Demand Driving Oil Markets Into Turbulence

Varied as they were, past energy crises have had one key thing in common: They were all viewed from a supply perspective and amenable to supply-side fixes. A vocabulary existed for dealing with such upsets. Data was ample and its quirks accepted. The 2020 Covid-19-climate convergence flipped that, moving demand uncertainty to the fore in oil market analysis. Any notion that this autumn’s “energy crisis” signaled a return to supply-side dominance should be dispelled by the crude price plunge that has greeted the spread of the Omicron coronavirus variant. Demand uncertainty will remain the strongest driver of oil markets indefinitely. Since the dynamics are poorly understood, the data questionable and the demand spigot not adjustable to stabilize oil markets in the way Opec-plus has learned to do with supply, the only evident way forward is through turbulence. Getting through it as quickly as possible will be the preferred response — not a return to fashion for fossil fuels.

The phrase “energy crisis” or “oil crisis” has been used loosely over the decades, sometimes to describe a surge in prices, as in the 1970s; sometimes to describe a price collapse, as in 1986 and 2014, and sometimes even when price blips were short and inconsequential.

However, all were seen as starting with either oversupply or a supply shortage. The validity of that perception was sometimes debatable — as in 2008. But there was enough truth in it that supply continued to be used as the key variable in forecasting market balances. The demand side of forecasts weren’t quite an afterthought, but close.

Over the last two years, this view of oil markets was challenged — and arguably discredited — by the sharp drop in demand brought on by the global pandemic and also by rapid acceleration in the transition to non-carbon-emitting forms of energy.

The oil industry, investors and governments alike have struggled to come to grips with markets in which demand is the driving factor. First, it feels uncomfortable because it puts outsiders — those who buy oil products — in control. Oil producers, be they countries or companies, naturally like to feel they understand and have some degree of control over the terrain on which they operate.

Practical impediments also abound. Factors affecting demand for particular oil products in different parts of the world have been studied a bit, but data are unreliable for many places and periods. Trends have not been followed with anything like the rigor applied to supply. So the analytical base for understanding changes in crude oil demand patterns is relatively weak.

This is the case because, until recently, forecasters and analysts routinely assumed that crude demand would always grow — and at an annual rate not much different from previous years. Diesel might grow faster than gasoline in some places, and naphtha lead the product pack in others, but the impact on crude wasn’t huge. Crude demand was treated as a function of economic growth. Recessions might throw calculations off now and then, but not by enough or for long enough to undermine the technique.

Another routine assumption was that consumption was largely unresponsive to price changes in the short and medium term. This was true particularly for transportation fuels, under the then-correct assumption that users had no alternative to gasoline and diesel, and would rarely choose to stay home rather than travel, even if travel became costlier.

First Confidence Erodes

Momentum behind electric vehicles (EVs) had started to undermine confidence in this assumption even before Covid-19 hit.

Then the 2020 shutdown of large portions of the global economy led to the first major drop in crude demand since the aftermath of the 1979-80 oil crisis, and to a sudden realization that EVs and other shifts away from fossil fuels were advancing the date when oil demand would top out forever.

That suddenly made consumption a key variable for markets. Since markets are by definition two-sided, it didn’t mean that supply would cease to be a factor in pricing at all. But yet another simple assumption was made: Supply would be ample on the far side of the demand peak or even excessive, if producers didn’t ratchet down fast enough. For oil, price and investment risk were all on the downside.

This assumption has quickly proven to be overly simplistic, especially in light of repeated shutdowns ordered by governments, interspersed with enormous infusions of cash to keep those shutdowns from triggering an economic depression. The result has been a dizzying roller-coaster ride for oil consumption.

The soaring prices brought on by an extended climb in demand back toward — albeit not yet to — pre-Covid-19 levels this autumn doesn’t mean oil markets are off the roller coaster and the risk is now mainly on the upside. The high prices spawned claims that the world is facing an old-fashioned supply shortage, something the industry can easily fix if governments and investors will just let them get on with it.

But that notion has, in turn, been dispelled by the plunge in crude prices as the Omicron variant soured sentiment, across oil and other financial markets. It’s all just part of the pandemic roller-coaster ride.

Then Demand Erodes

The real concern for the oil industry, the reason the current roller-coaster ride is destined to end badly for oil, starts with EV sales. The pace at which EV sales are growing continues to confound the forecasters, and is now approaching 100% per year across world markets — 83% by one measure, 123% by another. What’s sure is that the speed is breathtaking: BNEF expects sales of battery-only and plug-in hybrids to comprise around 25% of global auto sales by 2025 — just three years from now — up from 2.6% in 2019.

The day is very fast approaching, if it isn’t here already, when structural changes to the economy, including but not limited to EV sales, will be visibly eating into oil consumption. Demand will no longer be a simple function of economic growth or shrinkage. It will have its own dynamic that can’t be calculated using historic oil demand growth data — leaving aside the quality of such data.

In its Net Zero by 2050 scenario, the International Energy Agency tried working backward to get around problems in forecasting without meaningful historic data. It set the goal in advance and calculated a path to get there — one out of an endless number of possibilities. It’s a helpful exercise. But it doesn’t offer a usable guide to how much oil and gas the world will want at any particular point in time before 2050.

Since calculating demand is so problematic, it’s quite possible that supply will miss the mark more often than not, keeping prices volatile and giving regulators all the more impetus to shield electricity markets from fossil fuel price swings, and drivers to buy EVs to take advantage of relatively stable power prices.

One thing oil price spikes will certainly not bring is a longer market life for oil. Nor will they make policymakers in Beijing, New Delhi or Washington love fossil fuels again. On the contrary.

Sarah Miller is a former editor of Petroleum Intelligence Weekly, World Gas Intelligence and Energy Compass.