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     Feb 10, 2005
Dealing with runaway oil prices
By Andrew McKillop

Recent data from the Organization for Economic Cooperation and Development's (OECD's) International Energy Agency (IEA), the US Energy Information Administration (EIA), leading oil analysts concerning world production and inventory in key consumer countries, together with "traditional" claims by certain analysts that OPEC (Organization of the Petroleum Exporting Countries) is still able to "overproduce" is taken by some commentators as offering a prospect for oil prices sliding below the current, rising levels in the region of about 36-45 euro/barrel (US$45-55), perhaps by mid-2005.

Optimism regarding non-OPEC supply growth is, however, muted at this point, with the only major upturn to counter non-OPEC production decline by the three largest OECD producers (US, Norway and the United Kingdom) coming in the shape of Azerbaijan-Turkey pipeline deliveries from Caspian-region producers. Deliveries are slated to build to not much above, and probably less than, 2.5 million barrels/day (mbd) from spring, 2005. World demand growth remains very strong - at about 3%/year or 2.5 mbd per year - with exceptional growth being recorded not only in the emerging industrial superpowers of China and India, but also in East Europe, the US and West Asia.

World oil stocks, depending on the country and using periodic data from the IEA, EIA and oil analysts, in fact remain well below the average figures for the 2000-2003 period. Combined with recent - extreme - figures from the IEA for world oil production (well over 82 mbd), the overall reading is that world oil markets will remain tightly supplied with generally uptrending prices, right through the period to 2010.

The base for this situation is, in particular, world demand growth. This "vintage" growth has been consistently underestimated now for more than two years, not only by the oil majors and national economic forecasting institutions, but also by major oil importer country agencies, such as the IEA and EIA. These two agencies, in their periodic publications and data series, have continued to forecast slower demand growth likely to "go forward" while publishing real figures for the real world that show "vintage" growth in nearly all markets.

The base for this "surprising" growth in world oil demand, and reason why demand is growing faster than in the 1990s, is unstoppable growth of all forms of commercial energy demand by very fast-growing economies, including China, India, Brazil, Pakistan, Iran and Turkey. In addition, the type and nature of economic growth at the world level, also including the older, slower-growth OECD economies, has become more oil-intensive. This is reflected in the US (taking about 26% of world oil output) by consistent and large oil demand growth coming out of the 2001-02 recession in what has essentially been a "jobless recovery".

Weather trends have become ever stronger, even key factors in deciding price movements - again reflecting the tightly balanced, low stock context that is generated by world demand growth trends moving ever further away from the "low growth paradigm" of the early 1990s. World oil demand has moved up with higher oil prices, which themselves lead to faster economic growth through raising "real resource" prices and revenues to generally low-income exporters of non-energy minerals, metals and agro-commodities.

Another factor tending to drag oil prices higher is strong growth of natural gas demand in several world regions, while supply flattens and then shrinks. For the two largest gas consumer regions, the US and Europe, the fast emerging picture is one of serious shortfalls in regional and national gas supplies becoming "structural" pricing factors. Gas prices in the US will certainly never return to those in the "cheap oil interval" of 1986-99, when daily traded prices averaged around $2/million British thermal units (MMBTU), and oil prices held at around $18-30/barrel. The emerging gas price paradigm for US consumers is now in the $7-10/MMBTU range, equivalent in energy economic terms to oil at around $38-55/barrel.

Gas prices in Europe are "traditionally" above US and Asian prices; faster decline of European gas production (depleting at 5%-6%/year) compared with US domestic output (depletion around 2%/year) will for some time maintain or reinforce this differential. In turn, this will drive European oil prices closer to price levels in the US, negating market proximity-transport cost differentials that tend to reduce European oil prices relative to US. Gas at $10/MMBTU results in oil at 40-45 euro/barrel becoming competitive and the emergence of these price levels will push day traders to erode residual negative price differentials against oil, effectively raising its price in both markets.

Oil prices and world growth
Since late summer, 2003 and for about four months into 2004, US economic growth was likely running at close to its record post-war rate of about 7.5%, last achieved for a whole-year (12 month) period in 1984. At the time, expressed in dollars of 2003, yearly average oil prices were in the region of $52- 65/barrel. In 2004, through June-September, as oil prices moved up to and beyond $50/barrel, the OECD and International Monetary Fund (IMF) consistently revised economic growth estimates for Europe, Africa and Latin America. The IMF estimated that world economic growth in 2004 would be at least 4.5%, the highest in over 10 years. World merchandise trade growth in late 2004 was at about 15%/year, the highest in over 15 years. These real-world, real-economy data provide a direct challenge for those who regularly claim that "high oil prices hurt economic growth".

As in 1984, faster economic growth in 2003-2004 is in no way hindered by higher oil prices, and in fact is likely accelerated by higher oil and energy prices spinning off higher prices for non-oil raw materials, agro-commodities and other "real resources", and raising the purchasing power of generally low-income exporter countries of "real resources". In addition, higher oil and other "real resource" prices - these resources quoted and traded in US dollars - automatically levers up world liquidity, which then buoys and reinforces world solvent demand. At the same time, the emerging industrial superpowers of China and India have such generally low economy-wide oil and energy-intensity (around 1/8th to 1/15th per capita oil-intensity of the US and EU countries) that they are easily able to absorb much higher oil and energy prices without strain to their balance of payments.

Over the past 39 years, the oil price impact on world oil demand trends has been complex and variable. In the chart and Table 1 below, I compare year-peak oil prices in constant 2003 dollars and average demand together with demand trends on a three-year base.



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/
year

Year
peak oil price in 2003
US$ per barrel
(light volume crudes)

1965

3310

31.23

11.39

+17.2%

3.65

$9/bbl

1968

3520

39.04

14.25

+25.1%

4.05

$9/bbl

1971

3750

51.76

18.89

+32.6%

5.04

$15/bbl

1974

3980

59.39

21.68

+14.8%

5.44

$56/bbl

1977

4200

63.66

23.23

+7.2%

5.53

$39/bbl

1980

4410

64.14

23.41

+0.7%

5.31

$82/bbl

1983

4650

58.05

21.18

-9.6%

4.56

$59/bbl

1986

4890

61.76

22.54

+6.4%

4.60

$32/bbl

1989

5150

65.88

24.04

+6.6%

4.67

$32/bbl

1992

5400

66.95

24.43

+1.6%

4.52

$29/bbl

1995

5610

69.88

25.51

+4.4%

4.54

$25/bbl

1998

5870

72.92

26.62

+4.3%

4.51

$18/bbl

2001

6130

75.99

27.74

+ 4.2%

4.53

$31/bbl

2004

~6400

~82

~29.75

+7.6%

~4.67

$~55/bbl

Data sources:
 
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 editions;
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 the author.

The oft-repeated but unproven claim that high oil prices hurt economic growth also lacks proof of its logical corollary, ie "low oil prices favor economic growth". The fast fall in economic growth rates in all OECD countries following the "liberation" of Kuwait in 1991 was accompanied (in fact driven) by fast falling oil and energy prices. In any case, cheap oil in 1991 led to no spontaneous upsurge or recovery in US or other OECD country economic growth. The huge oil price falls of 1985-86 did not lead to faster economic growth in any major OECD country through 1986-88 either.

Conversely, the "Baghdad Bounce" so often predicted by business and finance "experts" for the US and world economy in the run-up to the US and UK invasion of Iraq in 2003 was most certainly upward - for oil prices. Economic growth rates, already at high levels in South and East Asia, were either unaffected, or marginally increased by the economic context in which oil prices bounced upward and continued bouncing upward as Iraq descended into chaos. From early 2004, with continuing and strong growth of the oil price, the "trickle down" effect of higher oil, gas and "real resource" prices began to take effect. Since early 2004, economic growth rates in most world regions, including Europe, Africa and Latin America, have been repeatedly re-estimated upward by the European Commission, OECD and IMF. In addition, and for about 4 months from late 2003, even the erratic US economy showed some signs of "vintage" economic growth before falling back to lower and more hesitant trend rates of about 3.75% to 4.5% in mid-2004.

It is easy to identify non-cheap oil as a cause of this "bounce" or "rebound" of world and regional economic growth trends outside the US, and not the cause of hesitance and fragility in the special case of the US economy. In end-2003 and in the first 9 months of 2004, there were no signs, anyplace in the world, of fast-falling economic growth rates. This is claimed to be "despite high prices" by the vast majority of institutions and "experts", but it is also easy to turn this argument around.

Real world oil demand
According to data published by the IEA, world oil production in January 2004 was running at over 81 mbd. By mid- to late-summer 2004, IEA estimates indicated world oil demand running around 81.75-82.5 mbd. The same IEA source (the "Oil Market" bulletins) indicates in previous issues that average daily demand for 2002 was well below 76.5 mbd (in the range of 76.1-76.4 mbd).

Growth on a 24-month basis (2002-2004) is therefore up to 7%, and for the 36-month period (2001-2004), growth of world oil demand was at least 7.5%. This is the highest rate of growth for over 25 years. We can surmise that if 2001 had not been exposed to the dotcom-telecom crash and the 9/11 terror attacks, leading to a fast fall in economic growth, world oil demand growth in 2001-2004 could easily have exceeded 9%.

This underlines a central argument for oil prices continuing their upward trend since 1999: average three-year growth rate trends held at no more than about 4%-4.5% through the 1990s, with per capita oil consumption staying flat at close to 4.5 barrels/year since the early 1980s. This has now changed quite dramatically. Demand growth rates have increased fast, raising per capita average oil demand, proving that "low-oil-demand-growth-low-oil-prices" is in no way a "fixed paradigm". This paradigm shift, we should note, is occurring in a real world situation of oil prices increasing while world oil demand continues to expand very fast - a context in which higher oil prices lever up world oil demand.

A new paradigm, of rising per capita rates, as experienced in the "high oil price" period , is more than possible. This implies a sharp accentuation of "bottlenecks" or persistent under-supply to an ever-tightening world oil market. It is noted, first, that world per capita average oil demand increased fastest through 1965-77, (table above) in spite of the first oil shock quadrupling crude oil prices. No "price elastic" reduction in per capita demand followed from the first oil shock of 1973-74 (295% increase in nominal dollar prices). The current context is therefore comparable: oil prices are rising, creating a context favorable for faster economic growth (especially outside the OECD). This reinforces world oil demand growth, which is outstripping population growth, resulting in recovery of world per capita average oil demand.

Going forward, three "new paradigms" for annual average per capita demand can be posited, as shown in the table below. All of these paradigms lead only to one conclusion: sharply higher oil prices. In addition, these potential new trend rates of per capita demand and world demand growth on a three-year base are themselves driven by a world economic context of faster economic growth arising in part from higher energy and real resource prices. Any remaining tendency for "loss of market share" by OPEC members can only disappear with the type of vintage growth in world oil demand that is now under way. It is also noted that the per capita average demand figures used (4.75, 5 and 5.25 barrels/capita/year) are in no way "extraordinary" numbers. In 1980, with oil prices briefly attaining $100/barrel in 2003 dollars, and a year-round peak value for a basket of lighter crudes around $80/bbl, world per capita consumption averaged about 5.3 barrels.

TABLE  2

2010 world oil demand
for two population growth scenarios and three annual average per capita demand scenarios ('Low' and
'High' population growth; 'Low', 'Medium' and 'High' annual
average per capita demand)

AVERAGE
PER
CAPITA DEMAND
Barrels/year

WORLD POPULATION 2010
Millions (year average)

HIGH         LOW

YEAR TOTAL DEMAND 2010

Billion barrels (Gby)

LOW      HIGH

YEAR AVG

DAILY

DEMAND
Mbd in 2010

 GROWTH
 FROM
 2002

 Mbd 
 growth
(8 year
 growth)

Low      4.75

6900

6800

32.3

32.8

88.5-89.8

~ 12.5 Mbd

Medium   5

6900

6800

33.8

34.5

92.5-94.5

~ 17 Mbd

High    5.25

6900

6800

35.4

36.2

97-99.2

~ 21 Mbd


Population growth forecast for 'Low' projection assumes UN forecasts of slowed
annual rates of growth for the 2020-2030 period are attained by 2004-2010.
'High' population projection utilizes current trend of world demographic growth
(85-90 Million/year).
World average per capita oil demand figures: 'High' case
does not exceed 1980 average (5.3 bcy)

Emerging and "structural" under-supply
There can be plenty of discussion as to what "structural" under-supply would mean with world oil output likely to start trending down soon, from its peak that may be well below 90-92 mbd (according to geologists and analysts such as Younquist, Deffeyes and the ASPO group). The key word for analyzing price-demand relationships and the much-predicted but slow emerging "gas bridge to the future" is "soon". This paper sets out to suggest that under almost any circumstance and any hypothesis, there will be a widening supply gap driven - not opposed - by rising prices. The above scenarios (Table 2) are very far from adventurous or unrealistic. Barring major catastrophe, the population projections for 2010 are likely to come about, leaving only the average per capita or demographic demand as the factor with most margin for error. Here, we can develop the supporting rationales for a likely increase in world average per capita demand, as summarized below:

Non-implementation of Kyoto Treaty - Other than the EU, Japan and Canada, there is little likelihood of ratification and implementation by major oil consumer and importer countries, including the US, China, India and other emerging industrial countries. In the countries of possible or probable implementation, average per capita or "demographic" oil demand is broadly in the range of 12 (Europe, Japan) to 18 barrels/capita/year (Canada). Reductions of more than 10%-15% from these very high demand rates are unlikely within a period of less than 5 or 10 years from the start date of implementing Treaty obligations (2008-12), without strong coercion and intense economic recession, and thus have little or no impact on 2010 forecasts.

Fast growth of oil demand by new industrial powers - both gas and oil demand growth by China, India and other fast emerging industrial economies is in the range of 6%-15%+ per year (5%-9%/year for oil and 12%-18%/year for gas). Fast growing private car fleets and development of the consumer societies in these countries can follow the pattern set