In early May 2008 prices for crude oil are hovering around US$ 120 per barrel, and some are suggesting that they may reach US$ 200 per barrel. What does this mean for demand for oil in the world, in developing countries and, particularly, in China?  

 

The last thirty years of the twentieth century taught us very clearly that the basic laws of economics do apply to oil and ‘what goes up, must come down’. The high oil prices of the 1970s and early 1980s led to a marked change in behaviour, especially in OECD countries. Greater energy efficiency and switching to forms of energy other than oil  led to a 20% decline in total oil consumption in OECD countries between 1979 and 1983. Only in 1995 did consumption return to the levels of the mid-1970s. This response, combined with a substantial increase in production of oil from outside OPEC countries, provided the underlying cause for the subsequent fall of oil prices from highs above US$ 30 per barrel in the early 1980s to less than US$ 10 per barrel in 1986. Sustained high prices do indeed lead eventually to a fall in prices, but when and to what level is quite unpredictable. Last time it was thirteen years between the initial price rise in 1973 and the crash in 1986. The current upward trend in prices started in 1998. How long will we have to wait this time?

 

As before, the OECD countries are reacting to the high prices. Oil consumption in the USA fell by 1% in 2006. In Europe, oil consumption rose just 2% from 1998 to 2006, and was static in 2006. However it is the developing economies which have been and are continuing to drive the growth in world oil consumption. Since 1990 the developing countries outside the former Soviet Union have accounted for 60% of the world’s increased consumption of oil, and China alone has accounted for 23%.

 

In 2004 when world oil demand rose suddenly and stimulated an acceleration in the rise of oil prices, China’s oil consumption rose 16% which compared with a rise of  4% for the whole world and an average of 6% for other emerging economies. In that year China account for 33% of the increase in world’s demand for oil. Indeed the problem for players in the world’s oil markets is that China’s incremental demand for oil is so volatile: 10% in 2003, 17% in 2004, 3% in 2005, and 7% in 2006 and 2007. With China’s domestic production of crude oil rising at just 1-2% per year, and imports now accounting for 50% of consumption, these changes in overall demand for oil have a large impact on China’s net imports of oil from the international markets. These net imports grew by 30% in 2003 and 40% in 2004, were static in 2005, and rose by 15% in 2006.  The level of these net imports has a profound affect on international prices.

 

Thus those trying to predict the world’s future demand for oil in the short-term (a few months) and medium-term (a few years) pay special attention to China, for China is the unpredictable player which can make a major short-term impact on more steady and predictable trends driven by underlying demand in OECD countries and in other emerging economies. And, of course, the medium-term is composed of a series of short-terms, and therefore it is always important to understand the short-term.

 

But let us start with the underlying trends which might drive China’s oil demand, before looking at the short-term pressures.

 

China’s economic growth has been rising steadily each year since 2001 and according to official statistics reached 11.4% in 2007. The first quarter of this year has seen some success in government attempts to rein in this growth, with GDP up by just 10.6% on an annualised basis. All other things being equal one might expect these efforts to continue and growth rates to continue to decline slowly for a few months or longer. But the key unknown is the extent to which the economic downturn in North America and Europe will affect China and other emerging economies. A prolonged and deep recession in the West would undoubtedly have a significant negative impact on China’s economy and therefore on the country’s consumption of oil.

 

 At the same time China’s energy intensity is falling steadily as government policies to constrain energy consumption start to bite. Official statistics indicate that energy intensity fell by 3.27% in 2007, an improvement on the decline of just 1.23% in 2006. But much of the effort to constrain energy demand has been directed at industry, particularly heavy industry, and industry uses mainly coal and electricity, not oil. It is not yet clear whether demand for oil, which is used mainly for transport, is behaving in the same way as demand other forms of energy. Will demand for oil also start to rise more slowly or will it behave differently from other forms of energy?

 

The main forces driving demand for oil upwards in China are the transport sector, the petrochemicals industry, agriculture and residential use of liquefied petroleum gas. It is the transport sector in particular where the government has over many years failed to introduce policies to constrain the demand for oil. Until recently transport policy seems to have been based on roads, automobile manufacturing and private car ownership. These forces have been further supplemented by the unwillingness of the government to pass cost increases for oil products through to consumers. Thus citizens are encouraged to buy cars and to drive them. The number of light vehicles on the roads has increased threefold since the year 2000, and is projected to double or triple again by 2015.  Only recently have some cities started to invest heavily in public transport.

 

One critical yet quite unpredictable variable concerns China’s strategic stocks of oil. These have been under construction for several years and some sites are already complete. As and when China starts filling these tanks, the impact on oil prices is likely to be significant.

 

There are a number of factors constraining demand for oil, in addition to the possible decline of economic growth. Tough fuel efficiency standards and higher taxes for large new vehicles will have a beneficial effect on demand over the coming years, but not in the short-term. Likewise plans to develop coal-to-liquids and biofuels may also have a moderating impact on medium and long-term demand. In the short-term the government has taken measures to reduce the use of oil in both power generation and in other industries.

 

So, looking to forward over the next seven years, existing forecasts suggest that China’s net imports of oil, in all forms, may rise from nearly 200 million tonnes in 2007 to between 300 and 400 million tonnes by 2015. Those who believe that the economic recession in the west will be deep and contagious and those who believe that China will successfully implement energy efficiency policies relating to oil consumption would tend to favour a level of net imports nearer 300 million tonnes. Those who are more optimistic about the world economy and more pessimistic about the government’s oil policies would  favour a higher level. The difference between the two is substantial in terms of the pressures on international oil markets.

 

To gain a different perspective, let us look at the short-term outlook. During the first quarter of 2008 the level of imports of both crude oil and oil products have risen at an annualised rate of nearly 15%. Actual levels of consumption have been artificially constrained by a number of supply restrictions, including the unwillingness of oil companies to run their refineries at full capacity and lose yet more money (see my column last month). Despite these shortages, demand for oil in the first three months of 2008 appears to have risen at an annualised rate of 5%, and the main season of agricultural use is only just starting.

 

The priority of the government in recent weeks has been to maximise the availability of oil and this is likely to continue until at least the time of the Olympic Games. The government has exhorted the companies to import and refine more oil. Further, it has agreed to continue paying subsidies for the loss-making oil refining operations not only to Sinopec but also to PetroChina, and now on a monthly basis not just once a year. This new policy may be driven not just by the commercial needs of the companies themselves, but also by the desire of the government to support the share prices of these companies which are major stocks in the domestic stock markets. With domestic stock markets having fallen nearly 50% since last autumn, the government cannot afford to have another downward pull on share prices, not least because of the social unrest a further decline in the stockmarkets might trigger. Likewise, fears over rising inflation have led to the government continuing to resist pressures to raise the end-user prices for gasoline and diesel.

 

So, in the short-term, all the pressures on oil demand in China seem to be upwards. If that was not enough, continuing electrical power shortages in Guangdong may be driving manufacturers to bring out their diesel generators to keep their factories going. It was this use of oil that was a key factor in the unexpected surge of demand in China in 2003 and 2004.

Philip Andrews-Speed is Director of the Centre for Energy, Petroleum and Mineral Law and Policy at the University of Dundee, UK