Oil continues to make the world go round

Recently, the McKinsey Global Institute disseminated a forecast of energy demand through 2020 based on different scenarios involving four variables: gross domestic product, light vehicle fuel efficiency standards, electric vehicle sales and energy productivity.

Not surprisingly, gross domestic product (GDP) has a significant effect especially in the short run. In 2006, global energy demand was 463.9 quadrillion BTUs which is expected to rise an average of 2.25 per cent annually based on gross domestic product growth at pre-crisis levels.

The worst case for GDP is very severe downturn which McKinsey defines as the "worst global downturn since the Second World War". Here, demand dwindles to 1.85 per cent This translates into a rise of 21.9 per cent over the 2006 level by 2015 under the pre-crisis scenario and only 13.7 per cent assuming a very severe downturn. For 2020, the forecast is 36.6 per cent and 29.3 per cent respectively.

These numbers are based on the assumption that light vehicle fuel efficiency regulations remain in place. But what would be the impact if all countries moved to EU standards?

Using the pre-crisis scenario, growth under EU standards would be 2.15 per cent versus 2.25 per cent with existing regulations - a piddling tenth of one per cent. The same minuscule effect applies to the very severe downturn scenario as well. A rise in the proportion of electric vehicles sold has an even smaller impact.

The largest effect comes from potential improvements in energy productivity. Under the pre-crisis scenario, annual growth drops to about one per cent compared to the 2.25 per cent already noted if existing regulations remain in effect. In the very severe downturn scenario, demand growth drops to only 0.61 per cent - less than one percent - and only one-third of what it would be under existing regulations.

Energy productivity includes both demand abatement and energy production efficiency. Demand abatement offers the greatest immediate opportunities for reduced consumption.

The 1970s oil crisis demonstrated that both the US and Europe could significantly curtail demand through simple conservation measures such as encouraging citizens to use air conditioning wisely, insulate homes to reduce heat loss during the winter, reduce miles driven by careful planning of commutes and so forth.

But demand abatement may prove more difficult in emerging nations simply because of the political risk of denying end-user consumers once they finally have opportunities for comfort, convenience and economic welfare like those enjoyed in developed nations.

Energy productivity is also affected by improvements in technical efficiencies. For example, this may include the use of solar power, biomass or better design for appliances.

While near-term improvements to oil prices will come from economic recovery, longer-term prospects also depend on what transpires with energy productivity.

The driver for productivity improvements is undoubtedly the rapidly escalating concern over the global environment.

"Green" efforts are definitely springing from grassroots sources. And now that the United States has a less obstructionist view on environmental issues and a sympathetic president in the White House, that will create a greater consensus among nations accelerate the environmental agenda.

From the supplier perspective, what is the worst case scenario from McKinsey?

Demand growth would be only 0.54 per cent if the effect of the financial crisis on gross domestic product is very severe downturn, if all countries move to EU standards, if half of all cars sold in 2020 are electric and full opportunities were captured to improve energy productivity.

Crude oil is now trading around $68 up from about $50 in April. But recall that only five months were required for the price to drop from its July 2008 high of $143 per barrel to $38. This dramatic reversal was due to increases in production capacity coupled with falling demand. That caused global inventories to swell.

That precipitous drop, says the International Monetary Fund (IMF) in its World Economic Output report (April 2009), was due largely to illiquidity in commodities markets in late 2008. But that is past and prices will be mostly determined by how quickly supply projects are restored and more importantly on basic demand and supply. Further, says the IMF, technical analysis suggests that the market is expecting prices to rise.

The IMF's analysis forecasts a restoration of previous demand levels sometime between 2010 and 2013. The deciding factor will be economic recovery.

In fact, some observers think a price spike that exceeds pre-crisis levels is likely. The reason is that some large investments in supply projects were curtailed due to credit restrictions. At the same time, with economic recovery those industries which are big petroleum users - shipping, petrochemicals, air travel - have a highly elastic response to an upturn. The net effect will be to stretch the gap between demand and supply.

Demand pressure is also coming from emerging nations. Last year, overall demand for oil dropped slightly - the first decline since the 1980s. But the IMF blames advanced economies - particularly the United States and Japan. Demand in developing countries continued to increase.

The Organisation of Petroleum Exporting Countries (Opec) noted in its 2008 World Oil Outlook that investments in capacity were at $160 billion through 2012. Some of the 120 projects have been trimmed due to the financial crisis though momentum to develop new capacity (five million barrels per day over 2007 levels) is likely to continue apace.

But Opec notes that other factors have been involved such as periodic weakness in the US dollar and expansion of trade in "paper" barrels - oil futures traded on both regulated and unregulated over-the-counter exchanges.

Currently, 18 paper barrels are traded for each physical barrel.

Opec has expressed concerns that this paper barrel trading has distorted pricing in underlying oil markets "far beyond the limits of healthy liquidity-providing level."

Opec is also more modest in its predictions of demand growth. Through 2030, their report says, growth is forecast at 1.7 per cent per year assuming no significant departures in current energy-related policies and technologies.

The Opec report also recognises that renewable (non-fossil fuel) energy sources have grown at extremely high rates. But the low initial base means that portion of the market is likely to remain small in absolute terms for at least two more decades.

Indeed, ample reasons exist to believe that demand may accelerate much more rapidly than predictions by the IMF, Opec and others.

One reason is that emerging countries now account for the majority of growth and their share will increase in the future.

McKinsey's data shows that 56.7 per cent of growth came from developing countries in 2006. By 2015 that will rise to between 61.3 per cent and 64.1 per cent depending on which scenario you choose. This is important because of the seemingly insatiable appetite developing nations have for new energy capacity. These needs must be met long before renewables can much of a contribution.

Another reason, says Opec, is the potential for increased vehicle ownership in developing countries. Four billion people live in countries with less than one car per 20 people. Thus the potential for demand growth is huge.

China, for example, expects the number of cars sold to rise from 30 million in 2006 to perhaps 156 million in 2020 - more than a five-fold increase. If the Chinese owned as many cars as Americans, that number would rise to 858 million. By some estimates, the world now has about 600 million cars.

However, Opec also notes that aggressive measures by the US and Europe to cut fossil fuel consumption could lower demand by as much as four million barrels per day by 2020. Some of these initiatives to reduce the dependence could be ameliorated by technologies such as carbon capture and storage could bring emissions into an acceptable range.

In the final analysis, it's impossible to have a clear prediction of oil prices.

Over the past 15 months, oil prices have spectacularly demonstrated their ability to whiplash in response to short-term changes in demand and supply plus speculation in paper barrels.

But these market theatrics belie the fundamental nature of the petroleum industry.

It moves to a long-term rhythm.

Globalisation has stoked an almost insatiable demand for new energy in developing countries.

Thwarting that demand would in effect all but halt these nations' economic progress.

That means that pressure will focused on cleaning up oil before abandoning it.

And replacing oil's role in the global energy system with new and different sources will take decades.

- Rod Monger writes on international business, economic and political issues.