Sunday, August 3, 2008

Many underestimate the effects of U.S. demand destruction on oil prices

The price of oil has risen 60% since last year; speculation, emerging market demand, insatiable U.S. demand, and restricted supply are all culprits for the surge. However, in the end, it’s all about supply and demand. The effects that reduced U.S. demand for oil will have on global prices are underestimated. I see that slower global growth, led by U.S., will push oil prices back below $100/barrel by the end of 2008.

The current story is all about rising global demand for oil (which, by the way, started well before this year)

Current supplies across the globe were likely sufficient to sustain some level of previous economic growth in 1985, but rising growth rates in emerging economies has strained supplies of fossil fuels.

Table Source: International Monetary Fund

Fuel supplies (or lack of) will become a key issue over the next several decades as key economies continue their growth cycles: China, for example, grew 12% during 2007, while Russia grew 8%. As these economies become more developed, average citizens will want more of the goods and services that we in the industrialized world have come to take for granted: refrigerators, cars, air conditioning, televisions, DVD players, MP3 players, fitness centers, and many other energy-based goods. You name it: If they can afford it, they will want it.

According to the IMF, growth in 2008 and 2009 across the emerging economies is projected to be 6.9% and 6.7%, while growth across the advanced economies is projected to be just 1.7% and 1.4%. Some argue that this will put severe pressure on the price of oil, and no matter how much advanced economic growth slows, oil prices will continue to rise.

According to Bloomberg, Jeffrey Rubin, chief economist at CIBC WorldMarkets Inc. in Toronto who has correctly forecast higher oil prices since 2000, said: "The U.S. recession will be a footnote as far as the oil market is concerned. Supply isn't growing and demand is growing robustly in the developing world."

I disagree. Economists do not give enough credit to the magnitude of U.S. demand, at 24% of total oil demand in 2007, and the potential impact that its destruction will have on the price of oil.

Global oil demand is changing

Two very important things are happening to world oil markets. First, Asian economies are cutting fuel subsidies, reducing emerging market demand for oil. For years, governments have sponsored (subsidized) inexpensive fuel costs by paying for a large portion of the fuel. Only recently, and driven by record oil prices, Taiwan, Indonesia, Malaysia, and more importantly, China have cut subsidies for fuel products.

Second, U.S. demand for oil is falling. In the first quarter of 2008, U.S. demand dropped 1% to 23% of world oil demand since last year. In the near term, I believe that the destruction of U.S. oil demand will well-outweigh the pressures coming from strong emerging market growth – especially while emerging markets cut fuel subsidies.

The oil demand of key emerging economies, like China, is just too low compared to that of the U.S. In 2007, China held just 9% of world oil demand and grew 10% a year, Russia held 5% of world oil demand and grew 8%, while the U.S. held 24% of world oil demand and grew 2% in 2007. Even though U.S. economic growth is small compared to that of emerging economies, its continued destruction will lower oil prices significantly. I expect that oil prices will sit around $100/barrel by the end of 2008.


Why oil prices have surged

Let’s address Congress’ most recent pet-project, speculation. A senate report found that market speculation has contributed to rising oil prices, but that is up to debate. There are all kinds of speculation (seeking a higher investment return based on price) investments, but Congress’ real concern was short selling, or betting that the price would fall. An investor would promise to sell oil at the current price in hopes that prices would fall so that when the contract came to term, the investor would snatch up the oil at a lower price and still sell at the high price. Thank goodness that the House speculation bill was tossed away in favor of drilling talks.

The supply of oil is fixed. It is a non-renewable resource; if the world wants more of it, it must be found. If N. Pelosi and crew want to reduce “dependence on foreign oil,” then why not drill for it off the American coastline? Drilling for oil that is accessible is much easier than drilling for oil that is inaccessible (perhaps in the Colorado Rocky Mountains).

In the long run, sustained emerging market growth must be accompanied by increasing supply. If it is not, then the price of oil will rise to clear the markets. Let’s hope that OPEC (Organization for Petroleum Exporting Countries), that currently supplies 43% of world oil, will spend some of its record oil revenues (Petrodollars) on infrastructure for future oil supply.


Please leave comments. Best, Nontruths

1 comment:

  1. Charles Krauthammer of the Wash. Post points out that Pelosi says "I'm trying to save the planet." She fails to realize that places like Nigeria have awful environmental oversight and cause so much pollution compared to the effects drilling in Alaska or other US coastlines. It will be interesting to see how long the US demand declines. My '93 Camry is still getting great mileage.

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