How Much Will Low Oil Prices Stimulate Demand?

• Since weak oil demand growth is a major ingredient in the current oil price crash, higher demand stimulated by low prices could be a moderating factor.
• While US demand has risen since prices fell, there are several reasons why the global response may be slower to appear and less dramatic.

One of the main factors that will determine the depth and duration of the current slump in oil prices is the extent and timing of a resulting rebound in demand. It is likely to occur first in countries like the US, where fuel taxes are low and consumers see the results of lower oil prices at the  gas pump relatively quickly--a $1.65 per gallon drop already, since June. However, other factors besides taxes could impede faster demand growth elsewhere. 

From 2007 to 2009 the combination of high oil prices and a weak economy reduced US petroleum demand by almost 2 million barrels (bbl) per day, compared to its 2006 peak. The first volumes backed out of the market were imported refined products, which had grown rapidly from the mid-1990s until 2005. Low domestic demand and expanding US oil production then led US oil refiners to seek new markets, particularly in Latin America. US petroleum product exports have increased by around 1.7 million bbl/day since the recession began.

These refiners might reasonably expect their domestic and foreign markets to grow faster with oil prices dramatically lower. So far, it's hard to see more than hints of this in the lagged data from the US government or API, which reported December gasoline demand at a 7-year high. It's also hard to discern how much can be attributed to oil prices, rather than to US economic growth and a falling unemployment rate. The October update of vehicle miles traveled from the US Department of Transportation was still well below its 2008 peak but showed a modest upward trend, although that seems to have begun before oil prices fell.

Other indicators are also mixed. By the end of last year sales-weighted fuel economy of new vehicles sold in the US had declined by 0.7 miles per gallon from its August 2014 peak. That reflected US consumers buying larger vehicles, including more SUVs, fewer hybrids and only slightly more plug-in electric cars than in the prior year. Despite this retreat, full-year-average fuel economy tracked by the University of Michigan still showed a more than 5 mpg gain since 2007, equating to 20% better fuel efficiency. So the roughly 45 million cars and light trucks sold in the US in the last three years--nearly a fifth of today's light-duty fleet--will use less gasoline than the ones they replaced, even in the most robust response to low gas prices imaginable.

Globally, growth prospects seem equally mixed. Since last July the International Energy Agency has reduced its forecast of 2015 petroleum demand growth by a cumulative 500,000 bbl/day, to +0.9 million bbl/day, as the global economy weakened.  These conditions could combine with currency-related effects to dampen, or at least delay, a potential surge in global oil demand due to low prices. 

Because oil is traded in US dollars, the dollar's recent strength shrinks the oil savings experienced by other importing countries. While all of these countries are paying less for oil than they did last summer, exchange rates have eroded 10-30% of that benefit. The chart above displays this effect for the Euro and Japanese Yen. Closer to home, currencies like the Mexican and Colombian Pesos have depreciated by 12% and 29% since June, respectively.  That could prove significant, since Mexico's refined product imports from the US averaged over 500,000 bbl/day in 2014 (through October), along with over a million bbl/day to the rest of Latin America.

Since petroleum products are sold in local currency, after tax at the pump, consumers in many countries have seen a smaller drop to which they might respond, compared to US consumers. The average German gasoline price has fallen by just 19% since June and the average UK price by 20%, compared to 42% in the US. Meanwhile state-controlled gasoline prices in Brazil and Mexico have  gone up. That's unlikely to induce more driving.

So far the weekly figures  for US refinery throughput are up compared to last year, implying higher expected product sales. However, US inventories of gasoline and diesel fuel have also been growing for the last several months. If rising demand doesn't erode inventory gains soon, refiners may need to reduce processing rates, and that would feed back to oil prices. The next few months of energy statistics should tell a very interesting story.

 

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.

Oil Price Hangover

The price of oil is an odd thing. It's watched by millions of people every day, especially when it reaches uncomfortable levels, yet no two observers agree on all the details of how it's determined. Having traded the stuff professionally, I've always given a lot more credence to the fundamentals of supply and demand than to the influence of speculators as the main driver of day-to-day price movements, though it's clear that both supply and demand are pretty complex constructs in their own right these days. For some time, however, I've also been intrigued by the extent to which current oil prices seem to be affected by their own history, something more in keeping with behavioral economics than the kind I learned in grad school. When I consider all the factors converging to yield this morning's price for the prompt (April 2010 delivery) West Texas Intermediate crude oil futures contract, it's hard to rationalize a value just over $80 per barrel any other way, without taking into account that less than two years ago it was nearly $150 per barrel-- though just a year ago it stood at $40, after a dip into the mid-$30s.

Over the weekend I happened to look back at some scenario work I did almost six years ago, when oil prices were rising steadily but before they had passed the $50 per barrel mark for the first time. Though it seems hard to credit now, at the time even that milestone seemed nearly unimaginable for the group of energy industry managers participating in the workshop I was leading. WTI had just broken through $40/bbl, which represented the highest nominal oil price any of us had seen in our careers, a record set in the lead-up to the first Gulf War. Although the prices in the early 1980s, after the Iranian Revolution, were higher on an inflation-adjusted basis, we had just lived through a couple of decades in which oil had notably failed to keep up with general inflation. Of course from our current vantage point $40 or $50 now seems cheap, and that's precisely the point. With an all-time high of $145 still relatively fresh in memory for "anchoring" purposes, $80 might not seem low, but it hardly provokes the kind of anxious political pronouncements that flavored the 2008 US presidential campaign.

Things couldn't be more different than the first time we passed $80/bbl in September 2007, when there was much talk of the risk premium on oil prices due to tensions with Iran, as well as the impact of a weakening US dollar. Most importantly, the global economy was still booming and OPEC was having trouble keeping up with growing demand, particularly from the developing economies of China and the Middle East oil producers themselves, along with the US at the tail end of the bubble. By contrast, despite expectations for a recovery in 2010, today's oil market is dominated by weak demand, with average US demand for oil and its products in 2009 down by 10%, or 2 million barrels per day (MBD) from '07. The global appetite for oil fell by 1.5% in 2009, with only Asia and the Middle East registering any growth. Inventories are ample, refineries are running at extremely low rates of utilization--partly due to some ill-timed capacity increases--and OPEC has as much spare oil production capacity as it did in 2003, when WTI was in the $30s.

So why isn't oil back in the $30s or $40s, rather than the $70s and $80s, particularly with the dollar having strengthened by almost 6% since the beginning of the year? Certainly a big part of the credit or blame, depending on your perspective, belongs to OPEC, which has managed to take 2-3 MBD of production off the market and keep it there, with minimal cheating and without triggering a price war driven by members whose national budgets needed significantly higher oil prices or sales to balance. It's also clear that since the beginning of the last decade the marginal cost of incremental non-OPEC production has gone up significantly, whether from Canadian oil sands or deepwater Gulf of Mexico platforms. Part of that is due to the fact that these are intrinsically costlier barrels to produce, but it also owes a lot to the costs of raw materials and construction involved. Those soared during the last decade, weakening subsequently but not returning to their former levels. That means that the much lower oil prices we saw briefly at the end of 2008 and beginning of 2009 aren't sustainable for any length of time, though precisely where a realistic floor now lies is anyone's guess.

Arriving at a price of $80/bbl despite slack demand, ample global supply and a refining sector that's losing money doesn't require nefarious speculation, but it probably depends on two crucial factors: Most oil deals today are negotiated as a stated premium or discount relative to a handful of grades like WTI and Brent that involve as many financial players as refiners who must process the stuff and try to make a profit on it. And for those few, correspondingly more influential markets in which traders must negotiate an actual price and not just a differential, traders' price expectations are anchored by the history of the last couple of years. Once you've seen oil above $100 without the world ending--though it came close--you simply can't look at the market the same way you did before. If the range of possible prices is now seen as $40-$150, rather than $15-$35, today's circumstances understandably yield a mid-range interpretation, backed by an expectation that OPEC would intervene even more strongly if prices began falling towards that uncertain floor--a threat the credibility of which is greatly enhanced by OPEC's remarkable cohesion and discipline over the last year or so, perhaps providing more psychological anchoring in the form of availability bias.

So in a strange sort of way, we may still be experiencing the consequences of the extraordinary oil price spike of 2007-8, which was itself either an outgrowth of the global financial bubble, or a major, independent contributor to the ensuing collapse, in classic oil-shock fashion. While the extreme prices of that period have receded, they haven't vanished from the market's memory, and so they may continue to influence prices for some time to come, until the next spike or oil-price collapse resets them again.

Deficits, Dollars, and the Price of Energy

The latest revision to the forecasted federal deficit has implications beyond the sustainability of current government spending. Reading a pair of high-profile, skeptical assessments of Peak Oil in the context of a $9 trillion deficit projection for the next decade, it occurred to me that the most serious risk of higher oil prices in the near future might not be flagging production or surging demand but the further depreciation of the US dollar. The quickest route back to $4 gasoline could run through Washington, DC, rather than Riyadh or Beijing, and that might not be as helpful for renewable energy as its advocates might guess.

The main worry I've heard expressed about the size of the federal deficit has focused on the risk of inflation. However, high deficits carry another risk that could have a much more direct effect on energy prices, which in turn could help re-ignite inflation. The problem is acute because it goes well beyond the one-time impact of federal stimulus efforts, which have apparently ballooned this year's deficit to $1.6 trillion. Fundamentally, there is a persistent and growing gap between government revenue and expenses, exacerbated by high unemployment and lower income--and thus lower tax collection--particularly from the top quintile of earners who have consistently been paying 86% of the federal income tax. Unless that gap can be brought back into line with recent history, the government will soon face a difficult choice. Financing a steady stream of trillion-dollar annual deficits will require either interest rates high enough to attract investment from all over the world--and thus high enough to stifle a nascent recovery--or the monetization of the debt by means of the Federal Reserve printing even more money than recently. The latter course, which seems likely to be more politically palatable, despite Dr. Bernanke's reappointment, would inevitably weaken the dollar and lead in fairly short order to higher energy prices.

We got a taste of this effect in 2007, when oil prices and the dollar moved in opposite directions in an oil-dollar price loop that looked more than merely coincidental. A weaker dollar encourages producers to raise prices, or to consider pricing their output in a stronger, more stable currency. Meanwhile, non-US consumers experience stable or falling energy prices that encourage demand growth, which eventually leads to higher prices in all currencies. Either way, US consumers would see higher prices for petroleum products, though it's not clear how much further demand could fall in the near term, with US oil consumption already running 10% below 2007's, on a comparable year-to-date basis.

The dollar has already weakened by about 10% against the Euro and 5% vs. the Japanese Yen since March, as the resolution of the financial crisis and early signs of a global recovery have eased the fears that prompted a classic flight to dollar safety. This shift merely returns the exchange rate to roughly its level of pre-crisis 2008. Oil prices have risen by around 40% over the same interval, though how much of that is due to a weaker dollar is far from clear. However, from today's $70/bbl level, another 25% drop in the value of the dollar could return us to the threshold of $100 oil.

Higher oil prices due to a weaker dollar would not necessarily be beneficial for biofuels and other alternatives to oil, either. If we learned anything from the oil price spike of 2006-'08, it was that higher oil prices don't automatically make alternative energy more competitive. If only oil prices were moving, it might be helpful, but the only way to achieve that is through taxation, not inflation or currency depreciation. Just as oil functions in a global market, so too the components of the main alternative energy technologies have become global, with wind turbines and solar panels sourced globally and in high demand in many regions. So too for the steel and other basic materials for constructing such installations, as well as the grains and oilseeds turned into ethanol and biodiesel. A weaker dollar wouldn't just mean higher oil prices, but higher prices at least for all of the new energy sources to which we are turning in our effort to address climate change and bolster our energy security.

At an average price for 2008 of $93/bbl, oil made up just 15% of the value of the goods and services we imported last year, and a weaker dollar would see the prices of a host of other things--cars, electronics, call-center assistance, for example--go up, as well, fueling inflation and further depressing our standard of living. That scenario is hardly inevitable. A sea change on the part of the American public could convince the Congress and administration that we are finally prepared to pay for the government we have been demanding, or to see government services fall to a level commensurate with the level of taxation we appear willing to bear. Or the Fed could start raising interest rates to defend the dollar, in spite of the consequences for economic growth and unemployment. I'm pretty sure which choice I'd vote for.

Is Oil Shock 2.5 Imminent?

The rebound of oil prices has been getting a good deal of attention, lately, though we haven't yet reached the point at which, like much of last year, the daily closing price of WTI is reported on every evening news broadcast. I've even seen the dreaded "s-word" bandied about, implying that oil might have become disconnected from its fundamentals in ways that ought to worry those responsible for ensuring that the nascent economic recovery is not extinguished before it can gather momentum. Such fears look premature at this stage. Despite reaching $70 per barrel during last Friday's session--an increase of 107% from its post-crash lows last December--crude remains far below its highs of 2008 and currently trades at a level it first reached in spring 2006. Nor does it seem likely that US demand would support a return to $4 gasoline, which helped alter consumer behavior in ways that set the stage for oil's precipitous collapse and could do so again.

To understand current pricing, we have to pull apart the threads affecting supply and demand. On the supply side, the dampening effect of high oil inventories is offset by worries that high decline rates from mature fields and deferred and canceled production projects are setting the stage for a repeat of the capacity crunch of 2004-7 as soon as global demand growth resumes. Last week's Economist did a fine job explaining how each oil bust contains the seeds of the next boom, and why that cycle could be even shorter this time around. And in a recent "Heard on the Street" column, the Wall Street Journal's Liam Denning provided some insightful analysis on how traders playing the spread between short- and long-dated oil futures can translate higher prices for the out-year contracts into a boost for near-term prices. (He also questions the sustainability of China's recent oil import spike.) But if current oil prices are being dragged up by concerns about future supply--abetted by inflation fears and the recent weakness of the dollar--weak demand and its demonstrated elasticity should forestall an imminent return to last year's peak.

In recent weeks US gasoline demand has rebounded close to last spring's level. Driving season still matters, it seems, and we've seen pump prices respond accordingly. This reflects more than just the recent strength in crude oil. The NYMEX "gas crack", the spread between prompt gasoline and crude oil futures, averaged $2/bbl higher in April and May than in February and March, at the same time crude oil added $30/bbl. However, this strength is merely relative. US gasoline demand in the first quarter of 2009 was the lowest for that period since 2003, and that's before taking into account the approximately 175,000 bbl/day of demand--around 2%--met by higher mandated ethanol blending, after adjusting for energy content. Moreover, demand for distillate fuels--diesel and heating oil--is off even more than for gasoline. This isn't just a US phenomenon, either. The International Energy Agency sees global oil demand down by 2.6 million bbl/day, or 3%, vs. last year. That's no one's idea of a surge.

When we sum up all these developments, we see a very different dynamic than the one that took oil prices to the brink of $150/bbl. Then, demand seemed insatiable, and the capacity crunch was a measurable reality, not just a future prospect. Today, oil supply and demand and the global economy are linked in a set of counter-acting feedback loops. Higher petroleum product prices put greater pressure on price-sensitive consumers, whose ranks have been swelled by the recession. Even countries that insulate their consumers from the global oil market may have to adjust if prices edge closer to $100/bbl. So while higher oil prices could threaten economic growth, the demand response to higher prices--and any hesitation in expected growth--seem just as likely to stall oil's momentum and send it lower. This is a delicate balance, and it could be upset by many factors, including a sudden change in the value of a key currency, or an unanticipated supply disruption. Only time will tell whether, just as Oil Shock 1.0 (the Arab Oil Embargo) was followed a few years later by Oil Shock 1.5 (the Iranian Revolution), last year's Oil Shock 2.0 will soon be followed by version 2.5, or give way to entirely new scenario.

Weak Dollar Fallout

Wednesday evening I was interviewed by a news radio station in Kingston, Jamaica. Unfortunately, it took place by telephone, rather than on location. Most of the host's questions concerned the likely course of oil prices, and she was particularly interested in the role played by the depreciation of the US dollar. Today's Washington Post includes a helpful set of graphs charting oil's rise over the last year in US and Canadian dollars, Sterling, Euros and Yen. Compared to the currencies of our major trading partners, the dollar's weakness explains about a third of the one-year change in what we pay for oil. Even if market fundamentals drive oil prices somewhat lower over the next year, as seems likely, the US and countries with currencies linked to ours might not get much relief, if the dollar continues its slide.

The article accompanying today's graphs mentions the usual factors spurring on oil prices: geopolitics, OPEC, and the weak dollar. The influx of portfolio investment into oil markets--a.k.a. "speculation"--is directly related to the decline in equity markets, and to inflationary expectations caused by spikes in consumer and producer prices and the general consensus that the Federal Reserve will focus on lubricating the economy, rather than fighting inflation. So investors seek stable value and positive returns in commodities, and the prophecy becomes self-fulfilling, for now, worsening the trade and fiscal imbalances contributing to a weak dollar. As bad as that cycle is for Americans coping with rising food prices, resetting adjustable-rate mortgages, and high fuel prices, it is disastrous for small developing countries.

Since January 2007, oil prices have gone up by about $40 per barrel, adding roughly $14 billion to our monthly oil import bill--$170 billion on an annualized basis. As painful as that has been for our $14 trillion economy, imagine what it has done to countries such as Jamaica, with a $13 billion GDP that relies on imported oil for most of its energy needs, and with a currency that has actually declined slightly against the US dollar. A $1 billion increase in their oil import tab isn't just an extra burden; it's a crisis.

The primary focus of the Jamaican radio discussion in which I participated was on the estimated oil price that should go into their national budget. Given their reliance on imported oil, that figure will largely determine how much is left over for all other consumption and investment, public and private. Guess too low, and programs and projects will be slashed later, or more money borrowed. Guess too high, and necessary programs get cut now, causing hardships and squandering political capital. $80 per barrel might look right based on the fundamentals, but can they afford to bet that the dollar won't drop another 10%, or that Venezuela--their main oil supplier--won't finally follow through on one of its unpredictable leader's threats? Many other resource-poor countries are in a similar bind, with a lot less control over the outcome than we have.

The Oil-Dollar Price Loop

Positive-feedback loops have become a familiar concept, thanks in part to the science of climate change. A warmer atmosphere melts icecaps and glaciers, which in turn reflect less sunlight back into space, causing the atmosphere to warm further, and repeat. Such relationships exist in many systems, and an article in yesterday's Wall Street Journal started me wondering if we are experiencing such a loop involving oil prices and the value of the US dollar. If so, the practical limit on the dollar price of oil could be much higher than we might otherwise expect.

Over the last several years I've discussed many reasons why oil prices have increased so dramatically, compared to their level prior to 2004. It's a long list, including the shift in power from commercial oil companies to national oil companies, and from non-OPEC producers to OPEC, geopolitical tensions, the growth of Asia, inventory, speculation, and even the lagged impact of the late 1990s oil price collapse. At first glance, though, because oil is normally traded in dollars, the value of the dollar itself might not seem to belong on that list. In a world awash in oil, it probably wouldn't. However, a dollar that is shrinking relative to other major currencies has at least two effects on oil, in a market that is already tight.

First, it reduces the income of producers, who sell in dollars. That leaves them less cash to reinvest in new production. At the same time, it makes oil cheaper in the currencies of other consuming countries, relieving the pressure on them to consume less and helping them to out-compete us for the world's available oil exports. Each of these factors alone would tend to drive up the dollar price of oil; with the oil market being driven by supply constraints (OPEC quotas) and rising demand, both effects operate. More importantly, they appear to work in a self-reinforcing fashion, linked back through their impact on the dollar.

So imagine a closed loop, and follow it around a cycle:

1. The value of the dollar drops.


2. Non-US demand rises and supply tightens, as discussed above.


3. The dollar price of oil increases.


4. The US trade deficit worsens, and foreigners hold more dollars than they need to buy US goods or assets.


5. Return to step 1.

Events such as this week's interest rate cut by the Fed also feed this cycle, by weakening the dollar while propping up our economy and thus our oil demand. Of course, none of this happens instantaneously or in isolation. Many other things influence oil prices, exchange rates, and the other components of this highly-simplified feedback loop.

There's also a natural point at which these loops start to de-couple, and we could be nearing it. The growth of China and other large developing countries may be driving global oil demand, but we still import a quarter of all the oil that's exported around the world. Once the price gets high enough to dampen US oil demand and imports--or when the underlying factors weakening the dollar have the same effect--then this loop starts to run down. But at what oil price does that occur? I expected it long before we reached $80 per barrel, and there are signs that demand is slowing. Total petroleum products supplied in the US, one measure of demand, was down by about 0.5% for the last six weeks, compared to the same period last year, and total crude oil and petroleum product imports were down by a larger fraction. Time will tell whether this is a trend, or a random fluctuation. Meanwhile, I'll be watching exchange rates more closely than I used to.