Not long ago we argued that as a rational business strategy, oil producers should raise prices, hold back production, restrain capital spending and make hay while the sun shines. It was a Milton Friedman-like bit of advice.
Don’t worry about the world economy, the impact on poor countries, or how the policy helps the Russians to finance the Ukraine war. If it is not illegal, then do it. The long-term consequences of that strategy to the prospects and reputations of the oil producers might be bad, but if the producers have already concluded that they have limited long-term prospects and no reputational upside anyway, why worry? With more recent numbers in as well as Saudi Arabia’s decision to cut production in mind, let’s take another look. What accounts for oil consumption? If the answer, short term, is not price, then why not raise prices? First for the facts, a look at worldwide oil consumption, world real gross domestic product (GDP), and real price of oil, all from standard sources for the years 2000-2022.
In those years, petroleum consumption rose an average of 1.1% a year, real GDP 3.6% a year and oil prices 12.2% a year. However, on a year-to-year basis, the best explanation of the percentage change in world oil consumption is the percentage change in that year’s real gross domestic product. Adding price to the formula did not improve the analysis, at least not in the short term. The impact of price may come later, as users of oil adjust consumption, changing processes or scrapping old furnaces as they reach replacement age. Figure 1 shows the relationship between oil consumption and economic activities.
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Now, let’s look ahead. Back in 2000-2020, world GDP grew roughly 3.6% per year. Economic gurus, taking into account the potential decline in the working-age population as well as damage wrought by COVID and war, think that economic growth in 2020-2050 will be closer to 2-3%. With that rate of economic growth, based on previous experience, we could expect oil consumption to grow less than 1% per year. But it looks as if the oil market could suffer a disconnection from past trends, just as it did after the Oil Embargo of the 1970s, but this time caused by electrification of vehicles. Transportation accounts for 50-60% of oil consumption. Electrification of transportation, then, will threaten the biggest market for oil. Based on automobile company electrification timetables, we calculate that world oil consumption could peak around 2035. Assuming that other oil markets hold up, oil consumption would then decline 20% through 2050. (BP, which makes an excruciatingly detailed analysis of energy demand every year, sets the peak oil consumption year at 2030, after which oil consumption declines 25-75% by 2050.)
So, here’s a reasonable scenario: slow growth for the coming 7-12 years, then a decline, with the question being: how fast is the decline? Consumers need the oil, and will pay for it in the meantime.But don’t live in denial about the decline, though. Your biggest customer has handed you a timetable for its withdrawal from your market and is putting up billions of dollars to make the move. What should oil producers do? In a way, that future resembles a bubble. Everyone playing in the market knows that the good times will end, and most of those players, unfortunately for them, figure that they will be the ones to close their positions profitably before the bubble begins its slow contraction. But here’s the thing about bubbles. They may last for years but they don’t contract slowly. They burst. And the first sign of impending doom is a slowdown in market momentum. That’s when the players all decide to get out at once (and don’t succeed) and the bubble bursts. If we are right, oil producers should avoid making commitments that will pay off years from now when the market could be far weaker than at present. Don’t try to catch a falling knife. To the extent that there will be winners after 2035, they will be the lowest cost producers.
To sum up the oil market: slow growth ahead, followed by even slower growth. The industry’s most important customer, the transport sector, has turned faithless, and declared its intentions to rely on another energy source. In the meantime, though, consumers with existing vehicles need petrol and will pay what they have to to obtain it. That is the business. Not permanent, or pretty, but profitable for now.