2007 November 11 Sunday
When Will Oil Demand Destruction Kick In?

Oil prices are approaching a point where total demand might start dropping.

Société Générale's "Oil Burden" index, which measures oil price impact on global gross domestic product and has a base of 100 set in 1975, sat at just 75 at the end of last year - when average prices were $30 below current levels. While the company hasn't crunched the index numbers at current prices, "We have a feeling we are now approaching the 100 [index] level," he said. He noted that energy costs are now eating about 4 per cent of U.S. disposable income - similar to levels at the heights of the 1970s oil crises.

He suggested $120 a barrel could represent the level at which oil's damage would be on par with the 1970s. But others feel the threshold could be even higher - because the emerging-market economies that have been driving demand growth seem less bothered by high prices than their developed-world counterparts.

In the early 1980s world oil demand shrank as all the projects and changes in lifestyle made to reduce the burden of high oil prices began to take effect. Shifts toward more fuel efficient cars, changes in industrial processes, and the installation of more insulation all cut demand. At some point the collective decisions of many participants in the world economy will lead to demand reduction. But at what price of oil?

Developed countries (the United States especially) will cut back their oil demand sooner than the developing Asian countries will. Part of that difference is due to more rapid Asian economic development. Faster development means a faster rise in the demand for energy.

This means that US demand will start declining first. Yet in spite of that US demand decline total demand might not drop when US demand drops. So prices might keep going up. US demand destruction will just free up oil for use by China and India. Lifestyle changes and industrial restructuring in the US in the 1980s lowered the price of oil for the US and the US economy benefited from that price decline. But this time around the US restructuring and investment in energy saving capital equipment will not deliver an energy price decrease.

Just how far oil prices rise will depend on how soon and how rapidly demand destruction occurs. The price of oil has gotten high enough to wake up people. Car buying habits have shifted in the direction of smaller ones. Entrepreneurs, venture capitalists, and managers of big corporations are looking for ideas on how to save on energy costs and how to develop products that will let others cut costs.

The rising energy prices are going to cause a big burst of policy making in national governments. Corporations will line up for and against the many proposals. An interesting article in the Wall Street Journal about Dow Chemical's positions on energy policy highlight the many interests which drive corporate decisions on energy policy.

Sometimes, because Dow is so sprawling, its stake in an energy-policy fight isn't clear even to the company. Consider a pending House proposal to require electric utilities to generate 15% of their power from renewable sources by 2020.

It sounds good to Mr. Ellebracht, the R&D chief in the unit developing solar technology. In fact, it sounds doubly good: The proposal would let utilities meet the rule partly by raising energy efficiency -- and Mr. Ellebracht's unit makes insulation, too.

But the idea worries two other Dow fiefs. The people who operate power plants at Dow chemical factories fret that a mandate on use of energy from renewable sources might require Dow itself to buy costly renewable power. And the people who buy natural gas as a factory raw material worry that the mandate might actually raise gas prices.

All of this corporate calculation on which policy proposals to support will become largely irrelevant if we break out of the world oil production plateau with a downward turn in oil production. Government policies will have little effect as compared to declining oil production.

Which way oil production is going to break - up or down - is probably the biggest economic question we face right now. It is even more important than the rise of Asia or the retirement of the baby boomers. A downward break will throw us into something akin to an economic depression.

Share |      By Randall Parker at 2007 November 11 08:50 PM  Economics Energy

Kenelm Digby said at November 12, 2007 3:24 AM:

Basically, the only 'law' in economics that actually means anything is the law of supply and demand.
If the need for a certain commodity is great enough people are prepared to pay exhorbitant prices in order to satisfy their need - think of the ridiculous level of house prices in England, where houses are all but unaffordable to 90% of the population, but the prices just won't budge - after all everyone needs a roof over their head and by hook and by crook people get the money from somewhere to satisfy this most basic and primal of demands.
Similarly consider the exhorbitant price of cigarettes in England, and how little the ridiculous price for a pack 0f 20 ($12 equivalent) has destroyed demand as the government health watchdogs want it to.
Other examples abound - usually of illicit goods such as hard drugs.
I would put the demand for gasoline in particular and oil in general into the category of one of those products that satisfy a primal, unsatisfiable deamand and which therefore no 'exhorbitant' price will destroy the demand for.

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