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Oil Falls as Demand Worries Outweigh Prospects of OPEC Cut

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Many investors assume that energy use is a relentless upward march as populations grow and consumers acquire more gadgets. But oil consumption has contracted meaningfully in the past, most notably in the first oil shock, when demand fell from roughly 67 million barrels per day to 59. And recall that the oil price shock was a major driver of reduced consumption.

Today we have what looks to be a close to global recession in the making, driven by a financial crisis, a fall in consumption in major economies, and a resulting decline in international trade. Although oil prices have fallen over 50% from their peak, that is unlikely now to have much impact on demand. And doubts are on the front burner as oil prices fell overnight (Brent crude is down over $2.50 to $67.18 at this hour)

One factor that the oil bulls have repeatedly invoked is demand from China. The figure I have seen oft cited is that Chinese demand will continue to rise at 7;8% per annum. It is important to note that while China has been a major force in the increase in energy use, Chinese and Indian consumption combined are roughly 1/4 US + EU+UK demand. So a small percentage fall in advanced economy consumption could exceed increases in Chinese and Indian demand.

In addition, Paul Ting of Energy Vision’ “China Energy Report” dated October 21 (hat tip reader Michael) makes no bones about its outlook for China “Oil Demand Improved but Still Anemic.” Key points from the report:

• China’s third quarter GDP growth was 9%, with September GDP growth rate estimated at between 7.8% to 8.1%.
• We have to go back to the late 1990’s to see annual GDP growth at the sub-8% level.
• We note that the September export was strong, with the $29.4 billion trade surplus the strongest of the month. Hence the 9% GDP growth in the third quarter was not export induced, but rather reflecting domestic weakness. Should the global economic malaise result in weaker export, then further weakness may be expected.
• On the energy front: the latest statistics showed that China’s September demand growth rate was 5.5%, excluding inventory effect. Preliminary inventory based on regional data suggest that September had witnessed 4.2% of further inventory build. Incorporating this trend, the September demand growth was 4.1%
• While the September demand growth rebounded from the anemic .8% growth in August, the demand growth is still lackluster. The demand growth is in line with our expectation that the near term demand growth should be at the level of 5% to 6%.
• We note that the September demand of 7.824 was still the second lowest of the year.
• In addition, the September product import was the lowest of the year.
• In particular, gasoline import of 31 MBD was the lowest of the year. Gasoline export exceeded import by 21 MBD, marking the first time since April that China re-entered the gasoline net export market.
• Diesel import also was low, as expected. The September diesel import was only one-third of the July level.
• Fuel oil demand and imports were both low. Fuel oil demand fell by a whopping 23%.
• Coal export fell sharply. China’s coal import again exceeded it export level.
• Lastly, we believe that it is significant to note that today (October 21) Sinopec reduced the wholesale diesel prices by about 7 c/gallon in selective metropolitan areas. This effectively reversed the puzzling Beijing price increase a few days ago. Market forces can sometimes trump government mandates. The combined impact of weak economic growth, weak demand and artificial high prices resulted in the current price reductions.
• That is the strongest evidence yet that China’s demand is more elastic than commonly believed.

Note the major messages above: Chinese GDP growth and energy demand has fallen off even though exports are still robust. Thus a fall in exports will lead to a further reduction in growth and energy use. And the growth lever that Ting cites, 5%, is already below the 7%+ that was assumed until recently for China.

Various news stories focused on the dilemma facing OPEC. The Financial Times stressed the divergent interests of the group’s members:

Opec is expected on Friday to decide to slash production…But newly released data reveal that the cartel’s vastly divergent economic circumstances will make the divided group’s decision of how much to cut even more difficult.

PFC Energy, the Washington-based industry consultants, calculated that Opec countries needed next year’s oil prices to be anywhere from $10 to $100 to keep their import expenditures and export revenues in balance. The tiny nation of Qatar needs oil to be only $10 a barrel, while Iran requires $100. Saudi Arabia, Opec’s most powerful member, needs oil to average $50 a barrel….

Comments by energy ministers have already begun to reflect their countries’ divergent economic needs. Estimates of how much Opec will have to cut range from 500,000 barrels a day to 2.5m, with some favouring a multiple step approach.

Algeria and Libya, Opec’s less aggressive price hawks, pushed for Friday’s emergency meeting and back a large cut in production. Venezuela and Iran, the perennial hawks, have also demanded decisive action.

But Saudi Arabia, Opec’s most powerful member, has kept quiet. All the market has to go on are anonymous comments published this week by Al-Hayat, the Saudi-owned paper, which appear to reflect Riyadh’s more conservative thinking.

The paper quoted an unnamed source expressing “doubt that demand for oil will adjust [downwards] requiring a substantial cut in production”, adding that it was still uncertain whether even 500,000-1m b/d needed to be cut.

That contrasts with Chekib Khelil, Algeria’s energy minister, who said this week: “There is no doubt that all members agree that oil inventories are very high and supply is higher than demand by around 2m barrels per day.”

Iran, Venezuela and Nigeria have even more divergent views as internal problems robbed them of the ability to boost production when oil prices were high and their peers – especially Saudi Arabia – were reaping the benefit of their better-functioning oil industries.

The International Monetary Fund estimates oil and gas exports from countries in the Middle East and central Asia this year will amount to $1,100bn (€839bn, £651bn), up from $700bn in 2007. To balance their budgets, almost all the active Opec members of the Gulf Co-operation Council need oil prices to trade between $23 and $49 a barrel.

Francisco Blanch, analyst at Merrill Lynch, said: “Most GCC countries bear similar budget burdens, but Iran, Venezuela and Nigeria do not. More interestingly, these three countries have already been at odds with the broad Opec policy in recent months, perhaps reflecting their own domestic production problems.” He added: “More important, Opec members have completely different agendas.”

Saudi Arabia and many of its Gulf neighbours worry more about high oil prices eating into their own market share as the world invests in developing expensive pro jects outside Opec, including in alternative energy.

Note we have seen lower estimates of Saudi Arabia’s production costs, an average cost more like $30 per barrel, but its marginal costs would therefore be higher, but the PTC analysis is using a different methodology, that of the level required to keep from going into a current account deficit. Given the large FX surpluses some OPEC members have, that may not be a binding constraint on some, at least short term.

The New York Times discusses the difficulty of finding the right production level and the possibility that the cartel may lack the discipline to halt a price decline:

The problem for the oil exporters, who meet for an emergency session in Vienna on Friday, is to find a way to stop the price drop at a time when oil consumption is falling markedly in industrialized countries. Even the Chinese economy, long the biggest engine of growth for oil demand, seems to be cooling.

Most analysts expect the group to announce a production cut of at least a million barrels a day, which would be more than 1 percent of the world oil supply….

History suggests that OPEC will face a tough time propping up prices as oil consumption slows and the world teeters on the edge of a global recession, analysts said. Some experts warn that if the cartel took too much oil off the market, it could push prices up so much as to worsen the global economic crisis.

“OPEC’s problem is they don’t know how much demand is falling,” said Jan Stuart, an energy economist at UBS. “So the risk they run is either they don’t do enough, or they do too much. That’s a tough choice.”

Nobuo Tanaka, the executive director of the International Energy Agency, said a cut in production could harm consumers and delay an economic recovery. “The slowdown may be prolonged,” Mr. Tanaka told reporters on Monday in Paris, where the energy agency, which advises industrialized countries, is based…

The biggest question is what price the cartel is prepared to defend. In 2000, producers adopted a price band of $22 to $28 a barrel, and adjusted production levels accordingly. The mechanism was imperfect, and many producers felt it constrained them, but it basically worked to ensure stability in oil markets.

But defending a price requires spare capacity, so that production can be raised if prices get too high, as well as discipline on the part of OPEC members, so that production can be lowered when prices fall. OPEC abandoned its price band when its spare capacity virtually disappeared in 2005 amid rapidly rising global oil demand.

Now, with consumption growth slowing sharply and new oil projects coming online, some spare capacity has become available…

The cartel, which controls 40 percent of the world’s oil exports, has found it difficult in the past to get all its members to abide by production cuts. When prices fall, producers have an incentive to increase their output to maximize revenue, not stick with OPEC quotas.

Further observations from Bloomberg in “Crude Oil Falls as Waning Demand Outweighs Prospect of OPEC Cut “:

Oil prices dropped as stocks declined and the U.S. dollar climbed to 20-month high against the euro, reducing the appeal of commodities as an inflation hedge. OPEC, supplier of more than 40 percent of the world’s oil, is poised to announce an output cut at an emergency meeting this week.

“It’s about the real economy and that’s going to drag demand down,” said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo. “The market may have priced in an OPEC cut already so they may have to do a little more than what the market expects.”…

Gold, copper and soybeans also fell yesterday. Investors often sell crude and other dollar-priced commodities when the U.S. currency gains, undermining their use as an inflation hedge. The dollar was at $1.3014 per euro at 9:45 a.m. in Singapore after rising 2.1 percent yesterday and reaching $1.3051, the strongest level since February 2007.

U.S. gasoline demand dropped 6.4 percent last week from a year ago, the 26th consecutive weekly decline, a MasterCard Inc. report yesterday showed.

“There’s a chronic mismatch between demand and supply,” said Michael Ivanovitch, president of MSI Global Inc. “There’s very little growth in the U.S. and Europe.”

The Organization of Petroleum Exporting Countries may disregard pleas from consuming nations on the brink of recession by cutting output by at least 1 million barrels this week, a Bloomberg News survey showed.

Thirty of 33 analysts surveyed yesterday and today forecast that OPEC will decide to cut output by 1 million barrels a day or more at the meeting in Vienna which was brought forward from November. That’s more oil than Australia consumes. OPEC also may signal plans for an additional reduction of at least 500,000 barrels by early 2009.

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7 comments

  1. Anonymous

    I know I’m stating the obvious, but demand in emerging markets is relatively elastic because of the high relative price of oil compared to salaries in those countries. When oil prices peaked, many people in emerging markets were spending 50% of their income on gasoline. In some countries, this triggered significant conversion of vehicles to LNG.

  2. Anonymous

    The cival unrest around the world could get might ugly in the not too distant future. The Shah of Iran could easily get thrown out!

  3. larryang

    Anyone know of studies with numbers and figures on the effects of the decrease and/or removal of gasoline subsidies in China, etc.?

    Removal of the subsidies would cause the demand to react faster to price.

  4. William Mitchell

    Elasticity appears to have been unexpectedly high in the US, as well. The abruptness reaction of declining vehicle miles, and the speed of transition from Escalades to Accords, came faster than in the 70s.

  5. john bougearel

    Yves,

    Excellent, no scratch that, outstanding post!

    You just get better every day don’t you? :-)

Comments are closed.