Substitution Effects Capping Future Oil Demand Growth

It is often said that the cure for high oil prices is high oil prices. Kuwait’s oil minister Mustafa Al-Shamali announced today that $100 to $110 a barrel is a fair price for oil but history may prove the minister wrong. History would argue that oil is a cyclical industry and that prices above competitive substitutes for oil invite fuel switching. Evidence is mounting that such substitution is already taking place.

Global oil demand growth has varied substantially over the last 60 years, with much of the variation directly attributable to response to movements in price. The average annual growth rate of oil demand from 1950 to 1973 was about 6.7%, but after the oil price shocks of the 1970s and early 1980s, demand growth slipped to only 1.6% for two decades. As oil prices were rising, substitution effects ushered in rising competition among a variety of fuels – including coal, natural gas, and renewables – in the industrial, residential, commercial, and power generation sectors across the globe. The same kind of transformation is taking place again and this time, the impact on the transportation sector is likely to be more significant this time around than the 1980s as improved natural gas and electricity vehicle fuel technologies proliferate. Citi suggests that oil-to-gas substitution in transportation, petrochemicals, industrial use and space heating could plateau oil demand growth by the end of the decade. All in all, Citi believes that as much as 20 million b/d of oil demand could be substituted away by natural gas.

Even if Citi’s optimistic assessment that some 9 million b/d of trucking diesel demand could be lost to natural gas doesn’t materialize, trends suggest that a combination of air quality and greenhouse gas emissions limits at ports could prompt a massive exodus of 3 million b/d in marine bunker fuel oil use in the coming years. Another 5 million b/d of demand is at stake from petrochemical firms that will find natural gas and NGLs a more economical feedstock than oil-based naphtha. Saudi Arabia has already announced it wants to eliminate its 1 million b/d plus crude oil burning for electricity, and other countries, notably Japan, aspire to do the same. Fuel switching to natural gas is also under consideration for rail, drilling production equipment and residential heating use.  

Pricing oil too far above its energy content relative to other energy resources is quickly driving the process of making other fuels or technologies commercially viable as substitutes for oil. The market in 2030 or 2040, rather than centering around a peak in conventional oil outside the Gulf as generally expected in the Middle East, might be more likely to center around a peak in demand.

As China responds to high global oil prices with policies encouraging energy efficiency as is currently unfolding, Chinese demand growth will also flatten out. Energy Intelligence Group projects that Chinese oil demand will end only 4% higher this year than last, versus double digit growth in the last decade. In July, Chinese oil demand actually fell compared to a year ago.

Under circumstances where China adds efficient equipment in the industrial and other sectors similar to investments made in the United States in the 1980s, it could shave as much as 4 to 5 million b/d off the growth in Chinese oil use, the Baker Institute calculates. Citi adds that China is pushing natural gas into its heavy trucking industry. Over 1,000 LNG filing stations are planned in 80 Chinese cities that already have more than a thousand such stations. The Institute of Transportation Studies at UC Davis will convene a conference on the topic this month in Beijing, co-hosted by the Development Research Center of the State Council. The Conference “Exploring Options for Natural Gas in Transportation in China” will bring together important Chinese policy makers, automotive and oil industry leaders and leading natural gas, automotive and academic experts and analysts to discuss the potential of natural gas to transform China’s trucking industry from a cost, energy security and air quality basis. Stay tuned for conference proceedings which will discuss the potential for natural gas to substitute for oil in China.