Recession & Oil Demand
Oil industry players find themselves buffeted by contradictory trends. On the one hand, the oil supply has not expanded adequately in recent years to accommodate demand from emerging markets. On the other, the current recession has led to a collapse of near-term demand. Energy investors and oil industry managers are left mulling how to respond to the current environment and whether to forge ahead with investment or wait cautiously on the sidelines. Understanding the linkage between recession and oil demand may provide some guidance.
The US has regularly suffered recessions. According to the National Bureau of Economic Research (NBER), recession has struck America 20 times in the last century, every five years on average. It is not a rare or unusual event. In fact, it is the relatively unbroken prosperity of the last 25 years which is unprecedented. There is no comparable period since economic statistics were first gathered.
As financial crises go, the current recession is arguably the worst since the Crash of 1929. However, as recessions go, the current economic situation is relatively severe, worse than those of 1991 or 2001, for example, but to date less severe than the double-dip recession of 1980-1983. Most recessions last less than 18 months from peak to trough and in fact only three in the last century, including the Great Depression, were longer. Economists are currently split on the course of the recession. Some argue for a mid-year trough, which would represent an 18 month contraction. This represents the more optimistic case. It is supported by January job loss numbers at expected levels and by the relative stability in share prices, which tend to bottom six months before the real economy. More pessimistic economists point to weaker than expected consumer spending and project a Q3 trough.
How does oil demand respond in recessions?
In the US, oil demand declines during recessions. In a mild recession, as in 1991 and 2001, demand will drop from peak by about 0.5 million barrels per day (mbpd), or about 3%, during the trough month. In a severe recession, as in 1974 or 1981, demand will fall by perhaps 1 mbpd, or as much as 7%. In the current recession, oil demand briefly dropped nearly 3 mbpd from its peak, about half of which occurred in September 2008 in the aftermath of the collapse of financial markets following the bankruptcy of the investment bank Lehman Brothers. If we allow that this will be a severe – but not catastrophic – recession, then a drop of 7%, or 1.5 mbpd of US consumption from peak to trough, is entirely possible. This would suggest US demand could fall from its December 2007 level of 20.3 mbpd to 18.5-.19.0 mbpd near the middle of this year.
How does the US experience translate into global impact?
Until Until 1990, US business cycles dominated global oil markets. The US recessions of 1974 and 1979 (following the Iran crisis) were widely felt and in both cases global consumption fell. However, after 1990, US recessions barely registered on global oil consumption and trend lines remained largely intact.
The current recession has had a dramatic effect on global oil consumption which in September 2008 fell 3 mbpd below its historical peak, with most of this explained by the drop in US consumption. Going forward, global consumption could drop by up to 7% from peak to trough, that is, by 6 mbpd. However, the emerging economies are unlikely to fall as much; therefore, a total drop of around 4 mbpd (about 5%) to 83 mbpd would seem in the right range.
This projection comes with a significant caveat. In the first half of 2008, sky-high oil prices were visibly suppressing consumption and indeed the lion’s share of decrease in US consumption occurred during the first half of the year. With the collapse of the oil price, fuel has become much more affordable, enticing drivers back into their cars. This shows in the EIA’s statistics. Although US consumption has remained below peak levels, the gap narrowed every month from September through to year-end. For December, global demand, as recorded by the EIA, shattered the all-time record of November 2007 by 1.2 mbpd. These numbers suggest that low oil prices, even in a weak economy, can stimulate demand.
More recently, the trend appears to be reversing itself. Provisional EIA figures for January suggest a drop in US demand of approximately 400,000 barrels per day from December, suggesting that falling incomes are beginning to outweigh lower oil prices. By rights, global oil demand should decline perhaps 2-3 mbpd by the end of the first quarter.
And what of the recovery?
As a crude rule of thumb, the recovery from the trough should take approximately as long as the drop from the previous peak to the trough. Therefore, if we assume that the current recession will last 18 months and bottom in mid-year 2009, then consumption should recover its earlier peaks around the beginning of 2011. Where will it go from there? The recession of 1980-1983 shows that oil demand can stay suppressed for many years. Nearly a decade passed until global oil consumption regained its 1979 levels. But that period was anomalous. Demand dropped because OPEC raised the price of oil to nearly $40 / barrel from $15 and it stayed above $30 until 1986 when two recessions had managed to wring incremental demand out of the system.
A more likely scenario is one which has accompanied every other recession in the last 35 years. In these, after the recession, demand recovered its earlier level in fairly short order. In some cases, the recovery from a recession was accompanied by soaring demand. For example, from the end of the first oil shock in 1974 until the second oil shock of 1979, demand increased by nearly 9 mbpd. What was occurring during this period? The US and Western Europe were completing the process of motorization. The automobile was becoming a staple of everyday life.
How will oil demand recover from this recession? The driver is likely to be China, just as it has been since 2003. China is becoming middle class and with that comes an appetite for automobiles. The country is already the world’s largest manufacturer of vehicles and will quickly become the world’s largest car market. The process of motorization experienced in the western world from 1950-1970 is beginning to occur in China now. And China has by far the world’s biggest labor force, of 800 million, almost twice that of America, the European Union and Japan combined. As they become wealthier, many Chinese will be looking to acquire a vehicle. How will this affect oil demand? Consider a similar period in western development: In just 12 years, from 1960 to 1972, global oil demand increased by almost 30 mbpd, nearly four times the current output of Saudi Arabia.
Therefore, the recovery may look more like the recovery of 1974, where a decline in demand was followed by a rapid rebound.
How should an investor or acquirer time the market?
Oil demand is a coincident indicator for economic activity: it typically peaks with peak economic activity and bottoms at the trough of the recession. Therefore, the impact of weak demand should be most acute for the oil sector when the economy hits bottom. As we do not discount more optimistic forecasts for a mid-year bottom for the economy, we believe investors would be better served by being prepared to lock in transaction values at that time (noting here that we have not made any estimate of the timing of oil demand to equity valuations, corporate liquidity positions, or negotiating psychology). Investors should consider making investment preparations in the first quarter – assessing markets, preparing strategy, obtaining approvals and selecting targets – to be prepared to capitalize on emerging opportunities from the second quarter forward. Bleak as the recession can be, 2009 may well be remembered as the entry point for the next economic cycle.
Steven Kopits
Managing Director, Douglas-Westwood, New York
Douglas-Westwood is a leader in market analysis and transaction support in the energy sector, with recognized expertise in offshore oil and gas exploration and production, as well as wind and tidal power. The company’s market survey, research, analysis and strategy services are used by clients in 50 countries with over 550 assignments completed since formation in 1990. In the past year alone, the company has completed market due diligence on M&A and financing deals totalling $10 billion. Its client roster comprises the world’s leading financial and energy companies, including JP Morgan, Morgan Stanley, Simmons & Company International, RBS, Shell, BP, ExxonMobil, Schlumberger, Baker Hughes, 3i and Arcapita.
