The Macroeconomics of Oil Supply and Demand - Ignoring the Background Noise

With oil prices now at two-year highs, I thought it was time to take another look at the current situation in the world’s oil markets according to the International Energy Agency (IEA) and a brief look at their predictions for the future.  The IEA recently released its monthly Oil Market Report dated March 15th, 2011 and it contained some very interesting statistics for the month of January 2011.  The IEA also recently released their 2010 World Energy Outlook that contains some very interesting prognostications for the future. 

Let’s start by looking at recent consumption data from China.  During the month of November 2010, for the first time, China's oil consumption rose above 10 million barrels of oil per day (BOPD) reaching a high of 10.2 million BOPD.  Much of the increased consumption was due to the large-scale use of diesel-fueled electrical generation after local governments closed coal-fired plants and rationed electricity to meet central government efficiency and emissions targets.  These measures may have resulted in increased consumption of approximately 200,000 BOPD.  We still have to keep these numbers in perspective; on a per capita basis, China consumes slightly more than one-tenth of the oil that is consumed by the United States (2.3 barrels of oil per person versus 21.8 barrels of oil per person).

According to the IEA, in the month of January 2011, China's year-over-year oil demand rose an amazing 15.3 percent.  In the last year, demand grew by 2.7 million BOPD.  China's imports were up 17.5 percent year-over-year to 4.8 million barrels of oil per day, up less than originally predicted because domestic offshore production was 200,000 BOPD higher than expected and reached 4.3 million BOPD in November 2010 but China's oil production did drop back to 4.1 million BOPD in December 2010. 

Here's a graph from the IEA's 2010 World Energy Outlook report showing China's share of the projected global increase for various forms of energy and comparing their contribution to increased demand for the years from 2000 to 2008 to 2008 to 2035:

Now, let’s take a look at what the IEA has to say about world oil production and consumption to put the whole China demand and production growth into perspective. 

Let’s start with the supply side of the ledger.  Here is a graph showing the IEA's projection of world daily oil production from 1990 to the year 2035.  They project that oil production will ramp up to 96 million BOPD from its current level of just over 88 million BOPD:

Note that the dark blue wedge on the graph that represents daily oil production from existing producing oil fields narrows to the right of the graph.  This drop in production is a naturally occurring decline in production as oil fields age.  However, it is critical to note that the IEA fills in the drop in production with production from fields that have been discovered but that are not yet producing and from fields that are yet to be found in roughly equal proportion.  Two major risks are involved; first, fields that have been discovered and not producing sometimes produce either more or less than reservoir models predict and second, there is absolutely no guarantee that new fields will be found that will fill in the additional production gap of nearly 20 million BOPD.  The prediction that new fields will be found is strictly an exercise in statistics and look how well that worked in Alaska’s National Petroleum Reserve.  Those two factors make it very difficult to assess the probability of achieving the IEA's daily production projection of 96 million BOPD by 2035.  As well, notice how thin the wedge of non-conventional oil production is; according to IEA projections, we should not be counting on the tar sands, shale oil or other alternative means of producing oil to bail us out should demand outstrip supply.

To balance growing demand from Asian countries, the IEA is counting on production increases from Saudi Arabia, Iraq, Brazil, Kazakhstan (the Caspian Sea), Venezuela and Canada to bail the world out of potential shortages between now and the year 2035.

Fortunately for all of us, at this point in time, OPEC’s effective spare capacity of just over 4 million BOPD remains a calming influence (I’d say in relative terms) on the world’s oil market, but it has nevertheless fallen to its lowest since late 2008.

On the demand side of the ledger, the IEA is projecting that oil demand will peak at 88 million BOPD before 2020 and then fall to 81 million BOPD by 2035 as OECD nations cut their demand for oil more than non-OECD nations (primarily China and India) increase theirs.  Cuts in demand for oil are anticipated to come from the use of both plug-in hybrid electric vehicles and electric vehicles; the IEA projects that these two vehicle types will comprise 70 percent of vehicle sales by 2035.  As well, increased energy efficiencies will be realized through the use of technology and the substitution of alternative energy sources.

Back to the present situation in the world of oil.  In their January 2011 Oil Market Report, the IEA discusses the possibility of “collateral economic damage” from higher oil prices.  They use a rather clever term, “oil burden”, to quantify how higher oil prices impact the global economy.  Oil burden is defined as global oil expenditures divided by global GDP.  In 2010, average oil prices of $80 per barrel resulted in an oil burden of 4.1 percent.  If $100 per barrel oil becomes the norm in 2011 (and it’s showing no sign of falling short of that level), the oil burden will increase to 5 percent, a level which has led to economic difficulties in the past as shown on this graph:

Despite the fact that the price of oil has been volatile to the downside over recent trading sessions, when the entire macroeconomics of the demand and supply scenario is carefully assessed, is it any wonder that we are seeing West Texas Intermediate trading at highs not seen since early 2008?  We all know how that particular story ended, don't we?  I think that it is most important that we ignore the hour-by-hour and day-by-day prognostications and background noise so generously supplied by the  bobbing heads on the business channels and look at the fundamentals of long-term supply and demand.  What we see in that examination is far from pretty and, unless alternatives are in place soon, the world is going to be a very different place for the coming generation, particularly when 1.6 billion people are waiting for their turn to take a "drink from the fountain of prosperity".

As an aside, by the end of 2011, China is expected to possess the ability to store 281 million barrels of oil in reserve, equal to 60 days of imports.  China began its program of strategic oil reserve storage in December 2007 when it set up the China National Petroleum Reserve Centre.  The first phase of construction was completed in 2008 and had a storage capacity of 14 million tons.  The second phase of construction commenced in September 2010 and the third phase will be completed by 2020 when China will have the ability to store nearly 600 million barrels of oil, a four month supply.  The Reserve will assist China’s economy by sheltering the country’s industries from rapid price increases that had affected China in 2008.  At least, it would appear that China is capable of seeing beyond the day-to-day volatility of the oil markets.