Thought of the Day: Oil Demand Destruction: At What Price?
The issue of demand elasticity in crude is a complicated one. As a global commodity used as both fuel and feedstock around the world, demand response to price is affected by myriad factors. However, the US motor gasoline market, accounting for over 10% of global oil demand, is easily the largest, single market. So we believe that demand displacement in that market is a good proxy for global demand displacement, certainly over the short-term.
In 2005 Katrina gave us a good look at price shock behavior in the U.S. gasoline market. In that case, the high fuel prices were driven by refining and distribution disruptions due to storm damage to refiners – not by high crude prices. Even though crude was below $70, which should have yielded a $2.50/ gasoline market, gasoline spiked above $3.00/gal. Without the supply disruption in refined products, crude prices should have been around $95 to drive gasoline that high. But that still was a good look at demand behavior. At that time $3/gal retail was the trigger.
Summer ’06 saw a return to $3/gal gasoline, again driven a bit more by refining capacity issues than crude oil prices. Peak summer demand was flat year over year, so the return to $3/gal was arguably taking some growth out of the market but the market was beginning to absorb the increase.
In summer ’07 gasoline again danced around $3. And again, at least during the summer months, the gasoline price was a bit higher than the crude prices indicated they should have been. However by winter ’07, high gasoline prices were definitely being driven by higher crude oil prices. Gasoline and crude prices rose steadily through the first half of the year to their peaks around $4 and $140. As a result, peak summer demand was definitely reduced by the price increase.
The difference in ’08 and the prior three years was that the move up in price was definitely part of a trend, rather than a seasonal spike. As a result, the consumer’s perceived the higher prices as a longer term phenomenon. In ’05 everyone complained but long-term behavior was really affected. But by ’08, consumers began to materially alter behavior to compensate for the new price regime.
So we believe the trigger is somewhere around $3.50. Definitely below $4. Probably above $3. So $3.50 isn’t a bad guess. The trick with demand clearing price movements is that by definition the market doesn’t stay there very long – it corrects. So we have very little data around that price from 2008. The financial melt-down in the back half of the year also undoubtedly impacted demand. Looking at the relationship between crude oil and retail gasoline prices, $3.50/gal for retail gasoline corresponds to a WTI price around $115/bbl.
While we believe the recent strength in crude oil prices is likely driven more by inflationary factors than by supply demand fundamentals, prices have been rising none the less. Regardless of the cause of the price increase, demand elasticity will kick-in at some point, and we believe that point is around $115/bbl. Elasticity is by definition “stretchy”, so crude can certainly trade above that level. But we believe that $115 represents something of a ceiling for crude prices, at least for now.
***********************************************
Above from a recent report by Global Hunter Securities. Its somewhat comforting to see that they believe oil prices are still around $30/bbl. away from the point of triggering significant demand destruction.
Per a recent trip up to Quebec City, prices there are already well past GHS' demand destruction threshold -- around C$1.15/ltr. or US$4.40/gallon. Just curious, is this representative of other parts of Canada, and if so, do you sense that this is impacting driving habits and/or car purchases?
As an aside, we have been going up to QC around this time of year for the last 5 years or so, its got a rare combination of old world charm (in "Old Quebec"), great Christmas shopping, plus great skiing nearby. The missus was complaining about the poor exchange rates (i.e. C$ is now par with US$), but I explained to her that the same events that caused that situation (i.e. strong resource markets, US$ weakening, etc.) are what also caused our stock portfolios to perform quite well this year. |
