The invisible assassin stalking oil demand

FT.com

The conventional wisdom holds that global oil demand will continue to rise. Demographics and the need to fuel emerging markets make it so, says the consensus in the energy industry. However, the consensus is wrong. This is due to the substitution of natural gas – often obtained through the hydraulic fracturing of shale rock, or fracking – for oil, and fuel-efficiency mandates in many key countries. The prospect of oil demand hitting a plateau this decade is much more feasible than the market seems to think.

The shale revolution in the US has already upended energy markets. There is more to come. US natural gas prices have recovered from below $2 per million British thermal units (the standard metric for natural gas prices) over the past 12 months, but it still remains much cheaper than oil. The market seems to be slowly accepting that the spread between gas and oil will stay wide for the foreseeable future.

This has resulted in a rush in the US to substitute natural gas for oil. It will soon go global. Environmental concerns, politics and sheer availability are all facilitating the spread of the substitution trend.

The usual bullish arguments for oil demand growth rely on China and other emerging markets and the low level of car usage rates among consumers in these countries. More money, more drivers, goes the logic.

What these arguments miss is that in 2010 cars only accounted for about 22 million barrels a day out of a global oil market of 87 million b/d, to use the size given by OPEC, the oil cartel. The rest of the demand comes from trucks (13mmbd), aircraft (5mmbd), ships (4mmbd), railways (2mmbd), petrochemicals (9mmbd), other industrial activity (14mmbd) and power (5mmbd) or heat generation (9mmbd).

Almost all of these sectors are using more and more natural gas, rather than oil. Aviation is an exception, though even here Boeing has a concept aircraft that runs on liquid natural gas and this year Qatar Airways made its first commercial flight running on a blend of conventional jet fuel and an oil-type fuel made from natural gas.

It is important to note that this shift is neither far off nor hypothetical. We are not looking at hydrogen-fuelled cars or Japanese methane hydrates. The substitution is already happening.

In the US the shift is visible in strategies of many companies, from Warren Buffett’s railway BNSF, to UPS and FedEx parcel delivery fleets, and Apache and other oil and gas exploration and production companies shifting their fracking and high-horsepower drilling rigs to run on gas as opposed to diesel.

The abundance of cheap gas in the US is helping drive an industrial renaissance. The US petrochemical industry is resurgent. US ethylene cracking – the process for making ethylene, a mainstay of the petrochemical industry – capacity is set to increase markedly from 2016, fuelled by cheap ethane and natural gas liquids. This is going to pressure foreign ethylene producers just as European oil refiners are buckling under the pressure exerted by their US counterparts.

Europe’s regulations are also putting pressure on its oil industry. In February the European Commission issued draft legislation that would mandate LNG filling stations be located every 400km on the core trans-Europe highway network. This same legislation will mandate LNG filling stations be located at all 139 maritime and island ports in Europe, also by 2020.

Crucially, China is also beginning to make the shift. There 8 per cent of heavy duty truck sales in 2012 were LNG-fuelled, taking the number of LNG trucks on the road to more than 40,000. This is partly down to economics but environmental concerns are also important, with many city governments increasingly worried about pollution.

In the US, Europe, Japan and China, tighter fuel economy mandates are increasing the fuel economy of the world’s fleet of vehicles. For example, research by Citigroup estimates that new vehicles’ fuel economy is increasing by about 2.5 per cent a year.

This change in fuel economy is enough to significantly cut the expected growth in global oil demand – and, of course, oil prices. When you add in the shift from natural gas to oil, it should be enough to stop the forecasters of another boom in oil prices in their tracks.

Seth Kleinman is global head of energy strategy at Citigroup.

Copyright The Financial Times 2013.