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.

The Persistence of Change

Weakening demand appears to be the main oil market driver these days, with the US having just tallied its 12th consecutive monthly decline in gasoline demand, year-on-year. For the moment, at least, good old supply and demand have displaced imminent Peak Oil and a perceived commodity bubble as the dominant narrative. If we needed further evidence of that, the market's collective yawn at Russia's threat to the Caspian pipelines passing through Georgia ought to serve nicely. But how much of the recent decline in consumption is attributable to the price elasticity of demand, and how much to the weakening US economy? The answer is of more than passing interest, signifying whether we're likely to see a bounce in demand once the pump price catches up with the 20% decline in the price of West Texas Intermediate crude oil since the 4th of July.

The US average retail gasoline price has fallen for six weeks and currently stands at $3.74 per gallon. Barring an unexpected oil-price rally or a major refining problem, unleaded regular prices beginning with a "4" should soon disappear at all but the most expensive stations, even in California. Perhaps this is just a case of the August doldrums, but the price of oil is currently stuck in a range that defies the principal explanations for its behavior earlier this year. With the market clearly responding to fundamentals, its path from here will depend heavily on whether consumers continue to drive less, and that depends on the relative importance of the psychological impact of $4 gasoline, compared to a broad range of economic factors including falling home prices, tightening credit and surging inflation--some of which is attributable to high fuel prices.

The last stretch in which US gasoline demand declined for 12 consecutive months occurred in 1990-91, a period that also coincided with a spike in fuel prices--thanks to Saddam Hussein--and a recession. The Gulf Coast hurricanes of 2005, which gave the country its first taste of $3 gasoline, caused only a brief drop in demand. Within 3 months of Katrina's landfall monthly US gasoline demand had resumed its year-on-year growth, consistent with the robust economic growth (helped by the housing bubble) that we were experiencing at the time. Nor did the recession of 2000-2001 prevent gasoline demand from growing by 1.6%, with only a few months exhibiting declines versus the same month of the previous year. Of course, gasoline was well under $2 at the time.

It seems to require an unusual combination of low growth and high prices to overcome the inherent gasoline demand trend of the US economy and shock consumers into conservation mode. Since the economy seems unlikely to recover soon, the persistence of the recent changes in consumer behavior concerning fuel consumption and new car selection thus hinges on just how cheap $3.50 gas will seem to America's drivers after a couple of months over $4.00 per gallon. In the absence of more dramatic events, this could also determine the price of oil on Election Day, a parameter that could influence that contest's outcome.