Oil: The New Reality

As demand continues to increase, how will the U.S., Asia, and Europe cope with sustained high oil prices? S&P takes a look

Rising oil prices are pinching the wallets of consumers worldwide. And although oil may be in for some short-term drops, most experts agree that the days of cheap gasoline are gone and prices will continue to climb steeply over the long term. Can oil production keep up with rising demand, particularly from India and China? And will alternatives be available before it's too late? With so many questions, and so few answers, the only thing there's no shortage of is uncertainty.

Oil approached a record $145 barrel in early July. Although many observers believe the price is higher than supply and demand justify, it continues to rise. Moreover, the normal symptoms of too-high commodity prices—building inventories and significantly declining usage—have not appeared.

Standard & Poor's (MHP) continues to believe prices will come down in the short run but that they are cycling around a rising trend. Demand continues to mount because of economic growth in Asia. Oil output is increasing only slowly, in part because so much of the world's supplies are now in the hands of national oil companies, which have less incentive to raise production. The amount of oil still in the ground, though unknown, is clearly finite.

Skyrocketing Asian Demand

Energy demand in non-Japan Asia is climbing much faster than in the developed countries. Although U.S. oil use rose at a 1.8% annual rate in 2000-05, and Western European demand was up only 0.4%, Asia-Pacific demand jumped 3.0%. These relative growth rates will probably continue for 25 years. During the current decade, projections are for China's energy demand to rise 9.9%, nearly double the Asia-Pacific average. By 2030, Asia is expected to use more energy than North America and Europe combined.

Energy intensity (energy used relative to gross domestic product) is high in most Asian countries, with the major exception being Japan. China, Taiwan, and South Korea are near the world average (measuring GDP on a purchasing-power-equivalent basis), while Japan is one of the most energy-efficient economies in the world. India and the other developing Asian economies, however, are far less efficient. They do have an advantage, in that they generally depend more on coal, and less on oil, than the world average. Although liquids account for 37% of world energy production, they are only 29% of production for the group of Asian nations that are not currently members of the Organization for Economic Co-operation & Development (OECD)—that is, all nations in the region except Japan, Australia, New Zealand, and South Korea. For instance, coal is 55% of current Asian production but only 27% for the world. China accounts for more than 40% of the world's use of coal and, as a result, has already passed the U.S. in total carbon emissions. Although China will probably increase nuclear production eightfold by 2030, its economy will still depend primarily on coal.

Many of these countries, notably China and India, subsidize energy consumption by controlling electricity and gasoline prices. Although this practice has shielded these economies from the most harmful aspects of energy price increases, it leaves their trade positions exposed and certainly makes overall energy efficiency lower. These subsidies are likely to cease. China has already moved to phase out controls on gasoline prices.

The U.S. Energy Information Administration (EIA) projects that non-OECD Asian demand will rise at a 3.2% annual clip through 2030, a total rise of 119%. About half the increase should come from coal, and by 2030, Asia will use nearly double the amount of coal that OECD countries use. Although the use of liquids will rise slightly less than the total, non-OECD Asia will still account for 73% of the rise in oil demand over the period.

OECD Asian demand will be subdued, rising only 0.7% per year, in line with the OECD average. Japan will remain one of the world's most energy-efficient nations. With the country's population growth negative and GDP growth soft, Japan's energy demand will be nearly flat—up an average of only 0.1%/year. Korea, Australia, and New Zealand, however, will increase energy usage over the period.

Price Rises Hurt U.S. More

The U.S. remains the world's largest energy consumer, accounting for 22% of world use in 2005. Because its taxes on gasoline are relatively low, the U.S. has suffered one of the largest percentage increases in energy costs. As a result, demand is dropping more sharply than in most other developed economies, and Americans are feeling more economic pain—although it is hard to tell whether energy costs or home prices are the primary cause.

The overall energy intensity of the U.S. is near the world average, but it has the highest per-capita energy consumption of any major country. As economies develop, they tend to become less energy intensive, reflecting shifts in their mix of industries. But countries with low population density tend to have higher energy costs because of higher transportation costs. The energy intensities of Canada and Australia are similar to that of the U.S., and all three are well above Japan and European countries, which have similar GDPs but much more concentrated populations.

The EIA expects U.S. energy consumption to rise 0.7% a year for the next 25 years, in line with the OECD average. Coal will account for a greater share of energy production, while oil will drop to 37% of production from its current 40%. The increase implies nearly flat per-capita energy use over the next 25 years.

Europe's High Gas Taxes

Europe is a relatively efficient energy user and will likely continue to be so in coming decades. The EIA expects European energy demand to rise only 0.5% a year, with oil consumption up only 0.1% annually. In per-capita terms, however, the trend is similar to that in the U.S.

High taxes have made Europe more energy-efficient and its economies less sensitive to oil price hikes. Not only is energy a smaller share of GDP than in the U.S., but because of the taxes, a change in the oil price has much less impact, in percentage terms, on gasoline prices and, consequently, on demand. Thanks to their North Sea reserves, Britain and the Netherlands meet most of their energy needs domestically, and France requires relatively few imports because of its large nuclear power industry. Other European countries, however, depend heavily on energy imports and are thus experiencing major trade problems.

The European Central Bank (ECB), unlike the Federal Reserve, has elected to look at total rather than at core inflation. As a result, it will raise interest rates in response to higher energy costs—in spite of its weak economies. We expect two rate hikes by the ECB, which will further strengthen the euro and damage European export competitiveness. Although this will not have a major impact on European economies, it is a reason to expect continued sluggish economic growth through 2009.

Can Supply Keep Meeting Demand?

Where the energy will go is easy to estimate. The harder question is where will it come from? The EIA estimates that world consumption of liquid fuels will rise to 112.5 million barrels a day in 2030, up from 85.6 million in 2005. Almost three-quarters of this is for transportation, where there is little practical alternative—at least today.

The EIA expects three sources to meet this rise in demand: OPEC production is expected to climb by 12 million barrels a day, conventional non-OPEC sources by 9 million, and nonconventional sources (tar sands, shale oil, heavy crude, and biofuels) by 7 million. Whether producers can actually achieve these increases is highly questionable. The EIA puts out alternative forecasts based on differing price trajectories. Under a high-price case (oil at $186 a barrel by 2030), demand would be only 99 million barrels a day, still up 15 million barrels from 2005.

The bottom line is that the future of oil prices remains highly uncertain. No one knows how much oil is available or how expensive it will be to get it out of the ground. Deep-sea deposits are especially uncertain, with estimates based on old seismic analyses. Coal seems reasonably plentiful for the near future, but coal could run afoul of global warming concerns. It seems probable that oil prices will be significantly higher in 25 years than they are today. But will they be slightly higher, or much higher, and how easy will it be to find alternatives? The sooner we start finding answers to these questions, the easier the transition to a new energy world will be.

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