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False dawn for oil

EVs, fuel-economy standards and perceptions of supply abundance are not about to end oil-market volatility

Oil industry leaders, investors and government officials contemplating medium-term (say five-year-forecast) oil prices should be wary of the words "new normal". Consensus sees shale and electric vehicles (EVs) indefinitely penning crude oil prices in the $40-$60 range that has held since early 2015, with the exception of a single sharp decline below $30 in early 2016. We contend that the oil market remains firmly in a "boom-bust" era, characterised by large structural imbalances, and the absence of an effective swing producer, with no end in sight. Oil's recent relatively tight range is no more a new normal than the prior "new normal" interlude around $100 was from 2010-13. Medium term, expect surprisingly strong demand—despite efficiency and substitution policies—to help ignite the next boom phase. What we call "peak demand" should appear first in the next couple of years.

The unprecedented near quintupling in oil prices from 2003 to 2008 and then the 60% implosion in 2014 reflected a historical shift to a structurally unbalanced market needing, but lacking, an effective swing producer to stabilise oil prices. That oil prices ranged around $100 between 2009 and 2014 doesn't negate a return after more than eight decades to a "boom-bust" era. History shows oil prices can exhibit temporary stability during boom-bust eras, such as the mid-1920s.

Nonetheless, today's consensus is that oil prices have entered a "new normal" range with a ceiling around $60, as succinctly described by two IMF officials in October 2016: "For one thing, shale oil production has permanently added to supply at lower prices. For another, demand will be curtailed by slower growth in emerging markets and global efforts to cut down on carbon emissions. It all adds up to a "new normal" for oil."

There's some dissent, mainly on the supply side: Saudi Arabia and the International Energy Agency regularly warn that the collapse in investment is sowing the seeds of a "supply gap", future shortage, and price boom. There's much less debate among barrel counters about demand, however. The Energy Information Administration's (EIA) latest outlook represents consensus expectations that non-OECD demand will grow while OECD demand stagnates.

The recent and relatively docile $40-60 range is but an eye in a volatility storm that arrived over 10 years ago and shows no indications of abating

We think demand will be stronger. Looking first at the non-OECD, government forecasts have underestimated oil-demand growth by staggering amounts: in 2015 alone, the EIA upwardly revised non-OECD oil demand by 1.3m barrels a day between forecasts just a year apart.

Turning to the OECD, consumers have slowed or reversed the steady decline in per capita oil demand since oil's last boom phase some 10 years ago. Demand in the OECD has actually grown annually by 300,000 b/d on average since 2014, after declining at roughly the same rate since 2011. Nevertheless, official forecasts of future per capita demand in the OECD continue to fall. The EIA estimates OECD per capita demand to be roughly 5.5 litres/day in 2020, down 20% from their forecasts 10 years prior.

Like the non-OECD, Europe has also seen a recent boom in SUV sales, leading oil demand to surprise to the upside as less efficient cars bring up gasoline demand. But the first real test of policy-induced peak demand should come in the US over the next few years, when the EIA expects that federal fuel regulations and California's Zero Emission Vehicle (ZEV) mandates will trigger a sharp and permanent decline in gasoline demand. The IEA also forecasts a similar near-term peak in US gasoline demand.

EIA forecasts, starting in the coming year, assert that US gasoline demand will peak and sharply decline by approximately 10% (9.4m b/d today to under 8.5m b/d by 2025). The agency expressly attributes the peak and subsequent decline to federal fuel-economy regulations like the Corporate Average Fuel Economy (or Cafe) and California's ZEV. This forecast is a mirage. Barring a recession, US gasoline demand will continue to surprise to the upside for three reasons: historical precedent, consumer preferences, and weaker-than-advertised policy.

The EIA also predicted peak demand in the early-to-mid-1980s, following circumstances similar to the most recent forecast: an oil-price spike and the imposition of new fuel-economy regulations. But subsequent gasoline demand surprised to the upside as the regulations eased off, gas prices fell, and consumers plumped for bigger, thirstier cars.

Consumer preferences are a second headwind for policy-driven peak demand. The sales-weighted fuel economy of new car sales in the US has flattened since 2014, abruptly halting the steady growth seen since the records began in 2007. Total light truck sales as a share of total vehicle purchases have increased to new highs since 2014, after being negatively impacted by soaring oil prices.

With historical precedent and consumer preferences leaning against imminent peak gasoline demand, the burden indeed falls to policy—specifically federal efficiency regulations and California's ZEV mandates. The 42-year history of the Cafe programme proves that neither Congress nor the president will force Americans into cars they don't want to buy. After oil prices collapsed in 1986 and consumers turned to heavier cars, the Reagan administration lowered Cafe standards.

Soaring gasoline prices after the turn of the millennium helped convince the US to unfreeze and then increase the standards again. But less well understood is that Washington also reformed Cafe to address concerns about consumer safety. Cafe's fixed fleet-wide efficiency standards were replaced with much more flexible attribute-based standards—built to be loosened, should consumer preference shift towards heavier cars in times of low gas prices, a trend we have seen in recent years.

300,000 b/d—Annual average demand growth in OECD since 2014

The Trump administration is expected to relax Cafe standards further by April 2019. But even if left unchanged, reformed Cafe is unlikely to result in the aggressive 54.5-miles-per-gallon figure by 2025 often seen in the press. Consumer preference trends under the attribute-based standard will shift that figure far lower. The Environmental Protection Agency acknowledged as such in its 2016 mid-term review, finding that the 54.5-mpg-by-2025 base-case had already declined to 51.4 mpg, due to changes in consumer trends between 2012 and 2016. Those headlines also overstate the impact of efficiency regulations on gasoline demand, as they are statutory numbers, achieved in laboratory conditions only.

Also don't bet on California's ambitious ZEV mandates coming close to projected targets. Since its inception in 1990, California relaxed ZEV mandates eight times, often replacing them with delayed, even more aggressive targets that were subsequently revised downward as well. California's Air Resources Board recently reported that the state is falling short of the governor's goal of 1m EVs on the road by 2020 (and 1.5m by 2025).

Without a strong policy push to put more EVs actually on the road, continued massive declines in battery costs will not materialise. This is of pivotal importance to the proponents of the EV "disruption" model narrative, such as BNEF, RethinkX, and others, whose forecasts hinge on sharply declining battery costs. These forecasts assert that policy mandates to produce EVs will yield economies of scale for battery production, lowering unit costs for battery packs to finally make EVs competitive with gasoline-powered vehicles. But if California's ZEV mandate turns out to be another policy miss, those batteries won't be produced and sold in the amounts needed to generate the cost reductions required to ensure the timely demise of oil in transportation.

The recent and relatively docile $40-60 range is but an eye in a volatility storm that arrived over 10 years ago and shows no indications of abating. "Peak demand", first in the US gasoline market, is the next big "surprise" and will coincide with supply tightness to trigger the next boom phase in oil prices, exacerbated by super-tight Saudi spare capacity and ample geopolitical disruption risk. The new normal is boom and bust.

This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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