Oil: The New Reality

As demand continues to increase, how will the U.S., Asia, and Europe cope with sustained high oil prices? S&P takes a look

by David Wyss From Standard & Poor's RatingsDirect

Rising oil prices are pinching the wallets of consumers worldwide. And although oil may be in for some short-term drops, most experts agree that the days of cheap gasoline are gone and prices will continue to climb steeply over the long term. Can oil production keep up with rising demand, particularly from India and China? And will alternatives be available before it's too late? With so many questions, and so few answers, the only thing there's no shortage of is uncertainty.

Oil approached a record $145 barrel in early July. Although many observers believe the price is higher than supply and demand justify, it continues to rise. Moreover, the normal symptoms of too-high commodity prices—building inventories and significantly declining usage—have not appeared.

Standard & Poor's (MHP) continues to believe prices will come down in the short run but that they are cycling around a rising trend. Demand continues to mount because of economic growth in Asia. Oil output is increasing only slowly, in part because so much of the world's supplies are now in the hands of national oil companies, which have less incentive to raise production. The amount of oil still in the ground, though unknown, is clearly finite.

Skyrocketing Asian Demand

Energy demand in non-Japan Asia is climbing much faster than in the developed countries. Although U.S. oil use rose at a 1.8% annual rate in 2000-05, and Western European demand was up only 0.4%, Asia-Pacific demand jumped 3.0%. These relative growth rates will probably continue for 25 years. During the current decade, projections are for China's energy demand to rise 9.9%, nearly double the Asia-Pacific average. By 2030, Asia is expected to use more energy than North America and Europe combined.

Energy intensity (energy used relative to gross domestic product) is high in most Asian countries, with the major exception being Japan. China, Taiwan, and South Korea are near the world average (measuring GDP on a purchasing-power-equivalent basis), while Japan is one of the most energy-efficient economies in the world. India and the other developing Asian economies, however, are far less efficient. They do have an advantage, in that they generally depend more on coal, and less on oil, than the world average. Although liquids account for 37% of world energy production, they are only 29% of production for the group of Asian nations that are not currently members of the Organization for Economic Co-operation & Development (OECD)—that is, all nations in the region except Japan, Australia, New Zealand, and South Korea. For instance, coal is 55% of current Asian production but only 27% for the world. China accounts for more than 40% of the world's use of coal and, as a result, has already passed the U.S. in total carbon emissions. Although China will probably increase nuclear production eightfold by 2030, its economy will still depend primarily on coal.

Many of these countries, notably China and India, subsidize energy consumption by controlling electricity and gasoline prices. Although this practice has shielded these economies from the most harmful aspects of energy price increases, it leaves their trade positions exposed and certainly makes overall energy efficiency lower. These subsidies are likely to cease. China has already moved to phase out controls on gasoline prices.

The U.S. Energy Information Administration (EIA) projects that non-OECD Asian demand will rise at a 3.2% annual clip through 2030, a total rise of 119%. About half the increase should come from coal, and by 2030, Asia will use nearly double the amount of coal that OECD countries use. Although the use of liquids will rise slightly less than the total, non-OECD Asia will still account for 73% of the rise in oil demand over the period.