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OPEC’s other problem: weak demand for oil

By now, everyone is aware of the serious threat rising shale output from the United States poses to OPEC. But sluggish demand growth in response to the quadrupling of prices between 2002 and 2012 is at least as a big a challenge for the cartel. Consumption in the developed economies peaked at 50 million barrels per day (b/d) in 2005 and is still just 45 million b/d nine years later, according to the U.S. Energy Information Administration (EIA).

Developing economies consumption has risen by 12 million b/d over the same period (around 9.5 million b/d outside the Middle East). Net growth of 4.8 million b/d over nine years is slower than the Organization of Petroleum Exporting Countries (and other forecasters expected a few years ago. Oil demand in Asia is not growing quickly enough to offset stagnating consumption in the advanced economies and absorb all the extra supply from shale.

OPEC has confronted this problem before in the early 1980s, when consuming countries took unprecedented steps to reduce demand in response to the oil shocks of 1973 and 1979.

Nuclear power programs in France and Japan, the conversion of heating systems from fuel oil to gas, stricter fuel economy standards for new motor vehicles and punitive taxes on motor fuels were all deliberately intended to cut oil consumption.

Slowing demand growth as much as rising supplies contributed to the price crisis in 1986, just as it is now causing a similar problem for OPEC in 2014.

Oil consumption (and energy consumption more generally) is strongly responsive to price changes provided they are sustained for long enough.

In the short term, the quantity of oil consumed is not sensitive to price changes (the price elasticity of demand is low). The lack of short-term feedback has misled many commentators to conclude that demand is not responsive to prices at all. But that is wrong.

In the medium and long-term, oil and energy demand is highly responsive to price changes. Price elasticity is a function of time. And time is the most important but under-appreciated variable in analysis and forecasts of commodity markets. Total U.S. energy consumption actually fell in both 1974-75 and again in 1980-82 in response to the oil price shocks.

More broadly, periods of low oil and energy prices in the 1950s and 1960s, and again in the late 1980s and early 1990s, corresponded with rapid growth in U.S. energy consumption.

By contrast, the rising cost of oil in the late 1970s and again in the 2000s brought growth in energy demand to a virtual halt. In the 10 years ending in 1972, a period of low oil prices, U.S. energy efficiency (measured in energy consumption per unit of real GDP) was unchanged.

In 1972, U.S. businesses and households consumed a little over 15,600 British thermal units of energy for every $1 of GDP, according to the EIA. Energy consumption per $1 of GDP was virtually identical to 1962 once dollar amounts are adjusted for inflation.

In the 10 years ending in 1986, however, a period in which oil prices soared, efficiency increased at an average rate of 3 percent every year.

Energy consumption per unit of real GDP plunged from 14,800 British thermal units in 1976 to just 10,800 in 1986.

The pattern has been repeated more recently. Low prices in the late 1980s and 1990s saw average efficiency improvements of just 0.8 percent per year in the decade to 1996. High prices in the 2000s drove efficiency gains of 2.6 percent a year in the decade to 2006, three times as fast.

U.S. efficiency improvements have been mirrored in Europe and Japan, albeit on a more modest scale, because other OECD economies made greater strides in the 1980s and had correspondingly less scope to improve in the 2000s.

Efficiency improvements in developing economies have been smaller because in many cases businesses and households have been sheltered from the full impact of rising oil costs by subsidies and price controls.

In any event, underlying demand for oil and energy is rising rapidly as emerging economies modernize, urbanize and develop a large middle class, which is more than enough to offset efficiency improvements.

But even in developing countries, demand for oil in particular and energy more generally has grown more slowly than predicted five years ago in response to the escalation in costs.

The problem is a familiar one for OPEC. “My main worry was that if we increased the price of oil too much we would merely reduce the demand for it in future,” former Saudi Oil Minister Zaki Yamani told his biographer about the acrimonious debate within the cartel over price rises in the 1970s.

“I have always said price increases should come in small doses. … Gradual increases can be absorbed. It’s very dangerous for everyone involved when price increases come as a shock.” Yamani explained.

The quadrupling of oil prices between 2002 and 2012 was every bit as much of a shock as the rise between 1973 and 1980, and the response has been the same. Consumer countries have sought to replace oil with cheaper alternatives (for example biofuels mandates in the U.S.). Vehicle fuel efficiency standards have been tightened. And businesses and consumers have changed their driving behavior to cut fuel consumption (improving route planning and cutting back on discretionary journeys).

The result has been the same as in 1986, leaving OPEC with sluggish demand at precisely the same time that rival supplies are surging.

The solution is also the same. Prices must come down and stay down long enough to discourage investment in non-OPEC production and get demand growing strongly again.

But there is one crucial difference between the 1980s and 2010s. In the late 1980s and early 1990s, low oil prices eventually encouraged complacency. The drive for fuel efficiency faded.

In the 2010s, however, the drive for greater fuel economy is linked to climate change as much as rising oil prices. Most of the energy efficiency, conservation and substitution policies enacted since 2005 have had the dual purpose of reducing demand for increasingly expensive oil and curbing greenhouse emissions.

Government support for biofuels, electric and natural-gas powered vehicles, and increased fuel economy were all introduced to support climate change goals as much as energy security. Climate change will give energy efficiency policies much more stickiness than in the 1980s and 1990s.

In that sense, OPEC may face a bigger challenge in using low prices to buy back some of the demand growth lost in recent years. The rapid modernization of developing economies will work in the cartel’s favour, but climate change policy works against it, as OPEC tries to rebalance the market.

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