Sunday, May 11, 2008 12:33:18 AM
OIL SHOCK AND ENERGY TRANSITION
by Andrew McKillop
Chief Strategist, Vertus Sustineo Asset Management, New York Former Expert-Policy
and programming, Divn A-Policy, DGXVII-Energy, European Commission Presentation
to POGEE Conferece, Karachi, May 2008
May 7, 2008
Introduction – Intense evidence of global oil crisis
Despite stagnant or slightly falling oil and gas intensities (See table) in some of the 'mature postindustrial' high energy consumer nations of the OECD group, the OECD countries still have an average oil intensity of more than 10 barrels/capita/year. China and India have oil intensities of about 2.5 barrels/capita/year (China), and 1.3 bbl/capita/yr (India). Any quick reduction in global oil demand can in fact only come from the OECD countries, now importing ‘embodied oil’ in the form of energy-intensive industrial and consumer goods from China, India, Pakistan, Turkey, Brazil and other Emerging Economies
As we know, global automobile production and world car fleets are growing at about 6.5%pa, and the fleet is about 98% fuelled by oil and LPG, with a small amount fuelled by CNG (compressed natural gas) and the biofuels. Global trade growth continues at around 10%pa, driving fast growth of 100% oil-fuelled ocean shipping. World airline fleets, and air passenger and freight movements are growing at about 7%pa, and airplanes are 100% oil dependent. In part due to soaring food prices, world agricultural machinery sales, such as tractors and combine harvesters, is growing at over 7%pa. Average engine horsepower sizes, and fuel consumption of the nearly 100% oil-dependent world agricultural machinery fleet is growing at close to 8%pa. World construction, urban development including ‘instant new cities’ in the GCC countries, and roads, bridges, tunnels and other construction or transport-linked, oil-dependent activity is increasing at record annual rates.
There is therefore no problem at all concerning global oil demand ! The only, and real problem is world oil supply. Outside the older OECD countries of the North, the emerging industrial and economic superpowers of China and India, and other fast-growing Emerging Economies are experiencing totally ‘classic’ urban industrial economic growth. This generates strong and sustained growth of demand for all forms of commercial energy.
If not a slogan, the conventional OECD-bias concept of global oil, gas, coal and electricity demand is that these mostly-fossil based forms and types of commercial energy have predictable and slow-growth patterns. This idea was developed in the 1990s, when the OECD North had very slow economic growth, deperessing global economic growth but permitting extreme growth of the “paper asset bubble” on OECD or Old World stock markets. But since about 2003-2005 this Old World view of global energy, with stable production and supply patterns, and very low prices delivering Cheap Energy is less and less true. Many different reasons can be cited, over and above ‘BRIC growth’ or increasing oil, gas, coal and electricity demand of Brazil-Russia-India-China. Other reasons range from accelerated depletion of global oil reserves and climate change, population growth, and higher energy prices themselves.
For a variety of quite complex, but convergent reasons also applying to minerals and metals production – especially the precious metals gold, platinum, silver – rising prices do not lead to any automatic increase in production and supply. This can appear bizarre, but is a proven and real fact, and is very clear for world gold and platinum production, both of which are extremely energy-intensive and oil-dependent for their extraction, processing and supply.
This factor also applies to world oil, natural gas, and coal. Increasing prices are not producing an ‘instant kick’ upwards in supply. In fact, world production is tending to stagnate for natural gas and coal, as well as oil, exactly at the time prices soar to all-time records ! Energy trading, to be sure, also magnifies price rises in just the same way it intensifies price crashes, due to speculation and greed or the ‘poker table and casino-type’ basis of commodities and energy trading. Finally we can cite strong seasonality of demand for oil, as another factor that generates big price swings, but on the supply side, since Q3 or Q4 2007, seasonal variation of Isupply is now very low, due to depletion, resulting in possible price peaks over 150 USD/bbl for this Summer 2008, when the North hemisphere car and air travel season drives up demand for gasoline and kerosene, resulting in strong demand for crude oil.
There is one very simple ‘bottom line’: Energy Transition towards reduced energy intensity in OECD countries, development of alternate and renewable energy, and reduction of dependence on all fossil fuels is becoming imperative. In other words we have less and less choice. Organized and coherent transition however requires high and stable energy prices, led by oil, ensuring sufficient financial resources and demand signals for energy transition, also providing the public opinion and political impetus to act now for energy transition.
Petro Keynesian Belle Epoque Growth
It is easy to argue, and not difficult to prove that sharply rising oil, gas and energy prices increase economic growth rates. The simplest proof of this is to compare average energy prices in the low-growth, low energy price 1980s, with today. Comparing the two, for almost any nonOECD economy, and specially the Emerging Economies we find that with much higher energy prices, today, economic growth rates are also much higher.
Of course this can be treated as chicken-and-egg, and the increased economic growth can be claimed as driving, or pulling energy prices higher. In fact a comparison of the periods 1995-2000 and 2002-2007 lays this lie to rest: oil, energy and commodity price hikes preceded the general upturn in economic growth rates. Stronger global economic growth came after energy and commodity prices started to recover from about 15 years of record low prices. In the nonOECD emerging industrial and economic superpowers iof China and India this cause-and-effect sequence is very clear. Logically, low or suboptimal economic growth would tend to lower energy demand growth rates, which in turn would tend to push oil and gas prices lower. Logically also, when oil and energy prices reach certain 'thresholds' they feedback into the economy as 'belle epoque growth', which in turn bolsters their prices, and keeps feeding back as strong economic growth. Only 'pain ceiling' oil and energy prices can break the process.
In 'classic' economics this conception is sidetracked by the 'price elastic paradigm', by the fear of inflation, and by the rejection of either keynesianism or 'petro-keynesianism'. At all costs, for defenders of the New Economy, energy and resource costs must be kept low, and the relative value of services, employing nearly all persons in the high-energy 'postindustrial' societies of the OECD group, must be kept high in a slow-but-sure economic growth context and model. Certainly since 2002-2003, this is not the real growth process at work.
The above has many ‘perverse’ or apparently illogical implications.
These are notably: (1) low economic growth favours or causes low oil prices; and (2) the only process reducing oil demand growth, throug the long period 1945-2008, has been economic recession, or a sharp cut in global economic growth.
We can conclude that the 'supply side solution' to high oil prices – producing more oil or hydrocarbon liquids notably the biofuels – is getting difficult and will soon be impossible, until and unless world economic growth rates fall back in serious fashion. Unfortunately, whenever there is economic recession, financial resources available to both conventional, and renewable energy development falls away very fast, ensuring future shortage whenever demand picks up.
Only by cutting demand can slow growing global oil and energy supply meet still-growing, but reduced world demand and consumption. In turn, this means
Cutting energy intensity or average demand-per-capita in the most energy-intensive OECD countries, where considerable ‘fat to trim’ exists
Allowing and enabling continued growth of energy consumption in the Emerging Economies, within a Global Energy Transition framework
Setting a program for this, with economic, financial and legislative means and powers, that is a GLOBAL ENERGY TRANSITION PLAN which will obviously and necessarily be mutliateral and UN-linked, IMF-linked, and IBRD and regional bank-linked.
Makrket mechanisms, to be sure and certain, can only be counted on to produce laughable but costly financial and industrial disasters such as the 2006-2007 biofuels boom. Outside Brazil’s sugarcane ethanol program, which can compete against 120 USD/bbl oil, other ethanol production, and biodiesel from edible vegetable oils are only able to drive up food prices, while producing very high-priced, supposed ‘oil saving’ fuels. At current vegetable oil prices, eg. palm oil and rapeseed oil, the vegetable oil needed to produce a barrel of biodiesel costs about 150 – 160 USD/bbl, before any costs of factory operation! Investor interest in the biofuels is now very low, but only after many hundreds of millions of US dollars investment was made and wasted. This is why we need coordinated and long-term institutional, financial and technical supporting frameworks for a Global Energy Transition Plan.
Demand destruction, price elasticity and the real world real economy
So-called ‘price elastic’ responses by consumers and users - falling demand with rising prices - is swamped by the growth impact of rising energy and non-oil raw material prices on world economic and trade growth. A very simpl and clear example concerns gasoline and diesel fuel in Europe 2006-2007. Price rises were about 33% in the period but demand only fell by 3% . Natural gas demand in Europe is growing quite fast, as prices rise very fast. This “perverse zero elastic’’ impact of higher oil, natural gas, coal and electricity prices is due to what I call Petro Keynesian Growth, in other words higher oil, metals, minerals and food prices rapidly increase global economic growth rates. The basic driver is oil prices, and this process will continue to operate until extreme oil price levels are attained, which is unfortunately now possible.
World annual average per capita or ‘demographic’ oil demand is a key indicator, which also has oil price forecasting applications. Demographic demand has regularly but erratically increased through the long period 1965-2007, from about 3.5 bcy in 1965, through a peak during the ‘inter-shock period’ of 1975-1979, and slowly growing again, with rising oil and energy prices, since about 1998
World per capita average oil demand and oil price trends 1965-2007
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 edns, Platts, Thomson Financial.
Peak annual oil price (2-month basis) for volume traded light crudes. World oil prices and deflators 1965-2007, are calculated by this author using multiple sources., including 'Oil economists handbook' Vols 1 & 2, G Jenkins, Elsevier Applied Science, various editions, Platts Oilgram, OPEC bulletin, Bloomberg, California Energy Commission ‘Delphi oil price forecasting series’, the ICE, etc.
BARREL PRICE IN 2005 DOLLARS PER BARREL (left side scale) AND AVERAGE OIL DEMAND PER CAPITA IN BARRELS/CAPITA/YEAR (right hand scale) Average year prices WTI grade in blue Oil intensity in red
Impact of Oil Shocks on demographic demand
The term ‘oil shock’ can have many meanings, but the essential element of the term is very large price changes in a short period of time. On this base, there have been at least 4 ‘oil shocks’ since 1973, that is 3 upward price shocks (1973-74, 1979-1981 and 1999-2009 (?)), and 1 downward price shock (1985-86). Everytime, changes were very big.
In nominam terms, not corrected for inflation and purchasing power of US dollar used to purchase oil, price rises were
1973-74 : about 295% 1979-81 : about 115% 1999-2008 (April) : about 915%
The oil price crash of 1985-86, basically due to Saudi Arabia unilaterally deciding to hike output to about 12.25 Mbd (a level it has never re-attained) drove down prices by about 70%.
None of these price shocks had an immediate and large impact on demographic demand, unless we accredit the thesis that the 1980-83 world economic crisis was either solely, or mainly caused by very high oil prices, and brought about the large cumulative falls in demographic oil demand through 1980-85, with the demand rate of 4.42 bcy in 1985 being the lowest in the entire 1979-2007 period.
The fast growth of world natural gas supplies needs to be underlined. Since the early 1980s, world gas supplies have increased at an annual average close to 4.5%, far higher than average oil supplies and demand. Gas prices are still low, but increasing quite fast, like coal prices, which was heavily (gas) or extremely (coal) underpriced relative to oil. In fact, we can note, gas and coal remain cheap relative to oil, and this explains why natural gas demand is growing at about 4.5% and coal demand at about 6.25%, while oil demand growth is only 1.5% to 1.75%pa
Declining growth rate of oil demand, to be sure, is linked to rising prices but also aided and accelerated by long term de-industrialization and accelerated electrification in many OECD countries (very fast growth of electricity demand), in the same period. In several OECD countries, with very low growth rates of the economy (1.25% to 2%) in 2007, their electricity demand continued to increase at 5%pa or more.
These factors are likely at least as important as high oil prices in causing the observed fall of global average per capita, or demographic oil demand. Troubling yet further any supposed ‘price elastic’ response or trigger for the fall in oil demand is the fact that demographic demand had begun to fall by 1977-78, a period in which oil prices did not grow rapidly, nor attain especially high peak price levels.
Three essential points have to be mentioned. In the 1973-79 period, after a 295% oil price rise in nominal terms through 1973-74, there was almost no reduction in world per capita oil intensity. This is very similar to the process since 1999, but in this case (1999-2007) demographic oil demand increases with increasing price.
After 1979-81, when oil prices briefly attained similar price level to Jan-Feb 2008 (that is about 110 USD/bbl in dollars of 2008), demographic oil demand started falling. But this was during the worst economic recession since 1929-31 ! Without global economic recession, and with the US Federal Reserve printing money and bailing out near-bankrupt US investment banks, oil prices can go a lot higher in 2008. As we can see from the table and Chart (above) increasing demographic oil demand is a powerful cause of rising oil prices.
Also, when oil prices fall, specially in 1985-86 when Saudi Arabia felt obliged to hike output, and was physically capable of raising output , which is probably not the case today, the decline in the demographic rate of oil demand began to accelerate. What is most notable, however, is that the demographic rate continued to fall after prices had fallen well below the highs of the 1979-81 period. As the Table above shows, the 1995 demographic rate was almost unchanged from that of 1985, but oil prices had been more than halved in real terms. Perhaps most important to note is the third point: since 1999, and the ‘price shock’ of 1999-2007 (a price rise of about 915% in nominal terms), the demographic demand rate has continued to rise.
We can conclude there are enormous or fantastic lead-and-lag processes and factors that play a role in the link between oil production, supply, demographic demand and oil prices.
The real impact of higher oil prices: Global economic growth
This can be called Petro Keynesian Growth because real impact of higher oil prices, certainly up to the range of even 90 – 100 USD/barrel, is to increase economic growth at the global, or worldwide level. This is the main reason why demographic oil demand in the 1975-79 period, with barrel prices constantly increasing, and rising (in real terms) to levels close to prices in late 2007 and early 2008, was significantly higher than it is today.
It should be clearly understood that if the demographic rate in 2008 was the same as 1979, that is over 5 barrels/capita/year, world oil demand in 2008 would be well over 96 Million barrels per day in 2008. There is considerable and realistic doubt on the world oil supply system to produce and sustain more than about 90 Mbd. The CEO of Total SA, for example, has said in 2007 that he thinks that 100 Mbd might be briefly achieved, but not sustained. This is probably an exageration: producing and sustaining more than about 90 or 92 Mbd is likely impossible.
The likely production rate for Peak Oil on an all liquids basis will probably be about 90 Mbd. Increasing gas-to-oil (GTL) conversion, biofuels and the syncrudes will probably not palliate this intrinsic supply crisis, which by 2010-2012 will be joined by supply crisis for global natural gas and LNG supplies. This will radically increase world coal demand causing huge demand for new production, local transport and shipping infrastructures, of course raising coal prices.
The “Petro Keynesian Growth” process is easy to describe: Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, and then on metals, minerals and agrocommodity exporter countries, most of them Low or Mid Income (GNP per capita below $1000/year). Almost all such ‘real resource exporter’ countries have very high marginal propensity to consume. World trade growth accelerates, and world liquidity is raised, tending to reduce real interest rates.
In other words, any increase in revenues in commodity exporter countries, due to prices of their exports increasing in line with, or being ‘indexed’ to the oil price, is very rapidly spent on purchasing manufactured goods and services of all kinds, including capital good, industrial equipment, urban development, etc. In the 1973-81 period, in which oil price rises before inflation were of 405%, the New Industrial Countries (NICs) of that period - notably Taiwan, South Korea and Singapore - experienced very large and rapid increases in solvent demand for their export goods, leading to large and sustained increases of oil demand by the Asian Tigers in that period. Today, exactly the same process leads to China and India rapidly increasing their oil, gas and coal demand as prices for fossil fuels increase very fast.
Global economic recession and higher oil and gas prices
The global economy, today in 2008, faces very serious problems due to many factors. These include falling economic growth or recesssion in USA, Europe, Japan. Rising inflation is one immediate impact of falling economic growth, and can generate a “vicious spiral” unless economic growth is restored or inflation falls. Food price inflation, partly due to high priced oil to operate agriculture machinery, process foood and transport food to cities is now very strong.
We must not forget that inflation is also due to currency and monetary problems. In particular and today, the moneys of Emerging Economies, including Pakistan, Turkey, China, India are all under-valued against US dollar. Conversely, the Euro is highly over-valued against US dollar. This is a very unstable, fragile context and may lead to major FX readjustment and realignment before end-2008, and perhaps cause a major monetary crisis. This context will also tend to increase global inflation and bolster oil price rises.
As we have however found in 2006-2007, no immediate economic recession can occur with oil at even $75 per barrel. Much higher oil prices would be needed to cause a global economic recession, and as noted above monetary crisis and global inflation due to many factors including fast economic growth outside OECD countries, climate change, soil erosion, biodiversity loss, population growth, urbanisation, and other factors, are also the cause of global inflation. Oil and natural gas prices are not at all the unique cause of global inflation.
Without strong economic growth and sustained higher prices for oil and gas it is unrealistic to expect that any ‘energy transition’ can occur, for example the type of energy transition that is implied (but not exactly stated) by international effort to mitigate climate change. The mechanism is application of the Kyoto Treaty and its linked Joint Implementation Clean Development Mechanisms (JI CDM) in some countries outside Europe, Japan, Australia, NZ and Canada. Application of Kyoto Treaty in Europe and Japan has only shifted electric power production to natural gas-fired, and triggered rapid development of wind electric farms, now at saturation level in several EU27 countries. Oil demand has not been seriously reduced, and natural gas demand has increased quite fast, despite very slow or stagnant economy in Europe and Japan.
Oil demand is itself driven by higher prices - Demand shock
The Table below (Demographic rate, oil and natural gas) shows what we can call almost unlimited upward growth potential for world oil and natural gas demand. This itself tends to suggest we will have very high prices for traded oil and natural gas, until and unless there is very strong and sharp, global economic recession.
Current world oil demand trends extend down from 25.6 bcy for the USA to well below 0.2 bcy in rural areas of low income developing countries (LDCs). While it is totally impossible that this could happen, the world’s current 6.35 Bn population consuming oil at US per capita rates would generate a demand of around 445 Million barrels/day (Mbd). At the other extreme, at 0.2 bcy world total oil demand would be telescoped to under 3.5 Mbd. The current 4.5 bcy world average is around one-third the average in European Union countries, but more than 4 times per capita average consumption in India, and over 3 times that of China - which will soon become the world’s biggest industrial economy.
Annual increase of the world’s population, which is continuing to fall as a percentage rate, and in absolute numbers of annual increment to global population, is now running at about 70 Million. We can note that China, by about 2015, will have a very rapidly ageing population, similar to many EU27 countries and Japan today.
At a demographic demand rate of 4.75 bcy the ‘latent’ or potential annual growth in world oil demand is itself about 1.25 Mbd, assuming no change in the energy economy, no fuel substitution, and also no economic growth.
Table : Global Demographic rate - oil and gas demand, 2006-2007
Surprising growth of world energy demand
The BP Amoco Statistical Review has for some years prefaced its annual editions by noting what it call ‘surprising growth’ of world energy demand since 2000 - approaching 2.75%-3.5% annual and about 6.5%pa for coal and nearly 7%pa for electricity. For oil, BP claims the so-called “10-year trend rate” is about 0.9% to 1.4%pa, and in 2008 the Chief Economist of BP claimed that BP ‘now believes in Peak Oil’ but only because global demand growth for oil is so low that oil production will fall, due to weak demand !
Any imagined ‘price elastic’ response as a potential cause of world oil demand growth shrinking back to BP’s claimed “10-year trend rate” can be forgotten when we note the real impact of higher oil prices on world oil demand.
Through the 1975-79 period, when oil prices increased quite fast and briefly attained, in 1980, prices comparable to 2007 (but not 2008) prices in real terms, world oil demand growth easily achieved 4% annual. Just one year of 4% growth in global oil demand, today, would produce a catastrophic supply shortage and very rapid fall to near-zero of world crude oil and product stocks and inventories. Prices would instantly explode.
During the first 6 months of 1979, before higher interest rates triggered an intense worldwide economic recession, oil demand was increasing at an annual rate of close to 4.5%, with prices in 2008 dollars close to 90 or 100 USD-per-barrel. It is therefore easy to suggest the “10-year trend rate” that BP claims, and is also taken seriously by OPEC’s economists, that is maximum growth of global demand less than about 1.3%pa was a simple aberration due to extreme high interest rates causing global economic recession, followed by very slow recovery of the global economy in the 1990s.
Restored or strengthened economic growth through oil shock and Petro Keynesian Growth also changes the type of growth towards more energy-intense industrial and manufactured products, and away from more services based, lower energy activities. This ‘perverse’ factor itself increases oil intensity of world economic output and raises the ‘oil coefficient’ or percentage increase in oil demand for a percentage point growth in the economy for any country or bloc. BP and OPEC economists do not seem to understand this, and use extreme low coefficients in their forecasting method for global oil demand, going forward. We can be rather sure ‘surprisingly firm’ demand will tend to remain, for much more costly oil, coal, gas and electricity.
The near-term future
Understanding the mechanisms in play is vital for making accurate and realistic forecasts of future world oil demand and oil prices. Rational estimates of global oil demand growth, despite 100+ dollars per barrel, are in the range of 1.6 to 1.75 Mbd in 2008, not the absurdly low estimates produced by US EIA, OECD IEA, BP, OPEC, Exxon Mobil, ENI, Shell and others, including the investment banks such as Goldman Sachs, Lehman Bros, Merrill Lynch, etc.
More realistic and credible demand forecasts can be made, as shown below:
Table : 2010 world oil demand forecasts (Million barrels/day, 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 utilises current world demographic growth trend (about 70 M. per yr).
Geopolitical and other price-shaping factors
Real market supply and price sentiment will ever more depend on policies decided by, and events affecting Russia and Saudi Arabia, as well as Iraq, and to a lesser degree Nigeria and Venezuela. Outside the major producers, political events in small African oil exporter countries, due to the very tight supply situation, can also have major impact on prices.
Institutional unpreparedness regarding world oil supply/demand is high, or even extreme – almost all EU27 leaders now say that ‘very high oil prices cannot be controlled by national policies’, in other words consumers and industrial users of oil will have to put up with high, and likely rising prices. Apart from a recent visit to see his ‘friend and ally’ King Abdullah, the George Bush Administration of USA does little or nothing to seek lower oil prices.
However, current and actual growth trends for world oil demand, and emerging shortfalls for world oil supply were clearly in place by end-2003, or before, suggesting that official energy and oil institutions are not yet prepared for Peak Oil and probable 150-dollar oil. The economic consequences of oil prices simply exploding out of sight still does seem to be taken seriously.
The implications of continually underestimating demand growth, combined with overoptimistic, and in fact entirely unrealistic forecasts for net oil exports from Saudi Arabia, Iraq, and the other 3 major Gulf region producers, together with very optimistic notions of Russia’s capacity or willingness to continue increasing its export capacity, is a certain and sure recipe for Oil Shock. In this uneasy context, we cannot expect oil prices to fall very significantly or for long periods.
Conclusions
Cheap Oil is seen by the decision making elite in the richer nations as the ‘passport to economic growth’. This is pure fantasy. Only ‘extreme’ oil prices (probably above $150/barrel) will cancel, abort or overturn the global economy expansionary impacts of higher oil prices
Since about 1995 ‘demand shock’ has begun to operate in the world economy for a number of economic, social or ‘secular’ and technical reasons, leading to considerably higher underlying growth rates of world oil demand. Current ‘trend growth rates’ for world energy and world oil demand are closer to 1.75% or 2%pa than the unreal under-estimates of many ‘official’ sources, including most big energy corporations.
Cheap oil and energy remains the essential base of conventional economic development and conventional social progress anyplace in the world. This in turn is a powerful motor for continued and strong demand growth for fossil energy, worldwide. Upward potential for personal consumption of fossil fuels is essentially unlimited in this context.
Only Global Energy Transition, with a coherent and firm Plan, and adequate financial and legislative frameworks can resolve the very big problem of global energy supply
© 2008 Andrew McKillop
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Andrew McKillop
by Andrew McKillop
Chief Strategist, Vertus Sustineo Asset Management, New York Former Expert-Policy
and programming, Divn A-Policy, DGXVII-Energy, European Commission Presentation
to POGEE Conferece, Karachi, May 2008
May 7, 2008
Introduction – Intense evidence of global oil crisis
Despite stagnant or slightly falling oil and gas intensities (See table) in some of the 'mature postindustrial' high energy consumer nations of the OECD group, the OECD countries still have an average oil intensity of more than 10 barrels/capita/year. China and India have oil intensities of about 2.5 barrels/capita/year (China), and 1.3 bbl/capita/yr (India). Any quick reduction in global oil demand can in fact only come from the OECD countries, now importing ‘embodied oil’ in the form of energy-intensive industrial and consumer goods from China, India, Pakistan, Turkey, Brazil and other Emerging Economies
As we know, global automobile production and world car fleets are growing at about 6.5%pa, and the fleet is about 98% fuelled by oil and LPG, with a small amount fuelled by CNG (compressed natural gas) and the biofuels. Global trade growth continues at around 10%pa, driving fast growth of 100% oil-fuelled ocean shipping. World airline fleets, and air passenger and freight movements are growing at about 7%pa, and airplanes are 100% oil dependent. In part due to soaring food prices, world agricultural machinery sales, such as tractors and combine harvesters, is growing at over 7%pa. Average engine horsepower sizes, and fuel consumption of the nearly 100% oil-dependent world agricultural machinery fleet is growing at close to 8%pa. World construction, urban development including ‘instant new cities’ in the GCC countries, and roads, bridges, tunnels and other construction or transport-linked, oil-dependent activity is increasing at record annual rates.
There is therefore no problem at all concerning global oil demand ! The only, and real problem is world oil supply. Outside the older OECD countries of the North, the emerging industrial and economic superpowers of China and India, and other fast-growing Emerging Economies are experiencing totally ‘classic’ urban industrial economic growth. This generates strong and sustained growth of demand for all forms of commercial energy.
If not a slogan, the conventional OECD-bias concept of global oil, gas, coal and electricity demand is that these mostly-fossil based forms and types of commercial energy have predictable and slow-growth patterns. This idea was developed in the 1990s, when the OECD North had very slow economic growth, deperessing global economic growth but permitting extreme growth of the “paper asset bubble” on OECD or Old World stock markets. But since about 2003-2005 this Old World view of global energy, with stable production and supply patterns, and very low prices delivering Cheap Energy is less and less true. Many different reasons can be cited, over and above ‘BRIC growth’ or increasing oil, gas, coal and electricity demand of Brazil-Russia-India-China. Other reasons range from accelerated depletion of global oil reserves and climate change, population growth, and higher energy prices themselves.
For a variety of quite complex, but convergent reasons also applying to minerals and metals production – especially the precious metals gold, platinum, silver – rising prices do not lead to any automatic increase in production and supply. This can appear bizarre, but is a proven and real fact, and is very clear for world gold and platinum production, both of which are extremely energy-intensive and oil-dependent for their extraction, processing and supply.
This factor also applies to world oil, natural gas, and coal. Increasing prices are not producing an ‘instant kick’ upwards in supply. In fact, world production is tending to stagnate for natural gas and coal, as well as oil, exactly at the time prices soar to all-time records ! Energy trading, to be sure, also magnifies price rises in just the same way it intensifies price crashes, due to speculation and greed or the ‘poker table and casino-type’ basis of commodities and energy trading. Finally we can cite strong seasonality of demand for oil, as another factor that generates big price swings, but on the supply side, since Q3 or Q4 2007, seasonal variation of Isupply is now very low, due to depletion, resulting in possible price peaks over 150 USD/bbl for this Summer 2008, when the North hemisphere car and air travel season drives up demand for gasoline and kerosene, resulting in strong demand for crude oil.
There is one very simple ‘bottom line’: Energy Transition towards reduced energy intensity in OECD countries, development of alternate and renewable energy, and reduction of dependence on all fossil fuels is becoming imperative. In other words we have less and less choice. Organized and coherent transition however requires high and stable energy prices, led by oil, ensuring sufficient financial resources and demand signals for energy transition, also providing the public opinion and political impetus to act now for energy transition.
Petro Keynesian Belle Epoque Growth
It is easy to argue, and not difficult to prove that sharply rising oil, gas and energy prices increase economic growth rates. The simplest proof of this is to compare average energy prices in the low-growth, low energy price 1980s, with today. Comparing the two, for almost any nonOECD economy, and specially the Emerging Economies we find that with much higher energy prices, today, economic growth rates are also much higher.
Of course this can be treated as chicken-and-egg, and the increased economic growth can be claimed as driving, or pulling energy prices higher. In fact a comparison of the periods 1995-2000 and 2002-2007 lays this lie to rest: oil, energy and commodity price hikes preceded the general upturn in economic growth rates. Stronger global economic growth came after energy and commodity prices started to recover from about 15 years of record low prices. In the nonOECD emerging industrial and economic superpowers iof China and India this cause-and-effect sequence is very clear. Logically, low or suboptimal economic growth would tend to lower energy demand growth rates, which in turn would tend to push oil and gas prices lower. Logically also, when oil and energy prices reach certain 'thresholds' they feedback into the economy as 'belle epoque growth', which in turn bolsters their prices, and keeps feeding back as strong economic growth. Only 'pain ceiling' oil and energy prices can break the process.
In 'classic' economics this conception is sidetracked by the 'price elastic paradigm', by the fear of inflation, and by the rejection of either keynesianism or 'petro-keynesianism'. At all costs, for defenders of the New Economy, energy and resource costs must be kept low, and the relative value of services, employing nearly all persons in the high-energy 'postindustrial' societies of the OECD group, must be kept high in a slow-but-sure economic growth context and model. Certainly since 2002-2003, this is not the real growth process at work.
The above has many ‘perverse’ or apparently illogical implications.
These are notably: (1) low economic growth favours or causes low oil prices; and (2) the only process reducing oil demand growth, throug the long period 1945-2008, has been economic recession, or a sharp cut in global economic growth.
We can conclude that the 'supply side solution' to high oil prices – producing more oil or hydrocarbon liquids notably the biofuels – is getting difficult and will soon be impossible, until and unless world economic growth rates fall back in serious fashion. Unfortunately, whenever there is economic recession, financial resources available to both conventional, and renewable energy development falls away very fast, ensuring future shortage whenever demand picks up.
Only by cutting demand can slow growing global oil and energy supply meet still-growing, but reduced world demand and consumption. In turn, this means
Cutting energy intensity or average demand-per-capita in the most energy-intensive OECD countries, where considerable ‘fat to trim’ exists
Allowing and enabling continued growth of energy consumption in the Emerging Economies, within a Global Energy Transition framework
Setting a program for this, with economic, financial and legislative means and powers, that is a GLOBAL ENERGY TRANSITION PLAN which will obviously and necessarily be mutliateral and UN-linked, IMF-linked, and IBRD and regional bank-linked.
Makrket mechanisms, to be sure and certain, can only be counted on to produce laughable but costly financial and industrial disasters such as the 2006-2007 biofuels boom. Outside Brazil’s sugarcane ethanol program, which can compete against 120 USD/bbl oil, other ethanol production, and biodiesel from edible vegetable oils are only able to drive up food prices, while producing very high-priced, supposed ‘oil saving’ fuels. At current vegetable oil prices, eg. palm oil and rapeseed oil, the vegetable oil needed to produce a barrel of biodiesel costs about 150 – 160 USD/bbl, before any costs of factory operation! Investor interest in the biofuels is now very low, but only after many hundreds of millions of US dollars investment was made and wasted. This is why we need coordinated and long-term institutional, financial and technical supporting frameworks for a Global Energy Transition Plan.
Demand destruction, price elasticity and the real world real economy
So-called ‘price elastic’ responses by consumers and users - falling demand with rising prices - is swamped by the growth impact of rising energy and non-oil raw material prices on world economic and trade growth. A very simpl and clear example concerns gasoline and diesel fuel in Europe 2006-2007. Price rises were about 33% in the period but demand only fell by 3% . Natural gas demand in Europe is growing quite fast, as prices rise very fast. This “perverse zero elastic’’ impact of higher oil, natural gas, coal and electricity prices is due to what I call Petro Keynesian Growth, in other words higher oil, metals, minerals and food prices rapidly increase global economic growth rates. The basic driver is oil prices, and this process will continue to operate until extreme oil price levels are attained, which is unfortunately now possible.
World annual average per capita or ‘demographic’ oil demand is a key indicator, which also has oil price forecasting applications. Demographic demand has regularly but erratically increased through the long period 1965-2007, from about 3.5 bcy in 1965, through a peak during the ‘inter-shock period’ of 1975-1979, and slowly growing again, with rising oil and energy prices, since about 1998
World per capita average oil demand and oil price trends 1965-2007
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 edns, Platts, Thomson Financial.
Peak annual oil price (2-month basis) for volume traded light crudes. World oil prices and deflators 1965-2007, are calculated by this author using multiple sources., including 'Oil economists handbook' Vols 1 & 2, G Jenkins, Elsevier Applied Science, various editions, Platts Oilgram, OPEC bulletin, Bloomberg, California Energy Commission ‘Delphi oil price forecasting series’, the ICE, etc.
BARREL PRICE IN 2005 DOLLARS PER BARREL (left side scale) AND AVERAGE OIL DEMAND PER CAPITA IN BARRELS/CAPITA/YEAR (right hand scale) Average year prices WTI grade in blue Oil intensity in red
Impact of Oil Shocks on demographic demand
The term ‘oil shock’ can have many meanings, but the essential element of the term is very large price changes in a short period of time. On this base, there have been at least 4 ‘oil shocks’ since 1973, that is 3 upward price shocks (1973-74, 1979-1981 and 1999-2009 (?)), and 1 downward price shock (1985-86). Everytime, changes were very big.
In nominam terms, not corrected for inflation and purchasing power of US dollar used to purchase oil, price rises were
1973-74 : about 295% 1979-81 : about 115% 1999-2008 (April) : about 915%
The oil price crash of 1985-86, basically due to Saudi Arabia unilaterally deciding to hike output to about 12.25 Mbd (a level it has never re-attained) drove down prices by about 70%.
None of these price shocks had an immediate and large impact on demographic demand, unless we accredit the thesis that the 1980-83 world economic crisis was either solely, or mainly caused by very high oil prices, and brought about the large cumulative falls in demographic oil demand through 1980-85, with the demand rate of 4.42 bcy in 1985 being the lowest in the entire 1979-2007 period.
The fast growth of world natural gas supplies needs to be underlined. Since the early 1980s, world gas supplies have increased at an annual average close to 4.5%, far higher than average oil supplies and demand. Gas prices are still low, but increasing quite fast, like coal prices, which was heavily (gas) or extremely (coal) underpriced relative to oil. In fact, we can note, gas and coal remain cheap relative to oil, and this explains why natural gas demand is growing at about 4.5% and coal demand at about 6.25%, while oil demand growth is only 1.5% to 1.75%pa
Declining growth rate of oil demand, to be sure, is linked to rising prices but also aided and accelerated by long term de-industrialization and accelerated electrification in many OECD countries (very fast growth of electricity demand), in the same period. In several OECD countries, with very low growth rates of the economy (1.25% to 2%) in 2007, their electricity demand continued to increase at 5%pa or more.
These factors are likely at least as important as high oil prices in causing the observed fall of global average per capita, or demographic oil demand. Troubling yet further any supposed ‘price elastic’ response or trigger for the fall in oil demand is the fact that demographic demand had begun to fall by 1977-78, a period in which oil prices did not grow rapidly, nor attain especially high peak price levels.
Three essential points have to be mentioned. In the 1973-79 period, after a 295% oil price rise in nominal terms through 1973-74, there was almost no reduction in world per capita oil intensity. This is very similar to the process since 1999, but in this case (1999-2007) demographic oil demand increases with increasing price.
After 1979-81, when oil prices briefly attained similar price level to Jan-Feb 2008 (that is about 110 USD/bbl in dollars of 2008), demographic oil demand started falling. But this was during the worst economic recession since 1929-31 ! Without global economic recession, and with the US Federal Reserve printing money and bailing out near-bankrupt US investment banks, oil prices can go a lot higher in 2008. As we can see from the table and Chart (above) increasing demographic oil demand is a powerful cause of rising oil prices.
Also, when oil prices fall, specially in 1985-86 when Saudi Arabia felt obliged to hike output, and was physically capable of raising output , which is probably not the case today, the decline in the demographic rate of oil demand began to accelerate. What is most notable, however, is that the demographic rate continued to fall after prices had fallen well below the highs of the 1979-81 period. As the Table above shows, the 1995 demographic rate was almost unchanged from that of 1985, but oil prices had been more than halved in real terms. Perhaps most important to note is the third point: since 1999, and the ‘price shock’ of 1999-2007 (a price rise of about 915% in nominal terms), the demographic demand rate has continued to rise.
We can conclude there are enormous or fantastic lead-and-lag processes and factors that play a role in the link between oil production, supply, demographic demand and oil prices.
The real impact of higher oil prices: Global economic growth
This can be called Petro Keynesian Growth because real impact of higher oil prices, certainly up to the range of even 90 – 100 USD/barrel, is to increase economic growth at the global, or worldwide level. This is the main reason why demographic oil demand in the 1975-79 period, with barrel prices constantly increasing, and rising (in real terms) to levels close to prices in late 2007 and early 2008, was significantly higher than it is today.
It should be clearly understood that if the demographic rate in 2008 was the same as 1979, that is over 5 barrels/capita/year, world oil demand in 2008 would be well over 96 Million barrels per day in 2008. There is considerable and realistic doubt on the world oil supply system to produce and sustain more than about 90 Mbd. The CEO of Total SA, for example, has said in 2007 that he thinks that 100 Mbd might be briefly achieved, but not sustained. This is probably an exageration: producing and sustaining more than about 90 or 92 Mbd is likely impossible.
The likely production rate for Peak Oil on an all liquids basis will probably be about 90 Mbd. Increasing gas-to-oil (GTL) conversion, biofuels and the syncrudes will probably not palliate this intrinsic supply crisis, which by 2010-2012 will be joined by supply crisis for global natural gas and LNG supplies. This will radically increase world coal demand causing huge demand for new production, local transport and shipping infrastructures, of course raising coal prices.
The “Petro Keynesian Growth” process is easy to describe: Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, and then on metals, minerals and agrocommodity exporter countries, most of them Low or Mid Income (GNP per capita below $1000/year). Almost all such ‘real resource exporter’ countries have very high marginal propensity to consume. World trade growth accelerates, and world liquidity is raised, tending to reduce real interest rates.
In other words, any increase in revenues in commodity exporter countries, due to prices of their exports increasing in line with, or being ‘indexed’ to the oil price, is very rapidly spent on purchasing manufactured goods and services of all kinds, including capital good, industrial equipment, urban development, etc. In the 1973-81 period, in which oil price rises before inflation were of 405%, the New Industrial Countries (NICs) of that period - notably Taiwan, South Korea and Singapore - experienced very large and rapid increases in solvent demand for their export goods, leading to large and sustained increases of oil demand by the Asian Tigers in that period. Today, exactly the same process leads to China and India rapidly increasing their oil, gas and coal demand as prices for fossil fuels increase very fast.
Global economic recession and higher oil and gas prices
The global economy, today in 2008, faces very serious problems due to many factors. These include falling economic growth or recesssion in USA, Europe, Japan. Rising inflation is one immediate impact of falling economic growth, and can generate a “vicious spiral” unless economic growth is restored or inflation falls. Food price inflation, partly due to high priced oil to operate agriculture machinery, process foood and transport food to cities is now very strong.
We must not forget that inflation is also due to currency and monetary problems. In particular and today, the moneys of Emerging Economies, including Pakistan, Turkey, China, India are all under-valued against US dollar. Conversely, the Euro is highly over-valued against US dollar. This is a very unstable, fragile context and may lead to major FX readjustment and realignment before end-2008, and perhaps cause a major monetary crisis. This context will also tend to increase global inflation and bolster oil price rises.
As we have however found in 2006-2007, no immediate economic recession can occur with oil at even $75 per barrel. Much higher oil prices would be needed to cause a global economic recession, and as noted above monetary crisis and global inflation due to many factors including fast economic growth outside OECD countries, climate change, soil erosion, biodiversity loss, population growth, urbanisation, and other factors, are also the cause of global inflation. Oil and natural gas prices are not at all the unique cause of global inflation.
Without strong economic growth and sustained higher prices for oil and gas it is unrealistic to expect that any ‘energy transition’ can occur, for example the type of energy transition that is implied (but not exactly stated) by international effort to mitigate climate change. The mechanism is application of the Kyoto Treaty and its linked Joint Implementation Clean Development Mechanisms (JI CDM) in some countries outside Europe, Japan, Australia, NZ and Canada. Application of Kyoto Treaty in Europe and Japan has only shifted electric power production to natural gas-fired, and triggered rapid development of wind electric farms, now at saturation level in several EU27 countries. Oil demand has not been seriously reduced, and natural gas demand has increased quite fast, despite very slow or stagnant economy in Europe and Japan.
Oil demand is itself driven by higher prices - Demand shock
The Table below (Demographic rate, oil and natural gas) shows what we can call almost unlimited upward growth potential for world oil and natural gas demand. This itself tends to suggest we will have very high prices for traded oil and natural gas, until and unless there is very strong and sharp, global economic recession.
Current world oil demand trends extend down from 25.6 bcy for the USA to well below 0.2 bcy in rural areas of low income developing countries (LDCs). While it is totally impossible that this could happen, the world’s current 6.35 Bn population consuming oil at US per capita rates would generate a demand of around 445 Million barrels/day (Mbd). At the other extreme, at 0.2 bcy world total oil demand would be telescoped to under 3.5 Mbd. The current 4.5 bcy world average is around one-third the average in European Union countries, but more than 4 times per capita average consumption in India, and over 3 times that of China - which will soon become the world’s biggest industrial economy.
Annual increase of the world’s population, which is continuing to fall as a percentage rate, and in absolute numbers of annual increment to global population, is now running at about 70 Million. We can note that China, by about 2015, will have a very rapidly ageing population, similar to many EU27 countries and Japan today.
At a demographic demand rate of 4.75 bcy the ‘latent’ or potential annual growth in world oil demand is itself about 1.25 Mbd, assuming no change in the energy economy, no fuel substitution, and also no economic growth.
Table : Global Demographic rate - oil and gas demand, 2006-2007
Surprising growth of world energy demand
The BP Amoco Statistical Review has for some years prefaced its annual editions by noting what it call ‘surprising growth’ of world energy demand since 2000 - approaching 2.75%-3.5% annual and about 6.5%pa for coal and nearly 7%pa for electricity. For oil, BP claims the so-called “10-year trend rate” is about 0.9% to 1.4%pa, and in 2008 the Chief Economist of BP claimed that BP ‘now believes in Peak Oil’ but only because global demand growth for oil is so low that oil production will fall, due to weak demand !
Any imagined ‘price elastic’ response as a potential cause of world oil demand growth shrinking back to BP’s claimed “10-year trend rate” can be forgotten when we note the real impact of higher oil prices on world oil demand.
Through the 1975-79 period, when oil prices increased quite fast and briefly attained, in 1980, prices comparable to 2007 (but not 2008) prices in real terms, world oil demand growth easily achieved 4% annual. Just one year of 4% growth in global oil demand, today, would produce a catastrophic supply shortage and very rapid fall to near-zero of world crude oil and product stocks and inventories. Prices would instantly explode.
During the first 6 months of 1979, before higher interest rates triggered an intense worldwide economic recession, oil demand was increasing at an annual rate of close to 4.5%, with prices in 2008 dollars close to 90 or 100 USD-per-barrel. It is therefore easy to suggest the “10-year trend rate” that BP claims, and is also taken seriously by OPEC’s economists, that is maximum growth of global demand less than about 1.3%pa was a simple aberration due to extreme high interest rates causing global economic recession, followed by very slow recovery of the global economy in the 1990s.
Restored or strengthened economic growth through oil shock and Petro Keynesian Growth also changes the type of growth towards more energy-intense industrial and manufactured products, and away from more services based, lower energy activities. This ‘perverse’ factor itself increases oil intensity of world economic output and raises the ‘oil coefficient’ or percentage increase in oil demand for a percentage point growth in the economy for any country or bloc. BP and OPEC economists do not seem to understand this, and use extreme low coefficients in their forecasting method for global oil demand, going forward. We can be rather sure ‘surprisingly firm’ demand will tend to remain, for much more costly oil, coal, gas and electricity.
The near-term future
Understanding the mechanisms in play is vital for making accurate and realistic forecasts of future world oil demand and oil prices. Rational estimates of global oil demand growth, despite 100+ dollars per barrel, are in the range of 1.6 to 1.75 Mbd in 2008, not the absurdly low estimates produced by US EIA, OECD IEA, BP, OPEC, Exxon Mobil, ENI, Shell and others, including the investment banks such as Goldman Sachs, Lehman Bros, Merrill Lynch, etc.
More realistic and credible demand forecasts can be made, as shown below:
Table : 2010 world oil demand forecasts (Million barrels/day, 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 utilises current world demographic growth trend (about 70 M. per yr).
Geopolitical and other price-shaping factors
Real market supply and price sentiment will ever more depend on policies decided by, and events affecting Russia and Saudi Arabia, as well as Iraq, and to a lesser degree Nigeria and Venezuela. Outside the major producers, political events in small African oil exporter countries, due to the very tight supply situation, can also have major impact on prices.
Institutional unpreparedness regarding world oil supply/demand is high, or even extreme – almost all EU27 leaders now say that ‘very high oil prices cannot be controlled by national policies’, in other words consumers and industrial users of oil will have to put up with high, and likely rising prices. Apart from a recent visit to see his ‘friend and ally’ King Abdullah, the George Bush Administration of USA does little or nothing to seek lower oil prices.
However, current and actual growth trends for world oil demand, and emerging shortfalls for world oil supply were clearly in place by end-2003, or before, suggesting that official energy and oil institutions are not yet prepared for Peak Oil and probable 150-dollar oil. The economic consequences of oil prices simply exploding out of sight still does seem to be taken seriously.
The implications of continually underestimating demand growth, combined with overoptimistic, and in fact entirely unrealistic forecasts for net oil exports from Saudi Arabia, Iraq, and the other 3 major Gulf region producers, together with very optimistic notions of Russia’s capacity or willingness to continue increasing its export capacity, is a certain and sure recipe for Oil Shock. In this uneasy context, we cannot expect oil prices to fall very significantly or for long periods.
Conclusions
Cheap Oil is seen by the decision making elite in the richer nations as the ‘passport to economic growth’. This is pure fantasy. Only ‘extreme’ oil prices (probably above $150/barrel) will cancel, abort or overturn the global economy expansionary impacts of higher oil prices
Since about 1995 ‘demand shock’ has begun to operate in the world economy for a number of economic, social or ‘secular’ and technical reasons, leading to considerably higher underlying growth rates of world oil demand. Current ‘trend growth rates’ for world energy and world oil demand are closer to 1.75% or 2%pa than the unreal under-estimates of many ‘official’ sources, including most big energy corporations.
Cheap oil and energy remains the essential base of conventional economic development and conventional social progress anyplace in the world. This in turn is a powerful motor for continued and strong demand growth for fossil energy, worldwide. Upward potential for personal consumption of fossil fuels is essentially unlimited in this context.
Only Global Energy Transition, with a coherent and firm Plan, and adequate financial and legislative frameworks can resolve the very big problem of global energy supply
© 2008 Andrew McKillop
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