Oil fundamentals including demand remain an important determinant of oil prices. What do recent economic forecasts for Europe, China and the EU for 2012 mean for oil demand?
Macroeconomic forecasts for 2012
Here I review the forecasts of two authorities on global economic affairs, IHS and the IMF. This is summary for the IHS (2011):
“If Europe only suffers through a mild recession and China does not experience a hard landing, then world real GDP growth will slow from 4.2% in 2010 and 3.0% in 2011 to around 2.7% in 2012. On the other hand, if the recession in Europe is much deeper and/or the slowdown in China more pronounced, then the global economy will be headed for much weaker growth and possibly another recession.”
They are fairly optimistic about the USA, predicting growth of 2%, as well as projecting growth of 7.5-8% in China.
The IMF (2011) predicted global growth of about 4% in 2012, down from “over 5% in 2010”. They were less optimistic about the USA, warning that a political impasse over fiscal consolidation, a weak housing market, a rapid increase in household saving rates or deteriorating financial conditions could. The optimism of the IHS report is due to the fact that some of these factors have started to look up between the months of publication between the two forecasts (September for the IMF, December for IHS).
Despite the relative overall optimism, caution is due. Much depends on the response of the USA and China to a likely European recession. Much of the demand contributing to the apparent recovery of the past few years has been created by the public sector. We have yet to see the precise impacts of fiscal tightening, and the only way we can continue along the current trajectory is if the economic activity stimulated by the public sector successfully transfers to the private sector. As yet it remains unclear whether this will happen.
What global output forecasts means for oil demand
The gross domestic product of the USA ($14.6Tn), the EU ($16.2Tn) and China ($5.9Tn) represent more than half of global GDP ($63Tn). These markets determine oil demand to a large extent, as well as representing a barometer for other countries in their regions. Here I consider three ways of assessing the impact of changes in GDP on oil prices:
- Income elasticity of demand of crude oil
- Changes in the energy intensity of GDP
- Import dependence
According to Hamilton (2008), historically the income elasticity of demand (IED) for crude oil in the USA has been near unity. This means that roughly, a 1% change in GDP means a 1% change in oil demand. However, in recent decades the IED has declined and it is now well below unity. He explains that the IED in China is likely to be high, and we can assume it is already low in Europe. From the perspective of IED, there are three factors to consider when assessing the impact of macroeconomic forecasts on oil demand:
- Share of output produced by country/region
- Output growth forecasts for country/region
- Income elasticity of demand for a given country/region
Although the USA and Europe produce around half of global GDP, their respective growth forecasts are far less dramatic than that of China. They also have a low income elasticity of demand relative to China.
The second way of considering the impact of GDP on energy demand is through energy intensity. The following are the energy intensities of Europe, the USA and China, expressed as GBtu per 2005 dollar of GDP per capita:
- USA: 7.6
- EU: 5.5
- China: 11.2
China's is very high; indeed, of all countries, only Russia's is significantly higher. Looking at the projections for these energy intensities, we can see a general downwards trend in all countries, and this is most pronounced for China. From energy intensities we learn:
- China's energy consumption per unit of GDP is considerably higher than in most OECD countries, amplifying the effect of its growth on oil demand
- There is a projected downward trend in energy intensity (-2.6% per year for China, -1.8% globally) that offsets the impact of GDP growth to an extent
A third point to consider is import dependence. Since China's additional oil needs are increasingly being supplied by the global market, its level of imports are growing as a proportion of overall consumption (Hayward, 2009), so Chinese imports are growing quicker than their total oil demand. The USA, on the other hand, is steadily increasing its production levels (see this article on SA for example), so increases in demand are being offset by increases in production. Due to declining production in the North Sea and other areas, EU import dependence has also been steadily increasing in recent years.
Putting IED, energy intensity and import dependence together, there are a host of countervailing trends at play here. Putting upwards pressure on oil demand are:
- GDP growth, especially in the developing world and China in particular
- The high energy intensity of GDP in China
- The positive outlook for the USA
- The import dependence of China
Putting downwards pressure on crude oil prices are:
- A European recession and EU import dependence
- Decreases in energy intensity, especially in China
Overall, unless economic forecasts prove too optimistic, we can assume a steady but modest increase in oil demand in 2012. However, demand growth is likely to slow down somewhat relative to the previous year.
The impact of oil demand on prices
Coleman (2012) finds that global GDP is statistically significant determinant of oil prices. He finds that a one standard deviation change in GDP (about 1.7% since 1970, by my calculations) leads to a $6-8 change in oil prices.
Fan and Xu (2011) find that since the global economic crisis fully set in in mid-2008, the Baltic Dry Index is a highly significant determinant of oil prices. They find that standard deviation in the BDI, oil demand moves by 0.3 standard deviations. According to Hamilton (2008), a standard deviation in oil prices constitutes a movement of around 15%.
One cautionary study is that of Mu and Ye (2010), who discuss the importance of China's oil imports to oil prices. They test for correlation and causality between movements in crude prices and Chinese imports betweeen 1997-2010, and find neither. However, I believe the approach of Fan and Xu (2011) to be methodologically superior, since the separate oil price movements into three separate structural periods, the latest one being since 2010. They find that this greatly enhances the explanatory power of their model, and that fundamentals play a different role at different times. Given the general evidence of the importance of fundamentals, including demand, to oil prices, and the contribution of China to increasing demand, it is fairly safe to say that Chinese demand growth is likely to have put an upward pressure on prices.
Oil demand is one of many determinants of oil prices, yet it remains significant. In general, 2012 should see a modest increase in oil demand, which can be expected to largely maintain its current upward pressure on prices. The demand impacts of a European recession alone are unlikely to cause a significant drop in oil prices, despite the fact that the rate of demand growth is likely to slow down relative to 2011.
- Coleman, L. (2012), 'Explaining crude oil prices using fundamental measures', Energy Policy.
- Fan, Y. and Xu, J. (2011), 'What has driven oil prices since 2000? A structural change perspective', Energy Economics.
- Hamilton, J. (2008), 'Understanding Crude Oil Prices', The Energy Journal.
- Hayward, D. (2009), 'China's Oil Supply Dependence', Journal of Energy Security.
- IHS (2011), 'Top 10 Economic Predictions for 2012'.
- IEA, 'International Energy Outlook 2011'.
- Mu, X. and Ye, H. (2010), 'Understanding the Crude Oil Price: How Important Is the China Factor?' The Energy Journal.
- OPEC, 'World Oil Outlook 2011'.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.