Oil is about to enter a phase of demand destruction: what it means and what implications it has

Oil returns to the load. After a few days of relief in prices (they fell by $40 in a short time), oil seems to have resumed its upward path given the stagnation of the war in Ukraine and the absence of quick and effective alternatives to replace Russian oil on the market. This Monday, the barrel of Brent is trading comfortably above 110 dollars, levels that, if maintained, will force a rebalancing of the market through ‘demand destruction’a painful process for which the International Energy Agency has already begun to prepare us.

Demand destruction in economic terms refers to a permanent or sustained decrease in the demand for a certain good (normally energy: oil or gas) as a last response to very high and persistent prices. Faced with scarcity and high prices, consumers look for ways to reduce the consumption of that good or try to find alternative ways that directly avoid its consumption.

The high price of oil has led to historically high prices for gasoline and diesel in developed countries. Economic theory ensures that the demand for oil is rigid in the short term, since the economic structure cannot change overnight. the morning: changing the operation of combustion engines or heating systems is time-consuming and expensive. But if the price of oil goes up a lot and stays there for a few months, the result can be lower consumption without the need to change the structure of the economy: This is demand destruction.

JP Morgan economists believe the oil market is rapidly approaching this scenario. For demand destruction to occur, oil has to stay near $120 for a few months.

However, “given the supply shock and barring progress in the peace negotiations, immediate demand destruction will be the only way to rebalance the market short term. Looking beyond the immediate, if oil stays around $120 for a few months, the hit to oil demand could be about 1.2 million barrels a day this year, leaving oil consumption at about $550,000. barrels per day below 2019 levels”.

Natixis analysts comment in a report that despite the latest movements in oil prices, the direction of the conflict between Ukraine and Russia will continue to be the key factor in prices in the short term. While a reduction in tension could end the current structure of backwardationthe continuation of the conflict increases the risk of sanctions (in the style of those imposed by the US or the UK), which could jeopardize imports of Russian oil in Europe.

Can Russia be replaced?

“While there are in theory enough barrels to fully offset the loss of Russian crude exports to Europe, the rate at which these barrels could reach the market is too slow compared to the immediate loss of Russian volumes. As such , in a scenario of total sanctions, the oil market would be forced to resort to demand destruction… This would be accompanied by oil prices significantly higher initially”assure Natixis analysts.

From the IEA they are somewhat more pessimistic and believe that this phase of demand destruction could be just around the corner. In its latest bulletin, the IEA has included within its scenarios a drop in demand due to the high prices of crude oil that responds to a drop in consumption derived from the high price of oil.

The IEA notes that “Russia may soon be forced to turn off the oil taps, as declining domestic demand is combined with an increasingly overwhelming voluntary embargo by international customers, as Sanctions scare away more buyers We estimate that, as of April, about 3 million barrels of Russian oil production could disappear from the market. As a result, total oil production plummets to around 8.6mb/d in April and since we cannot know how long the crisis will last, we have maintained that level until the end of the year.”

Given this scenario, the IEA has revised down oil consumption between the second quarter of 2022 and the end of 2022 by one million barrels per day. “There are actions that governments and consumers can take to rapidly reduce short-term demand for oil.” The IEA forecasts that demand destruction will be around 500,000 barrels per day in the remainder of the year. However, the fall in consumption could be greater if countries adopt a combination of measures to overcome the rise in crude oil quickly. Following feet together the decalogue of IEA recommendations could reduce crude oil consumption by 2.7 million barrels per day.

Some past examples of demand destruction due to an intense increase in prices are those of the oil crises of 1973-74 and 1979. During 1980, the ‘oil weight’ (the share of world GDP spent on oil imports) reached 7.3%. The impact of these higher oil prices on the economy, in addition to the strong short-term demand destruction (and the economic crises it triggered), prompted the world to look for new ways to continue to progress without having to consume so much energy derived from the Petroleum. Natixis experts explain that significant efficiency gains were achieved thanks to technological innovation by pushing oil out of power generation in favor of alternatives such as nuclear power and natural gas.

Another episode of demand destruction closer to home took place between 2007 and 2008 and had some reverberations between 2011 and 2014. On this occasion, in addition to the two crises that occurred in between, the developed world worked to improve the efficiency of cars, improved public transport and alternatives were sought (although linked to oil) that diversified the production of crude oil such as fracking in the US or operations in ultra-deep waters in Brazil.

Now, if oil stays high for a while (just like natural gas), in addition to short-term demand destruction, this could mean the definitive boost to renewable energies in the medium and long term. Price movements generate the most powerful incentives. The sales of electric cars or the installation of solar panels in homes and businesses, together with a greater investment in improving batteries to store energy, may be some of the trends that will receive a greater boost as a result of this new peak in oil .