Paul Kedrosky: Will People Change Permanently or Temporarily at $200 Oil?

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June 7, 2008

Will People Change Permanently or Temporarily at $200 Oil?

An important implicit question in the great interview with Goldman Sachs oil analyst Arjun Murti in Barron's this weekend. What oil price will make U.S. consumers change their behavior enduringly, versus simply adjust temporarily and then return to status quo?

Let's talk about the possibility of crude hitting $200 a barrel. If we get there, how does it play out?

Our view has been that the price will keep going up to the level where it meaningfully reduces demand. This is Economics 101; we need more supply or less demand. And because there are various political and geologic constraints on growing supply, we're left with looking for the price at which demand is reduced. We've never thought we knew what that exact number is. But we've tried to look at the 1970s, notably the economic impact of gasoline prices that ultimately led to a reduction in demand.

How does the current situation compare with the 1970s?

In the 1970s, you had a traditional supply shock. You took a bunch of oil off the market, and the price rose very quickly in a short period of time. That led to lower demand that proved sustainable, because the market worried that the supply wouldn't come back. It has been, up until the last three or four months, a much more gradual increase -- and therefore, people have generally been able to get used to the price. And it's allowed demand to be more resilient than even we thought it would be.

But if crude does hit $200 a barrel, what kind of prices will we see at the pump?

Oil at $150 to $200 a barrel would imply between $4 and $5.75 a gallon.

At which point you probably see a falloff in demand, right?

We are already starting to see a drop in demand in the U.S., but they are still having demand growth in the non-OECD countries, including China, the Middle East and Asia. The OECD [Organization for Economic Cooperation and Development] countries are mainly the U.S., Europe and Japan. The real question: At what point do the non-OECD economies slow down? The other thing about U.S. demand is, at what point do you have sustainable change in consumer behavior? So if the price temporarily goes to $4 [a gallon], but immediately falls back to $3, it's likely that people will keep driving cars with poor gasoline mileage. But if people believe the increase in oil prices is more sustainable, they might shift to taking mass transportation, if available, driving hybrids or taking the other kind of actions that are necessary to reduce demand on a sustained basis.

Do you see a sustained drop in demand at $200 a barrel?

That is the big question. We have always assumed that, at some point, you get a sustained drop in demand. Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number. The questions are: How long do prices stay high? How sharply do they rise? And do people truly change their behavior or are they just temporarily driving less? It's an unknown at this point.