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OIL DEMAND — WHY SO STRONG?

by Andrew McKillop

 

Oil prices, economic growth and adjustment

In October 2004 the call of finance and economic policy makers in Europe, Japan and other OECD countries is for “oil saving and energy conservation”. Oil prices around 55 US dollars-per-barrel (USD/bbl) are set to stay above 50 USD/bbl and may ‘test’ price levels beyond 60 USD/bbl. This context proves, even to the most ardent defenders of the New Economy, that the ‘supply side’ is unlikely to fly to the rescue. Calls for OPEC or Russia to increase supply are unlikely to bring down prices, either in the short-term or long-term. The most powerful reason is world oil demand growth.

Probably the most pervasive myth in energy-economics is that “high oil prices hurt economic growth”. Calculation of supposed ‘elasticity of economic growth’ with the oil price — that is the percentage point fall in world or national economic growth with a 10-dollar or 15-dollar rise of the barrel price from some ‘normal price level’ (eg. 30 USD/bbl to 40 USD/bbl) — is now a major artisanal activity for so-called ‘experts’. The most humorous aspect of this sagacious calculus is that each ‘expert’ has a different figure, and different time horizon for the ‘inevitable fall’ in economic growth that they are paid to forecast, by heavily reworking and distorting easily available, real world economic and energy-economic data. An example of this cottage industry is the recent estimate by Morgan Stanley’s chief economist Stephen Roach that world economic growth will be ‘shaved’ by 0.3% in 2005, from 3.9% to 3.6%, through oil prices moving from the ‘right price’ of 33 USD/bbl to ‘economy hurting’ 50 USD/bbl.

The US economy attained it highest-ever postwar growth of real GDP, achieving what today would be the certainly impossible all-year (12-month) rate of 7.5%, in the Reagan re-election year of 1984. At the time, in dollars of 2003 corrected for inflation and purchasing power parity, the oil price range for daily traded volume lighter crudes was about 55-68 USD/bbl. Today, with oil prices set in the range of 50-60 USD/bbl, US economic growth on an annual base is likely above 3.75%, and achieved more than 4.5% on an annualised base, earlier this year. Outside the US, economic growth forecasts by the OECD secretariat for all regions of the world, including oil-importing China and oil-importing India, have either been maintained, or significantly raised since June 2004, as oil prices have increased. In September, the IMF issued forecasts that world economic growth in 2004 will be well over 4.5%. World merchandise trade growth in 2004 is running at its highest rate for over 15 years.

More important, regional economic growth trends in oil-importing low income countries of Africa, and oil-importing emerging economies of Latin America (notably Brazil) have in 2004 strongly rebounded from recession or low growth in 2001-2003. That is, economic growth in these countries has been levered up as oil prices have increased — for the simple reason that higher oil price entrain price rises for non-oil minerals, the metals (eg. iron ore and steel, copper and aluminium), and certain energy-intensive agrocommodities. In brief, the revenue effect due to fast increasing oil prices vastly outweighs the cost effect, and is particularly strong as oil prices move into the 45-60 USD/bbl range.

This is a simple fact of global macroeconomics, but contains a very sombre ‘bottom line’ for the oil-intensive and oil-wasteful, older developed countries of the OECD bloc, erroneously called ‘postindustrial societies’. Typical oil intensities per head of population in these countries are extreme relative to the fast growing, industrialising ‘behemoth economies’ of Asia — whose oil demand is on a relentless upward track. In addition, in the lowest income countries of Africa and Asia, and in poor countries and rural areas of middle income countries of Latin America, oil intensity per capita is so low that its upward potential is simply ‘unlimited’. The emerging picture, therefore, is for world oil demand to continue its recent explosive upward trend. Real solutions and responses to this new long-term outlook, for the OECD bloc, feature strong intervention to restructure the economy for oil saving, and the most rapid possible development of ‘sustainable infrastructures’ based on renewable energy.

 

Oil prices and oil intensities of the economy

Over the last 30-40 years, particularly since the early 1980s, the world economy has become ever more integrated and interdependent. This has had strong, long-term impacts on oil intensity of national and regional economies, and the world economy. Thus, taking the more oil-intensive EU countries of the EU-15, Japan, and the USA, there has been an apparent decline in their oil intensities, measured in barrels/capita/year (bcy) through the period of about 1975-1996, but this decline has stopped in most of these countries for at least 5 years (since about 1996-1999). This apparent, and no longer effective decline has been much utilised by economic and financial authorities — notably by US Federal reserve chairman Greenspan and ECB president Trichet — to repeatedly claim that the OECD is “less dependent on oil” than at the time of the 1973-74 and 1979-81 Oil Shocks.

Typical and apparent declines in oil intensity, measured in bcy, vary from about 10%-33%, for example the oil intensity of France has declined from about 16 bcy in 1973 to 11 bcy in 2002 (and has slightly increased since 2002). In the US and Canada, oil intensities remain in the 18 (Canada) to 25 bcy (USA) range. For the EU-15 in 2004 the group average is about 12 bcy, as in Japan and South Korea or Taiwan, with little variation between ‘developed high income OECD’ countries.

It is however only necessary to glance at the structure and value of trade between OECD countries, and in particular China, India and Brazil to find that in overall terms the OECD is an exporter of services, with a very low oil intensity per unit value, and an importer of industrial products with a high oil intensity per unit value. In other words, oil demand has been ‘exported’ or delocalised by trade. The oil intensity of production has fallen in the OECD countries since 1973, but the oil intensity of consumption has remained little changed. Since about 1996-1999, the oil intensity of both production and consumption has increased in most OECD countries (notably the USA).

Overall trends since 1965 at the aggregate world level are as shown below in Table 1

 

Table (1) World per capita average oil demand and oil price trends 1965-2004

Year World population
Year average
Millions
Average daily oil demand
Mbd
‘all liquids’
Billion barrels consumed per year Change on previous 3-year value (percent) World per capita average (bcy) Barrels/capita per year Year peak oil price in 2003 dollars per barrel (light volume crudes)
1965 3310 31.23 11.39 + 17.2% 3.65 USD  9/bbl
1968 3520 39.04 14.25 + 25.1% 4.05 USD  9/bbl
1971 3750 51.76 18.89 + 11.4% 5.04 USD 15/bbl
1974 3980 59.39 21.68 + 14.8 % 5.44 USD 56/bbl
1977 4200 63.66 23.23 + 7.2% 5.53 USD 39/bbl
1980 4410 64.14 23.41 + 0.7% 5.31 USD 82/bbl
1983 4650 58.05 21.18 - 9.6% 4.56 USD 59/bbl
1986 4890 61.76 22.54 + 6.4% 4.60 USD 32/bbl
1989 5150 65.88 24.04 + 6.6% 4.67 USD 32/bbl
1992 5400 66.95 24.43 + 1.6% 4.52 USD 29/bbl
1995 5610 69.88 25.51 + 4.4% 4.54 USD 25/bbl
1998 5870 72.92 26.62 + 4.3% 4.51 USD 18/bbl
2001 6130 75.99 27.74 + 4.2% 4.53 USD 31/bbl
2004 ~ 6400 ~ 82 ~ 29.75 + 7.5% ~ 4.67 USD ~ 55/bbl


(estimated 2004 outturn)

Population data/ UN Population Information Network (year average or “June” population estimate)
World daily average oil demand each year : BP Statistical Review of World Energy, various edns.
Peak annual oil price (2 month basis) for volume traded light crudes. World demand and price deflator 1965-2001, and price forecast for 2004 are by this author.

 

Presented in graphic terms (see below) world average oil demand in bcy has tracked oil price trends, with important and major ‘lead-lag’ variations in time. Perhaps most important for deciding and forecasting future trends, the period 1960-75 can de described as the ‘swan song’ of classic or Belle Epoque economic growth in the now aging OECD societies and economies. At the time, typical economic growth rates for these countries was around 4%-4.5% per year, and typical oil demand growth rates were around 4% per year.

 

 

Inelastic demand and faltering supply

The period of 1965-1977 is of particular interest for forecasting the near-term outturn. During that period oil prices attained well over 75 USD/bbl in 2003 dollars but world oil demand growth outweighed any ‘price elastic’ effect able to trigger a fall in world average per capita consumption. The role of fast economic growth, and the utility and necessity of oil in the economic growth process led to world oil demand growing much faster than world population. This in turn resulted in world oil consumption increasing faster than population, raising the bcy average. We can therefore easily suggest that oil prices of above 75 USD/bbl will be needed to trigger a fall in the oil intensity of the world economy, in the absence of concerted, international effort for oil saving, energy conservation and energy transition.

This ‘retrospective’ analysis concerns a far less-integrated world economy than the present, and a world population that has grown by over 50% or 2.2 Billion since 1977. World average per capita oil demand is on the one hand tightly correlated with GNP/capita, urbanisation and industrialisation (that is ‘economic development’), and on the other remains extremely high in the older, aging OECD ‘postindustrial’ economies and societies. Conversely, bcy figures for the fast emerging economies of China, India, Brasil and Pakistan are still low or very low, compared to the OECD. In other words, these countries, together with other emerging lower income countries, and very large rural population groups in many middle income countries have almost unlimited upside potential for oil demand.

This can be demonstrated very easily. If we take the most extreme oil intensity in the OECD, of the USA at about 25 bcy, this oil intensity is quite simply impossible to reproduce at the world economy level. See Table 2 below

 

Table 2. Demographic rate of oil demand, 2004

Country/Region bpy World demand at this rate
USA 25.6 445 Mbd
Italy 12.4 215 Mbd
China 1.6 29 Mbd
India 1.3 23.5 Mbd
Rural areas, LDCs 0.2 3.5 Mbd
Real world 4.67 81.5 Mbd
---------------------------------------- ----------------------------------------
World annual population growth Annual ‘latent demand’ increase
85 Million 1.1 Mbd

Sources:
Population data from UN Population Information Network, Oil demand
BP Amoco Statistical Review of World Energy, 200 and 2004

 

We can surmise what would happen to world oil prices if world average bcy attained, for example, its most recent peak (see Table 1) of about 5.5 bcy in 1977, at which time average oil prices for lighter grade, volume crudes was in the region of 40 USD/bbl in 2003 dollars, or the 1980 average bcy of 5.3 bcy with oil prices around 80 USD/bbl in 2003 dollars. The result would be a jump in world oil demand to about 95 Mbd, the equivalent of about six years growth at current rates of growth (now running at about 3% per year).

This current growth trend of about 3% or 2.5 Mbd each year is at least double the rate claimed to be the ‘long term trend’ or ‘long term average’ by many oil corporations, energy agencies and economic planning authorities until the very recent past, that is 2003-2004. It is however only a fraction of demand growth rates generated by the fast economic, industrial and urban growth of the OECD countries in the 20 years before 1975 (see Table 1). World oil demand — but not world oil production — could in fact be ‘trending back’ to annual growth rates able to generate 10%+ growths in 3-year periods. There is therefore ‘demand shock’, this shock being due to faulty and unrealistic analysis of oil demand trends and determinants of world oil demand in a global economic context of very fast industrialisation and urbanisation of very large population countries and groupings.

Oil (and natural gas) demand growth potentials are in fact extreme or ‘unlimited’ given the rapid and self-reinforcing industrial and urban growth, and intense growth of car and vehicle fleets in countries such as China, Iran, India, Turkey, Brasil and Pakistan. This trend was forseshadowed by the ‘explosive’ and ‘classic’ economic growth of the Asian Tiger economies, fastest in the period of 1966-1986. In this period, countries such as Taiwan and South Korea increased their national oil consumption by about 700% to 1600% in volume terms, rapidly achieving average per capita rates of around 10 — 12 bcy, the EU-15 average of today.

>If we assumed that China and India were able to achieve simply one-third or one-half of the current EU-15 oil intensity per capita (12 bcy) by 2010-2015 this generates the following oil demand forecasts for China and India at the 2010-2015 horizon (Table 3).

 

Table 3. Oil demand potential, China and India at one-third and one-half 2004 average per capita oil demand of EU-15 ‘postindustrial’ countries (one-sixth to one-quarter US average bcy, 2004)

  Population in millions
year 2012
Oil demand at 4 bcy
Million barrels/day
Oil demand at 6 bcy
Million barrels/day
China 1400 15.8 23.3
India 1350 14.8 22.2
Total for 2 Countries, horizon 2010-2015 30.6 45.5

 

The near-term outlook

What counts for the near-term and mid-term, the next 3-5 years, is that world oil supply will almost inevitably trail world oil demand. That is, growth of world supply after compensation for annual depletion losses now running at about 1.25 — 1.5 Mbd and set to increase, will be unable to satisfy the essentially inelastic growth of demand. This will continue until and unless oil prices rise well above 75 USD/bbl, or an intense, worldwide economic recession is triggered through indiscriminate use of the ‘interest rate weapon’ in the OECD.

The growth of oil prices through April-October 2004 has in fact, and unlike the myth of ‘hedge fund speculators’ or what the Wall street Journal likes to call the ‘terror supporting activities’ of the OPEC “evil cartel” through denying oil supplies, traced an emerging context of structural undersupply. This is reflected by increasing difficulty for companies and national authorities to rebuild stocks in a context of ‘surprising’ demand growth and ever more fragile supply. This underlying market shortfall will be increasingly difficult to resolve on the supply side, as world oil demand growth continues to increase.

 

Energy transition or economic crisis?

Only the oil-intensive and oil-wasteful ‘postindustrial’ countries of the OECD bloc have the capacity — and strict national interest — to rapidly limit this fast emerging supply gap. The OECD bloc can, and in fact will have to dust off ‘old ideas’ on oil saving and energy saving, and energy transition to renewable based infstructures in the very short-term future. As in the 1973-1980 period, before the arrival of so-called ‘supply side’ or New Economics, there is again growing interest in oil saving, energy conservation, development of non-oil (and non-gas) alternative and renewable energy sources, and the treatment of huge inequalities and injustices in North/South relations. These have recently been brought to the UN in the form of a proposal for action in favour of the poorest communities and nations of the world by the presidents of France and Brasil, and the Prime Minister of Spain. As we can note from the above, the very poorest nations and peoples have the most unlimited upward potentials for oil consumption — while the realistic outlook, in fact imperative for the older, oil-intensive OECD countries and economies is a very fast reduction in their average oil demand per capita.

This is in the very strictest national interest of the OECD countries, because the so-called ‘reduction of economic vulnerability’ of the OECD countries to oil price rises (a favorite theme of US Federal reserve chairman Greenspan) is only apparent. Oil demand of the aging, ‘postindustrial’ societies of the OECD bloc has been delocalised or exported to fast-growing industrialising countries. The OECD countries then re-import the oil consumed for producing the industrial manufactured goods that are increasingly produced outside the North, but sold and consumed inside the ‘postindustrial’ North. Reduction of overall, econmy-wide and society-wide oil intensity in the North, therefore, is a fond wish or myth, like any slogan of so-called New Economics.

The programme for oil-saving in the North can be given targets, which of course can only seem ‘extreme’. Given the current and emerging context for world oil demand, of " one new Saudi Arabia " or " two new Russias " being needed every four years, that is world oil demand growth running at about 10 Mbd every 4 years, the imperative of oil demand reduction in the most oil-intensive economies and societies is very clear. Targets for oil saving will likely have to be at 5% or more reduction of oil demand per year. In the USA, we can note, current oil demand growth trends, and declining domestic oil production, result in oil import demand growing at about 5% - 6%/year. Oil saving programmes in the US would therefore need to target annual reductions in oil demand well above 5%. As oil prices increase to 60 USD/bbl and beyond, the interest in, and need for this programming will become clearer — even to policy makers brought up on New Economy myths and slogans. The real and first impacts of higher oil prices in the oil-intensive, oil-wasteful economies of the OECD, in the current economic structure context of the Northern economies, are not inflationary, but deflationary. This will soon become very clear.

 

Deflation and ‘the migration of economic growth’

Overall, and in the OECD bloc t he inflationary impact of higher oil and energy prices is more than compensated by ‘structural’ deflationary trends. The demographic and social impacts include rapidly aging populations (Europe and Japan) leading to a fast increase in non-working populations, lower real incomes, for example through longer work weeks and falling unionization of labour, increasing ‘structural’ unemployment, impoverishment and marginalisation of ever larger groups within ‘postindustrial’ society. Through more centralized and monopolisitic commercial structures, deflation is advantaged by falling producer prices but higher final retail prices, leading to reduced participation by small producers on the supply side, and deferred purchase and reduced sales volumes for higher volume consumer goods on the demand side. Economic and industrial organization changes include delocalisation and net transfer of employment outside the OECD, slowed capital investment spending, aging and poorly maintained, energy inefficient national economic infrastructures adapted to the ‘cheap oil’ period of 1986-99, etc.

These and other trends, in the OECD bloc, create or maintain a ‘slow growth’ context, where deflationary trends and stuctures act against economic growth. Over the period 1985-2000, closely corresponding with the ‘cheap oil interval’ of 1986-99, economic growth rate averages for OECD countries fell by about 50%, in some cases much more (for example Germany, Japan, Italy, France). Higher oil and energy prices further intensify the deflationary context that resulted, and which ‘drags’ growth potential downwards. The net result in global economic terms has been a ‘migration’ of economic growth, delocalised from the slow growth OECD, to faster growing nonOECD countries — along with the oil and energy demand needed for that economic growth.

It is therefore the older, aging societies of the North and not the fast industrialising countries, nor the poorest, vastly less oil-intensive economies and societies of low and lower income countries that will be first and hardest hit by rising oil prices. The deflationary structures and trends noted above, which are intensified by higher oil prices inside the North, will likely result not in an inflation crisis, but deflationary recession inside the OECD countries.

When or if the ‘interest rate weapon’ is applied inside OECD countries, because of belief by policy makers in the myth that “high oil prices cause inflation” this will most certainly result in inflation. Higher interest rates will quickly increase inflation and transmit inflationary trends among the OECD countries. The inflation outburst will of course be attributed to or blamed on oil prices. In the current economic, financial and monetary context, it would however be close to suicidal for fiscal authorities in the OECD countries to sharply raise interest rates, but similar suicidal “good management” was utilised in the early 1980s, in response to high oil prices, resulting in very intense recession and very high inflation.

Under any scenario, therefore, economic growth rates will likely fall in the OECD while they continue to increase or remain very high in nonOECD emerging economies. The net result for world oil demand will be little or no significant fall in ‘demand pressure’, due to world economic growth remaining high outside the OECD. This again leads, perhaps with a few year ‘grace period’ to structural undersupply and continuously rising prices, or higher oil price ‘spikes’ in a continuing context of rising oil, energy and ‘real resource’ prices.

 

Energy transition

The only real and lasting solution is energy transition — particularly transition away from near total dependence on oil and gas in the OECD countries. This can be given targets, inevitably ‘extreme’ because of the recent past of about 20 years in which non intervention and ‘supply side’ economics were supposedly capable of managing all and any ‘shortfalls’ in oil and energy supplies, while ‘continuously reducing’ the oil intensity and oil dependence of the OECD economies. In reality, neither of these fond wishes, or myths have occurred or apply in the real world and real economy

Target ranges for oil saving in the OECD countries will need to be in the range of 5% - 10% per year, perhaps integrated within frameworks for sustainable development related to the Kyoto Treaty process, and able to be implemented by no later than 2008. Savings at these high annual rates will be necessary from or before 2008 if decision makers in the OECD seek to seriously influence the very short-term prospect of structural undersupply leading to oil prices remaining far above 50 — 60 USD/bbl for the foreseeable future. How these savings will be achieved is a complex issue, requiring intensive study, and above all international negotiation and agreement, notably between the emerging industrial-urban economies (especially China, India and Brasil) and the older, aging OECD bloc.

Under any scenario, the renewables and especially hydroelectricity, solar and OTEC, will be given the prime attention they deserve. It is noted that apart from wind and geothermal energy, both of which are being or can be rapidly developed in the OECD North, the bulk of renewable energy potential concerns the lower latitude developing countries. In addition, the extreme oil intensity of current transport, habitat and hi-tech agriculture and fishing in the OECD bloc will necessitate large structural changes in current practices, involving greater but more extensive, renewable energy-based national or regional food, habitat, transport and infrastructure development.

 


Andrew McKillop   Founder member, Asian Chapter, Internatl Assocn of Energy Economists
Former Expert-Policy and programming, Divn A-Policy, DGXVII-Energy, European Commission