McKinsey: The next oil shock

Two-dollar a gallon gasoline is one of the few brights spots for consumers during this economic slump. Evidently, people expect cheap gas to be with us for a while. The Wall Street Journal reports today that small cars like the Honda Fit, Toyota Yaris and Chevrolet Aveo have all but stopped selling. Says one dealer: “We’re big people and we like big cars.”

That could be a big mistake. Cheap gas prices probably won’t last. So, at least, says a new report from the McKinsey Global Institute, called Averting the Next Energy Crisis: The Demand Shock. While energy demand will stagnate during this recession, the report says, the world will need more coal, oil and gas once the global economy recovers. And, while the supplies of coal and gas appear to be plentiful enough to prevent long-term price inflation, McKinsey expects demand for oil to outpace supply, thereby creating another oil-price shock as soon as 2010 to 2013.

“As soon as we get the economy up and running again, we’re going to find ourselves in a world when prices are going to fly up,” says Scott Nyquist, a leader in McKinsey’s energy practice.

Like most of what comes out of McKinsey, this report is smart, fact-based, packed with charts and graphs, thorough (150 pages), and neutral when it comes to policy. Here are its key findings, based on a “moderate” case economic scenario, which assumes a global economic recovery in 2010:

Energy demand will grow by 2.3% per annum from 2010 to 2020. This will happen even if, as expected, energy consumption in the U.S. and Japan remains virtually flat. Indeed, McKinsey expects energy demand to decline in some sectors, such as cars, which are becoming more efficient and in the pulp-and-paper industry, as people shift from paper to digital media. (The upside of the decline of newspaper, if you like.) Developing regions will account for 90% of the energy growth, the report says:

Emerging bands of middle-class consumers and industries in emerging markets, particularly China and the Middle East, are crossing the $5,000 per household or $1,500 per capita income threshold above which consumers and industries have historically demonstrated a strong demand for the comfort, convenience, and environmental benefits that come from using oil.

CO2 emissions will grow, but slightly more slowly, by about 2 percent a year from 2006 to 2020. Air transport, steel and petrochemicals will be the fastest-growing sectors. Again, much of the increase is projected to come from China and India—so it’s imperative for business, governments and environmentalists to do all they can to spread clean energy technology to China and India to slow that growth down.

Interestingly, McKinsey’s forecast of oil supplies is lower than those of the IEA, EIA and OPEC. Such forecasts are notoriously unreliable, depending as they do on the politics of such countries as Nigeria, Mexico, Venezuela and even the U.S. (think about the ban on drilling in the Artic National Wildlife Refuge), as well as potential improvements our ability to extract  oil. The report doesn’t attempt to forecast oil prices but it does see the likelihood of “significant volatility as the market moves from a level at which production is marginal ($30–$40 a barrel), to a level at which that new investment is marginal ($60–$80 a barrel), to scarcity pricing (above $100 a barrel) in relatively short periods.”

Is this cause for worry or government action? After all, if prices rise, people will consume less oil and turn to alternative sources. That’s how markets are supposed to work. So while the looming supply-demand imbalance of interest to people in the energy sector (as well as to car buyers), do governments need to respond?

Nyquist suggests that they do. “We have a bias as a firm to be more market oriented,” Nyquist told me. “But we also see market inefficiencies in the energy sector.” There may be good reason, he said, for government policies that are designed to encourage more prudent consumption of oil or to smooth out the probable price increases.

For one thing, demand for oil can’t respond quickly to price signals. It takes time to make buildings more efficient or turn over the fleet of cars and trucks on the road. Price spikes threaten the economies of importing nations like the U.S. What’s more, there are compelling environmental and national-security reasons for reducing the U.S.’s demand for oil, even now when prices are low.

So what can be done? McKinsey identifies a number of options, including:

1. Remove subsidies that keep oil prices low in places like Saudi Arabia, Iran amd Venezuela. The chance of this happening seems slim.
2. Increase the size limit for trucks in the U.S. and Europe. Why not? Megatrucks would mean bigger but fewer trucks on the road.
3. Improve efficiency. Particularly of cars and trucks, using either standards or tax incentives to do so.
4. Remove trade barriers to sugar-cane ethanol. A no brainer. Sugar-cane ethanol has lower carbon emissions and its price per equivalent barrel of oil is about $40. Only the corn lobby stands in the way
5. Require all cars sold in the U.S. to be flex-fuel cars. The cost is about $100 a car, and the potential benefits are great because more biofuels could be blended into the gasoline supply.

Even if we take all those steps, oil prices will rise over time. So, if you’re in the market for a car, think small.  I’m hearing good things about the new Honda Insight and the new Ford Fusion.  And I love my Honda Fit. Do yourself and the planet a favor.

Tagged as: McKinsey Global Institute, Scott Nyquist