May 21, 2008

James Hamilton: Oil Price Fundamentals

James Hamilton at Econbrowser looks at the question of what's been driving oil prices higher, market fundamentals or speculation? I've got some additional comments down below.

The developed economies consume a disproportionate share of the world's energy, with North America and Europe accounting for about half of the total oil use in 2006. However, it is the newly industrialized countries and oil producers that account for the recent rapid growth in demand, with Asia and the Middle East accounting for 60% of the increase in petroleum use between 2003 and 2006. North America and Europe contributed only 1/5 of the growth.

Particularly dramatic in this growth has been China, whose petroleum consumption between 1990 and 2006 increased at a 7.2% annual compound rate. It's always amusing to project these impressive exponential growth rates. If that rate of growth were to continue, China would be using 20 million barrels a day by 2020, about as much as the U.S. is today. By 2030, China would be up to 40 mb/d, twice the current U.S. consumption.

Are such projections plausible from the point of view of potential demand? During 2006, China used about 2 barrels of oil per person. For comparison, Mexico used 6.6-- Chinese oil consumption could triple and they'd still be using less per person than Mexico is today. The U.S. used almost 25 barrels per person. According to the data collected for a new research paper by Max Auffhammer and Richard Carson, there were 3.3 passenger vehicles per 100 Chinese residents in 2006, compared with 77 in the United States. Yes, I would say that these astonishing numbers for potential future Chinese oil demand are not at all inconceivable.

...

I do think there are prospects for a significant boost to world petroleum production this year, thanks to a number of big new projects scheduled to begin production. The Wikipedia database reports 7 mb/d in eventual gross new production capacity eventually expected from projects that are supposed to begin producing during the current calendar year. Before you get too excited about that number, however, several cautions are in order. First, 7 mb/d refers to the eventual peak production, not the amount that can be produced this year. Second, there is inevitably some slippage and delays. For example, the list includes 250,000 b/d from Thunder Horse, BP's Gulf of Mexico project that was initially hoped to start giving us oil in 2005, but is still undergoing repair work. Third, the above tabulation refers to gross new capacity, much of which is needed to replace declining production currently being observed in the world's mature producing fields. At any point in time, some of the world's producing fields are well into decline, some are at plateau production, and others are on the way up. It is not clear what average decline rate is appropriate to apply to aggregate global production, but a plausible ballpark number might be 4%. That would mean that in the absence of new projects, global production would decline by 3.4 mb/d each year. To put it another way, a new producing area equivalent to current annual production from Iran (OPEC's second biggest producer) needs to be brought on line every year just to keep global production from falling. Of the 7mb/d in gross new capacity from the projects tabulated above, projects in Saudi Arabia, Russia, and Mexico account for about a third of this gross increase. Data currently available for the first two months of 2008 show actual production in Saudi Arabia down 350,000 b/d from its average 2005 value, though the latest news suggests that Saudi production may be close to returning to 2005 levels. Mexican production is currently down 400,000 b/d from 2005, and Russian production is down 100,000 b/d from its average level in the second half of 2007.

To summarize, I think we will see some net production gains this year, and expect this to bring some relief for oil prices. But I cannot imagine that the projected path for China above will ever become a reality. Oil prices have to rise to whatever value it takes to prevent that from happening.

So yes, I do believe that speculation has played a role in the oil price increases, particularly what we've observed the last few months. But it's a big mistake to conclude that speculation is the most important part of the longer run trend we've been seeing.

I've been studying petroleum consumption for a number of months now, and have done my own forecast for China through the year 2012 (a five-year forecast). Although I haven't had the chance to post the executive summary of my Northeast Asia forecast on my new business blog, J2TM, China's petroleum consumption rate on a per-capita basis is very, very small. Hamilton said that China "used about 2 barrels of oil per person" in 2006, but the actual number is 1.0256 barrels per person. Likewise, the petroleum consumption growth rate on a per capita basis has been very weak as well. The Chinese compound annual growth rate between 1985 and 2006 was 1.86% per year. I'm forecasting a per capita growth rate of 0.61% to 0.88% for the period between 2006 and 2012. Of course, aggregate consumption growth rates should be somewhat higher but, at current consumption growth rates, it will take decades for China to reach Mexico's consumption level, let alone that of the U.S. (To be honest, I don't think that China will ever get that far; I suspect most oil worldwide would be gone before China could get up to the U.S.'s level of gluttony.)

Overall, though, I agree with Hamilton's analysis; I think oil prices are primarily driven by market fundamentals. There
probably is some speculation at work here (as there is for commodity prices), but I think a relatively stable level of supply and an ever increasing level of demand are the primary factors bringing oil prices higher.

(Update: Thanks to Dr. Hamilton for his comment; I went back to my original analysis and found an error in my original analysis (it only affected China, thank God). Mea culpa! According to my new analysis, the annual compound growth rate for Chinese petroleum consumption between 1985-2006 was 6.64%, not the 1.86% I wrote above. Likewise, my new petroleum forecast has a growth rate of 5.79% through 2012, by which time I would expect per capita petroleum consumption to be 2.8362 barrels per person. I also ran out the projection for China's consumption through the year 2030; by that time consumption would be 8.4452 barrels per person; China would reach Mexico's current consumption level in the year 2026; in that regard my initial forecast is not too far off - almost two decades instead of "decades." I still stand by my comment regarding China matching American consumption. That sort of forecast is just too far into the future to be of any value, IMO. So, I stand corrected, and I thank you for that.)

5 comments:

James Hamilton said...

From EIA (http://www.eia.doe.gov/emeu/international/RecentPetroleumConsumptionBarrelsperDay.xls), China in 2006 consumed 7.273 mb/d. From CIA (https://www.cia.gov/library/publications/the-world-factbook/geos/ch.html), China's population is 1330 million. 7.273 mb/d x 365 d/y / 1330 m persons = 2.00 b/person-year.

Anonymous said...

I would not call the US' consumption of oil gluttony. The US consumes oil in the primary form of gasoline/diesel/jet A for transportation. While there is a leisure component to the consumption, most of the consumption is for production. Going to work, transporting goods, etc. etc. There are quite simple solutions to this, but they will not be addressed until oil production truly peaks.

I challenge you to find out how much electrical power for industry, lighting, etc. in the US is actually generated from crude oil derivatives. Probably insignificant quantities of oil relative to the amounts used for transport.

JDsg said...

I would not call the US' consumption of oil gluttony.

Well, I do. American oil consumption outstrips any other country by very large margins. In 2005 (last available numbers), American oil consumption was 20,802.16 thousand barrels per day; the second highest country was China, with 6,720.00 thousand barrels per day (32.3% of the American total); the third highest country was Japan (5,353.19 thousand barrels perr day; 25.7% of the American total). The US consumed more oil than all of Europe (16,276.58 thousand barrels per day) and Eurasia (the former Soviet Union; 4,072.90 thousand barrels per day) combined. The US doesn't have the world's highest per capital consumption (those usually go to small island countries), but on an aggregate scale, they're far past all other countries. It's gluttony, pure and simple.


The US consumes oil in the primary form of gasoline/diesel/jet A for transportation. While there is a leisure component to the consumption, most of the consumption is for production. Going to work, transporting goods, etc. etc.

It doesn't matter how the US uses the oil; more or less all countries use petroleum for the same reasons (transportation, industrial, residential and commercial, electrical generation). The problem is that the US uses far more oil than anyone else.


There are quite simple solutions to this, but they will not be addressed until oil production truly peaks.

The problem is not production, but consumption. Yes, the solution is very simple: STOP USING SO MUCH OIL!


I challenge you to find out how much electrical power for industry, lighting, etc. in the US is actually generated from crude oil derivatives. Probably insignificant quantities of oil relative to the amounts used for transport.

You obviously haven't read more of my blog; I addressed this issue last December. As a primary source of energy, petroleum went mostly to transportation (69%), followed by industry (24%), residential and commercial (5%), and electrical generation (2%). My question to you is, why are you focusing on the pebble when you should be concerned with the stones and boulders behind it?

Anonymous said...

STOP USING SO MUCH OIL!


Right, take a look at the export data from 2001-2005:

http://www.intracen.org/tradstat/sitc3-3d/indexpe.htm

This is why the US utilizes more oil than other countries.

JDsg said...

I'm not quite sure what your point is with respect to the ITC statistics. (BTW, I am very, very familiar with these stats.) If you mean by the number of different categories the US has exports of, well, so what? The vast majority of other developed economies have exports in just as many categories as the US (and a couple of countries have exports in even more categories than the US). If you're talking about the amount of exports that are shipped out of the country, then the US comes in third, behind Germany and China, both of whom have higher dollar amounts of exports than the US. (Likewise, as a whole, the European Union has more exports than the US.) See the CIA World Factbook.

So, by your logic, I'm guessing you think that the more a country exports, the higher its petroleum consumption. But it obviously doesn't work that way when, for example, China exports more than the US but, as I mentioned yesterday, uses only one-third the amount of oil the US does. No, the US is very much an oil glutton.