London, 19 April 2011: Reuters

With the oil market now focused on the question of demand destruction, analysts and market participants are struggling to understand and articulate how demand responds to a sharp run-up in prices. Some analysts distinguish between reversible "demand restraint" and permanent "demand destruction".

Restraint is a temporary loss of consumption due to changes in behaviour and is likely to be quickly reversed if prices fall. Destruction is a permanent loss owing to deployment of new technologies and long-lived behavioural and policy changes that ensure demand remains at a lower level even if prices fall back.

For the more formally inclined, the difference between restraint and destruction is the difference between a movement along the demand curve and a shift in the curve itself.

CONTINUUM

In a more realistic analysis, demand restraint and demand destruction lie at opposite ends of a continuum of demand responses to rising prices. At one end are simple behavioural changes -- taking public transport rather than using a car, making fewer discretionary journeys, choosing to relocate rather than commute -- that reduce fuel consumption but can be easily reversed if oil prices decline.

In the middle are consumption choices embedded in lumpy and long-lived investment decisions -- such as engine size and fuel economy when buying a car, or the choice of fuels when building a new power plant -- that have much more enduring effects and that continue to affect consumption for years afterwards even if fuel prices revert to a lower level.

At the far end are policy-driven changes that make fuel consumption insensitive to subsequent price movements -- such as higher fuel economy standards, requirements for ethanol blending or a switch from oil-burning to nuclear power. These put consumption on a completely different trajectory no matter what happens to prices.

Behavioural changes correspond to demand restraint or a movement along the demand curve. They occur quickly in response to a change in prices because they require no great investment in new technology to conserve or substitute for fuel consumption.

Consumption choices embedded in long-lived investments correspond more closely to demand destruction. Because only a small proportion of the capital stock is replaced each year, demand destruction occurs slowly. But once it has set in, the effects are likely to linger for years or decades until the capital stock is renewed again.

Consumption choices embedded in public policy can be the most enduring of all since there is little or no likelihood they will be reversed, at least not for many years, given the "stickiness" of new legislation and regulations. Demand lost because of public policy is the most complete form of demand destruction.

Note that behavioural changes, investment decisions and public policy are all sensitive to both the magnitude of price increases and their duration (actual and expected). The higher prices rise, the more incentive to make behavioural, investment and policy changes to reduce consumption.

The longer price increases are maintained and expected to persist, the more capital stock will be renewed with lower fuel consumption technologies and the more consumers will adjust to their spending patterns.

Several analysts claim to see signs of temporary demand restraint but no evidence of sustained demand destruction yet in response to the surge in oil prices over the past six months. But given the slow pace at which demand destruction occurs, that is hardly surprising. It does not mean demand destruction is not happening and will not continue to weigh on consumption in the years ahead.

EVIDENCE

There is plenty of evidence rising prices have curbed oil consumption in the past decade, even in advanced industrial economies such as the United States, where analysts sometimes say easy options for fuel efficiency and substitution have been exhausted following earlier oil shocks in 1973-74 and 1979-80.

Perhaps the largest and most permanent losses of petroleum demand have come in response to the Energy Policy Act 2005 and Energy Independence and Security Act 2007, which mandated the blending of billions of gallons of ethanol into the U.S. fuel supply and toughened fuel economy standards for new cars and light trucks.

Both laws were passed in response to concerns about rising energy prices. Long after they were enacted and oil prices fell in 2009 and 2010, they continue to destroy increasing amounts of consumption every year through progressively higher blending requirements and economy standards.

There are clear signs high fuel prices have also affected consumer behaviour and investment. The attached charts show the number of vehicles registered in the United States, miles driven and measures of average fuel consumption and economy from 1970 to 2009, as reported in the Federal Highway Administration's annual "Highway Statistics".

Oil shocks in 1973-74 and 1979-80 resulted in notable declines in registrations and fuel consumption, as well as big improvements in fuel economy. The last decade is more complicated. The recession of 2008-2009 coincided with the largest decline in car registrations (new and old) for more than 40 years -- as well as the deepest downturns in fuel consumption and miles travelled since 1980.

Much of the downturn in 2008-2009 was cyclical and is likely to be reversed as the economy picks up. Car journeys have been picking up strongly since June 2009, according to the Federal Highway Administration's monthly "Traffic Volume Trends".

But the downturn in car use is not exclusively due to cyclical factors. Even before the recession, there was a marked slowdown in additional vehicle registrations. The average number of miles travelled per vehicle declined consistently each year from 2005. Fuel consumption grew at the slowest rate since the oil shock at the start of the 1980s.

Some of the slowdown was probably due to structural factors including demographics as vehicle ownership reached saturation levels and the shift from urban areas to long distance commuting from the suburbs and exurbs was completed.

But it also coincided with a period of strongly rising gasoline prices that significantly raised the cost of both discretionary and work-related travel, which probably contributed to the slowdown in fuel demand.

The U.S. vehicle fleet is elderly and turns over slowly. The median age of vehicles on U.S. roads was 9.4 years in 2008, according to the U.S. Bureau of Transportation Statistics, up from 8.3 years in 1998 and 6.5 years at the start of the 1990s. Less than 10 percent of the fleet turns over each year. So high oil prices take a long time to filter through to average fuel economy.

Nonetheless, high prices do gradually translate into reduced fuel consumption and a strong incentive to stop using aging "gas guzzlers" and replace them with more efficient vehicles. Once improvements in fuel efficiency have become embedded in the car fleet, they stay there for a long time, owing to the slow turnover rate. Despite growing demand growth from emerging markets, gasoline sales to U.S. drivers still accounted for 10 percent of global oil consumption in 2010 (9 million barrels per day in a total of around 86 million). There is plenty of scope to raise fuel economy within the U.S. car fleet. Soaring prices are likely to force a further reduction in journeys and rise in efficiency.

Similar trends are underway around the world as motorists across Europe, Asia and emerging markets receive a strong signal to cut discretionary use and shift to more fuel efficient vehicles. So while demand destruction may not yet be visible on the weekly and monthly consumption data, that does not mean it is not occurring. The total impact will accelerate the longer that prices remain at current levels.

And it will continue to bite into petroleum demand for years to come even if prices settle back below $100.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.