What is Demand Destruction and Should We Be Worried?

The energy market (and the world in general) has seen drastic changes since 2020; a worldwide pandemic will do that. Oil price fluctuations from literally below $0 to well over $100 a barrel within two and a half years have challenged businesses and consumers alike.

The war in Ukraine and the resulting sanctions against Russia have only compounded the problem, contributing to the national average price at the pump inching towards $6 a gallon in June 2022.

Fears over potential demand destruction for refined fuels are not surprising at all. When reading headlines, it’s natural to be nervous about the short-term and long-term impacts on the energy market – but is demand destruction an actual concern? We’ll attempt to answer that question in this blog.

What is demand destruction?

“Demand destruction” is a phrase being mentioned by some in the oil and gas industry. But let’s look at what this specific, statistically meaningful condition really is and what it isn’t.

 

What demand destruction is

Understanding demand destruction requires a grasp of the relationship between supply, demand, and pricing. When supply is high, consumers will buy less, because they already have what they need, and feel no fear of running out. As excess inventory piles up, prices begin to fall, in an effort to get rid of the product at any price. When demand is high, the principle of scarcity comes into effect; consumers worry about having enough product to perform daily tasks, and will pay more to ensure they can do so. This puts pressure on existing supply, raising prices.

Demand destruction is not part of that normal “supply & demand” cycle. Instead, it is when persistent high prices or limited supply for a product reduces demand leading to a permanent, widespread abandonment of the product. Let’s look at a simple example of demand destruction within the oil and gas industry (before there really was an oil and gas industry!)

In the early to mid-1800s, whale oil was one of the primary sources of heat and light. In the late 1850s, oil was discovered in Pennsylvania. By 1860, kerosene from petroleum entered the market as a heating and lighting option, offering a cheaper alternative to expensive—and increasingly scarce—whale oil.

At that time, whale oil was almost three times as expensive as kerosene. The resulting decline in demand for whale oil became permanent, with kerosene replacing whale oil as the dominant fuel source by the late 1860s.

 

What demand destruction is not

For most commodities, the relationship between supply, demand, and price factors is not static – they are elastic, constantly fluctuating in response to market and supply chain changes. The key difference between demand elasticity and demand destruction is whether or not the changes are permanent. In usual circumstances, once prices have achieved an unsustainable price (where consumers can no longer afford the product), inventory piles up, and prices fall as retailers attempt to get rid of inventory.

Generally, oil is seen as a relatively inelastic commodity. When oil prices are high, people still need to commute to work and school, heat their homes, and engage in other activities reliant on oil. Thus, they will absorb the cost of gas, and reduce other expenditures less critical to daily life; e.g., going to a restaurant for dinner.

The problem happens when there are sustained high prices. Gasoline prices might cause consumers and businesses alike to make temporary adjustments in their usage to control costs. For example, companies may reduce certain operations or turn to alternative fuel sources. Consumers may make changes like biking instead of driving to work or canceling an upcoming road trip.

Demand destruction and the energy market

Now that we’ve clarified what demand destruction is and is not, let’s see how the concept relates to the downstream fuels industry.

Let’s imagine the following scenario: gas prices continue to rise, leading to a significant consumer purchasing shift. Gas-efficient vehicles become more popular, as would electric cars. Subsequently, even if oil prices go down, the demand for gasoline would have been permanently damaged, never to recover.

But is that really what we see at the moment? Are the individual changes we are seeing a result of price elasticity or demand destruction?

Defining it as demand destruction would depend on these changes being permanent – and the data suggests that is not the case, at least not yet. Even if inflation persists well into 2023 (as most economists think it will), no one truly believes that refined fuels products are going the way of whale oil.

Despite record gas prices, many analysts see signs of robust underlying demand overall. A similar situation was seen when ‘demand destruction’ was tossed around during the Great Recession of 2008 and 2009, only for gas consumption to recover and rise past previous levels over the following decade.

Various factors make demand destruction unlikely in the foreseeable future. These factors include demand coming out of the pandemic, the effects of inflation, and the cost of energy alternatives.

 

The pandemic

For millions, the pandemic meant two years of lockdowns, quarantines, and postponed vacations. This pent-up desire to travel has led to increased tolerance of high fuel prices. Many are willing to pay more to travel instead of losing out on another year of travel.

According to the US Travel Association’s most recent report, despite rising prices, auto travel has increased above 2019 levels.

 

The impact of inflation

While it is true that the price of fuel is skyrocketing, the price increase has to be understood in the context of overall inflationary pressures.

In May 2022, energy prices rose nearly 35%, the greatest increase since 2005. Meanwhile, food costs saw the highest inflation levels in over 40 years, and housing prices rose to a level not seen in 30 years.

Clearly, high fuel prices are not the only factor affecting consumers’ increased costs of living.

 

The cost of alternatives

Demand destruction could only happen if there were cost-friendly alternatives to refined fuels readily available to consumers.

Specifically, demand destruction for refined fuels would only occur if a majority of consumers and commercial fleets got rid of their internal combustion engine (ICE) vehicles for electric vehicles (EVs). However, EV prices are also surging, due to supply chain issues and a critical shortage of the semiconductor chips necessary to build modern automobiles—ICE or EV. In all but rare cases, trading an older car for a newer one is an economic loss for a household. Most financial advisors believe that taking on the increased cost of a new vehicle for the purpose of spending less on gasoline is an expense that will take many years to recoup—if ever. While the cost-of-ownership curve inexorably bends towards EVs, a massive abandonment of ICE vehicles for EVs is many, many years away.

Should we be worried?

So, are we seeing the start of demand destruction in the energy sector? The simple answer is no.

While a temporary decrease in demand due to high prices is expected, this suppressed demand is highly unlikely to be permanent. Current policies and market data suggest that we aren’t anywhere close to “demand destruction” yet.

Yes, the world has changed, and so has the energy sector. The last few years have taught us accurate demand data and analysis are more critical than ever.

Learn more about how DTN Refined Fuels Demand can give you the actionable insights you need about overall market demand, and real-time data so you can act with certainty and build your company’s prosperity.