Oil prices have dipped a bit this week, but still remain at their highest levels in nearly three and a half years. The reasons are by now familiar to most readers who pay attention to the daily whims of the oil market: OPEC cuts, falling inventories, geopolitical unrest and strong demand growth, to name a few.
But at what point do higher prices start to destroy some of that demand, erasing one of the most significant bullish factors influencing the market right now? As John Kemp over at Reuters points out, there isn’t a magical threshold in which demand is humming along swimmingly and then suddenly drops off a cliff. There isn’t a binary response in that way.
Consumers respond in different ways to different prices, and the duration of high prices also matters quite a bit. Auto fleet turnover takes time, and people don’t rush out and buy a more fuel-efficient car immediately when prices spike. And as John Kemp rightly argues, demand will likely take a hit before we can detect it in the data.
Nevertheless, demand is sensitive to prices, which is to say it will slow or even decline if prices rise high enough. A brief look at recent history bears that out. Crude oil prices saw a historic run up in prices in the years preceding the 2008 record high spike and subsequent meltdown. That rally essentially ended a century-long upward trend in demand, which hit a high above 21 million barrels per day (mb/d) in the U.S. in 2006-2007. The financial crisis, a terrible economy, more efficient cars and a somewhat saturated auto market led to a temporary peak in oil demand, which was followed by several years at lower levels.
When oil prices rose back to $100 per barrel in 2011 following the Arab Spring, demand dipped even further.
Only when prices collapsed in 2014 did the U.S. start to see a revival in demand. U.S. consumers enjoyed more than three years of cheap oil, causing them to fall back in love with SUVs and pickup trucks.
However, we could be on the verge of another shift in the cycle, with WTI at a three-year high, sitting just shy of $70 per barrel. More importantly, the OPEC cuts, the prospect of supply outages in Iran and Venezuela, and the depletion of inventories down to average levels promise to push prices even higher. We haven’t seen any discernable change in demand just yet, but again, these things take time to show up in the data.
The IEA projects oil demand will rise by a robust 1.5 mb/d in 2018. The agency believes total demand will outstrip supply for the rest of this year, with the supply gap growing as time passes. That, of course, is predicated on the assumption that demand does indeed grow at that projected rate of 1.5 mb/d. But, at some point, if demand exceeds supply by enough, and inventories fall below average levels, prices will spike to much higher levels.
At that point, say, $80 or $90 or $100 per barrel, demand will have to start taking a hit. To reiterate, forecasting the precise price level, and the magnitude of the demand response, is tricky. But, suffice it to say, the oil market won’t see consistently high levels of demand growth – at 1.5 mb/d – year after year if prices are approaching triple-digit territory.
Then there is the matter of the short-term versus the long-term. Demand destruction might not occur instantaneously. It will take an extended period of high prices before consumers start really cutting back in a big way. But if prices stay high for several years – and there are plenty of reasons why that might not occur – the hit to demand could have more permanent consequences.
In other words, this time could be different. Unlike a decade ago, electric vehicles are increasingly competitive with traditional gasoline or diesel-fueled cars and at some point in the 2020s will reach cost-parity without subsidies. Higher oil prices tilt that equation in favor of EVs and could shift that timeline forward. A sustained period of high prices could accelerate the energy transition that most analyst sees as inevitable.
Comment by Nick Cunningham of Oilprice.com
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Frontpage December 30, 2017