Insight: Oil prices have peaked

Thanks in no small degree to a drop in global demand, oil prices, after breaching $147 per barrel, have tumbled more than 23 per cent to below $113. Barring a big hurricane in the Gulf of Mexico or a disruptive geopolitical event, oil prices appear to have peaked.

World oil consumption is now growing at a significantly lower pace than had been imagined a year ago. Last October, the International Energy Agency was forecasting global demand growth for 2008 of 2.1m barrels a day, with 750kb/d from the OECD and 1.33mb/d from emerging markets. In their latest monthly report, the IEA has slashed this by more than 60 per cent to 800kb/d, with OECD demand actually forecast to decline by over 600kb/d and emerging markets demand to grow by 1.4mb/d.

In our judgment, the IEA’s forecasts for emerging markets will turn out to have been far too optimistic by year’s end and OPEC countries will again complain about the inability of oil importers to guarantee sufficient demand growth to warrant investments in expanded production capacity.

Pointing fingers about who is responsible for the uncertainty of global demand may be futile. Clearly, higher prices and lower economic growth are taking a toll on US and other OECD country petroleum product demand. But now two other articles of faith are being challenged. First, the consensus thinking that emerging market oil demand has decoupled from industrial countries will be severely tested over the next half year. Second, the growing consensus that lower prices and higher economic growth will result in a rebound in global demand growth is wishful thinking.

Let’s look at both of these arguments in more detail. There is growing evidence that the economic malaise affecting many of the OECD economies is spreading into emerging markets, especially those whose growth is reliant upon the strength of their export markets.

For China, which has been responsible for more than half of global base metal demand growth and as much as one-third of global petroleum demand growth, challenging times are ahead for exporters and the metal and energy-intensive producers of steel, aluminium, cement, and other primary products.

Contrary to popular myth, these energy- intensive industries rather than the transport fleet are consuming the middle distillates that drive two-thirds of China’s petroleum demand growth. And now due to higher energy costs, an appreciating yuan, weak export markets, and a protectionist backlash, exports are falling, with ramifications for their demand for resources. With China at a crossroads and GDP growth slowing to 8 per cent, product demand growth could drop from its three-year average of 490kb/d to 350kb/d (up 4.4 per cent) in 2009.

Furthermore, debate remains over the relationship between subsidies and demand growth in emerging markets. Efforts to de- control prices in many Asian countries, have raised end-user prices significantly, some by more than 50 per cent. The few historical lessons about the effect of price hikes of such magnitude on demand growth point to structural tipping points. Japan’s product demand rose three-fold from 1965 (1.7mb/d) to 1973 (5.3m b/d). Since the oil shocks, Japan’s demand has never exceeded its 1973 figure. Similarly, South Korea’s demand grew by more than 300 per cent from 1987 (620k b/d) to 1997 (2.4mb/d), when the financial crisis forced a liberalisation of prices; again, demand has not exceeded its pre-crisis peak.

Complacent assumptions that lower prices will bring renewed demand growth ignore the reality of the demand response to extreme price shocks. The shocks stimulate the world to go beyond temporary reductions in discretionary consumption, and make large irreversible investments in energy saving technologies, permanently changing the structure and efficiency of transportation, industrial, commercial, and residential sector demand.

The old adage that “nothing cures high prices like high prices,” is as true today as in the 1970s. Those cures don’t only involve the supply side; the response from demand is as critical. We expect prices to stabilize at $90-100 per barrel but to still stimulate structural demand adjustments – we don’t foresee world demand growth exceeding 1mb/d per year for some time.

The writer is Chief Energy Economist at Lehman Brothers
(Head, Commodities Research - My Team)

Source: Financial Times, August 13, 2008