U.S. retail gasoline demand fell last week following sharp increases in prices at the pump, MasterCard Advisors' SpendingPulse report noted earlier this week. Average gasoline demand dropped 1.8 percent week-over-week and 3.0 percent year-on-year according to MasterCard, declining for the sixth straight week. Pricing levels, according to the report, is having an impact on US gasoline demand.
In addition, Goldman Sachs issued a research note claiming that demand destruction due to higher prices means that oil’s recent rally will not last and they expect oil prices to fall $25 to $35 a barrel from current levels. Keep in mind this is the same firm that in 2008 said oil prices were headed for $200 and that we were in a ‘commodities supercycle’. Crude oil prices fell 3% on the publication of the Goldman analysis.
In an opposing view a report issued by Bank of America Merrill Lynch this week is predicting a 30 percent chance that Brent crude could hit 160 dollars a barrel in 2011. The BOA report noted that "with oil demand expanding rapidly and Libya production down by at least 1 million barrels per day, we forecast (the) Brent crude oil price to average 122 dollars a barrel in the second quarter, and believe prices could briefly break through 140 dollars in the next 3 months."
Oil prices retreated on the Goldman forecast – but we think the concern is overdone and our position is closer to the BOA analysis. Demand for oil (and coal for that matter) is global, and a slowdown of demand in the U.S. will not impact the incredible gains in demand being seen in China and India. The decline in demand in the U.S. – if that is what we will see – will be modest at best. As long as the economy is growing energy use will increase, they correlate closely, and we don’t see the U.S. or global economy shrinking in the near future.
IEA Crude Oil Report
The monthly report on the oil markets issued by the International Energy Agency (IEA) this week also warns that higher crude oil prices may begin to cut into demand, but the agency retained their demand estimate for 2011. The global demand forecast remains unchanged at 87.9 million barrels per day for 2010 (+2.9 mb/d or 3.4% year-on-year) and a record demand of 89.4 mb/d forecast for 2011 (+1.4 mb/d or 1.6%).
The Organization of the Petroleum Exporting Countries also issued a report this week that said it expects oil demand to grow by 1.4 million barrels per day (bpd) this year, in line with the IEA forecast.
The IEA estimates that post-earthquake Japanese oil demand for power generation and reconstruction will offset any weakness. Additionally the IEA notes it is concerned about ‘random’ interruptions in supply that are difficult to forecast.
One of the interesting aspects of the IEA demand forecast is that they forecast a decline in demand in the first quarter in 2011 – the first decline in demand in 6 quarters – followed by a second decline in demand in the second quarter of 2011 (see IEA chart above). Demand will recover in the third and fourth quarter of 2011, resulting in a record demand for crude oil in 2011. The IEA’s quarter by quarter estimates are as follows:
Note that Europe is the main area where demand will decrease in the first quarter of 2011, and demand gains elsewhere will be modest. In their discussion of supply the IEA notes the civil war that has broken out in Libya which should substantially decrease production of that country’s low sulfur high API gravity oil – the light sweet oil that is easy to refine. The excess supply available in Saudi Arabia is thick high sulfur crude that is difficult to refine.
A graphical overview of changes in oil demand from 2010 to 2011 is quite interesting – note the leveling off of demand growth in North America in 2011, and the lower rate of growth in demand in 2011 from year earlier levels in Latin America, Middle East, FSU and Asia.
The IEA also maintains tight supply is another concern. Global oil output fell by around 0.7 million barrels per day in March to 88.27 million bpd due to civil war in Libya. If global supply were to stabilize at March levels for the rest of 2011, OECD inventory could slip to near five-year lows by year end.
Our take of IEA Report
Our overall impression of the IEA’s report is that it takes time for price increases to work their way through the economy in a way that creates significant declines in demand. As long as China and India’s economies continue to grow most of the incremental growth in demand of oil will remain in place. It is interesting to note that since last November the IEA has raised their demand estimates since they underestimated levels quite substantially (the upward revisions in global demand estimates since last November are in bright red, note 2010 demand growth estimates were raised by over 35%):
In the chart above (courtesy Financial Times) note the increase in demand in 2010 is one of the highest we have seen in decades – and the forecast increase for 2011 is above the decade-long average gain. Supply interruptions in Libya and elsewhere (force majeure was declared in some offshore platforms in Africa last week) mean that supply issues will be a larger problem then many expect – and the excess supplies are low quality high-sulfur oil.
Bottom line we think the IEA will most likely have to raise their demand estimates for the first and second quarters of 2011, possibly by a substantial amount, and supplies will be tighter than expected.
China Demand Growth: Frank Holmes of US Global Investors
Frank Holmes of US Global Investors had some commentary on their blog that supports our argument that oil demand might grow faster than the IEA expects:
. . . While Chinese oil consumption growth is expected to slow from the blistering 13.1 percent growth the country experienced in 2010, China is still expected to see a 6.6 percent growth in consumption this year. By 2015, the International Energy Agency (IEA) estimates that the use of oil in China will increase some 70 percent from 2009 levels, accounting for 42 percent of global demand over that time period.
One key driver of the increase in oil consumption is the continued rise in economic wealth of China and other emerging countries. Historically, the amount of oil consumed per capita is strongly linked with the country’s GDP per capita.
This chart from Barclays compares selected Asian countries’ use of oil over several decades by their population and GDP. You can see that Chinese per capita oil consumption is well behind the pace of its Asian peers when they had a comparable level of GDP per capita.
Currently, China’s GDP per capita is just over ,000 on a purchasing power parity (PPP) basis. That translates into consumption levels of just over 2 barrels of oil per person, per year. At the same PPP levels, Japan (over 18 barrels per person), Taiwan (about 6 barrels per person) and Korea (just over 4 barrels per person) consumed much larger amounts of oil at a similar level of GDP per capita. . . .
This means that the global oil market will remain tight for the extended future. Barclays says “relative to other sectors of economic activity, oil has become scarce, implying a need to divert ever larger shares of total economic resources into the exploration and recovery of oil.”. . .
What’s driving this growth? A portion comes from increased car ownership, which has grown from less than 1 percent to 13 percent over the past 10 years. In major cities, such as Beijing, more than 30 out of 100 households own a car.
Total sales rose from just over 2 million units per year in 2001 to roughly 10 million units by 2008. Since then, while much of the global economy has battled recession, automobile sales have risen another 60 to 75 percent.
In a comment this week Frank notes that China’s auto sales are steamrolling forward:
In China, a big driver has been growth in the Chinese automobile market. Auto sales increased 2.6 percent in February, and March data released by the Chinese Auto Association over the weekend shows auto sales grew 5.36 percent on a year-over-year basis in March.
Auto sales in China may slow a bit from recent levels but we expect sales to continue to increase – and expect GDP estimates of 9.5% growth for their economy to be close to the mark. At this level of growth energy use will increase by roughly 10% in 2011 in China. While coal is the main source of fuel in the country crude oil demand will also grow quite significantly in our opinion in 2011. Again, we think the IEA will be revising their oil demand estimates for the first and second quarter upward.
Saudi Excess Supply: Jeff Rubin
The Globe & Mail published an interesting analysis by Jeff Rubin yesterday on why with triple digit crude oil prices have not resulted in a massive increase in production from Saudi Arabia:
. . . The real reason Saudi Arabia can’t respond to today’s growth-threatening rise in oil prices is exactly the same one as their failure to respond to President Bush’s personal plea in 2008 for more production during the first encounter with triple digit prices. Saudi Arabia has nothing more to pump, save for very limited amounts of heavy sour oil that most of the world’s refineries can’t handle.
As that reality becomes more apparent, expect world oil markets to become more and more skittish.
If the loss of Libyan production has thrown the global oil market into triple-digits, what happens if Nigerian production takes a haircut during the course of its federal election like it did the last time the country went to the polls?
Or what about another supply disruption from any number of Middle Eastern oil producers whose streets fill every day with protestors demanding regime change?
The world is a pretty dangerous place when you no longer have excess capacity to offset disruptions.
Even if there are no further supply shocks, who is going to be pumping the fuel to meet another two million barrel a day increase in global oil demand that occurred last year.
If triple-digit oil prices can’t get Saudi Arabia to pump out its fabled 12.5 million barrier a day peak capacity, what can?
As Rubin points out, any excess capacity that Saudi Arabia may have is low quality, heavy sour crude that is difficult to refine and process.
Investment implications
Long term trends in the energy sector remain very positive for investors. Global crude oil demand is growing faster than global supplies, and as Asian economies expand their incremental demand requirements will keep prices higher than they hve been historically. We remain fully invested in the sector, and expect excess returns over the longer term.
