Wednesday, June 11, 2008

What price demand destruction?

“The price of oil will likely stay high or increase unless there is significant demand destruction.”

Most likely, you have heard or read this phrase lately, unless you’ve been living under a rock or simply do not care at all about the ongoing energy crisis.

This phrase is used by many analysts and economists as the only way out of high oil prices. This is mostly used by those who are deflecting blame for the high price of oil from the speculators. The explanation is that there simply is more real and actual demand now than there is supply. There is new real demand from the emerging economies. New real demand from increased world trade. New demand from a resource-hungry populace, especially the American consumers whose vehicles of choice have increasingly been the large gas-guzzling trucks and SUVs. The argument goes that there simply isn’t enough oil being pumped out of the ground to satisfy all this real demand.

Since increasing supply will, most optimistically, be difficult, costly, and take years to effect , price can only go down if demand declines. In other words, existing demand needs to be destroyed. Killed. Annihilated.

In a regularly functioning market, so the theory goes, the most efficient level of supply and demand will eventually be reached. If price goes too high, many market participants will simply buy less, either by looking for close substitutes, or foregoing consumption altogether. In short, the price will eventually settle at a level where the market is able and willing to pay for oil.

Demand destruction will be our salvation from high prices. Are we to be happy about this? Do we all believe that the demand that will be destroyed is that coming from the frivolous consumers of oil? Those who drive when they can easily walk? Those who fly when they can take the bus? Those who use gas and oil aimlessly and wastefully?

In other words, what is the cost of demand destruction? What demand is actually destroyed?

Well, I would start by guessing that the demand that is destroyed is not necessarily that coming from the most frivolous users. The demand that will be first to disappear is that coming from those whose purchasing capability is most stressed by the high price. It is they whose marginal propensity for oil consumption is steepest. In other words, a higher oil price kills demand from them first before killing it from others.

Who are these market participants most stressed by a high price? Here’s my list of those who, I’m pretty sure, are already thinking of ways to decrease oil consumption:
1. The poorest people
2. Companies with the lowest profit margins
3. Organizations that have only a fixed level of money for expenses, i.e., non-profits, NGOs, charitable organizations, etc.

Firstly, the poorest people. Because they are poor, let me make the assumption that their use of oil, if any at all, is not in any way frivolous to begin with. Using diesel oil for heating, for example. Anybody who lives in a place with harsh winter knows that heating is not a luxury. But with oil at its current price, it’s getting to look like it, regardless whether people may die without it or not.

Companies with slim profit margins. Increased global competition may have forced many of them to survive with barely any profit (See previous blog - “Today belongs to the big boys”). Many of these companies may actually be large employers, and their demise will put many people out of work, and some into poverty.

Fixed-expense organizations. These could include those charitable organizations who may otherwise try to help feed and shelter the poor, but can only do so for as long as their sources of incomes (donations) affords them to do so. High inflationary prices constrict their ability to allocate funds to more projects. So you see, demand destruction might actually take away all your possible lifelines, if you happen to be among the newly unemployed, poor, and without heating.

So what price demand destruction? The price is steep, most especially for those lowest on the totem pole of capitalism. They are represented in every nation on earth.

And because of the effectiveness with which capitalism has spread globalization, demand destruction in any one sector, from any place, on earth, can easily escalate to global proportions. To illustrate- higher oil means less industrial production in some countries. Less industrial production means less jobs. Less jobs means even lesser consumption. Even lesser consumption means lesser production for still other countries. And so on.

If governments do not effectively manage the process of demand destruction, we may all end up with no demand at all. And that is just as dire a crisis, if not more, than high inflation brought about by too much demand.

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