Oil Prices, Economic Growth and World Oil
Demand
Andrew McKillop*
Introduction
Conventional or received
wisdom, embodied in the notion of ‘price elasticity’ of demand, is that large
oil price rises will necessarily reduce economic growth and oil demand growth
rates, perhaps resulting in zero economic growth, or recession, and producing a
contraction of world oil demand on a year-by-year basis. The higher the rise of
oil prices, the faster it is assumed that ‘price elastic’ responses will play.
Higher oil prices will “of course” reduce economic growth, generate stock
exchange panics and produce inflation, leading to monetary and financial
instability; higher interest rates, and even a plunge into recession will be
needed to combat this menace through intensifying the fall in economic growth
rates “inevitably caused” by higher oil prices, thus cutting world oil demand.
As with any received
wisdom it must be demonstrated and proved, if it is have any more than the
status of belief, however comforting to its holders. In the case of the
relation between, and effects on economic growth of higher oil prices, the
notion that price elastic responses describe anything more than a single facet
of what are very complex, world economic adjustment mechanisms is without credibility
or foundation. In addition, before very elevated oil prices are achieved –
probably well above $70/barrel in 2003 dollars - world economic adjustment
mechanism will always result in higher oil demand through the economic
expansion, with or without inflation, that higher oil prices bring about at the
world, or ‘composite’ level. Only extreme interest rates, as in the early 1980s
in many OECD countries, can induce sufficiently violent and rapid contraction
of economic growth to temporarily reduce oil consumption.
Regarding the analysis and
forecasting of world oil demand growth, the notion that ‘classical’ price
elastic functions will apply when oil prices rise to levels approaching
$60/barrel (less than two-thirds the inflation adjusted price of 1981, some 22
years ago), and using these to forecast future world demand will necessarily
result in incorrect demand estimates. Ineffective modeling of the real
energy-economic adjustment mechanisms that come into play at times of fast
rising oil prices, and after transition to higher general levels of oil and
energy prices, can only give incorrect results. Bearing in mind that we are
rapidly approaching Peak Oil (see below) the price factor in world oil demand trends should receive much greater
attention.
Price elasticity of demand
is always thought of as negative – that is demand falls by a certain percentage
for a certain percentage price rise of some factor input, in this case oil.
Comfort for the belief that this ‘function’ should apply anywhere, in any
economy, at any stage of economic development is obtained through narrowly
focusing energy-economic performance of large OECD economies during times of
fast rising oil prices.
Thus, for the period 1979-83,
in which oil prices in nominal terms increased by about 115% (in the two years
1979-81), several large OECD economies showed year-on-year falls in oil
consumption, by volume, that attained nearly 10% in certain quarterly periods,
and well above 5% on an annual base. For example, in 1981 and 1982 volume oil
demand of the US and Japanese economies respectively fell by 6.5% and 4.9%
(USA) and 6.1% and 5.4% (Japan), all data being on a year-to-year base
(Reference/ McKillop 1). However, it should immediately be noted that preceding
the 1979-81 Oil Shock both economies showed consistent annual increases in their oil consumption (more
than 3% for the US in 1978), in their ‘adjustment and retrenchment’ following
the 1973-74 Oil Shock, in which oil prices had risen by about 295% to a level
of about $41/barrel in dollars of 2003. Through the period of 1975-79,
following a short and sharp initial downturn in economic growth and oil
consumption growth rates, both the USA, Japan, Germany and all other large OECD
economies showed fast adjustment of their economies. Typical economic growth
rates (real GDP, annual base) were in the 3%-4% region, at least twice the
typical growth rates of these countries today. By direct consequence – oil
being the ‘swing fuel’ par excellence - their annual oil consumption growth
rates were close, in percentage terms, to their percentage annual economic
growth rates measured by real GDP. This relationship, which can be called the
‘oil coefficient of economic growth’, was typically close to 0.75 (a 1% growth
in real GDP entraining a 0.75% increase in oil demand by volume). An economy in
which annual GDP growth rates and oil demand growth rates are closely similar
can be called ‘close coupled’.
It can be noted, here,
that because of economic cyclic factors, and energy-economy ‘structural’
factors (including electrification and fuel mix changes), even OECD service
dominated economies can become ‘overcoupled’, that is show a higher annual oil demand growth than
their growth rates of real GDP, or very closely similar ratios, around 0.95.
This is the current situation (since 1999-2000).
In the period following
the 1973-74 Oil Shock, during which nominal price rises for oil were about
295%, there was an initial ‘price elastic’ response, that is fall in oil demand
growth rates, for nearly all OECD economies. In no case, however, did this
stagnation or slight fall in oil demand exceed a 3% volume fall on an annual
base, or the period of ‘decoupled’ relationships between economic performance
and oil price changes exceed one year or four successive Quarters. As with
economic growth, oil consumption ‘bounced back’ rapidly, with typical oil
demand growth rates approaching three-fifths to three-quarters the annual rate
of real GDP growth. Conversely, and in a context of extreme interest rates, the
‘decoupled’ period in which annual oil consumption fell, always with stagnant
or falling real GDP, was very much longer for nearly all large OECD economies
after the second Oil Shock of 1979-81. The ‘decoupled’ period, in some cases,
extended to about 36 months or 12 successive Quarters, that is from 1980 to
1983. Other factors contributed to this context of sluggish and hesitant
adjustment, notably the accelerated electrification
of many OECD countries, itself a policy response to the first Oil Shock of
1973-74 (Reference/ McKillop 2). However, after each of the ‘classic’ Oil
Shocks of the 1973-81 period there was ‘retrenchment’ and then recovery. With
the return to economic growth there was a return to annual rises in oil
consumption within a certain period; the ‘decoupled’ period was much longer
when oil prices had attained a level of about $85/barrel in 2003 dollars (in
1981), than in the first Oil Shock adjustment period when they had attained
about $41/barrel in 2003 dollars (in 1974).
No extended ‘decoupling’
occurred after either Oil Shock. As might be expected in multiple series of
world wide economic adjustments to factor cost and output changes, many ‘thresholds’
and ‘triggers’ were (and always are) in play. The fact that adjustment was much
slower following the second Oil Shock can be considered normal given the oil
price level achieved, but the fact there was adjustment at all indicates the
intrinsic and total dependence of ‘classic’ or conventional economic growth on
increased oil consumption. Probably due to economic cyclic factors, and despite
the extreme interest rates applied at the time in most OECD countries (that is
a recessionary and defensive response aimed at cutting oil demand through
economic slump and mass unemployment), recovery in economic growth rates was
very vigorous.
In 1984, with year-average
oil prices in 2003 dollars still at about $63/barrel, a level that would be
considered ‘extreme’ today, the USA attained its highest ever annual economic
growth (+7.5%, real GDP) in the entire 1945-2002 period. Many other OECD
countries achieved high levels of economic growth in the period extending to
1985-86. In the period of very low oil prices through 1986-1991 that terminated
with Gulf War-1, itself a war for cheap oil, economic growth rates fell very
sharply throughout the OECD, with stagnant demand, or very slow growth of oil
demand itself reinforcing the fall in oil prices. Analysed on a Quarterly base, for changes in oil price against
changes in economic growth rates, the OECD group of countries, from the early
1990s to 1998-99, showed close coupling in the sense that each fall in economic
growth rates was usually preceded by
a fall in oil prices, and each small increase in average economic growth rates
was usually preceded by a rise in oil
prices.
This merely underlines
that whatever the policy response to much higher oil prices (either
recessionary and defensive, or expansionary that is ‘adjustment through
growth’) the advanced industrial nations soon renew their dependence on oil
consumption whenever their economies again start to grow. Without complete
restructuring of the economy, food production, and transport systems,
and de-urbanisation of population the world’s economies will in fact
remain ‘coupled’ with oil demand whatever the price, because of the complete
dependence of modern urban-industrial economies on oil and oil products. That
is, in other words, energy conservation or the reduction of energy demand
through transition to a low energy
economy will effectively be the only way that advanced urban and service
economies of the OECD ‘break the oil habit’.
Certainly in the last 50
years, economic growth as we know it has always required an increase in
commercial energy consumption, and particularly oil and gas. The rate of economic growth is the prime
determinant of the ‘coupling’ or relationship between the rate of economic
growth, and rate of increase in oil demand. Thus the interplay of generally
declining economic growth rates in the OECD bloc and changes of economic structure (increasing services,
electrification of the energy economy and ageing of the population) have all
tended to reduce ‘coupling’ of OECD country economic growth, such as it is,
with annual oil demand changes.
Comparing typical economic
growth rates for OECD countries (here the G-7 group), and both ‘traditional’
and ‘emerging’ New Industrial Counties, the dramatic differences of economic
growth rates are easy to see (Table 1), and these differences themselves
explain much of the ‘coupling’ of oil demand with economic growth found in the
NICs, and the decreasing ‘coupling’ in OECD countries.
TABLE 1 Economic growth rates (real GDP, annual
average) for selected countries
|
Country |
1968-79 |
1979-89 |
1989-95 |
|
South Korea |
5.8% |
3.7% |
1.8% |
|
Taiwan |
10.0% |
7.6% |
6.3% |
|
PR China |
6.8% |
9.8% |
10.1% |
|
India |
3.5% |
5.9% |
4.4% |
|
G-7 group |
3.2% |
1.5% |
1.4% |
Source : A Jolley,
CSES Working Paper N°5, ‘A New Era of Economic Growth’, CSES, Melbourne
University, Australia, 1996
It can be noted in passing
that in the last period (1989-95) oil prices, except for a 4-month ‘spike’
preceding Gulf War-1 in 1991, were at inflation corrected price levels less than those of 1973. This tends to rather confirm the
argument that cheap oil in no way facilitates or increases economic growth for
the OECD countries !
As already noted, the
notion of price elastic demand responses to much higher oil prices is based on
classical economic thinking, and draws on data for rather short and selected
periods of time, from large OECD economies for its support and demonstration.
Absent from the underlying conception are the questions of actual economic
growth rates, economic stage, ongoing industrialisation and urbanisation, the
development of commercial energy supply and utilisation infrastructures and the
economic demand-driven, increasing overall
utility of oil within a growing economy. However, these elements are all
critical for understanding ‘reverse’ or ‘positive’ elasticity of demand – that
is increasing oil demand with increasing
price. Classical price elastic notions are completely inapplicable for
describing oil demand changes under regimes of much higher prices in fast
growing New Industrial Countries as shown in Table 2, below
Table 2 Asian Tiger economic-driven, close-coupled adjustment to Oil Shock
|
Oil
Cons
1975 1976
1977 1978
1979 1980
1981
Singapore
141 165
165
170 183
181 208 Increase 1975-81 : 47.5% South
Korea 278
310 371
426
480 475
497 Increase
1975-81 : 78.8% Taiwan
ROC 214 271
304
353 358
388 359 Increase 1975-81 : 67.8% |
Source/
BP Statistical Review, various editions
In the period covered by
data in the above Table 2, nominal oil prices had increased by about 405%.
While these New Industrial Countries (NICs) had very briefly reduced their rate of increase of oil demand through
1973-74, and again in 1979-80, overall oil consumption growth through the period
of these 405% nominal oil price rises was very high. We can particularly note
that through 1974-76, that is including the period of rapid ‘bounce back’ or
recovery in economic growth and oil
demand of the NICs, their growth rates of oil consumption, by volume, were in
the 12%-15% range despite much higher oil prices continuing to ‘work through’
the pricing structure of economic inputs. The explanation, of course, is the economic stage of these economies (fast
industrialising, export-oriented), and their economy-wide utilisation of oil
and LPG-based energy using productive equipment, rather than electrified energy
economies, typical of ‘mature’ OECD economies.
Concerning the energy
economy, and avoiding any discussion of classical notions of ‘economic stage’,
the most essential elements for modelling and forecasting oil demand focus the
evolving shares of electricity, and oil, gas or coal based energy supplies and
systems within an economy. This brings in the concept of Total Primary Energy,
and Total Final Consumption (TFC), and also relates to questions of energy economic infrastructures.
Briefly, we can characterise and contrast the NICs, and large, older or
‘mature’ OECD economies with very high levels of service sector output as a
percentage of total GDP, by the second group of energy economies having a much
higher part of electricity in their TFC (Reference/ McKillop 3). Construction
and constitution of electricity supply systems, we can also note, requires very
high levels of economic and energy
investment. The claimed advantage of electricity-intensive economies, using
nuclear, coal or other non oil primary sources for electricity production –
that they ‘cannot be held to ransom by high oil prices’ – does not apply to
their formative stages, and also sets rather high ‘floors’ to the
‘compressibility’ of energy demand of all kinds, including oil, at times of
economic crisis (Reference/ McKillop 4).
On a world scale, and
overall, there is about a 50/50 split in economic output between OECD
countries, and all other nonOECD countries, including the new and giant NICs
China and India. It is interesting to note that in terms of world oil demand,
the split is about 55/45 in favour of (higher demand from) the OECD countries,
immediately underlining the relative oil inefficiency of total economic output of the OECD economies. Even today, in
early 2003 and after about 6 months of generally higher oil prices, economic
growth rates are tending to increase
in India and China, with inevitable oil demand increase by their close coupled
economies. Schematically, and by reference to economic stage, we can present
development stages, and oil demand driving factors of these stages, as
summarised below in Figure 1
Figure 1 Energy economic
stage oil demand characteristics
Economic grouping Period Oil demand close coupled with GDP growth
OECD countries 1950-75
Yes
1975-85
Yes, but discontinuous
1985-present Weak
Asian Tiger NICs 1970-90
Yes
1990-present Weaker,
declining
New NICs (including 1985-2000 Yes
China, India, Brazil) 2000-present Yes, but
declining
Low Income Countries 1970-90
Weak, but increasing
1990-present Yes,
increasing
Schematic only; ‘Close
coupled’ means oil coefficients approaching, or even superior to rate of real
GDP growth (Coefficient of unity = 1% oil consumption growth for 1% growth of
real GDP)
Again schematically, we
can present the case of typical, ‘classic economic development’ for countries
such as South Korea, India, Brazil or others, depending on the time frame used.
At the earliest stage of development, sometimes extending back to the 1930s or
before, their energy economic characteristics will include a high level of
renewable energy sources utilised to support an agrarian, low income society,
with very little urbanisation or industrialisation. Classical economic
development may occur relatively fast, more slowly, or not at all (as is the
case for many African economies). Only those countries which develop
industrially, and urbanize are considered a ‘success’, and this model of
development remains the basis of almost all loan financing and project
formulation by agencies and institutions such as UNDP, ILO, the World Bank, and
the regional banks.
In the case of South Korea
we find that per capita oil demand, now approaching EU-15 per capita rates, has
increased about 30-fold in 40 years.
Without question, therefore, the oil demand of such an economy is close coupled
in its early periods of fast growth and fast urbanisation and industrialisation.
Increasing electrification, whether as a conscious ‘oil dependence limiting’
policy or not, will certainly help to reduce oil coefficients over time.
However, in that part and period of the development process (in the case of
South Korea from about 1965-85) where additional energy demand arises from the
creation, and extension of energy dense infrastructures, oil coefficients of
economic will remain close to unity, and in some cases can exceed unity. This
can be understood from the example of the development of car manufacture and
highway construction, as well as construction of nuclear power plants, in South
Korea and other NICs. The mainly oil-based embodied
energy of car manufacturing plant, highway construction equipment and
materials, nuclear reactors, etc, both increases
energy intensity of the economy while enabling
(and forcing) economic agents and consumers to use more oil. Widespread
‘motorisation’ or the use of personal vehicles, in OECD and other countries, is
associated with increases in personal or per capita oil demand of 10 – 20 times comparing on a
‘before-and-after’ basis.
On a world wide base the
growth of the car industry and the world car fleet is a key vector for
increasing energy-, and particularly oil-intensity of economic activity. The
world’s car fleet now stands at about 775 million units and is increasing at a
world-wide average of about 6%/year, with the most rapid growth taking place in
the new NICs, notably China and India, where double-digit annual growth rates
are the norm. Through 1990-2002 the Chinese car fleet has increased at an
average of more than 13% per year, growth of the car fleet attained more than
50% in 2001-2002, and national production will soon attain 6 Million units/year
(Ref/ McKillop 5).
Given that classical
economic development has always featured declining relative prices for and
values of raw materials, unfinished products and energy, increasing oil
consumption is virtually axiomatic for the development process of
industrialisation and urbanisation that currently concerns at least one-half of
the world’s population. The time taken to transit from ‘early’ or oil-based and
oil-intensive economic development, to ‘mature stage’, electrified
energy-economic structures underlying the service-oriented economies of the
ageing OECD countries is typically more than 20 years. Due to this, any
forecasting of world oil demand trends without
integration of these considerations will inevitably be incorrect and of little
practical use.
As noted by Campbell
(Reference/ Campbell) we are moving quite rapidly towards Peak Oil, and may in
the next 7 or 8 years attain the absolute limit of world oil production at
around 83 Mbd. Even at the low aggregate rate of world oil demand growth that
held in the 1990-2000 period, impressive total growth of oil demand was
generated. In 1991, at the time of Desert Storm and the restoration of Kuwait
to full sovereignty and full oil output, world demand was about 66.5 Mbd. Today
it is about 79.5 Mbd, an increase of 13 Mbd, which is vastly more than Saudi
Arabia will ever be able to supply however much it might want to deplete its
oil reserves in the shortest possible time.
For the mass of economic
and business commentators, current oil prices in early 2003 incorporate an
‘Iraq war premium’ of up to $15-a-barrel, and do not reflect dramatically low
stocks in most major consumer countries, nor the hesitant and slow recovery of
Venezuelan production following the 2-month strike, the rising threat of major
civil disturbance in Nigeria, nor continuing elevated rates of oil demand
growth in East Asian economies, nor the impossibility of significantly
increasing Iraqi oil output within about 2 years after removal of sanctions,
nor declining oil and gas exploration success rates and falling makeover rig
activity worldwide, and so on.
At this time it is
impossible to accurately forecast the regional sequels of any US-UK invasion
and military occupation of Iraq, especially in the case of these countries
going ahead with their invasion but without the approval of the UN Security
Council. Nevertheless, it is unlikely that, in the event of invasion, Iraq’s
oil production will not fall by a
considerable amount and perhaps to zero for a certain period. Increase of Iraqi
production first to pre-invasion levels, and then to higher rates, will most
certainly take some considerable time, perhaps several years. Without invasion,
‘geopolitical uncertainty’ will remain, and any increase of Iraqi production,
perhaps to around 3 - 3.5 Mbd, may take 2 years or more, underpinning oil
prices at least at around $35/bbl. With invasion, and after a short period of
unrealistic downward bidding of oil prices – which will further increase
strategic stockpile constitution by countries such as China and India – prices
are likely to recover rather fast as no rapid increase of oil output occurs,
and the impact of lost Iraqi production begins to weigh on an essentially
finely balanced world supply-demand context.
By consequence we can
suggest that oil prices, through 2003, may ‘dip’ for some while after an Iraq
War itself determined by depleting world reserves, but will necessarily ‘bounce
back’ when the finely balanced supply-demand situation again tilts towards a
context where tight supply and falling inventories enable upward price movement
to again become dominant. On a year-average basis, prices may well remain
within the $25-$30/barrel range and may in fact increase outside this range by
winter 2003. If oil prices firstly remain ‘firm’, and then increase, this will
almost certainly be called an ‘Oil Shock’ by finance columnists and business
observers. In the case of ‘high’ oil prices remaining a part of economic
reality we can expect the energy economic mechanisms and factors, discussed
above, to play a part in deciding and shaping future world oil demand trends,
that is - on balance - underpinning demand.
The major reason for this
is that oil demand by fast growing manufacturing and export activities in the
NICs will tend to more than compensate any fall in oil demand by the OECD
economies due to recessionary trends, partly (and to a very small degree)
intensified by higher oil prices. For the oil demand driving factors of the
NICs, the most important factor is solvent
demand by low and middle income economies, for manufactured goods of all
kinds. This demand is made solvent, and increased rather rapidly, by large and
rapid oil price rises, through the impact of higher oil prices on world price
levels for energy-intensive metals, minerals and agrocommodities. Prices for
these commodities increase in line with oil prices, transferring wealth from
OECD consumer countries to low and middle income country exporters. These
latter countries, having increased revenue flows, address their newly solvent
demand to the NICs, which now include one-third of the world’s entire
population in the shape of China and India. In addition, these latter countries
have now entered the ‘dynamic’ of conventional economic ‘takeoff’ into energy
intensive, urban-industrial economies, thus reinforcing their own domestic
demand for oil in particular, as well as all other forms of commercial energy.
Leading indicators for
this process include commodity price trends on a quarterly basis, volume
movements of such raw materials, and orders received by NICs for their export
goods. Using such indicators, and comparing these with ‘ideal case’ U-shaped
demand-price oil coefficient curves (negative for OECD economies, ‘reverse elasticity’
for NICs), we can make good quality and above all realistic models for emerging world oil demand trends. For the OECD
economies (see McKillop/2) we find that only
oil price levels in 2003 dollars of above $60-$80/barrel induce either falls,
or stagnation in oil demand trends over periods of about 36-40 months, before
‘recoupling’ occurs. For the NICs, conversely, much higher oil prices lead to
an increase in consumption, because
of the macroeconomic mechanisms sketched out, above.
While it may be
conceptually pleasing, and undoubtedly saves time and work, by imagining that
all energy economies subject to large and rapid oil price rises will exhibit
‘classical’ price elasticities of oil demand, simple facts and figures, and a
few analyses, soon show that comparing the ageing, service oriented,
electrified economies of the OECD countries with those of the NICs is like
comparing carp and rabbits (or chalk and cheese). Very different energy
economic structures and mechanism are in play, producing entirely different oil demand outcomes under Oil Shock
conditions. Given that world economic output is now close to 50/50 OECD/nonOECD
it can be confidently said that ‘classical’ price elasticity functions used –
often in elaborate models – by many official agencies and institutions are at
least one-half wrong. Other methods, notably tracing raw material prices and
industrial output by NICs are needed to build modelling procedures able to give
reliable and realistic results.
The observed and simple fact
that economic growth is strong, or even accelerating
in the giant, emerging NICs of China and India, and is buoyant in several other
large-population industrialising countries (eg. Turkey, Brazil, Iran), will
ensure that oil demand growth rates at the composite or world level will be
unlikely to fall below the so-called ‘long term trend rate’ of 1.8%/year, that
held for the 1990-2000 period. Depending on oil price rises, and certainly with
price levels of up to $50 - $60/barrel, composite or aggregate world economic
growth rates are more likely to grow, than to shrink. In such case, overall
world oil demand growth rates may well break out of the ‘long term trend rate’,
that is used by OECD agencies such as the IEA to forecast future demand, and
attain levels of considerably above 2%/year (perhaps 2%-2.25% per year with
prices at $50-$60/barrel).
REFERENCES
McKillop 1 ‘On
Decoupling’, A McKillop, Intl Jrnl of Energy Research, Vol 14, N° 1, 1990, J
Wiley
McKillop 2 ‘Improving the
Quality of Oil Demand Forecasts’, A McKillop, Oil & Arab Cooperation
Quarterly, Vol 16, Issue 59, 1990, OAPEC, Kuwait
McKillop 3 As McKillop 1,
above
McKillop 4 ‘Energy and
Economic development in Developing Countries’, A McKillop, Oil & Arab
Cooperation Quarterly, Vol 12, Issue 1, 1986, OAPEC, Kuwait
McKillop 5 ‘The Chinese
Car Bomb’ A McKillop (in) The Final Energy Crisis, Pluto Press, fothcoming
Campbell ‘The Assessment
and Importance of Oil Depletion’, C J Campbell, (in) The Final Energy Crisis,
Pluto Press, forthcoming
_______________________________________
*Former
Expert, Policy And Programming, Division A-Policy, DG XVII-Energy, European
Commission, Brussels; Founder Member, Asian Chapter, International Association
For Energy Economics
Please
direct any questions directly to Andrew McKillop [andrewmckillop@onetel.net.uk]