives of Americans.
Just walk into the toy section of a Wal-Mart (WMT:NYSE) if you want proof that
China's emergence as a global economic power reaches deep into the lives of all of us
here in the U.S.
China manufactures about 80% of all toys sold in the U.S., even such iconic products as
Etch A Sketch. In 2001, Ohio Art moved production of Etch A Sketch (which it playfully
likes to claim is the world's first laptop) to Shenzhen near Hong Kong from Bryan, Ohio,
where the toy had been made for 40 years.
Count the ways this one example ripples across our economy:

• Manufacturing jobs that paid $9 an hour in Bryan are shipped to China, where
workers at the new manufacturing plant make 24 cents an hour.
• Toys are cheaper at Wal-Mart, where an Etch A Sketch sells for just $9.99.
(That's pretty remarkable for a toy that sold for an inflation-adjusted $23.99 in
2004 dollars when it was first introduced in 1960.)
• There's more pressure on the pensions and health benefits of U.S. workers
because most of the workers they're competing with don't get those costly "perks."

OK, you're familiar with the lost-job story by now. But the China syndrome -- which I'm
using as shorthand for all of the changes to the global economy brought about by the
entry of China, India and other rapidly growing economies onto the world stage -- is by
no means limited to job losses and lower prices at Wal-Mart. It extends far deeper into
our lives than most of us realize. And for better or worse, China will have even more of
an influence here in the years ahead.
Let me dust off my trusty crystal ball and sketch eight ways that China matters -- or will
matter -- in our everyday lives.
China has helped produce lower mortgage rates. China's influence in the U.S. bond
market extends far beyond its own purchases of U.S. Treasuries and "agency paper"
issued by Fannie Mae (FNM:NYSE) and the other government agencies that dominate
the market for mortgage-backed securities.
Price competition from Chinese manufacturers, who buy and sell in a Yuan pegged to the
U.S. dollar, kept the Japanese and other central banks on a Treasury-buying spree to keep
the value of the yen, the South Korean won and other Asian currencies from climbing to
the point that these countries lost export share to Chinese companies.
In the 12 months that ended in April, foreign central banks bought $260 billion in U.S.
Treasuries and agency paper, leaving the Federal Reserve's purchases of $33 billion
trailing in the dust. It's hard to gauge the total effect of all that foreign buying on U.S.
bond yields, but the buying has probably kept the yield on the U.S. 10-year Treasury note
down by somewhere between a half and a whole percentage point. And we have all
benefited because the rates on most U.S. mortgages are linked to the yield of the 10-year
note.
Of course, now that the Japanese look like they're temporarily out of the business of
supporting the yen, the effect works in reverse. In the short run, it's another force putting
downward pressure on Treasury prices -- and upward pressure on interest rates. In the
long term, though, foreign buying of Treasuries will keep U.S. interest rates lower than
they would be if the Treasury market had to depend on just U.S. buyers.
Chinese competition has cut inflation in manufactured goods and brought more
inflation in commodity prices. It's not just the lower costs that Ohio Art or Hewlett-
Packard (HPQ:NYSE) get by moving production to China that have reduced inflation
here in the U.S. Competition with cheaper foreign goods and lower-cost foreign factories
has made it almost impossible for companies to raise prices on manufactured goods sold
in the U.S. Even a modest price hike has been almost a guarantee that the company would
lose market share.
The deflation in manufactured goods, however, has been offset by inflation in commodity
prices in food and energy prices. So while the consumer price index rose 1.6% year over
year in March, food climbed by 3.2%. The cause competition in the markets from
Chinese buyers for everything from soybean oil to nickel.
Chinese demand has meant higher energy prices, especially at the gas pump. The
energy inflation being exported from China is a special case just because it's so extreme.
Wall Street broke out in a sweat after the March inflation numbers because inflation over
the last three months has revved up. If you annualize the change in the CPI during the last
three months, inflation is running at a rate of 5.1%. But that shrinks into insignificance
compared with energy inflation, which has run at an annualized 38% rate over the same
period.
I certainly don't expect energy prices to keep climbing at that rate, but I do expect
inflation in the sector to stay well above inflation for the economy as a whole. Energy
inflation was, after all, 6.9% in 2003. Consider this one example: Chinese consumers
bought 2 million new cars in 2003. By 2014, projections put 100 million cars on China's
roads.
China has resurrected 19th-century imperialism with a twist. In the bad old days,
imperial powers turned less powerful regions into colonies. From the colonies, they then
extracted raw materials and sold manufactured goods on their own very favorable terms
of trade. In the 21st century, don't expect a return to such naked grabs of real estate.
Instead, the industrial economies will fight a much more subtle economic battle to lock
up critical commodities.
You already can see this in northern Asia, where China and Japan have been brawling
over the route of an oil pipeline from Russia's Siberian fields. China thought it had a done
deal to send the pipeline to Daqing in the heart of China's oil-producing region. But Japan
now seems to have the inside track for a route that terminates in the Pacific port of
Nakhodka -- and bypasses China's oil fields.
The U.S. has one key edge in this global competition because it is the sole industrial
power with the ability to project military force just about anywhere in the world. A key
question is how often the U.S. will choose to employ that edge in the competition for
resources.
China has helped generate the explosive growth in for-profit education. When the
job market gets tough, the tough go back to school. And the toughest go back to school
while they're still employed. UBS Financial Services calculates that about 17 million
adults in the U.S. fit this bill. It's these people, fearful of the changes now sweeping
through the economy, who are fueling the boom in for-profit education. UBS projects
that revenue at a company such as Career Education (CECO:Nasdaq) will grow at a rate
of 55% a year over the next five years. Expect the traditional colleges and universities to
react to this market shift with increasing numbers of nontraditional, postdegree programs
for working adults. The college campus will be a very different place in a decade.
China will accelerate development of the next generation of the Internet. The new
global economic system assumes subassemblies are made in Malaysia, assembled in
China for a Japanese company and, finally, sold to U.S. consumers through Wal-Mart.
The flow only works if a company operating different functional divisions under different
ownerships can communicate vast quantities of information in real time. The Internet as
we now know it is showing signs of stress and overload. So companies operating within
this global economic framework will push for the Internet's next generation to reach
commercially valuable stability as quickly as possible.
China is increasing the importance of logistics to business. These global virtual
companies don't just have a need to communicate vast amounts of data. They also must
be able to track an immense number of real objects in varying states of market readiness.
It's hard enough to manage a supply chain if all you have to do is walk from one end of
the plant to the other to see if you have enough left-door arm rests to keep your SUV
production line rolling at full speed. Now imagine that the left-door arm rests are coming
from an auto-interiors assembler in Canada as part of an interior unit that itself relies on
parts makers in Shanghai, Detroit, Stuttgart and Malaysia.
That logistics nightmare will require new systems for tagging and tracking in real time;
these systems are just now emerging with radio-frequency identification tags and global
satellite positioning systems.
China could make bottlenecks a way of life. In an ideal world, the combination of high-
technology logistical systems with real-time data-sharing over the Internet would result in
part A arriving at site B just in time to meet up with assembly C. But the real world is
messier than that. Railroad cars wind up in the wrong place or just don't exist in sufficient
numbers. An unexpected spike in demand meets up with health scares like SARS, and a
key factory shuts down just at the worst time. I can see three results:

• Massive and rapid swings in the prices of limiting inputs such as railroad cars or
ocean freighters.
• A sharp spike in consumer dissatisfaction as we hear more and more often, "I'm
sorry. That's not in stock."
• A rapid differentiation between companies that actually master this system (and
gain lots of new customers and make lots of money) and those that don't (and go
out of business).

That's about as far as I can see with my crystal ball. And as with any exercise in
imaginative projection, I'm sure that any one reader will disagree with some or all of
these potential trends.
But I think we can agree on one thing: The economic phenomenon that we call China will
reshape daily life in the U.S. over the next decade in ways that we've just begun thinking
about.

Changes to Jubak's Picks

Sell BorgWarner. I think I'm spitting into the wind with BorgWarner (BWA:NYSE) ,
and it's time to sell before a modest loss becomes something truly damaging.
Car sales have shown signs of slowing under the impact of higher gas prices. Inventory at
General Motors (GM:NYSE) of its gas-guzzling Cadillac Escalade, for example, now
stands at 125 days of sales, about twice the target level. Wall Street fears that this is just a
sign of things to come as gas prices stay high and interest rates start to move up. This is
forcing automakers either to sweeten their financing deals for buyers or face slowing
sales.
I'm selling BorgWarner out of Jubak's Picks with a loss of 11% since I added it to the
portfolio on Jan. 13, 2004. (Full disclosure: I will sell my personal position in
BorgWarner on May 14.)

At the time of publication, Jim Jubak owned or controlled shares in the following equities
mentioned in this column: BorgWarner. He does not own short positions in any stock mentioned
in this column. Email Jubak at jjmail@microsoft.com.

--------------------------------------------------------------------------------
May 28, 2004
If Oil Supplies Were Disrupted, Then ...
By SIMON ROMERO

OUSTON, May 27 - With demand high, supplies squeezed, prices climbing and
refineries already running flat out, what if something really went wrong? Something like
a terror attack on crucial oil installations in Saudi Arabia or in the United States, or
something less sinister but just as disruptive, like a fire or accident at a major refinery or
port or a flare-up of civil or labor turmoil in Nigeria or Venezuela?

Industry experts say that the drum-tight American fuel market has become unusually
vulnerable to any such nasty surprises, because there is little spare capacity available and
because traders, executives and policy makers are nervous about terrorism and other
threats - to the point that crude oil now carries a "risk premium" of 12 to 25 percent,
analysts estimate.

"The problem is, we've already tasted some of these events in one form or another," said
Daniel Yergin, chairman of Cambridge Energy Research Associates, an energy analysis
company. "The threat of an oil shock is very tangible. If an oil trader wants to think about
risk, all he has to do is turn on the television."

Just how big a risk premium traders will demand on oil is a subjective calculation, driven
up or down from day to day by news developments. One energy strategist, Fadel Gheit of
Oppenheimer & Company in New York, estimated that worries about Nigeria contributed
about $1 a barrel; Venezuela another $3; the situation in Iraq, $4 more; and jitters about
new trouble in Saudi Arabia, $5 a barrel. "In a psychologically charged market, bad news
travels faster than good news," Mr. Gheit said.

Without the black cloud of vulnerability from the market, many analysts say, crude might
trade for $30 or $35 today instead of nearly $40.

Gasoline prices, in turn, reflect worries about crude oil volatility overlaid with jitters
about refineries and low inventories.

To be sure, there are important differences between conditions today and 30 years ago,
when tensions in the Middle East disrupted oil supplies. Few economists see much
danger of the rationing, gas lines, sharp inflation and deep recession of those years
recurring today. Energy is a smaller component of the overall economy now, prices are
still fairly low in inflation-adjusted terms, and measures taken after the oil shocks of the
1970's provide some protection, most notably the creation of the Strategic Petroleum
Reserve, with a capacity of 700 million barrels.

Even so, President Bush's decision to fill the reserve after the terror attacks of September
2001 has been one of the factors driving up oil prices in recent months, along with reports
that China, which recently surpassed Japan as the second-largest importer of oil, is going
ahead with plans to build its own petroleum reserve. The Bush administration has resisted
calls to release oil from the American reserve.

The reserve now holds about 660 million barrels, making it the world's largest source of
stockpiled petroleum. Other domestic stocks, held commercially in refineries, pipelines
or storage tanks, stand at about 299 million barrels, about 5 percent below the average
level of the last five years, according to the Energy Information Administration.

Analysts say another immediate issue is the ability to turn the available oil into fuels.
Consolidation over the last two decades has cut the number of refineries in the United
States in half, to 153 from 301, and the survivors are working at well more than 90
percent of maximum capacity.

Even a small disruption, like a fire or maintenance mishap, could quickly result in a
temporary price spike. For example, when a relatively small 85,000-barrel-a-day refinery
operated by Valero Energy in Krotz Springs, La., shut for less than a day earlier this
month because of a power failure, gasoline futures prices shot up by 5 cents a gallon.

No relief is in sight. "We haven't built a new refinery in this country for three decades,"
Lee Raymond, the chairman of Exxon Mobil, the nation's largest energy company, told
reporters this week after the company's annual meeting. "Refineries historically haven't
made money, and I don't see a lessening of environment restrictions."

As a result, the United States now imports about 10 percent of its refined gasoline,
mainly from Europe and South America. But many foreign refineries have struggled to
adapt as many states have switched to requiring cleaner-burning blends of gasoline this
year.

Political tensions in Venezuela, historically a leading supplier of both crude oil and
gasoline to the United States, have made matters worse. Opposition to President Hugo
Chávez within the state oil company, Petróleos de Venezuela, resulted in a management
purge that hobbled the company, to the point that the country has recently had to import
gasoline.

Analysts estimate that Venezuela is now producing only 2.5 million barrels of oil a day,
down from more than 3 million before the political crisis; much of the missing production
would have been destined for the American market.

Newer to the picture are the growing concerns about sabotage and unrest spilling over
from Iraq to other nations in the gulf. "The real fear factor is at the heart, within Saudi
Arabia," said Fareed Mohamedi, chief economist at PFC Energy, a consulting firm in
Washington. "The idea that terrorists could target specific facilities within the kingdom
brings the fear to a new level."

Attacks in early May that killed five Western contractors in Yanbu, a Saudi refinery and
petrochemical center on the Red Sea coast, did not disrupt oil supplies directly, but they
created anxiety about the security of other facilities, not least because Saudi officials have
suggested that the attacks may have been the work of a regrouping Qaeda terror network
that intends to strike again.

"That's why all the Saudi talk about increasing output has already been discounted
without having a downward effect on prices," Mr. Gheit of Oppenheimer said. "It's a
psychologically charged market that's trading on the fear that the O.K. Corral atmosphere
of Iraq could spread to Saudi Arabia."

A year ago, analysts say, the world could manage without Iraq's two million barrels or so
of daily production, but recovery in much of the developed world and roaring growth in
China and India mean that the global market now needs every drop.

In fact, global oil demand is expected to grow faster this year than at any time since 1988,
rising by about 2 million barrels, to 80.6 million barrels a day, according to the
International Energy Agency. So the production gains from the painstaking
reconstruction of Iraq's oil infrastructure in the last year have already been absorbed by
export markets. A failed attack in April on an important Iraqi offshore terminal was a
reminder of how tenuous those gains might prove to be.

Along with security concerns abroad, the fear of attacks on energy hubs within the United
States also haunts the market. While there is little public evidence that such attacks are
being planned, the F.B.I. issued a warning in March that Al Qaeda might be preparing to
blow up pipelines and refineries in Texas ahead of the November elections.

The Houston area, with two of the four largest oil refineries in the United States and
much of the infrastructure used to transport oil and natural gas around the country, has
been mentioned as the most sensitive potential target. The city is also the intellectual and
financial center for the global energy industry.

"A possible attack is absolutely a concern for us," said Rick Hagar, spokesman for the
East Harris County Manufacturers Association, which represents 125 industrial concerns
along the Houston Ship Channel, among them refineries, shipping companies and
petrochemical plants. "It's something to worry about night and day."

Copyright 2004 The New York Times Company | Home | Privacy Policy | Search |
Corrections | Help | Back to Top