Tuesday, March 18, 2014

Psychological Trigger Points For Crude Oil Demand Destruction

I've talked about demand destruction before in this blog. Demand destruction occurs when the marginal benefit of using more crude oil exceeds the marginal cost for people. Essentially, when oil prices go too high, people use less oil. On a personal level, this means that people may drive fewer miles by staying closer to home on the weekends, they might postpone a long-distance vacation, or they might start taking the bus or work from home instead of commuting by car. The Economist wrote a nice article on this phenomenon last year where they stated "in the rich world oil demand has already peaked: it has fallen since 2005."

While demand destruction occurs across every price up the ladder, there are certain psychological trigger points where people "wake up" to the fact that oil has gotten very expensive. Gas stations post their prices on the street and people notice when prices pass certain thresholds. In the United States, we price our fuel in dollars per gallon, and people definitely notice when regular gasoline passes $4 per gallon. In fact, when we look at the average US street price of regular gasoline, we see it bounces off a ceiling of $4 per gallon:

When Americans see $4 a gallon on their neighborhood gas station's sign, the price of oil immediately becomes front-of-mind and they start changing their behavior. Already, there are signs that motorization in the US has peaked. We can imagine that if gasoline prices rose past $5 per gallon, people would dramatically cut back on their gasoline consumption.

In Europe, gasoline is priced in Euros per Liter. The EIA keeps a summary of current prices in Europe here. In Germany, the largest economy in Europe, 48% of cars are diesel, so the price of diesel is more important than the price of gasoline. Looking at historic diesel prices in Germany we also see a ceiling, but it is at €1.5/liter:

We can imagine that the next threshold in Germany is €2/liter, at which point Germans would almost certainly cut back significantly on their fuel consumption.

In China, gasoline and diesel is priced in yuan/liter. Current prices are ¥1.77/liter for diesel in Beijing. In Chinese culture, many numbers have strong physiological associations. Seven a lucky number associated with "togetherness" - so today's price of ¥1.77/liter might be welcomed by people. Four is considered an unlucky number. In fact, many buildings in china don't have a 4th floor (similar to how many buildings in the west don't have a 13th floor). So while ¥2/liter is likely the next physiological threshold in China, we can imagine that if prices rose to ¥2.44/liter, they would be front-of-mind for people.

Converting Crude Oil Prices to Gasoline Prices
We can convert the price of crude oil to the price of gasoline by looking at the historical difference between these two prices. There are 42 gallons in a crude oil barrel, so a $100 crude oil price is $2.38 per gallon of crude oil. Obviously crude oil is the largest input cost for gasoline, but when you buy a gallon of gasoline you're also paying for taxes, marketing, distribution and refining costs. The EIA has created a nice graphic showing what you pay for in a gallon of gasoline:

Over time, the price of crude oil has become a larger percent of the overall cost of gasoline:

Today crude oil accounts for about 75% of the cost of gasoline in the United States and for about 35% of the cost of diesel in Germany (where taxes are far higher). Using historical data we can come up with a few simple rules of thumb for converting crude oil prices to local gasoline prices for the US, Europe and China:
  • United States: Crude Oil ($/bbl) / 31.5 = Gasoline Price ($/gallon)
  • Europe: Crude Oil ($/bbl) / 80 = Diesel Price (€/liter)
  • China: Crude Oil ($/bbl) / 61.5 = (¥/liter)
For the record, there are more accurate ways of doing this - like calculating the refinery yield for each product and adding on top of that the taxes and distribution cost for each region - but for this blog post some rules of thumb will suffice.

Demand Destruction Thresholds
Going back to our psychological demand destruction thresholds, we can use our rules of thumb to convert them to crude oil prices:
  • €1.5/liter in Europe: $120
  • ¥2/liter in China: $123
  • $4/gallon in the US: $126
  • ¥2.44/liter in China: $150
  • $5/gallon in the US: $157
  • €2/liter in Europe: $160
So looking at future prices, if crude oil hits $120-$125 per barrel, we will likely see demand destruction as certain psychological triggers are hit around the world. The next threshold appears to be $150-$160 per barrel, at which point demand destruction could be quite severe.

Monday, February 24, 2014


"It's hard to make predictions, especially about the future."

Peak Oil
  • What oil price can the global economy support without going into a recession?
  • Have we passed peak $50/bbl oil?
  • Have we passed peak $100/bbl oil?
  • With oil companies cutting back on capital spending, how will global oil production rates continue to increase?
  • Has global conventional oil production peaked?
  • Will increases in unconventional oil production be able to offset declines in conventional oil production?
  • What percentage of oil and gas well casings fail over a 1000 year time span?
  • How many earthquakes are the direct result of hydraulic fracturing and the resulting underground waste water disposal?
  • Do we have enough water to continue increasing the rate of shale oil and gas extraction?
  • Will we see peak oil because of peak demand or peak supply?
  • Once we pass peak oil, will we have a smooth transition to sustainable energy sources or will we have a collapse?
Climate Change
  • Once you account for the methane that leaks into the atmoaphere along the life cycle, is fracking for gas better or worse than coal for climate change?
  • What is a "safe" amount of global warming?
  • After all of the positive and negative feedback loops are accounted for, what is the real warming potential of a ton of greenhouse gas?
  • Given that warming potential, how many tons of greenhouse gas can we safely emit into the atmosphere?
  • How much economically-extractable hydrocarbon energy is left in the ground?
  • Is the amount of economically-extractable hydrocarbons in the ground higher or lower than the amount we can safely emit?
  • Is it possible with current technology to hold global warming to a safe level without harming our economy?
  • When will we see a global carbon tax?
  • Will China unilaterally tax carbon?
  • Will politicians fail to act on climate change until we see catastrophic climate disruptions (thermohaline shutdown, megastorms, megadraughts, greenland ice sheet collapse)?
  • If politicians wait until a crisis to act, will it be too late to halt climate change?
  • If we fail to act, is it possible to reverse climate change through geoengineering?
Economic Sustainability
  • Is it possible in this century to provide 10 billion people a developed-world standard of living without destroying the environment?
  • Throughout history, when governments have rapidly debased their currencies through money printing, it has always led to high inflation. This time though, all of the government are doing it at the same time and we haven't seen much inflation yet - is this time different?
  • How long can real interest rates remain negative?
  • What ever happened to breaking up banks that were too big to fail?
  • Why did the Federal Reserve Bank of New York say it would take 7 years to repatriate 674 tons of gold to Germany when they claim to have 6,700 tons of gold in their New York vault?
  • Can income inequality continue to get more severe every year without a triggering some kind of backlash?

"Plan for the future because that's where you are going to spend the rest of your life." -Mark Twain

Monday, January 13, 2014

2014 Predictions

I love New Years because it is the one time of year when experts seem to throw caution to the wind and make wild predictions about asset prices.  Of course, most of these predictions will be wrong because as Yogi Berra famously said "It's tough to make predictions, especially about the future."  But nevertheless it is fun to see how the experts view the market over the coming year.  So without further ado, here are the asset price predictions I scraped from around the internet:

Looking back at energy prices in 2013:

2014 Energy Price Predictions:
  • Oil: EIA: Down 4%
  • Oil: Survey of 27 experts: Down 4%
  • Oil: Eurasia Group: "a-better-than 50% chance...oil prices are cratering through $80": Down 25%
  • Oil: Credit Suisse: Down 5%
  • Oil: Chris Nelder: Up 3%
  • Natural Gas: EIA: Up 4%
  • Natural Gas: Chris Nelder: Flat
  • Coal: EIA: Up 1%
  • Solar: IHS: Down 10%
  • Solar: NPD Solarbuzz: Down 6%
  • Solar: GTM Research: Down 1%

Looking back at various asset class investments in 2013:

2014 Asset Class Predictions:
  • US Equities: Average forecast according to Bloomberg: Up 6%
  • US Equities: Goldman Sachs: Up 3%
  • US Equities: Goldman Sachs: "The S&P500 Is Now Overvalued By Almost Any Measure"
  • US Equities: Scott Minerd, Guggenheim Partners: "can  rise another 10% to 15% before it pulls back"
  • US Equities:  Peter Boockvar, Lindsey Group: Down 20%
  • US Equities: Emad Mostaque, NOAH Capital Markets: Down 20%
  • International Developed Equities:
  • Emerging Market Equities: Jan Dehn, Ashmore: "It is entirely possible that emerging markets will be the best performing asset class in the world [this year].”
  • Emerging Market Equities: George Magnus, UBS: “Emerging markets have a lot to worry about from a resurgent dollar”
  • Emerging Market Equities: Anatole Kaletsky: "Emerging markets will make a comeback"
  • Emerging Market Equities: Jeremy Grantham: "“My guess is that the US market, especially the non-blue-chips, will work its way higher, perhaps by 20-30 per cent in the next year or, more likely, two years, with the rest of the world, including emerging market equities, covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999."
  • Emerging Market Equities: Mohamed El-Erian: "Do not bet on a broad emerging market recovery"
  • US Bonds: LPL Financial Research: "Bond valuations remain expensive compared to historical averages"
  • US Bonds: Bill Gross: "should provide low but attractively defensive returns"
  • US Bonds: Bank of America: "Challenging year for fixed income"
  • US Bonds: Jeffrey Rosenberg, Blackrock: "Traditional bonds could experience losses"
  • International Bonds: Morgan Stanley and Goldman Sachs: Bearish
  • Gold: Emad Mostaque, NOAH Capital Markets: Up 20%
  • Gold: Bank of America: Down 11%
  • Gold: Barclays: Down 3%
  • Gold: Ole Hansen, Saxo Bank: prices have "bottomed out"
  • Gold: Philip Klapwijk, Precious Metals Insights: Down 2.5%
  • Silver: Bank of America: Down 21%
  • Bitcoin: Jason Hamlin: Up 250%
  • Bitcoin: Jason Hamlin (contradicting himself?): Up 500%
  • Bitcoin: Lightspeed Venture Partners: Up 500%
  • Bitcoin: "56% of bitcoiners": Up 1000%
  • Bitcoin: Cameron Winklevoss: Up 4000%
  • Bitcoin: Hugh Hendry: "I would buy Bitcoin if I could"
  • Bitcoin: Mark T. Williams: Down 99%
  • Bitcoin: Oliver Pursche: "bites the dust"
  • Bitcoin:  Lauren Orsini: "the end of Bitcoin as we know it"