Monday, March 24, 2008

Can Less Oil Consumption in the West Lead to Lower Global Demand?

By Peter McKenzie-Brown Until recently, there has been a constant refrain to the effect that Western economies seem undeterred by higher oil prices. Demand destruction does not seem to be taking place within OECD, even at today’s high numbers. The gist of the argument is that, compared to the situation in the 1970s, for example, oil is such a small part of GDP that the impact of energy prices is almost negligible. A lot of industrial demand destruction took place during previous periods of high prices, in the 1970s and 1980s. More recently, it has been taking place through the outsourcing to emerging economies of oil-intensive manufacturing. The chart shows that in transport, where fuel costs are almost everything, these notions do not apply. The ratio of the Dow Transports to the price of oil, which you calculate by simple division, illustrates how profoundly the lowest oil prices of recent years (1997-1999) helped boost such transportation industries as railways, airlines, trucking and shipping. It also shows how negatively higher prices have affected transportation shares in the years since. Here is the same chart in less abstract form, displayed in terms of its two constituents. In this chart and the one above, the RSI (relative strength index) and MACD indicators apply to the transport index. Click on the charts to see them full size, or click here for updates on the charts used in this article. There is nothing particularly profound in pointing out that the transportation industries are strongly affected by higher oil prices. To use air travel as the most obvious example, fuel represents something in the order of 60% of its operating costs. To what extent is that affecting other parts of the economy? High energy costs are causing industry outside the transportation sector to find ways to cut per unit energy costs, and that is significant. Also, North Americans are buying more energy-efficient vehicles, but so far that has been more a trickle than a flood. However, this chart suggests what I think may be a coming sea change in North America’s energy consumption behaviour. Before you read my interpretation of this graphic, see whether you can figure out why. NYMEX gasoline futures have only been traded for four years. Since data is so limited, we have to be careful how we interpret this chart, which shows wholesale gasoline and oil price changes, and also indicates (vertical blue lines) America's driving season. When I look at this chart three things seem obvious. The first is that gasoline prices peak during the American driving season. That makes sense, since the summer months are the period of peak demand. My second observation is that peak gasoline prices during the driving season are higher than the relative changes in the price of oil by a considerable margin. The third is that wholesale prices are reaching new highs well ahead of the driving season this year, reflecting much higher crude prices. To my mind, all this suggests a steep spike in gas prices coming, and a change in the recent dynamics of crude oil's crack spread. We Canadians, who buy gasoline in litres, pay the equivalent of about $4.50 per gallon out of smaller per capita incomes. Even at those prices, we are paying barely half of most European prices. But our American neighbors are complaining about pain at the gas pumps with gasoline below four bucks a gallon. Will much higher gasoline prices this year finally cause them to begin changing their driving habits? I should think so. Perhaps, like Canadians, they will finally begin driving smaller, more fuel-efficient cars, drive less and so on. If so, that would be a good thing, and it would lead to continued crude oil demand destruction, although on a small scale. There is solid evidence for this in a number of areas. US gasoline inventories are at their highest levels since 1993, for example, and gasoline demand is trailing last year's level. (However distillate fuel inventories - diesel and heating oil - are lower than last year, especially in the Northeastern US market.) Will these developments lead to global demand destruction? Not according to an excellent commentary from Paul Hodges. Hodges acknowledges that demand in OECD countries is flat to declining. "The major influence is the weather. This year is seeing a mild winter, so demand will probably be down around 1mbd (million barrels per day)." However, he says, demand outside OECD is growing at around 1.6 million barrels per day per year.
This is focused on China (390 thousand barrels per day growth in 2008), Saudi Arabia (150 kbpd), other Middle East (330 kbpd) and India (140 kbpd). The common characteristic of all these areas is a relatively young population, growing incomes, and heavily subsidised oil product prices. There seems little chance of any of these factors changing in the next few years. Governments do not want to stir up social unrest by increasing domestic prices, and have no pressing need to do so as they all have healthy fiscal positions. 2008 is also likely to see a particular boost in China in the use of transportation fuels, due to the Olympics.
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