Thursday, December 3, 2009

Dargay/Gately on Modeling Oil Demand

Year end is the season given to updates of long-range oil supply and demand forecasts, particularly from the OECD's International Energy Agency (IEA) and the US Energy Information Administration (EIA).  Many models used for forecasting rely on extrapolating past patterns.  However, is such a method reliable if those patterns reflect unrepeatable structural changes?

Is the oil demand pattern over past 40 years a reliable indicator of what may occur in the future? Or, as a very interesting research paper just released by NYU Professor Dermot Gately and Joyce Dargay of the Institute of Transport Studies at the University of Leeds in the UK indicates, has there been a one off structural change in the use of oil which if ignored and not backed out of past patterns could create a very large under estimation of potential oil demand? 

The one off structural change in oil demand was the global shift away from using oil for electrical power generation over the past 40 years.

Following is a summary of the paper in my words:

Dargay/Gately find that much of the efficiency in oil consumption in OECD countries since 1970 was due to oil being effectively phased out as an electricity generation fuel. The oil saved from electicity generation was used in transport. Transport demand for oil facilitates economic growth and is thus highly correlated with economic growth.

Now that this shift away from oil being used for electricity generation has been completed, growth in Total oil demand is going to be much more highly correlated to economic growth than it has been since 1970. Because of this, one cannot use growth in Total oil demand since 1970 as a predictor of future oil demand growth. Instead, growth in Total oil demand is likely to be higher than the 1970-today period.

Oil demand in 2009 is just over 84 million barrels per day (mbd). A major reason for the difference between the Dargay/Gately demand number by 2030 of 134 mbd and the IEA forecast of 105 mbd is due to Dargay/Gately incorporating the fact that the one off switching effect from electicity use to transport use cannot be repeated. Dargay/Gately are not stating that supply of 134 mbd or 105 mbd will be available. They are simply looking at the demand side of the equation and saying that if economic and population growth progresses as the OECD forecasts then the oil demand this implies is likely to be a lot higher than the IEA's forecast of 105 mbd.

The conclusion I take from Dargay/Gately's paper is that if supply is not available to meet this 134 mbd oil demand then economic growth cannot progress as the OECD forecasts and/or an extremely large and unprecedented change in the level of oil consumption efficiency will have to take place between now and 2030. This efficiency will likely be driven by high oil prices.

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