Think you can have higher oil prices and still have high demand?
That sounds counterintuitive, but one contrarian energy economist thinks so. UK-based Andrew McKillop is convinced that sustained high oil prices do not necessarily cause oil demand to decline over the long term.
He is equally convinced that the world is in for a prolonged period of oil prices of $50/bbl or more (in 2003 dollars) and yet that oil demand will continue to rise.
McKillop contends that the interaction of oil price and demand signals have been misread historically. This sets the stage for perpetually mistaken demand forecasts, he says.
And, as a subscriber to the theory that an imminent peak in world oil production is at hand, McKillop speculates that a possible oil price shock is in the cards and could begin as early as this year.
Misreading demand, prices
McKillop challenges conventional economic reasoning regarding the price elasticity of demand, which goes something like this: Large oil price rises will necessarily cut oil demand and economic growth. The resulting inflation and other financial instability that result can be tamed only through higher interest rates and even recession, which are then needed to reduce oil demand in a context where oil supply is perceived as growing as fast as or faster than demand.
But McKillop contends the relationship between oil prices is more complex than that.
"The so-called 'delinking' of oil from economic growth in the early 1980s was simply the interaction of intense economic recession and one-time energy savings due to energy conservation programs and policies engaged in the 1970s after the oil shocks of that time." Following each price shock, there was a period of retrenchment and then recovery in oil consumption.
He points out that oil demand in fact did rise after the 1973-74 oil price shock in the Organization for Economic Cooperation and Development countries—as much as 3% for the US in 1978. Then, oil demand growth generally tracked OECD economic growth, which was robust in large part because it was fueled by increased oil consumption. Conversely, during the 1990s, each fall in economic growth rates was preceded by a fall in oil prices, and each small increase in economic growth rates was usually preceded by a rise in oil prices. This points to his contention that it is the rate of economic growth that mainly determines the traditional coupling of economic growth to the rate of oil demand increases, not the reverse. He cites some key European economies in the past 5-7 years whose oil demand growth rates have outstripped real increases in gross domestic product.
The exceptions have come with the most severe oil price shocks, such as 1973-74, when oil prices rocketed by 295% to $55/bbl (2003 dollars).
"Without complete restructuring of the economy, food production, and transport systems and deurbanization of population, the world's economies will in fact remain coupled with oil demand whatever the price because of the complete dependence of modern urban-industrial economies on oil and oil products," he said.
The other major factor in an outlook for strong global oil demand growth is the transitioning of newly industrializing countries (NICs)—especially giants such as China and India—to the stage of maturing economies, such as the OECD's. Oil demand growth in the NICs, with their rapidly surging manufacturing and export activity, will more than compensate for any recession-induced fall in OECD oil demand.
McKillop speculates that only price levels above $60-80/bbl (2003 dollars) will cause OECD oil demand to stagnate or fall, for about 36-40 months before "recoupling" of demand and economic growth occurs.
Today's 'fragile' state
Today's "fragile" price environment features an ever-present risk of runaway prices with a supply interruption of as little as 3 million b/d sustained for a few weeks, says McKillop. In such a scenario, oil prices could reach $50-75/bbl before defensive interest rate hikes are put into play.
"Much better, both for world economic growth and for increased investment in the oil and energy industry, is stabilized oil prices in a range of around $36-45/bbl for the 2003-04 period," about what they were, in terms of today's dollars, during 1975-78.
McKillop projects world oil demand will rise in this timeframe by 2.25%, enough to put the global oil market on a razor's edge, he contends. Given the likely oil supply-demand balance, "the market has no way to go but up in price."
And that price, McKillop estimates, could be $55/bbl by this winter.
(Online July 12; author's e-mail: [email protected])
