Kemp: Time for a Good Sweating in Oil Markets

U.S. demand for petroleum products has experienced an unprecedented and broad-based decline over the last eight years as soaring oil prices have forced consumers to become more efficient and seek cheaper alternatives.

Consumption of oil-based products has fallen in every major category - from gasoline, diesel and jet kerosene to heating oil, fuel oil, petrochemical feedstock, petroleum coke and asphalt, according to the U.S. Energy Information Administration.

In every case, consumption has fallen in absolute terms and the decline is even steeper compared with the growth in population and the size of the economy since 2005.

The extent of demand destruction varies from a relatively small reduction in motor gasoline and diesel to steep falls in the use of heavy fuel oil, petroleum coke, asphalt and oil-based products as feedstock for making petrochemicals (http://link.reuters.com/nan92w).

The precise reasons also vary. Distillates, heavy fuel oil and petroleum coke have been replaced by cheaper and cleaner-burning gas in power generation and heating. Asphalt has been hit by a squeeze on state and local government budgets. Oil-based petchem feedstocks have been replaced by cheaper natural gas and condensates.

In some cases, government regulations have cut demand by requiring more-efficient vehicles or mandating the use of an increasing amount of non-petroleum fuels such as ethanol. In others, consumers and businesses have sought to limit the impact of rising fuel bills by switching to smaller vehicles or making fewer journeys.

Conservation and substitution have both played an important role in cutting oil consumption in the United States. In every case, however, the underlying cause for falling oil demand has been the price surge between 2002 and 2011.

It was rising oil prices which spurred lawmakers to enact new efficiency standards and biofuels mandates in the 2005 Energy Policy Act and the 2007 Energy Independence and Security Act. It was rising prices which encouraged the replacement of oil-based products by cheaper gas.

And it was rising prices which spurred haulage companies and households to reduce the number of journeys and switch to more fuel-efficient vehicles or ones powered by natural gas and other alternatives.

Falling demand is evident in the other advanced economies. According to University of California oil economist James Hamilton: "Oil consumption in the developed countries has fallen an average of 700,000 barrels per day every year since 2005, reaching a level as of the end of 2012 that is 8 million barrels per day lower than one would have predicted in 2005 on the basis of a simple extrapolation of the trend."

While the recession played a role, the primary factor according to Hamilton was the doubling in prices since 2005. "It was higher oil prices, not slower income growth, that was most important in forcing reductions in fuel use in North America, Europe and Japan," he wrote recently ("The changing face of world oil markets", July 2014).

Hamilton concluded: "The story behind the doubling of real oil prices since 2005 is thus quite simple: if prices had not risen, growth in demand, particularly that coming from the emerging economies, would have outstripped production. A big price increase was necessary to reverse the trend of growing consumption in the developed economies."

Prices have performed their signalling function and led to a reallocation of resources. The question is whether the process has now gone too far. Global demand is growing anaemically while production, notably from shale, is growing faster, more than offsetting a string of output losses across Africa and the Middle East, leaving the market oversupplied and beginning to weigh on prices.

There is strong evidence that prices over $100 per barrel have encouraged too much incremental production and not enough additional demand. Instead the market needs a period below $100, what legendary Standard Oil chief John D Rockefeller described as a "good sweating", to restore balance ("Shale, Saudi Arabia and Islamic State leave oil bulls sweating", Wall Street Journal, Sept. 28).

In the next couple of years, there will be plenty more headlines about cancelled projects and producers struggling to break even, as well as signs of recovering consumption. For oil bulls, that is reason to hope prices will soon recover. But it is more useful to see it as a necessary adjustment and reaction after several years of exceptionally high prices.

Only lower prices can slow the shale juggernaut and high-cost offshore exploration while slowing consumption losses in the advanced economies and encouraging faster demand growth in emerging markets.

John Kemp