Oil demand - have we seen the peak?

David Donora, Head of Commodities at Threadneedle, comments: "Are we experiencing a temporary drop in global crude oil demand or is it possible that we have now seen demand peak for the foreseeable future? Global demand for crude oil peaked at 86.44 mbd (million barrels per day) in the first quarter of 2008 as the price crossed through the psychologically significant US$100/barrel level on its way to US$147/barrel. According to the Energy Information Administration (EIA), demand has declined to 83.35 mbd in the first quarter of 2009, and is projected to average 83.76 mbd for the whole year. The price spike last year was a substantial shock to oil consuming countries, and combined with the deep recessions in those countries has clearly had a material effect on overall oil demand.

"While the statistics and demographics are on the side of the consensus view that crude oil demand will rebound and reach 90 mbd within the next few years, it is possible that the combined effects of weak global economic growth and persistently high oil prices, combined with technological innovation and the push towards energy security, could combine on a global basis to stabilise global oil demand in the near term and cause it to decline over the longer term.

Global Recession

"The most powerful factor in the short term is anaemic global economic growth. Apart from China, the economies that face the greatest recovery challenge are those that are also the largest consumers of oil per capita. Most notable is the US, which in the first quarter of 2009 was still consuming 18.8 mbd. Although US consumption has steadily declined from 20.8 mbd in 2005, it is still by far one of the largest, and least efficient, consumers of oil per capita in the world. Although the EIA projects increased US oil demand in 2010 of 1.5%, it is arguable that increasing unemployment, high levels of debt, a rediscovery of the virtues of saving and low GDP growth will create headwinds to any increase in demand from the consumer side for not just the next quarter, but for the next few years. In fact, there is scope for a further significant decline in US consumption if per capita usage trends towards the consumption levels of other developed countries.

High Prices Motivate Substitution

"Persistently high oil prices, both absolute and relative to other forms of energy, is an important factor which if sustained can have a material permanent effect on oil demand. In the short term, the price of crude oil is likely to remain high with periodic upside spikes. On a relative basis, by historic measures, crude oil is currently expensive relative to natural gas: the oil to natural gas price ratio is currently 12:1 whereas previously 7:1 would have been more typical. This gap is likely to persist and even widen until such time as gas can be used as a transport fuel substitute at a meaningful level and begin to erode demand for crude oil.

"North America has abundant resources of natural gas and a competitive industry. With numerous exploration and production innovations over the last two years for extracting gas from shale, the speed and economy with which production can be increased should not be underestimated. Add to that the new production of liquified natural gas that is scheduled to come on line over the next two years globally, and it is easy to see how the price of gas could remain compellingly competitive for some time as can be viewed as the fossil fuel that bridges the gap until technological innovations that offer economical alternatives can be developed.

Technological Innovation

"Over half of all oil consumed is used in transport and greater efficiency is the easiest area for improvement. However, China is the most rapidly growing automobile market in the world and China's car industry will develop quickly along with it. Without the legacy of a century of internal combustion engines, it can fast forward to a range of propulsion systems linked to forms of energy that the country can generate more cost effectively than petrol and that will be far more efficient from source to wheel. Early evidence suggests that electric, battery-powered vehicles will come into mass production quickly and begin to achieve a viable scale as early as 2010. Japan, Europe and even the US are all moving in this direction.

On 5 August 2009, innovation in and manufacturing of electric vehicles and battery technology in the US received a substantial boost from the US$2.4 bn Recovery Act grants. This reflects the seriousness of the Obama administration in tackling the issues of energy security and global warming and a desire to catch up with the industry leaders in Japan and China. There is urgency and competition in the transformation of the automobile industry - and transport generally - globally, which is reminiscent of the space race in the 1960s. The prizes for the country that achieves 150-200mpg equivalent performance cheaply and in style will be tremendous wealth creation and the reduced economic risk of no longer being dependent on oil imports.

Market Impact

"It has been striking how quickly the markets have looked past the current economic slump and have reinvested in equity markets and commodities. Of particular note has been the rapid rebound in prices of more cyclical commodities, such as base metals and energy, despite considerable idle capacity in many areas of industrial production and substantial inventories. Inherent in the rebound is the notion of scarcity of raw materials and energy at some point in the future, which therefore justifies their value as a long term investment. In this sense, current long term investment in commodities is part of the mix that will help to ration demand, support substitution and ultimately advance technological development at a much faster rate than would otherwise be the case. For energy markets, it suggests that with steadily increasing oil demand not necessarily being a forgone conclusion, there will be much more in the way of twists and turns than a one way bet."