INTERNATIONAL. OECD leading indicators are heading down, but look at emerging markets. If one were to judge the future evolution of global oil demand by merely looking at the OECD leading indicators and the WTI crude oil price action in July, the picture could hardly be more negative.

In a short period, oil prices have fallen by US$20 per barrel, while leading indicators in key OECD regions have continued to deteriorate, suggesting a synchronous global economic slowdown ahead. But when it comes to oil, looking at OECD demand and prices is deceptive. According to estimates in a new Merrill Lynch report, OECD as a group has contributed to just 15% of global oil demand growth since 2000.

One of the most puzzling developments in recent months has been the rapid rise in oil prices against a deteriorating economic outlook for the US. While the huge share of the US consumer in the global economy is now shrinking rapidly due to the credit crunch, domestic consumption in EMs has proved quite resilient. More importantly, we can not find a single year of negative emerging market oil demand growth in four decades, if we exclude the Former Soviet Union. On top of this, high prices have done little to dent EM oil demand growth historically.

In the near-term, the report concludes that the emerging market consumer should lend support to oil. EMs (excluding Former Soviet Union) have not experienced one single year of oil demand contraction in more  than four decades. There is every reason to believe that the rapid expansion in EM consumption will continue.

While the upside risks to oil prices may not be as acute as in first half 2008, strong EM performance will likely keep markets relatively tight in the coming months. Thus, Merrill said it is sticking to its average WTI oil price forecast of US$124 per barrel in third quarter 2008 and and US$119 in the fourth quarter.

Given the uncertainty surrounding the global financial sector, however, the bank said it remains a bit more cautious on 2009. It says volatility will stay very high, with oil prices responding abruptly to changes in monetary policy around the world, particularly those coming from the Fed and the People's Bank of China (PBoC).

OECD leading economic indicators pointing down sharply

If one were to judge the future evolution of global oil demand by merely looking at the OECD leading indicators, the picture could hardly be more negative. Leading indicators in the key three OECD regions, Europe, North America and Asia Pacific, are all pointing down South, suggesting a synchronous slowdown in growth. However, the slowdown in industrial growth embedded in the OECD leading indicators has not yet been felt globally as weak growth in the OECD countries has so far been absorbed by strong industrial growth outside the OECD.

Similarly, consumer confidence in OECD countries continues to deteriorate rapidly. In particular, consumer confidence in the United States has fallen well below the levels registered during the previous two recessions. In a rapid turn of events exacerbated by the credit crunch, US consumer confidence sentiment and expectations have now dropped to levels not seen since the two recessions of the early 1980s. In Europe, consumer confidence has also deteriorated in the last 12 months, albeit not nearly as sharply as in the United States. Perhaps more worryingly, major business confidence indicators in Europe are all pointing South.

While leading and confidence indicators are all suggesting a major deceleration in OECD economic activity, it is important to highlight once again that OECD economies have barely contributed to global oil demand growth in recent years. Merrill Lynch estimates that OECD as a group has just contributed to 15% of global oil demand growth since 2000, with 85% of the incremental oil demand coming from China, India, Brazil and a broad range of emerging economies.

More importantly, excluding the Former Soviet Union, it is not possible to find a single year of negative emerging market oil demand growth in more than four decades. This trend suggests that high prices do little to dent EM oil demand growth, and supports the view that oil demand will stay firm as long as emerging economies maintain a robust rate of economic growth.

Global rebalancing with more EM consumption, less exports

The positive side of global rebalancing means that consumption in emerging markets continues to expand very rapidly, in part sustaining a boom in car sales and other energy-intensive consumer products. In turn, export growth in China has decelerated very rapidly, from 33% in 2004 to 22% in the first half of 2008. This deceleration in export growth is already palpable across a broad range of emerging markets, and it is starting to take its toll on EM industrial production.

Against this background of expanding emerging market consumption and decelerating industrial output, the United States offers exactly a mirror image. Aggregate consumption is contracting at an extremely rapid pace and consumer-led gasoline demand is shrinking. Meanwhile, exports of goods and services outside the United States are increasing very rapidly. With a sustained weak dollar and a surge in manufacturing orders, this renaissance of the export sector in North America will likely lend support to domestic middle distillate demand. Still, continued demand growth in middle distillates will not likely be enough to keep aggregate US oil demand in positive territory.

In effect, retail sales in EM are still growing very rapidly. Even if US demand stays negative in 2008 and 2009, the rate of global oil demand growth will depend a lot more on EM economic growth than on North America over the next five years. There are reasons to be optimistic. Retail sales have continued to grow at a very healthy rate in places like Brazil, the GCC or Indonesia, although other emerging economies like Mexico have seen consumer confidence deteriorate in the past six months. Economic growth is also holding up relatively well in India and Merrill Lynch economists maintain a positive outlook for second half 2008 and 2009.

The strong growth in the consumer sector in emerging markets can be partly traced back to a rapid expansion in money supply growth and lending. Outside the OECD economies, money supply has expanded at a very fast rate from Russia to Brazil to India to Saudi Arabia in the last few years. Is this EM lending growth sustainable in the face of an Anglo Saxon credit crunch?

According to Merrill Lynch, a good part of the expansion in money supply and lending in EMs is linked to a significant improvement in the governance of local financial institutions. Moreover, as the majority of the expansion in lending in EM is generated via domestic savings, local banks do not need to rely so much on the ailing international capital markets for the time being. Of course, given the apparent oil supply constraints, the rapid increase in money supply has rapidly translated into higher oil prices. This combination of strong economic growth, rapid EM monetary expansion and fast EM currency appreciation could well continue to keep nominal oil prices high over the coming years.

Outside the OECD, money supply has expanded very fast. Given the apparent oil supply constraints, the rapid increase in money supply from Russia to Brazil to India to Saudi Arabia in the last few years has rapidly translated into higher oil prices. In conclusion the report says that the rapid expansion in EM consumption will continue, likely resulting in a supportive global oil demand environment during the remainder of this year.