Falling oil demand puts OPEC in a bind

-- John Kemp is a Reuters columnist. The opinions expressed are his own --

By John Kemp

LONDON (Reuters) - For the last two years, analysts have argued about how far oil demand would respond to the rise in prices.

But in the past few weeks evidence of a sharp decline in demand has become incontrovertible, resulting in big cuts in forecast oil demand, and posing a sharp dilemma for OPEC about how to respond when ministers meet on Nov 18.

The International Energy Agency (IEA) has been steadily dropping its demand forecasts for more than a year, as surging prices have forced conservation measures and substitution for cheaper fuels, while a slowing economy, especially in the United States, bites further into demand.

Back in July 2007, the agency forecast global crude consumption would hit 89.8 million barrels per day (bpd) in Q4 2008. Fifteen months later, the forecast had been cut by a massive -2.2 million bpd (-2.4 percent) to just 87.6 million bpd. Most of the reduction has been concentrated in North America, where the IEA has cut its prediction by -1.6 million b/d (-6.1 percent).

The IEA still believes crude consumption will be higher than in the same period last year (+400,000 bpd) -- but it would be the slowest rate of growth in more than five years, and the forecast increase relies on continued growth in China (+500,000 bpd) and the Middle East (+400,000 bpd) to offset projected declines in North America (-900,000 bpd).

It is not clear how well emerging market demand will hold up if the advanced economies tip into recession.

OPEC therefore faces an awkward choice over how to respond. It is under pressure to allow prices to settle at lower levels as its own contribution to stabilizing financial markets in consumer countries and averting a deep and prolonged worldwide recession.

Unless it begins to rein in supply now, the market could emerge from the winter heating season with higher stocks than normal, requiring even larger cuts in Feb 2009 or a vertiginous drop in prices reminiscent of 1998.

The difficulty is judging how much to cut supply to avoid a massive stock-build, while at the same time allowing prices to fall to buy back some of the demand that has been lost.

Despite its reputation as a profligate energy user, the United States achieved a real and lasting reduction in crude oil use following the oil shocks of the 1970s and early 1980s. Oil was substituted by natural gas for power generation, while much-maligned motor manufacturers achieved significant and durable improvements in engine technology.

Between 1973 and 2008, U.S. output rose +172 percent. The resident population rose +44 percent. Oil consumption was up just +14 percent. Per capita consumption was cut almost a third, from 34 bbls in 1976 to 23 bbls in 2008. Consumption per $1000 of GDP (2000 prices) fell two-thirds from 1.6 barrels to 0.6.

Some of the decline is more apparent than real. "Contained" petroleum consumption has fallen by less than the raw figures suggest, and natural gas consumption has risen sharply.

Manufacturing activity has shifted overseas to emerging markets such as China, and the attendant crude consumption moved with it.

Nevertheless, the oil shocks were followed by a significant structural decline in oil demand that has never been fully reversed.

Some of those gains were dissipated in recent years by the trend to larger cars, longer commutes from distant exurbs, and larger homes. Fuel economy of new vehicles sold in the United States improved from 26.9 miles per gallon in 1975 to 43.1 miles per gallon in 2008 (+60 percent).

But auto makers used the improvements to build bigger and more powerful cars. Average weight increased +28 percent while horsepower doubled. The result is that the achieved fuel efficiency of new U.S. vehicles has fallen from a peak of 22 miles per gallon in 1987 to 20.8 in 2008.

Meanwhile, the average floor area of newly built homes, and hence the space to be heated, has risen a fifth in just nine years.

Efficiency gains ground to a halt in the 10 years between 1993 and 2003. But as crude oil prices surged from around $30 per bbl in 2003 to a peak of $147 earlier this year, renewed pressure for conservation has been intense.

Households have largely abandoned the market for sport-utility vehicles in favor of smaller and more fuel-efficient cars. Even where they continue to use the same vehicle, there is evidence they are driving less. Bureau of Transportation Statistics data show the number of miles driven has fallen -2.1 percent since last autumn.

It is the first year-on-year decline since the government began compiling the data in this form in 1983. Pressure for increased fuel efficiency is replicated across other modes of transport. Union Pacific railroad has cut its reported diesel consumption per ton-mile 8 percent.

There are widespread reports of logistics systems reconfigured to produce shorter (less costly) supply chains and emphasize increased inventory holdings and fewer but fuller batch deliveries to minimize the number of miles traveled per unit sold. Airlines have slashed domestic schedules to run fewer but fuller planes and cut jet-fuel consumption.

Even in the power sector, the remaining molecules in the power stack have been almost phased out. Power producers' consumption of petroleum liquids has fallen -70 percent from 15.5 million bbls per month in H1 2003 to 4.5 million bbls per month in H1 2008.

Generators are on course to cut consumption by -49 million bbls by the end of the year -- equivalent to a massive five days' worth of U.S. crude oil imports.

Petroleum demand was therefore falling sharply even before the credit crunch became a crisis. But following the onset of the credit crunch, consumption appears to have collapsed. During the four weeks ending Oct 3, product consumption was almost -8 percent lower than in the same period last year.

The rapid decline in the product supplied mirrors last month's collapse in the Institute of Supply Management (ISM)'s widely watched business activity index from 49.9 to 43.5. It was the largest one-month fall since Oct 2001, and takes the index far below the 50-point threshold that divides expanding activity from a contraction.

The U.S. economy looks set to slow further in the next six months as the credit crisis spreads from the financial side of the economy to the real one. Oil consumption is almost certain to soften further unless there is a very harsh winter.

In the run up to the ministerial meeting, OPEC's task is to remove enough surplus barrels from the market to avoid a destabilizing inventory overhang when the winter is over, while not encouraging a renewed spike in prices that would intensify the recession in consumer countries.

But in stabilizing inventories and prices, ministers will also have to estimate how much demand is being lost as a result of long-term factors linked to the escalation in prices, and how much is being lost from a short-term cyclical downturn.

Cyclical effects should eventually reverse, but demand destroyed by structural shifts may be much harder to recapture.