A total of 1.7 billion unlevered consumers have GDP per head of US$5,000 to US$20,000 the report points out. No doubt, restoring credit flow is a key step in stabilising aggregate OECD demand. But global industrial production has fallen sharply, and the only way to fill the extraordinary â€œdemand vacuumâ€ created by the collapse of the credit bubble is to fuel demand for durables in emerging markets.
INTERNATIONAL. A new report released by Banc of America Securities-Merrill Lynch Commodity Research says there are many factors pushing for a rise in energy prices in the coming years, relative to other prices in the global economy.
A total of 1.7 billion unlevered consumers have GDP per head of US$5,000 to US$20,000 the report points out. No doubt, restoring credit flow is a key step in stabilising aggregate OECD demand. But global industrial production has fallen sharply, and the only way to fill the extraordinary “demand vacuum” created by the collapse of the credit bubble is to fuel demand for durables in emerging markets.
The annual GDP per head bracket of of US$5,000 to US$20,000, mostly in emering markets, is a sweet spot for the consumption of durable goods and for taking on leverage. As a reference point, Americans had a real GDP per capita of US$12,000 in 1980 as the multi-decade long credit bubble began, while Portugal did not cross the GDP per capita mark of US$10,000 until 1990.
Appetite for washing machines, freezers or cars rises rapidly when per capita income hits US$5,000. Thus, as a higher consumption of durables comes with a substantial increase in energy use, supply constraints could soon resurface. On the bank’s estimates, if global GDP grows by 3.6% every year over the next decade, annual energy demand will increase by 4 million bpd of energy in oil equivalent
terms. Given the natural limits to supply, policymakers will have to shift their attention to energy efficiency. The report sees global energy efficiency increasing by 1.8% year on year in the next decade, as global energy supply will likely only grow by 1.7% per annum.
As the global economy recovers, continued upward pressure on energy prices is needed to focus policy on energy efficiency. Limited spare capacity, strong underlying trend demand and the need for efficiency improvements all suggest that energy prices may have to increase again in the coming years relative to
other prices in the economy. Thus, Merrill reiterated its long-term WTI oil price forecast of US$72 per barrel in real terms. In turn, high oil prices will keep the energy sector share of global GDP above historical averages, and hold emerging market growth in check.
A global misallocation of capital is at the root of the crisis
The report puts forward the view that a global misallocation of capital sits at the heart of the current economic crisis. In simple terms, capital markets failed in recent years and channelled too much money into real estate, too little into energy. If capital had been efficiently allocated to the most productive sectors in the global economy, high savings rates in emerging economies would have enabled a high investment rate in key sectors. In turn, a high investment rate could have allowed for a higher rate of economic
growth in the long-run.
However, in the five years preceding the current crisis, excessive leverage and non-productive investment contributed to fuel both a credit bubble and an economic boom. Energy demand increased very rapidly as global GDP expanded at the fastest pace since the 1960s.
With the burst of the credit bubble, global economic activity collapsed. Industrial production across a broad range of developed and emerging economies came down very sharply in fourth quarter 2008 and first quarter 2009. This sequential decline in industrial and economic activity has brought aggregate output for key economies down to levels not seen in years. In the case of Japan, industrial output is now at the same level it was back in 1983, while German and American industrial activity has taken a step back of almost ten years.
Economic growth and primary energy demand
The world now faces substantial spare productive capacity. Due to the decline in activity, capacity utilisation rates have fallen across a broad range of industries in the economy. At the peak of the last business cycle, most economic sectors saw capacity utilisation rates above 80%. Now, utilisation rates have collapsed for a broad range of industries such as motor vehicles, semiconductors or chemicals. As a result, spare productive capacity has increased well above and beyond previous business cycle downturns in a number of economic sectors in the United States, and also in other countries.
The policy response has so far focused on fixing the banks. So far, governments have fought the economic crisis using expansive fiscal and monetary policy, and focused their efforts on fixing a broken banking system. Of course, the scarcity of consumer credit has quickly fed into many parts of the global economy from construction to travel and vehicles sales. Reinstating some normalcy into the credit markets is unquestionably the first step to stop the downturn in economic activity.
Looking farther out, the large fiscal and monetary policy stimuli and the bank bailouts should succeed in supporting aggregate OECD in the medium-term. Industrial production across a broad range of developed and emerging economies came down very sharply in fourth quarter 2008 and first quarter 2009. Credit facilities for key emerging markets will likely contribute to support emerging-market consumer demand and industrial activity in the coming quarters. So far, the sharp expansion in money supply and lending in China has already started to pay off, with car sales up 25% year on year in February and 10% year on year in March.
Can increased credit to emerging markets and OECD consumers do the trick?
However, if the energy and credit crises are indeed linked to the same market failure, the report ponders whether increased credit to EM and OECD consumers will help create a sustainable growth path for the global economy. Judging by the sharp global energy and commodity price increases of first half 2008, the recent trends of urbanisation, industrialisation and globalisation, particularly in the emerging markets, have proved unsustainable.
Simply put, a lot more energy is required to keep emerging markets on a fast growth track. Therefore, even if government policies are successful in reigniting the global economy, physical energy supply constraints will prevent a return to high world GDP growth rates. In this process, we could witness a second round of commodity price inflation.
A billion consumers have annual GDP per head of US$20,000-plus
According to the report, the only way to fill the extraordinary “aggregate demand vacuum” created by the collapse of the credit bubble is to fuel demand for durables in the emerging economies. For sure, stabilising OECD demand through better functioning banks is critical to restore healthier consumption levels than those observed in fourth quarter 2008. But the output gap in OECD economies is probably too wide to fill it with increased domestic lending. About 1 billion consumers enjoy yearly income per capita in excess of US$20,000 in advanced economies, but many of these rich consumers are over-levered. Thus, filling the output gap will require help from emerging market consumers. The report estimates, there are about 670 million consumers sitting on an annual GDP per head of US$10,000 to US$20,000, mostly in emerging markets and mostly unlevered.
Another 1 billion consumers in the emerging markets enjoy an income level per head of US$5,000 to US$10,000 per annum, also a critical mark in the consumption of durables. In fact, the appetite for domestic appliances such as washing machines, dishwashers or freezers increases very rapidly in the US$5,000 to US$20,000 per capita income range. Similarly, the purchase of cars and motorcycles increases exponentially in this income bracket, suggesting continued strong support to vehicle sales growth in the emerging economies over the next decade. Of course, increased consumption of durables and rising incomes also bring in a substantial increase in the consumption of energy per head.
Urbanisation is an extremely energy-intensive endeavour
The three key defining trends of today’s global economy remain urbanisation, industrialisation and globalisation. As moving people from the countryside to the cities is basically an exercise of turning low intensity solar power consumers into high-powered thermal fuel users, increased urbanisation rates in emerging economies will necessarily continue to push up increased energy requirements. And according to the United Nations Population Division, urbanisation trends in China, India and even Africa will continue to increase over the next decade, suggesting soaring energy requirements in the years ahead. On average, Merrill estimates that a 1% increase in urbanisation rates brings in a 1.5% increase in energy demand.
Industrialisation and urbanisation go hand in hand, as the organisation of economic activity around factories requires firstly more factories—to create network externalities—and then large urban centres—to create a steady supply of labour to the factories. This is precisely the process that has been taking place in China for the last two decades. Industrial activity and electricity generation are intrinsically linked, particularly in emerging economies. Consequently, most of the growth in power consumption has occurred in non-OECD economies in the last decade. Net, Merrill estimate that a 1% increase in global economic activity typically results in roughly a 0.9% increase in global energy demand.
Another key trend defining the world economy at the moment is globalisation. From an energy standpoint, this trend means that the world economy has a voracious appetite for transportation fuels or, more simply, oil. Sea, air and road transport will likely increase at a fast pace in the future, averaging an incremental
1 million bpd per year over the next decade. In line with this increase in fuel consumption, our equity analysts expect a rapid surge in global car sales and other modes of transport in the next few years.
China remains the one country to watch
Developments in China have been key to understanding commodity demand patterns in the past decade, due to its rapid industrialisation. Looking forward, the recent economic trends coupled with the global bank bailouts suggest that China will remain the one key country to watch over the next decade. The focus is now shifting, though, from the rapid growth in industrial activity with a goal to become the world’s manufacturing hub towards increasing domestic demand with a goal to help fill up the global output gap. The Chinese urban middle class is moving up the economic ladder, rapidly expanding its consumption of durables.
Domestic vehicle sales also continue to grow at a fast pace despite the global downturn. In fact, Chinese car sales have outpaced car sales in the United States during the last three months.
The sharp drop in global oil and energy demand in recent quarters has left some spare productive capacity available in the global economy. In particular, the fall in OECD energy use will likely enable emerging economies to expand again with affordable energy prices for the next two years. The report estimates spare global oil production capacity has jumped to 7 million bpd or 8% of global demand on the back of the sharp OPEC output cuts, while we can also observe significant increases in natural gas and coal spare productive capacity.
Increased spare productive capacity is good news for consumers in China and other energy-intensive emerging economies. In fact, the drop in global energy prices is one of the key reasons why EMs have turned towards more relaxed monetary policy to counterbalance the drop in economic activity. But energy demand in emerging markets can not grow unchecked for the coming decade simply because supply is constrained. The report estimates, maintaining an annual global GDP growth rate of 3.6% over the next decade will require yearly increments of 4 million bpd of oil in energy equivalent terms.
The next global policy wave will focus on energy efficiency
It is still uncertain what a “balance sheet” recession in North America and Europe will do to per capita energy consumption in these regions. The case of Japan suggests that a 1.1% annual drop in oil consumption is possible. But Europe is already rather oil-efficient on a per capita basis and further OECD
efficiency gains will depend mostly on US energy policy. At any rate, given the constraints on global energy supplies, we believe policymakers will shift their attention to energy efficiency once the ailing financial sector starts to recover. In that regard, we believe that there is substantial oil demand substitution potential in the replacement of boiler fuels, the removal of ethanol trade barriers, or a reduced shift towards diesel vehicles.
In effect, because oil is the scarcest energy source on a relative basis, it will probably lose market share relative to other energy sources such as coal, natural gas, nuclear energy or renewables. Even under the assumption of oil losing market share by 4% in the global primary energy consumption pie over the course of 2008-2020, we can still expect oil demand growth averaging at least 1% or 800,000 bpd in the 2011-2020 period. But becoming more oil efficient is only part of the solution, and the report estimates that net global energy efficiency will increase by 1.8% annually to allow world GDP to grow at an average rate of 3.6% over the next decade.
As the global economy recovers and demand for oil and other fuels starts to increase again, only a continued upward pressure on prices will provide the signal to refocus policy on energy efficiency. Commodity utilisation rates are still high compared to other sectors, so any rebound in economic activity will likely impact commodity prices before it hits other parts of the economy.
Low spare capacity availability on a relative basis, strong underlying trend demand and the need for energy efficiency all suggest that energy prices may have to increase again in the coming years, and therefore Merrill Lynch is maintaining its long-term real WTI crude oil price forecast of US$72 per barrel In turn, a high oil price will keep energy’s share of global GDP above historical averages.