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Are We Headed for Another Oil Shock?

As the global economy recovers from the current downturn, there is a significant risk that resurgent energy demand will coincide with tight supply, vaulting oil prices higher again. Indeed, prices are already on the rise. Research by the McKinsey Global Institute (MGI), combining macroeconomic modeling with an understanding of industry dynamics, finds that unless business leaders and policymakers act decisively on both oil supply and demand, there is a risk that a second oil shock could follow economic recovery—indeed, one that could be lengthier than the second price spike that hit the world economy in the 1970s.

In the 1970s there was a silver lining to the twin shocks. For a long time after, energy demand remained subdued and the world saw a revolution in energy efficiency and substitution. Never again, policymakers vowed, would they allow soaring energy prices to take their economies hostage.

As it did in the 1970s, energy demand likely will surge once the world economy expands again. MGI expects demand to grow more than 2% annually between 2010 and 2015, nearly a full point faster than in the period from 2006 to 2010. At the same time, we face a supply picture that is less promising than it was in the 1970s.

Sudden withdrawals of supply led to both 1970s oil shocks—an OPEC embargo in the first, and the collapse of Iranian oil supply in the wake of Iran's revolution in the second. But in the aftermath of both episodes, supply grew rapidly, boosted by the fact that OPEC and non-OPEC countries were able to take advantage of the discovery of new fields.

The Trouble with Supply Today, tight credit as well as uncertainty about oil price levels is compromising investment in new supply. Even after the credit crunch eases, producers could remain cautious in the face of strenuous efforts by markets such as the U.S. to lessen their dependence on imported oil, adding uncertainty to the demand outlook. In any case, even in a more benign investment environment, producers will find adding supply capacity more difficult than they did in the 1970s because of the challenge of producing oil from rapidly maturing oil fields and the difficulty of finding new low-cost oil fields.

One way to avoid imbalance in the oil market in the face of constrained supply is higher prices that dampen demand—but the transmission mechanism is much weaker today than it was in the 1970s due to energy subsidies and the lower energy intensity of many economies. In this context, fuel substitution and higher energy efficiency become vital checks on demand.

Here, too, the prospects appear less promising than they did in the 1970s. Back then, the twin oil shocks triggered improvements in energy efficiency and a substitution to different types of fuel, spearheaded by developed countries. These moves reined back demand for a long time. Such efforts continue today and are paying dividends—in the U.S., for example, both demand for fossil fuels and per capita energy consumption will fall between 2006 and 2020. Overall OECD fossil fuel demand will be almost flat.

But decisive action by developing regions is vital this time because they will account for 90% of energy demand growth between now and 2020. Even if the current recession proves to be deeper than the downturn in the 1970s, rapid growth in developing economies would boost global energy consumption significantly.

Reducing Global Demand There are many actions that policymakers can take, even in the short term, to abate energy demand in parallel with measures to ensure supply, and these need not come at a high cost. We calculate that investments to increase energy productivity that offer investors a return of 10% or more could reduce global oil demand by as much as 10% by 2020, or between 6 million and 11 million barrels per day—the amount required to keep demand and supply in balance.

But although some developing countries have taken action on energy efficiency—China's fuel-efficiency standards, for instance—these efforts are not yet sufficiently broad-based or robust. Moreover, it is unlikely that developing countries will substitute fuels at the rate witnessed in the 1970s when developed economies were able to make "easy" switches. Today, for example, residual fuel oil comprises only 12% of total petroleum-products demand, and nearly half of the total is used for marine bunkers where no real substitute is available. Finally, one potential quick win—the removal of fuel subsidies, largely in the Middle East—could cut 2 million to 3 million barrels per day of demand in 2020 but is unlikely to materialize for political reasons.

It may already be too late to avert a second oil shock that could develop as early as 2010, depending on how quickly the global economy recovers. This is not to say that developing countries should take a laissez-faire stance toward energy demand. A vigorous emphasis on shifting to fuels that are potentially more plentiful offers additional significant demand-abatement potential. Action to boost energy productivity—the output achieved for a given amount of energy consumption—in industry and buildings could abate 6 million barrels per day. (With higher energy productivity in light vehicles, this would rise to 8 million barrels per day.)

In developed countries, removing trade barriers to sugar-cane ethanol, requiring all vehicles to be flex-fuel, and reversing the recent shift to diesel in passenger vehicles would be useful steps. Increasing the size limit for trucks could save between 0.5 and 1.0 million barrels per day. In the longer term, investing in nascent technologies—particularly electric vehicles and biofuels—will come into play. Investing in public-transportation infrastructure also will be important, particularly in developing countries that are building new capacity on a large scale.

Any and every policy to abate energy-demand growth will make a useful contribution—in the short term, mitigating the damage of a second shock on the world economy; and in the long term, laying the groundwork for a sustained period of balance in oil markets that will underpin the world's future prosperity.
Scott S. Nyquist is a director in McKinsey & Co.'s Houston office and a leader in McKinsey's global energy and materials practice.

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