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.

Oil and Gasoline Prices: The Crack Spread

When a major US refinery shuts down, why do oil prices go up? This is counterintuitive. After all, a shut-in refinery means reduced demand for oil, and less demand should mean less price pressure, right? Wrong. Here's an account of the strange ties between oil and gasoline prices.

By the way, I could not find the original source of the excellent graphic above, although I know it comes from this blog.

By Peter McKenzie-Brown

The Question of Collusion: Motorists often express concern – call it anger, sometimes – about rising gasoline prices. Citing the reality that neighbouring service stations charge almost identical prices for gasoline, many consumers claim that oil companies illegally collaborate with each other to manipulate gasoline prices. It has frequently been shown, though, that market forces keep local prices the same. If a service station on one street corner charges a penny more per litre than its competitor across the street, motorists will buy from the competitor. It is in each dealer’s self-interest to match the competition’s price.

Economists have no trouble with this explanation of how companies set gasoline prices. It is nonetheless understandable how identical local pump prices cause motorists to suspect collusion by the oil companies – especially when those companies often raise gasoline prices, almost simultaneously, at the beginning of a holiday! Raising prices in anticipation of strong holiday demand is a marketing tactic, however, and not collusion.

Links between Oil and Gasoline Prices: The oil industry’s critics also argue that companies move gasoline prices up quickly when crude oil prices rise, but fail to bring them down when oil prices falter. This argument is also flawed, as a review of the ties between crude oil and gasoline prices in 2006 helps illustrate.

In the week of August 6, the average OPEC crude oil price hit what was then an all-time high: US$71.33 per barrel. That week Canada’s average price of gasoline also reached a peak, at $1.15 per litre. Compared to their averages during the previous two weeks, prices for both commodities rose by about 5 per cent. The following week, OPEC oil and gasoline prices dropped – in both cases, by about 5 per cent. By the week of October 1, which preceded Canada’s Thanksgiving holiday, OPEC oil had dropped by 22 per cent. However, the average price of gasoline for that week had declined to 86 cents – a drop of 27 per cent from its peak price two months earlier.

Oil and gasoline prices do track each other, but they are also influenced by other factors. The most important are crude oil prices and taxes.

Refining Problems and Gasoline Prices: In North America there has been a price disconnect between oil and gasoline in recent years. This is partly because the market for gasoline has been strong. This has worsened the limitations in America’s capacity to refine enough gasoline for its consumers.

Canada’s refining centres are at or near Vancouver; Edmonton; Sarnia and Nanticoke, Ontario; Montreal; and St. John, New Brunswick. There are also some smaller refining centres – notably Regina, Saskatchewan and Come-by-Chance, Newfoundland.

Canadians ordinarily produce more than enough gasoline for domestic use. We sometimes import gasoline because refineries need regular maintenance shutdowns or have unexpected operating problems. As the following chart illustrates, our imports are offset by exports to the United States.
The graph also illustrates the seasonal nature of gasoline consumption – we buy far more in the summer than in the winter – and the fact that Canada produces far more gasoline than we consume. Canada exports significant volumes of gasoline, primarily from refineries in Atlantic Canada to the U.S. eastern seaboard. Each year, Canadians consume more than 40 billion litres of gasoline and 25 billion litres of diesel fuel.

The bar on the far right of the chart shows Canada becoming a large net-importer of gasoline – for the first time in recent history – in May and June 2006. This occurred because the industry needed to modify many refineries to meet new refining standards. These shutdowns reduced gasoline production just as summer driving was ready to begin, and Canada had to import large volumes to meet demand.

During that summer, motorists witnessed higher, more volatile prices than they had in a long time. Canada was extremely vulnerable to unplanned refinery outages. That brief experience was a small reflection of a large, chronic problem in the United States, and America’s problems affect gasoline prices across the continent.

American Vulnerability: The US has become highly vulnerable to refinery shutdowns, and gasoline prices have developed a volatility that reflects both oil price movements and problems in the refining industry. To some extent, this vulnerability and volatility have splashed across the border into Canada. Gasoline is increasingly a global commodity.

Americans consume about 1.51 billion litres of gasoline every day. The United States is thus the largest gasoline consumer in the world, but it is also the largest refiner. The United States does not produce enough gasoline to meet its own needs, however. It always needs imports, and imported gasoline can be expensive.

“Turnarounds” (scheduled maintenance programs) at US refineries put pressure on international gasoline supply, including supply from Canada. But in recent years unexpected breakdowns at refineries have added urgency to the challenge of meeting consumer needs. These events and stronger demand during the summer driving season contribute to higher prices.

As a rough average, in recent years the US refining sector has operated at 90 per cent of capacity. Put another way, 10 per cent of US refineries have been out of operation at any given time. In that environment, imagine what happens when one or two refineries shut down, reducing capacity use to 89 per cent, say. In a tightly balanced gasoline market, this can cause steep and rapid price increases – something the world witnessed dramatically in 2005, as Hurricane Katrina shut down refineries and closed ports that could have imported gasoline from overseas. The panic that followed briefly took Canadian prices to an all-time high of $1.26 per litre.

A Spiral in Gasoline and Crude Oil Prices: One of the oddest phenomena in the present world of gasoline pricing is its impact on the price of crude oil. As this article has explained, it is logical for gasoline prices to go up along with oil prices. After all, refiners manufacture gasoline from crude oil, and rising input costs contribute to rising total costs.

However, higher gasoline prices also result in higher oil prices. This is less intuitive, for a number of reasons. If a large refinery shuts down, it is reasonable to expect gasoline prices to rise. Less gasoline will be produced, lowering supply; prices will therefore increase. Since there would be less demand for oil to refine, one would normally expect crude oil prices to drop. What actually occurs, however, is the opposite: When a big North American refinery shuts down, both gasoline and oil prices rise. Welcome to the world known to traders as “crack spreads”.

“Crack spreads” refers to the spread, or margin, that a refinery can earn by “cracking” (refining) a barrel of oil into such marketable products as gasoline, jet fuel and heating oil. Roughly speaking, three barrels of West Texas oil can be refined into two barrels of gasoline and one barrel of heating oil. If these products rise in value, the value of the barrel of oil they come from will also increase, even if refinery demand for oil has dropped. Thus an off-the-wall oil price spiral: rising crude oil prices increase the price of gasoline, and rising gasoline prices increase the price of oil.

Changing Dynamics: This article has reviewed many factors that are changing the dynamics of gasoline pricing. These factors include rising oil prices. Also, some taxes climb in response to escalating fuel costs, and this further complicates the issue of rising gasoline prices.

We are becoming increasingly reliant on gasoline as our society changes, and there are inefficiencies in the North American petroleum infrastructure that – because petroleum refining and marketing is such a huge industry – will take a long time to strengthen. Of course, this begs the question of whether the oil would be there to supply a larger, more efficient refining sector. That's a question for another day.

Ethanol: A Collision between Food and Energy

Drying out after the deluge.

By Dave DuByne

In the matter of ethanol production, China has two Achilles’ heels. Rising food prices and natural disasters are influencing bio-fuel production, and leading to new regulations for gasoline exports.

In the past, the country has satisfied nearly 100 per cent of its own grain demand. The autumn harvest accounts for 70% of the total annual production. In January this year, Chinese grain consumption for 2006-2007 was forecast to reach 144.5 million tonnes, with country-wide output reaching 144 tonnes.

In northern China, a drought has hit about 11.5 million hectares of arable land (1 hectare equals about 2.5 acres). And during the rainy season in the south, flood waters submerged about 9.7 million hectares, putting the total submerged and parched dry land at one-sixth of the country’s 120 million-hectares of arable land. Add to this damage to half a million hectares that have been devoured by rice-plant hoppers in Sichuan Province, and Beijing may have to turn to imports.

China leads the world in consumption of rice and wheat, and this year’s grain forecast is razor thin, consumption versus production. If China turns to imports, how much additional grain will be required, and how much will it drive up grain prices on the world market?

Inflation Worries: The Consumer Price Index (CPI) grew 5.6% in July 2007, the highest in ten years, with meat (especially pork) rising 43% in one year. Meat, poultry, eggs and grains led the index. The following month, in August, China declared a moratorium on the construction of most ethanol plants. Chinese officials recognized that producing corn-based ethanol was linked to rapidly rising food prices. Xu Dingming, an official of the National Energy Leading Group, told a recent seminar: “Food-based ethanol fuel will not be the direction for China. Unless ethanol can be produced using ‘non-staple crops,’ it won't be produced in China at all”.

On September 1st, the head of China’s Energy Ministry, Ma Kai, told a television audience that “For the long-term development of our Chinese nation, saving energy and reducing pollution are so important, so urgent. If we don’t change this situation… the economy will go badly and won’t go far”. It was the first televised large-scale appeal to consumers to change their lifestyles and conserve energy.

A week earlier, the National Development and Reform Commission (NDRC) called on China's major oil refiners to strictly control oil product exports. The NDRC is the government body in China that normally decides economic and pricing policies. Immediately following the order The Petroleum and Chemical Corporation (Sinopec), Asia's largest refiner, said it now plans to export no more than what is called for from its fixed long-term contracts, and PetroChina, the other major oil refiner in the country, cut August gasoline exports to 160,000 tonnes, a decrease of 33% a – the year's lowest figure so far. The China News Service added that, apart from contracted supplies such as those to Hong Kong and Macau, Sinopec will reduce oil product exports in all regions to the lowest level of the year.

Ethanol Production: There is still ethanol production in China coming from China’s largest ethanol producer, China Agri Industries. China Agri plans to open two more refineries this year – a 100,000-ton project in Hubei and a 300,000-ton project in Liaoning. These projects will use sweet potatoes as the feed stock. An additional 1 million tons of capacity also using sweet potatoes, awaits regulatory approval. If it gets permission to go ahead, this capacity will be added by the end of 2008.

China Agri has started using a different feedstock grain, sorghum, to produce ethanol. Sinopec and PetroChina have teamed up with China Agri in the downstream ethanol blending business. Other feedstock plants for China Agri ethanol plants include sugar cane and cassava. The shift of feedstock has caused a bump up in price of sorghum and sweet potatoes.

Ethanol production is an important part of China’s energy strategy. However, a billion and a half people watching their food prices double in the last two years have led to a lot of unhappy words. Energy consumption has collided with food production in a time of natural disasters. It seems the Chinese course of action is to curb exports of gasoline, keep it in the country to offset lost ethanol production.

Liquid Fuels: China has bountiful natural gas, hydroelectric power and coal supplies. Connected by pipeline, Tajikistan fills in the gaps, and there is no lack of energy for factories and power plants. The point is, of course, that crude oil is irreplaceable. There is no substitute, even in countries and regions rich in two out of three fossil fuels. Crude oil is the lifeblood of the economy, since it drives transportation.

Chinese road transportation networks use a combination of compressed natural gas (CNG), electric vehicles as well as ethanol blended gasoline, far more diverse methods and on a much larger scale than North America. Even so, this country can’t survive without large amounts of crude oil. Perhaps what we see happening here is a litmus test for future reliance on substances other than crude oil to power our transportation networks. If so, the effects of peak oil and depleting oil supplies worldwide will be far more damaging than most people expect.

It seems there is no “magic bullet” for our world’s energy problems. Even a combination of magic bullets isn’t enough. Right here, right now, staring you in the face: The vulnerability of ethanol production is all too obvious.

David DuByne is from the United States and is presently living and teaching Business English in Chongqing, China. He and webmaster Marc Hastenteufel are translating his website - Dave's ESL biofuel - into Mandarin Chinese. This English teaching website is devoted to bio-fuel and oil depletion. Robert Rapier, an expert on cellulose ethanol, gas-to-liquids (GTL), and butanol production, provides technical assistance in the renewables and conservation section.