Demand Destruction is a term used to describe a series of economic actions that occur when oil prices become too high for the global economy to absorb them. In this environment, the economy goes into a recession and the price of oil correspondingly crashes.
Oil’s primary use is as a transportation fuel – 81% of the world’s oil is refined into liquid transportation fuels (46% for gasoline, 9% for jet fuel and 26% for diesel and other liquid transportation fuels). The remaining 19% of the world’s crude oil production goes into heating oil, electricity generation, plastics, synthetic rubber, asphalt and tar, wax, lubricants, adhesives, solvents, explosives, paints, sealants, corrosion inhibitors, cosmetics, fragrances, pharmaceuticals, fertilizer, pesticides, food flavorings, food additives and other industrial and commercial products.
As oil prices increase, the input prices for the variety of goods listed above (including food) increases. These increased input prices, along with the increased transportation cost for these goods from higher fuel prices are normally passed on to the consumer. This increase in consumer goods prices is pure oil-price-induced inflation. While consumers must stomach these increased consumer goods prices, they must also pay more of their budget for gasoline. As the price of gasoline goes up, consumers will use less gasoline (which is what most economists are referring to when they talk about demand destruction in oil), but at the same time, the consumer will also be using more of their disposable income on gasoline, which leaves less money to spend on consumer goods (which are now more expensive due to oil-induced inflation). This creates a secondary (and more significant) oil demand destruction as the economy shrinks from lower consumer spending.
Of course this is a very simplistic way to look at the world economy, and obviously there are many other factors at play. There is evidence that the world’s developed economies have become less dependent on oil over the last few decades. As a result, oil price spikes may not have as damaging an effect on the world economies as they have had in the past. There remains a great deal of uncertainty over how oil price spikes effect the macro economy, but one way to look at the problem is as follows:
As the world economy grows, the short-run demand curve for oil shifts to the right. Normally the short-run oil supply curve would shift to the right as OPEC increases production and previously-uneconomical oil fields come back online in the rest of the world. But in a post-peak-oil world, OPEC’s ability to increase production is limited and this short-run demand curve cannot move any further to the right.
As you can see, in a peak-oil world, short-run quantity supplied hits a wall and the price of oil keeps increasing. This is the economic mechanism that causes a “price spike”.
When the price of oil become too high, the economies of the world can’t afford the additional oil cost; the world economy goes into a recession and the short-run demand curve for oil shifts back to the left. Since oil production is inelastic in the short-run, the price of oil plummets. This is the core of “demand destruction”.
As the oil price drops due to lower oil demand, the low oil price helps the economy slowly recover. This economic recovery brings more demand for oil and the cycle continues.
This cycle of oil price spikes, recession and oil demand destruction is referred to as the “bumpy plateau”. This mechanism may hide the true peak of world oil production for a number of years as oil price spikes and recessions cause the daily world oil production rate to vary significantly as we get close to and pass the point of world peak oil.
In the long run, as the worldwide oil production rate moves down the far side of Hubbert’s Peak, the supply curve will shift to the left at the global aggregate depletion rate, further increasing prices. In the long-run, high oil prices should help encourage increased investment in additional oil drilling as well as increased investment in oil alternatives such as shale oil and tar sands projects. However, due to the rapid nature of price movements and demand destruction, the market sends mixed price signals, hindering the investments needed to shift the long-run demand curve to the right.
Gold/Oil Ratio ($/troy ounce : $/bbl)
Average over 25 years – 16:1
Ratio when Oil hit $147/bbl (July ’08) – 6.5:1
Ratio when Oil crashed to $30/bbl (Dec ’08) – 27:1
Ratio when Oil hit at multi-decade low in 1998 – 27:1
Ratio today – 16:1
S&P500/Oil Ratio (Index in $ : $/bbl)
Average over 25 years – 29:1
Ratio when Oil hit $147/bbl (July ’08) – 8.5:1
Ratio when Oil crashed to $30/bbl (Dec ’08) – 29:1
Ratio when Oil hit at multi-decade low in 1998 – 107:1
Ratio today – 14:1
After running the data through a statistical trading model, I found the optimal trading triggers, based on these ratios.
If the S&P/Oil ratio goes below 12, oil is about to become so expensive that it will “break the system”, in this case, Sell Oil, Short the S&P 500.
When the economy crashes, if the Gold/Oil ratio goes above 20, oil is too cheap compared to gold, in that case, Buy Oil.
We’re currently seeing an upward swing in commodities prices. You should be holding oil and other commodities at this point. The best trigger to keep an eye on for the next few months is the S&P/Oil ratio – if oil prices begin to spike and this ratio drops below 12, Sell Oil, Short the S&P 500.