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.