Oil Demand: The Other Side of the Equation
Much attention has been paid in recent years to the prospects for expanding oil production. Many have argued that because it is becoming increasingly difficult and costly to expand oil production and because consumption is expected to continue rising as the economies of China and India grow, the price of oil must rise sharply, perhaps to as much as $200 per barrel in the near term.
Things have not worked out that way. First, oil production has continued to increase, especially in the United States, and the prospects are that it will continue do so. Second, economic growth has slowed and this has led to a slowing of the rate at which the demand for oil is growing. Further, the historical relationship between economic growth and oil consumption growth has changed in recent years. The fall in the price since last June indicates that demand is just as important as supply in determining the price of oil.
The Price of Oil Falls—Again
With the price of oil having fallen by 58% between June 2014 and early January 2015, we are witnessing another period that will be carefully analyzed among energy economists for some time. The price has fallen sharply before. In 1986, the price (as measured by the spot WTI price of crude oil) fell from $26 per barrel at the start of the year to $10.25 per barrel at the end of March, or by 61%. In 2008, the spot price skyrocketed to $145 per barrel in July, only to fall by 79% to $30.18 by late December that year (Figure 1).As shown in Figure 1, the spot WTI price averaged $132 per barrel on a monthly basis in June 2008. On a daily basis, the price peaked at $145 per barrel on July 3.
Figure 1 – Spot WTI and Brent Oil Prices
Much of the discussion concerning the fall since last June has centered on the dramatic turnaround and surge in U.S. production since 2008. This explanation emphasizes the role that supply shocks can have on prices. On an annual basis, U.S. oil production averaged 8.97 mm b/d in 1985, though it peaked at 9.17 mm b/d on a monthly basis in February 1986. Production fell almost steadily until 2008. In January 2008, oil production averaged 5.1 mm b/d. In December 2015, production is expected to reach 9.1 mm b/d, just shy of its February 1986 level (Figure 2). The increase in U.S. production since 2008 has more than offset production lost from unplanned disruptions in other major oil-producing countries (Figure 3).
Figure 2 – U.S. Crude Oil Production
Figure 3 – Unplanned Supply Disruptions vs. Monthly Increase in
U.S. Oil Production Compared to January 2008 Level
The increase in U.S. production since 2008 helps explain why the price has fallen sharply since last June. It is clear that had U.S. production not increased, the current balance between world supplies and consumption would be much tighter and the price would be much higher.
But the increase in production is just part of the story. By offsetting lost production due to supply disruptions, the increase in U.S. production contributed to a faster pace of growth in world production (Figure 4). Between September 2013 and September 2014, world production grew by 3.2 mm b/d (3.6%).
Figure 4 – World Oil Production
This increase exceeded the growth of world consumption. According to the Energy Information Administration, world oil consumption for all of 2014 is expected to have totaled 91.4 mm b/d, about 1 mm b/d higher than its 2013 level. The increase in production from September 2013 to September 2014 exceeded the increase in 2014 consumption by approximately 2.6 mm b/d. The slower growth in world consumption in recent years has contributed to the fall in the price of oil.
The long-term historical trend in world consumption is shown in Figure 5. From 1983 to 2007, world consumption grew at an average annual rate of 1.6%. In 2014, consumption grew by 1.1%, and for the period of 2008 through 2014, consumption grew by an average of just 0.25% per year. Similarly, U.S. consumption grew by an average of 1.3% per year between 1983 and 2007. From 2008 through 2014, it declined by an average of 0.35% per year. In 2014, U.S. oil consumption is expected to have totaled 19.1 mm b/d, down from 19.5 mm b/d in 2008.
Figure 5 – World Oil Consumption
Drivers of Oil Consumption
The importance of consumption’s role in determining the price of oil raises questions as to what drives consumption. Consumption is largely driven by the price of energy and by changes in total output, typically measured by the rate of economic growth. Energy use expands with population growth since a larger population leads to increased demand for energy-using items, such as automobiles and housing. Population growth also contributes to economic growth, and thus its impact on consumption is captured in measures of economic growth.
Expanding output—economic growth—requires more labor, capital goods such as machinery, and energy. A 1% increase in economic growth does not require a 1% increase in oil consumption, however. Increased energy efficiency, conservation, and structural change enable an economy’s output to expand without using as much oil per unit of output.
The price of oil also affects the level of consumption in a predictable way. The responsiveness of oil use to a change in economic growth is, however, much greater than its responsiveness to a change in the price of oil. This is not to say that the price is unimportant. Although the responsiveness (the elasticity of demand) of oil consumption with respect to a change in price is very small, the price is subject to much larger swings than economic growth. In 2008, for example, the WTI spot price rose by 46% between the start of the year and early July. By late December 2008, the price had fallen 79%. In contrast, as shown in Figure 6, the annual rate of world GDP growth generally falls within a very small range (perhaps between -2.0% and +4.5%).
Figure 6 – World GDP Growth Rates
Conservation and Energy Efficiency
Energy conservation contributes to reduced consumption. It entails some sacrifice of the benefits provided by energy, such as warmth when the thermostat is turned down in winter. One reason Japan appears to be energy efficient is that its citizens’ thermostats are normally set at about 55°F in the winter.
In contrast, increased energy efficiency—using less energy to power equipment or provide the same level of services—reduces consumption without such sacrifices. Of course, if an energy-efficient good is too expensive, buyers will end up sacrificing benefits of goods and services that are forgone because of this greater cost.
The increase in energy efficiency in the U.S. economy has been significant. The EIA found, for example, that homes built since 2000 consume 21% less energy on average for space heating purposes than older homes."Newer U.S. homes are 30% larger but consume about as much energy as older homes," Today in Energy, U.S. Energy Information Administration, February 12, 2013, www.eia.gov/todayinenergy/detail.cfm?id=9951. Much of the reason for this improvement is the use of more energy-efficient equipment for heating, cooling, and refrigeration as well as improved building shells and increased insulation.
Regulations on energy efficiency can reduce energy use. Examples include phasing out incandescent bulbs in favor of LEDs, requiring that refrigerators cool with more efficient motors, and raising the corporate average fuel economy (CAFE) standards.
CAFE standards now require that new automobiles get 54.5 miles per gallon by 2025. The legislation doesn’t guarantee that the higher mileage standards can or will be reached. There is also the cost of achieving these standards to consider—if the cost is too high, consumers will respond. They may reduce the number of cars they own or rely on other transport modes. Or they may follow the Cuban example and maintain their cars well beyond what is considered a normal lifespan. Still, the new standards will further reduce the rate at which gasoline consumption grows.
Of course, the entire fleet of vehicles will not average 54.5 miles per gallon even if cars produced in 2025 do. In 2012, the U.S. had approximately 200 million light-duty passenger vehicles. The average fuel efficiency of this fleet was 23.3 miles per gallon; if it had been 28.3 miles per gallon, gasoline consumption would have been reduced by approximately 400 million barrels (16.8 billion gallons) for the year, assuming that the number of miles driven was held constant. This represents a 17.6% reduction in gasoline consumption by light passenger vehicles.
Structural Changes in the Economy
Changes in the mix of economic activities also affect energy consumption. If energy-intensive manufacturing activities are moved offshore, energy use will fall relative to what it would have been. Conversely, if energy-intensive activities are brought back to the United States, as some are in response to lower natural gas prices, the energy intensity of the economy will be higher than if no reshoring occurred. An increase in energy intensity due to a structural change like this would not be an indication of reduced energy efficiency.
The location of economic activity and population also represent structural changes that affect the level of energy use. About 53% of homes built since 2000 are in the Sun Belt, where winter temperatures are more moderate. Of course, homes built in this region consume more energy for cooling, so the net effect on consumption would depend on a number of factors, including the relative cost of energy used for heating and cooling and the efficiency of related systems.
The Intensity of U.S. Oil Consumption
The combined impacts of conservation, energy efficiency, and structural changes are reflected in the intensity of energy use as measured by the ratio of the physical quantity of energy consumed (in BTUs) to real (inflation-adjusted) GDP.A BTU is a British thermal unit. One BTU is equivalent to the energy provided by the heat of one match. For that reason, BTU measurements are expressed in terms of thousands of BTUs or, for aggregate energy use, quadrillion BTUs ("quads"). Between 1970 and 2014, the intensity of aggregate U.S. energy consumption fell at an average annual rate of 1.9%. This may seem small, but had the intensity of energy use fallen by an average of 1.2% rather than 1.9%, U.S. energy consumption would have totaled 136 quads rather than the expected 99.5 quads for all of 2014.
The intensity of oil consumption fell at an average annual rate of 2.35% over the same period (Figure 7). This means that the relative importance of oil in the U.S. energy mix declined because of increased efficiency, conservation, structural changes, and, to some extent, a broadening of the U.S. energy mix, which has backed out the use of oil (e.g., for home heating).
Figure 7 – Intensity of Oil Consumption
The Long-Term Outlook for Oil Consumption
The outlooks for oil consumption in selected countries and regions based on the EIA’s most recent long-term forecasts are shown in Figure 8.U.S. Energy Information Administration, Annual Energy Outlook 2014, May 7, 2014; International Energy Outlook 2014, September 9, 2014. Even amid economic growth, oil consumption in the U.S. and in European OECD countries is forecast to decline slightly. China’s consumption is expected to increase from 10.8 mm b/d in 2014 to 20 mm b/d in 2040 while India’s consumption is expected to rise from 3.7 mm b/d to 6.8 mm b/d.
Figure 8 – Forecasts of Oil Consumption
The long-term forecast for total world consumption is shown in Figure 9. Between 2014 and 2040, consumption is expected to rise by 28.3 mm b/d, an increase of 31%. In addition to China and India, consumption will grow in the rest of Asia (excluding Japan), the Middle East, and Latin America.
Figure 9 – Forecast of World Oil Consumption
The Changing Impact of Economic Growth on World Oil Consumption
Economic growth will continue to be the main driver of oil consumption, although its impact on demand has decreased over time. Based on regression analysis using data from 1981 through 2014, in which the level of world oil consumption is a function of the price of oil (lagged one period) and the rate of world economic growth, a 1% increase in economic growth led to a 0.52% increase in oil consumption, holding all else constant.
When the regression is based on sub-periods, however, it appears that a break has occurred in how oil demand is affected by economic growth. Based on data for 1981-1999, a 1% increase in economic growth was associated with a 0.56% increase in oil consumption. In contrast, when the regression is based on the period of 2000-2014, a 1% increase in economic growth was associated with a 0.47% increase in consumption. That is, the economic growth rate had a stronger impact on the level of oil consumption during 1981-1999 than was the case for 2000-2014.
The reason the impact of economic growth on oil consumption has changed comes back to the factors of increased energy efficiency, conservation, and structural changes in world economic activity. With respect to the latter, possible changes include the influences of the internet and the rise in the share of service sector activity relative to traditional manufacturing as economies develop.
What Goes Down Must Come Up?
The price of oil has fallen dramatically since last June: where will it go next? If history is a guide, the downturn is temporary. Hydraulic fracturing in the United States has resulted in a surprising increase in output and other countries with significant shale formations would like to adopt the technology. Thus there is potential for continued production growth. Over the next year or two, the price of oil is likely to remain considerably below levels observed during 2011-2014, when oil traded in a relatively narrow band. Longer term, consumption will grow if the world economic growth rate remains in the 2-4% range.
The impact of economic growth on the level of oil consumption may have lessened but is still significant. A low price of oil contributes to increased world economic growth but also discourages production. And the law of demand necessitates that a lower price leads to increased consumption even in the absence of economic growth.
As consumption grows, the balance between oil supply and demand will tighten and the price will rise. It may be a few years before it reaches $90 to $100 per barrel, but a price below $50 per barrel does not appear to be sustainable for very long. The EIA’s latest short-term forecast is that the WTI spot price will average $55 per barrel in 2015 and rise to $71 per barrel in 2016. U.S. Energy Information Administration, Short-Term Energy Outlook, January 13, 2015.