A Closer Look at Emerging Markets and Oil Demand

 |  Includes: EEM, OIL
by: Elliott Gue

The International Energy Agency (IEA) recently announced preliminary findings showing that China has overtaken the US to become the world’s largest energy consumer. If the media attention this story received is any indication, the announcement surprised many.

Longtime readers shouldn’t have been taken aback by the news; one of the most important and longest-standing themes of this advisory is the growing importance of emerging markets such as China and India to the global energy puzzle. Investors can ill-afford to make forecasts about global energy prices by simply looking at the latest weekly inventory data from the US.

And investors will also need to recognize emerging markets’ growing need to secure resources. China is already buying up coal reserves in Australia, securing long-term supply agreements for natural gas with Russia and investing in oil projects across Africa, South America and the Middle East.

The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, a book I co-authored with two long-time friends and colleagues, Yiannis Mostrous and David Dittman, analyzes these powerful trends and details specific stocks that stand to profit from the changes underway. Published by FT Press, the volume is due for release later this month.

The excerpt below will give you a taste of what to expect.

A New Oil Age

In the summer of 1859, low on funding after more than a year of work, Edwin Laurentine Drake struck oil in a well drilled near Titusville, Pennsylvania.

Drake’s effort wasn’t man’s first attempt to drill for oil. Nor was his well a prolific producer, yielding little more than 20 barrels of oil per day. But it was the first to be commercially successful. This simple well, drilled to a total depth of 69.5 feet (21 meters), sparked an overnight boom in Pennsylvania and established Drake as an unlikely pioneer of the global Oil Age.

In recent years it’s become fashionable to deride oil and other fossil fuels as expensive and unsustainable energy sources. But let’s not forget history. In the 150 years since the self-proclaimed “Colonel” Drake drilled his Titusville well, the world has enjoyed an unprecedented wave of economic growth and human development that’s lifted billions of people from poverty. This era of prosperity and the wealthy industrial nations it spawned were largely built on cheap energy derived from fossil fuels. The Oil Age hasn’t unfolded without negative consequences, but it’s dishonest to deny that affordable energy has meant a better quality of life for much of the world’s population.

To modern ears it seems ridiculous to talk about cheap energy and crude oil in the same sentence. After all, when oil spiked to near USD150 per barrel in the summer of 2008, consumers all over the world experienced an energy shock unseen since the oil embargoes of the 1970s. But oil’s ubiquity is based on its cost advantage; it’s a versatile and concentrated source of energy. The oil era has made energy convenient in modern society and more available to a wider number of consumers than at any other time in human development. By any reasonable historical definition, crude oil is still a cheap source of energy--even at USD150 per barrel.

What was known as “rock oil” in Drake’s day quickly became one of the most successful products in history. The first major market for oil was illumination. Although taken for granted in modern times, lighting wasn’t commonplace in the middle of the 19th century; in fact, the ubiquity of public lighting was one of the most important factors separating nascent industrializing nations in Europe from the rest of the world. In that era, gas manufactured from coal was finding a growing market in street lighting but was not economic in all but the most densely populated areas. Quality household illumination was also a luxury in the middle of the 19th century. Whale oil--a wax derived from the blubber of certain species of whales--burned brightly and produced little smoke and odor but was expensive and unaffordable for many. Camphene--a mixture of turpentine and alcohol--was cheaper than whale oil but highly explosive and volatile. Around 1850 a Scottish chemist named James Young began the commercial manufacture of what he called “paraffine oil” (later paraffin), which was derived from coal. Widely known as coal oil at the time and in the Americas as kerosene, Young’s invention quickly gained popularity. By the time Drake drilled his first well, there were already 50 to 60 plants in the US designed to convert coal into kerosene for use in lamps.

But after Drake and other early drillers began producing oil in quantity in the 1860s, it quickly became apparent that synthesizing kerosene from rock oil was far cheaper than manufacturing the oil from coal. Some of the early US manufacturers of coal oil soon entered the petroleum industry, converting or shuttering coal oil manufacturing plants in favor of refineries to produce kerosene from crude.

Oil’s capacity to drastically lower the price of energy for illumination was apparent by the latter half of the 19th century. At one point in the mid-1870s, sperm whale oil sold for more than USD30 per gallon (USD1,260 per 42-gallon barrel) compared to less than USD0.65 for crude oil (See chart below). Kerosene meant that illumination was no longer a luxury. It became a staple of everyday life.

Click to enlarge

Source: Walter S. Tower, A History of the US Whaling Industry (Philadelphia: John C. Winston, 1907).

Perhaps even more important for the next chapter in the Oil Age was crude’s abundance. Within a decade of the Drake well, crude was already America’s fourth-largest export. By 1872 the North American oil industry was already producing about 7.6 million barrels of oil per year (320 million gallons) and exporting some 3.6 million barrels a year (151 million gallons), primarily to Europe.

At its height the American whaling industry produced a total of less than 325,000 gallons of sperm and whale oil combined per year.

Oil for Transportation

Cheap illumination was the first use of crude oil in the 19th century. But the world’s love affair with crude was only beginning. The big explosion in demand for oil came in the 20th century, as the automobile quickly moved from a curiosity for the wealthy to a mass market consumer product.

The synchronous development of transportation and petroleum has since been inextricably intertwined. Just as crude oil made illumination cheap and affordable for the masses, oil has democratized global transportation. Personal horse-drawn carriages were a luxury at the turn of the 20th century; within just a few decades the personal automobile was taken for granted by many consumers in the developed world.

The development of the automobile in America came early in the 20th century. In 1950, by which time Americans owned 50 million cars, crude oil finally overtook coal as the nation’s most important source of energy. By the early part of the 21st century, there were more than 250 million passenger vehicles in the US.

And it wasn’t just the number of cars in the US that exploded through the 20th century. The US Federal Highway Administration began keeping statistics on total vehicle miles traveled in 1960; the total number of miles US consumers drive each year has grown more than fourfold since.

My chart below shows the total amount of energy produced by crude oil consumed in the US, from the early days of the industry to the present. To make the figure comparable to the experience in other nations it’s expressed in terms of per capita energy consumption--the amount of crude oil used per person.

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Source: Energy Information Administration Annual Energy Review 2008, US Census Bureau, US Bureau of Economic Analysis

The chart illustrates three clear phases of demand growth for crude in the 20th century. The first phase was the near-parabolic growth in demand for oil from 1900 to 1950 as cars became increasingly popular and affordable for consumers. This acceleration phase was followed by a slightly slower rate of growth from 1951 through the early 1970s as the automobile began to mature as a consumer product and the US market began to reach a saturation point.

Per capita crude oil consumption peaked in the early to mid-1970s. US dependence on oil imports grew steadily in the 1950s and 1960s, and domestic production peaked in the early 1970s. To make matters worse, just as demand for imports began rising the 1973 OPEC embargo cast doubt on the security and reliability of that supply. Crude oil prices spiked, and Americans began to drive more fuel-efficient cars to cut costs. The average US car in 1970 got just 12 miles per gallon compared to more than 17 miles per gallon in recent years, a more than 50 percent jump. A final reason for the fall in US per capita crude consumption was crude’s decline as a fuel for electric-power plants. In the mid- and late 1970s the US consumed more than 1.7 million barrels a day of crude and related products in the generation of electricity. By 2008 that figure had fallen to less than 200,000 barrels.

The drop in crude oil consumption per capita in the final years covered by the chart also stands out. In 2008 the average American consumer used a little more than 21 million barrels of crude per day, the lowest since 1965. This is the result of the severe recession of 2007–09 that prompted consumers to pare back on driving and air travel.

The New Oil Age

Mark Twain once quipped that history doesn’t repeat but it does rhyme. Alongside the developed European powers the US was among the first countries to see rapid economic development, the democratization of transport, and the accompanying surge in per capita oil demand.

China, India, and other developing countries are now hitting the same development tipping point that the US, Western Europe, and Japan did decades ago. These emerging markets are entering the accelerated phase of oil demand growth so evident in the long-term charts of US and Japanese crude demand.

The patterns of oil consumption for the US and Japan we analyzed are based on per capita data. The immense population of today’s emerging markets magnifies the impact of this per capita growth, putting an unprecedented strain on global oil supply. Yuwa Hedrick-Wong, chief Asian economist for MasterCard International, estimates that USD5,000 in annual pre-tax income is the tipping point for Asian consumers. When incomes reach this point, discretionary spending takes off; consumers spend as much as 60 cents out of every incremental dollar earned. This estimate looks at least broadly consistent with the development of oil demand relative to GDP for Japan and the US.

My chart shows Chinese GDP per capita and Chinese demand for oil on a per capita per year basis.

Click to enlarge

Source: BP Statistical Review of World Energy 2009, Bloomberg Finance LP, World Bank

The relationship between GDP and oil demand is undeniable. The chart also shows that as Chinese per capita GDP growth accelerated in the mid- to late 1990s, so, too, did per capita oil consumption. Some of the fastest growth of all has come since 2000, when Chinese GDP per capita surpassed the USD4,000 level.

Rapid growth in Chinese oil and energy demand has become something of a cause for consternation in the developed world. Environmental groups decry the pollution caused by China’s growing dependence on energy produced by fossil fuels.

Some suggest that China should curb its rising demand or seek to utilize other, cleaner sources of energy rather than relying on oil. Unfortunately, developed-world critics all too often forget the central role oil and the cheap, concentrated energy it provides played in their countries’ development. Chinese consumers want to reap the benefits of the Oil Age, as have their counterparts in the US, Japan, and Western Europe. Western sanctimony can’t change the fact that China is following the same pattern of accelerated oil demand in direct response to rapid GDP growth that the US, Japan, and Western Europe experienced. If these experiences are any guide, China’s accelerated phase will last for years to come.

Chinese oil demand currently stands at just over 2 barrels per person per year, compared to around 20 barrels in the US, 14 in Japan, and 11 to 13 across most of Western Europe. While China’s demand on a per capita basis is already growing quickly, there’s a great deal of upside before the nation reaches per person consumption levels equivalent to the developed world. With a population of more than 1.3 billion people, even a small increase in per capita oil consumption spells a major jump in petroleum demand. An increase of just a quarter of a barrel per Chinese consumer equates to around 1 million incremental barrels per day of demand on the world oil market.

China overtook the US to become the world’s largest automobile market in early 2010. Despite a small drop-off in sales during the heart of the 2007-09 global recession and financial crisis, Chinese car sales show no signs of slowing down. In fact, sales appear to have accelerated in the immediate aftermath of the recession, as Chinese consumers who delayed purchases during the downturn resumed their erstwhile buying patterns. This implies still greater increases in individual energy consumption.

China gets most of the media attention, but it isn’t the only demand-growth story for the oil market. Indians consume less than one barrel of crude oil per person per year, roughly equivalent to Chinese per capita consumption in the mid-1990s. India’s per capita oil consumption growth has been steady though not quite as dramatic as China’s. However, India’s population growth has been roughly two times as fast as China’s since 1980, so these per capita figures understate India’s importance to the global oil market. And India’s per capita GDP is also not as high as China’s; it’s not unreasonable to believe that the country’s oil consumption will accelerate in coming years. With a population nearly as large as China’s, Indian oil demand will be a force in global oil markets.

The preceding is excerpted from The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, published by Financial Times/ Prentice Hall.

1. J. T. Henry, The Early and Later History of Petroleum (Philadelphia: Rodgers & Company, 1873).

2. Ibid.

3. Neil McElwee, “When Kerosene Was King,” Oil 150, essays/2007/02/when-kerosene-was-king (accessed November 22, 2009).

4. J. T. Henry, The Early and Later History of Petroleum (Philadelphia: Rodgers & Company, 1873).

5. Ibid.

6. Walter S. Tower, A History of the US Whaling Industry (Philadelphia: John C. Winston, 1907).

7. EIA Annual Energy Review 2008, (accessed December 10, 2009).

8. Bureau of Transportation Statistics, www.bts.gov/publications/national_transp... (accessed December 24, 2009).

9. EIA Annual Energy Review, (accessed December 21, 2009).

10. Dominic Ziegler, “The Weakest Link,” The Economist, February 6, 2003.

Disclosure: "No Positions"