The Price and Income Responsivenessof World Oil Demand

Dermot GatelyProfessor of Economics, NYU

NY Energy ForumDecember 11, 2007

Dermot.Gately@NYU.edu

NY Energy Forum December 11, 2007 Dermot Gately “The Price and Income Responsiveness of World Oil Demand” e-mail:

Dermot.Gately@NYU.edu website papers: www.econ.nyu.edu/dept/courses/gately/research.htm

Papers on OPEC and the World Oil Market: “How Plausible is the Consensus Projection of Oil Below $25

and Persian Gulf Oil Capacity and Output Doubling by 2020?" Energy Journal, 2001, 22(4), pp. 1-27

“OPEC’s Incentives for Faster Output Growth”, Energy Journal, 2004, 25(2), April, pp. 75-96.

“What oil export levels should we expect from OPEC”, Energy Journal, 2007, 28(2), pp. 151-173.

Papers on World Oil Demand:“The Asymmetric Effects of Changes in Price and Income on Energy and Oil Demand”,

Energy Journal, 2002, 23(1), pp. 19-55 (with Huntington) “Vehicle Ownership and Income Growth, Worldwide: 1960-2030”,

Energy Journal, 2007, 28(4), pp. 163-190 (with Dargay and Sommer) “Price and Income Responsiveness of World Oil Demand, by Product”

(with Dargay and Huntington), August 2007, with revised version to be posted soon

• Despite crude oil’s price tripling since 2003, oil demand has kept growing – in contrast to the demand declines that we experienced after similar price increases in the past. Why?

• World income has kept growing (SURPRISE)• Price-responsiveness of demand has been small

(not a surprise): o OECD: Been there, done that.o Developing Countries: except for residual/heavy oil,

demand has grown almost as fast as income.o Oil Exporters consumed 1.7 mbd in 1973, now 8.5 mbd.

Why has the price-responsiveness of oil demand been different this time?

1970 1975 1980 1985 1990 1995 2000 200510

20

30

40

50

60708090

100

2006 $per barrel(log scale)

Real Price of Crude Oil, 1971-2007

income growth slows sharply; oil demand falls

income kept growing; demand growth slows

but no decline

Why has world income kept growing?

• Price tripling was gradual, not abrupt• Asia plays a much larger role in the world

economy, and its growth continued strong• US economy sustained by financial institutions

throwing mortgage money out the windows• OPEC was smarter in keeping a lower profile,

which was less threatening than in the 1970s.

Why has world income kept growing?

• Price tripling was gradual, not abrupt• Asia plays a much larger role in the world

economy, and its growth continued strong• US economy sustained by financial institutions

throwing mortgage money out the windows• OPEC was smarter in keeping a lower profile,

which was less threatening than in the 1970s.• I’m saying this was a surprise, not that we should have expected it – bearing in

mind what Graham Allison once said about Kremlinologists after the Soviet collapse: “What they once told us was inconceivable, they now tell us was inevitable.”

1965 1970 1975 1980 1985 1990 1995 2000 20050

10

20

30

40

50

60

70

80

90

mb

d

Total Oil

Other Oil

Residual Oil

World Oil Demand (mbd)

10 20 30 40 50 60

Real Income (Trillions $, log scale)

5

6

789

10

20

30

40

50

60

708090

100

Oil

De

ma

nd

(m

bd

, lo

g s

ca

le)

1965

Total Oil

19731979

2006

OtherOil

Residual Oil

equi-proportio

nal growth

1965

1965

1973

1973

2006

2006

1979

1979equi-p

roportional g

rowth

World Oil Demand & Real Income, 1965-2006

Oil product shares of total demand, 1971-2005

1971 1975 1980 1985 1990 1995 2000 20050

10

20

30

40

50

60

70

80

90

100

% oftotal

worlddemand

Gasoline

Other Kerosene

Gas-Diesel

Jet Fuel

LPG

Residual Oil

MiscellaneousNaphtha

1. OECD demand reductions after the price shocks of the 1970s: mostly due to fuel-switching, away from oil. Been there, done that.

2. Did not un-do these demand reductions when price fell in the 1980s.

3. Cannot re-do these fuel-switching reductions in demand when price triples in 2003-2007.

Reduce Oil Demand When Price Jumps?OECD: Been there, done that.

1. OECD demand reductions after the price shocks of the 1970s: mostly due to fuel-switching, away from oil. Been there, done that.

2. Did not un-do these demand reductions when price fell in the 1980s.

3. Cannot re-do these fuel-switching reductions in demand when price triples in 2003-2007.

Personally, I haven’t reduced my heating oil use at all in 2003-2007. In fact not since 1981 have I reduced it – to zero, when I switched to natural gas.

Reduce Oil Demand When Price Jumps?OECD: Been there, done that.

Been there, done that: Sweden & USASw

eden

Electricity Generation

Residential Fuel Use

Industrial Fuel Use

USA

0

5

10

15

20

25

30

35

1971

1975

1979

1983

1987

1991

1995

1999

2003

Other

Nuclear

Hydro

Coal

Gas

Oil

0

2

4

6

8

10

12

1971

1975

1979

1983

1987

1991

1995

1999

2003

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

2

4

6

8

10

12

14

16

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

200

400

600

800

1000

1200

1971

1975

1979

1983

1987

1991

1995

1999

2003

Other

Nuclear

Hydro

Coal

Gas

Oil

0

50

100

150

200

250

300

1971

1975

1979

1983

1987

1991

1995

1999

2003

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

50

100

150

200

250

300

350

400

450

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

Conventional price-response: Econ.101

Oil Demand$0

$10

$20

$30

$40

$50

$60

Rea

l Oil

Pri

ce

year 1

year 2conventional,price-symmetric,price-reversibledemand

year 3

year 4

year 1: low price & high demandyear 2: price has increased,

demand is reducedyear 3: price increase is reversed,

and demand reductions are reversedyear 4: second price increase,

and demand reductions are repeated

The response to the second price increaseis the same as for the first.

Been there, done that: Asymmetric price-responsiveness

Oil Demand$0

$10

$20

$30

$40

$50

$60

Rea

l O

il P

rice

year 1

year 2

price-asymmetric,price-irreversibledemand

year 3

year 4

year 1: low price & high demandyear 2: price has increased,

demand is reducedyear 3: price increase is reversed,

but demand reductions are not un-doneyear 4: second price increase,

but demand reductions cannot be re-donebecause they w ere not un-done

The response to the second price increaseis much smaller than to the first.

Crude Oil Price and World Oil Demand: asymmetric price-responsiveness,

especially for Residual Oil

Total Oil Residual Oil Other Oil

0 2 4 6 8 10 12 14 16

Total Oil per capita(b/d per 1000 people)

$0

$20

$40

$60

$80

$100

Cru

de

Oil

Pri

ce

1965 1973

1980

1986

2006

0 1 2 3 4 5

Residual Oil per capita(b/d per 1000 people)

$0

$20

$40

$60

$80

$100

Cru

de

Oil

Pri

ce

19651973

1980

1986

2006

0 2 4 6 8 10 12

Other Oil per capita(b/d per 1000 people)

$0

$20

$40

$60

$80

$100

Cru

de

Oil

Pri

ce

1965 1973

1980

1986

2006

OECD:Fuel Inputs to Electricity Generation, 1971-2005

OECD North America

OECD Europe

OECD Pacific

0

200

400

600

800

1000

1200

1971

1975

1979

1983

1987

1991

1995

1999

2003

Other

Nuclear

Hydro

Coal

Gas

Oil

0

100

200

300

400

500

600

700

800

1971

1975

1979

1983

1987

1991

1995

1999

2003

Other

Nuclear

Hydro

Coal

Gas

Oil

0

50

100

150

200

250

300

350

400

1971

1975

1979

1983

1987

1991

1995

1999

2003

Other

Nuclear

Hydro

Coal

Gas

Oil

OECD: Residential Energy Use, 1971-2005

OECD North America

OECD Europe

OECD Pacific

0

50

100

150

200

250

300

350

1971

1975

1979

1983

1987

1991

1995

1999

2003

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

50

100

150

200

250

300

350

1971

1975

1979

1983

1987

1991

1995

1999

2003

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

10

20

30

40

50

60

70

80

90

1971

1975

1979

1983

1987

1991

1995

1999

2003

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

OECD: Industrial Energy Use, 1971-2005

OECD North America

OECD Europe

OECD Pacific

0

50

100

150

200

250

300

350

400

450

500

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

50

100

150

200

250

300

350

400

450

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

0

20

40

60

80

100

120

140

160

180

Mill

ion

To

ns

Oil-

Eq

uiv

alen

t

Other

Electric

Coal

Gas

Oil

OECD transportation oil demand

• Income-responsiveness of demand: increased vehicle ownership (but saturation in US) and larger, more powerful vehicles

• Price-responsiveness of demand: o slow adjustment in usage & fuel efficiencyo more symmetric than non-transport oil

demand with respect to price increases and decreases

Fuel-efficiency & weight of new US vehicles, 1975-2005: partially symmetric price-responsiveness

2500 3000 3500 4000 4500 5000

Weight (lbs.)

0

5

10

15

20

25

30

35

MP

G

30Ton-Miles

per Gallon

40

1975

2005

Cars andLight Trucks

50

1987

Residual Oil Other Oil

1971 1976 1981 1986 1991 1996 2001 20060

100

200

300

400

500

600

700

800

Crude Oil

USACanada

Japan

1971 1976 1981 1986 1991 1996 2001 20060

100

200

300

400

500

600

700

800

Crude Oil

USACanadaJapan

1971 1976 1981 1986 1991 1996 2001 20060

100

200

300

400

500

600

700

800

Crude Oil

France

Germany

Italy

UK

1971 1976 1981 1986 1991 1996 2001 20060

100

200

300

400

500

600

700

800

Crude Oil

France

Germany

Italy

UK

Real Oil Price Indices, 1971-2006 (1971 = 100): G-7 countries

Another reason for little response of world oil demand: although crude oil prices tripled in 2003-07, there have been much smaller increases in end-user prices including taxes.

10 20 30

Real Income per capita (Th.$)

3

4

5

6789

10

20

30

40

50

60

Oil

pe

r 1

00

0 p

eo

ple

(b

/d)

OECD

Residual Oil

Other Oil

Total Oil

equi-proportional growth

1971

2006

2006

1971

2 3 4 5

Real Income per capita (Th.$)

1

2

3

4

5

6789

10

20

Oil

pe

r 1

00

0 p

eo

ple

(b

/d)

Oil Exporters

Residual Oil

Other Oil

Total Oil

1971

1971

2005

equi-proportional growth

2005

Real Income per capita (Th.$)

0.1

0.2

0.3

0.40.50.60.70.80.9

11

2

3

45678

Oil

pe

r 1

00

0 p

eo

ple

(b

/d)

China

Residual Oil

Other Oil

TotalOil

2006

1971

2006

1 2 3 4 5

Real Income per capita

0.5

0.6

0.70.80.9

11

2

3

4

5

6

Oil

per

100

0 p

eop

le (

b/d

)

Income Growers

equi-pro

portional g

rowth Total Oil

Other Oil

Residual Oil

1971

2005

For the past two decades, Other Oil demand has increased as fast as income in China, the Income Growers, and Oil Exporters – albeit more slowly in the OECD.

Gately, “What oil export levelsshould we expect from OPEC?” Energy Journal, 2007

Gately, “What oil export levelsshould we expect from OPEC?” Energy Journal, 2007

1971-2003: 7.6% annual % growth for oil demand and 5.1% for GDP: oil grew much faster than GDP

IEA & DOE projections to 2030: OPEC oil consumption will grow much slower than GDP

Elasticity assumptions usedin our demand projections to 2030

Income elasticity of demand = % change in demand / % change in income(holding price constant)

Price elasticity of demand = % change in demand / % change in price(holding income constant)

Comparison of our projections to 2030with those of IEA, DOE, & OPEC

(with constant real prices)

Projections of World Oil Demand (mbd)

2005 2010 2015 2020 2025 203080

90

100

110

120

130

140

this paper

IEA Medium-TermOil Market Report

IEA World Energy Outlook (2007)

DOE InternationalEnergy Outlook (2007)

Conclusions • The story of world oil demand over the period 1973-2007 is a

tale of two oil products. Demand for Residual Oil has fallen by one-third, while the demand for Other Oil has doubled.

• Most of the reductions in oil demand were due to reductions

in residual oil (and home heating oil) after the two price shocks of the 1970s – the result of fuel-switching to coal, natural gas, and nuclear for electricity generation, especially in the OECD, rather than improved technological efficiency. These fuel-switching demand reductions were not un-done when oil prices collapsed in the 1980s – strong evidence of asymmetric price-responsiveness – and thus cannot be re-done when oil prices increase again. However, the world still uses 10 mbd of residual oil (of 84 mbd total), making further reductions possible.

Conclusions , continued • Now that Residual Oil’s share of Total Oil has declined from

28% in 1973 to 12% today, future changes in Total Oil demand are dominated by what happens to Other Oil. In most of the developing world, demand for Other Oil has increased almost as rapidly as income since 1973, and half as fast as income in the OECD.

• The price-responsiveness of demand for Other Oil has been much smaller than for Residual Oil, especially among the Income Growers, China, and the Oil Exporters. There has been some evidence of asymmetric price-responsiveness for Other Oil, but only within the OECD – the result of fuel-efficiency improvements that were not abandoned when oil prices fell. However, some OECD reductions in transport oil have been partially reversed by oil price declines, as consumers have chosen vehicles that are heavier and more powerful.

Conclusions , continued • Our analysis suggests – at current real prices – weaker

demand growth over the next decade in comparison with IEA and DOE, but much stronger growth beyond 2015. Over the period to 2030 we project that the ratio of world oil demand growth to income growth will be 0.53. In contrast, they project that – at current real prices – this ratio will be only 0.36 (IEA) or 0.34 (DOE). By 2030, this would be a difference of 20 mbd between our projections and theirs – roughly the production of two Saudi Arabias.

• Since such rapid demand growth is unlikely to be supplied, real world oil prices would have to increase substantially by 2030 in order to slow demand growth, or income growth would have to slow substantially, or both.