Dec 172014
 December 17, 2014  Posted by at 10:19 am Finance Tagged with: , , , , ,

Harris&Ewing F Street, Washington, DC 1935

This is another article from our friend in Aberdeen, Euan Mearns. It was first posted on Euan’s own site, Energy Matters. I earlier posted Euan’s The 2014 Oil Price Crash Explained on November 24, when the price of oil was still quite a bit higher than today. WTI ended that day at $75.74, it’s now $55.15. Here’s Euan:

A couple of weeks ago I had a post titled The 2014 Oil Price Crash Explained that was cross posted to over 20 other blogs including The Automatic Earth and Zero Hedge. In this post I use the empirical supply and demand dynamic described in that earlier post (Figure 1) to try and constrain the oil price a year from now and in 2016. The outcome is heavily dependent upon assumptions made about supply and demand and the behaviour of OPEC and the banking sector. Three different scenarios are presented with December 2015 prices ranging from $45 to $100 / bbl. Those hoping for a silver bullet forecast will be disappointed. Individuals must judge the scenarios on merit and decide for themselves which outcome, if any, is most likely.

Figure 1 The blue supply line is constrained by monthly production – price data from 1994 to 2008 and shows how supply became inelastic to demand post-2004. As demand continued to rise, prices rose exponentially to $148 / bbl in July 2008 before crashing all the way down again. The blue supply line in this chart is shown as a faint blue dashed line in all other charts to provide a frame of reference.

But first a look at the recent response of oil price dynamics to fluctuations in supply and demand.

OPEC spare capacity

Part of the key to understanding how the global oil market performs is to look at OPEC spare capacity data which gives a picture of how OPEC have provided or withheld capacity to try and retain order in the oil markets. OPEC suspending their market interventions has caused the recent oil price rout.

Figure 2 OPEC have tried to maintain order in the oil market. Rather than allow price fluctuations to control supply and demand, OPEC have aimed for a price that suits them and tried to maintain it by reducing and increasing supply in tune to fluctuations in global demand and non-OPEC supply. The picture of OPEC spare capacity therefore reflects fluctuations in the global oil market.

Over the past 10 years there have been three market cycles. Two of those have had roughly 3 years duration and amplitude of roughly 2 Mbpd (Figure 2). These sit either side of a larger cycle of 4 years duration and amplitude of 4 Mbpd caused by the 2008 financial crash. These cycles represent OPEC responding to global demand and non-OPEC supply changes. The smaller cycles may be viewed as “normal” and the larger cycle as rather extraordinary. OPEC intervention provided price stability of sorts. Without it we have price volatility that requires production to be balanced by varying demand and varying non-OPEC supply.

The spare capacity data suggests that demand / supply imbalance may last three years, requiring 18 months to work through to the mid-cycle point where over-supply turns to under-supply. It is by no means certain that the market will respond to the same time dynamic when we are now dependent upon natural production capacity wastage to occur as opposed to OPEC simply closing the spigot. But this is all I have to go on. The downturn in the current price cycle began last July and we are therefore just 6 months in. Another year of pain to go for the producers, that is unless OPEC decides to intervene.

Supply or Demand Driven Markets?

It is also difficult to discern if the current over-supply state is down to excess production capacity or a reduction in demand. Both are likely but my opinion is that the price rout is demand driven with many parts of the global economy performing badly – Japan, China and the EU to name but a few. These are about to be joined by OPEC, Russia and Canada.

The graphic below from the newly published December IEA OMR (oil market report) tends to confirm this view. 4Q14 supply is flat while demand is down. By 1Q15 a 2 Mbpd supply-demand gap is beginning to open tending to confirm the position laid out above.

Figure 2b The oil supply-demand view from the December IEA OMR.

Scenario 1

In 2015 demand falls by 2Mbpd relative to summer 2014 peak. New 2015 non-OPEC production capacity of 1.4 Mbpd (OPEC forecast) does not materialise leaving the supply curve as it is today.

This leaves the oil price around $60 a year from now (Figure 3). In the interim the price may go a lot lower as production capacity continues to rise before falling back to current level at year end; and because of short term trends driven by speculation.

Figure 3 Scenario 1 December 2015. Supply capacity grows and then falls back to where it is today. Underlying ills in the global economy sees demand drop 2 Mbpd from the July 2014 peak. The price ends up at around $60 / bbl, where it is today. But in the interim may go on an excursion to lower prices followed by recovery. Note that the 2014 demand line is retained in other charts to provide a frame of reference.

In 2016, low price causes a fall in global oil production capacity of 1 Mbpd and an increase in demand of 1 M bpd. These very small adjustments see the oil price rebound to $105 / bbl by December 2016 (Figure 4). Every cloud appears to have a silver lining if you are an oil producer, but global oil production capacity is cut by 1 M bpd in the process.

Figure 4 The low price of 2015 gives the oil industry a hangover in 2016 and supply drops 1 Mbpd. At the same time consumers party and falling supply collides with rising demand sending the oil price back up to $105 / bbl by December 2016.

Scenario 2

Under Scenario 2, the oil price rout causes high cost, high debt producers to default on loans creating a new banking crisis that spills over to the main economy. Re-run of 2008/9 though perhaps worse since most banks and national government balance sheets have not recovered from prior crisis.

Demand falls by 4Mbpd relative to summer 2014 peak, but supply capacity is also cut by 1 Mbpd owing to shale and other high cost operators going out of business. In December 2015 the oil price stands at $45 / bbl (Figure 5).

Figure 5 The fall in demand experienced so far causes trauma to many global producers that default on loans with knock on to banking sector and the broader economy resulting in further falls in demand during 2015. The price rout continues but is tempered slightly by non-OPEC supply being reduced by 1 Mbpd.

The low oil price works its magic on the global economy that rebounds strongly in 2016 pushing demand up by 2 Mbpd. But the $45 oil experienced in 2015 seals the fate of another 1Mbpd production capacity that is lost. Rising demand collides with falling capacity sending the oil price soaring back to $100 / bbl by December 2016. But the world has lost 2 Mbpd oil production capacity as a result of the price rout.

Figure 6 The price rout sees supply fall by a further 1 Mbpd. But the ultra low price causes a major rebound in demand of 2 Mbpd in 2016 from an “oversold” position. The oil price recovers to $100 / bbl.

Scenario 3

OPEC blinks first and with both Qatar and Kuwait cutting production in November, there are signs that this may be possible. Much depends upon Saudi Arabia who could conceivably raise production to counter the cuts made in other Gulf States. In Scenario 3, OPEC cuts production by 2 Mbpd by December 2015. While demand falls by 2 Mbpd from the July 2014 peak. The oil price recovers to $100 / bbl by next December 2015 (Figure 7).

Figure 7 Early in 2015 OPEC succumbs to pressure from several members and cuts supply progressively for a total of 2 Mbpd over the year. The net demand fall from the July 2014 peak is cancelled by the supply cut and the price recovers to $100 by December 2015.

This effectively means re-establishing the status quo of recent years. In this scenario, it is not necessary to look beyond 2015 since OPEC have re-adopted their strategy of market stability at a price that suits all – including the high-cost producers.


Each of the scenarios see strong recovery in oil price to the region of $100 come 2016. The main differences are in the extent and duration of short term pain and in the global production capacity. Scenarios 1 and 2 sees production capacity falling by 1 to 2 Mbpd come December 2016 and this would mainly be non-OPEC capacity that is destroyed handing greater control of oil markets to OPEC. Scenario 3 sees capacity maintenance and with re-establishment of status quo and high oil price, further expansion of N America. We need to wait and see if OPEC does what OPEC says.

My estimation of probabilities goes something like this:

Scenario 1: 40%
Scenario 2: 50%
Scenario 3: 10%

So my weighted forecast for December 2015 goes like this:

($60*0.4)+($45*0.5)+($100*0.1) = $56.50

Every year around this time I have a bet on the oil price a year from now. A year ago I bet $125 and my friend $110. Rarely have we both been so badly wrong. I lost again :-(

Ilargi: And of course Euan’s friend Roger Andrews has the first comment again:

Euan: Excellent piece of work. My weighted prediction for December 2015 is ($60*0.45)+($45*0.5)+($100*0.05) = $54.50/bbl. I’ve halved your already-low scenario 3 probability because I just don’t see OPEC – and certainly not the Saudis – cutting production first.

I think the Saudis have decided that preserving their historic market share is worth a few years of privation, particularly when they can live off their accumulated fat in the meantime. I say “a few years” because I don’t think it’s out of the question that the price slump could go on for that long.

Each of the scenarios see strong recovery in oil price to the region of $100 come 2016. Will this be the next “oil shock”?

Home Forums Oil Price Scenarios for 2015 and 2016

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    Harris&Ewing F Street, Washington, DC 1935 This is another article from our friend in Aberdeen, Euan Mearns. It was first posted on Euan’s own site, E
    [See the full post at: Oil Price Scenarios for 2015 and 2016]


    I think Euan and Roger have pretty solid assessments. The one thing I wonder about with regard to Scenario 2 in particular (though it would apply in general) is whether the supply curve would permanently (inflexibly) go more vertical above the demand curve each time the demand curve drops and some production capacity is permanently lost. At the very least wouldn’t it be more vertical than the 2014 curve? I don’t know if Euan doesn’t give enough weight to the financial (as opposed to economic) factors or if the supply curve really is somewhat flexible in that regard. What do you think, Ilargi?

    It might be interesting to look back at 2007-2009 to see what occurred. Of course, the shale boom has been a big factor since then. If that was a one-time phenomenon, the supply curve would become fixed in an even more permanently vertical slope to the right of the demand curve as that shifts lower (to the left). Or could shale come back from the dead? Isn’t that an even bigger question than what will OPEC do?

    Euan Mearns

    Capacity adjustments are made by moving the blue supply curve left or right. But you are correct to question whether or not the shape might change as well. It worked incredibly well on the way up and down in 2008. In a way it is a response curve of industry to changing demand. I guess we may find out in the next couple of years if there has been a fundamental change. For the time being, its all I have to go on.


    Having such low oil prices not only squashes non-opec oil and shale oil, but also all efforts to transition away from fossil fuels including conservation and renewables. It just locks us right back into the 20th century until the oil depletion reduces the excess capacity OPEC has. We lose another few years and another few billion barrels and the EROEI will be lower next time.


    Um, I may be a little thick, but why the assumption of 2016 demand rebound in all three scenarios? If credit is fully unwound and asset prices return to mean, how is the consumption paid for? Don’t forget, producer credit directly influences consumption as oil co. spending/salaries AND as knock-on spending in broader economy.



    “Each of the scenarios see strong recovery in oil price to the region of $100 come 2016.”

    ninjin said: “Um, I may be a little thick, but why the assumption of 2016 demand rebound in all three scenarios?”

    Ditto! Why the assumption that after LTO goes bankrupt in the US (and thousands of people get laid off…), that the marginal consumer is going to have the borrowing capacity to bring the marginal oil field back to life a few years hence? They can’t afford $100/b oil now. How will they afford it in the future?


    Good points, ninjin and Jb. It seems that they wouldn’t be able to afford it, Jb, which is what Nicole has predicted. So is it more realistic that the supply curve will move further to the left and the demand curve only slightly and briefly shifts to the right over the next two years?


    So, supply and demand (Fundamentals) are back again? With rates at artificial lows? In a world where Central Banks and governments control and manipulate financial systems?

    Manipulations which created this bubble in the first place will suddenly yield to fundamental process? Why now? Why, when the Fed is “All in” will it find religion and capitulate, clear it’s desk and go home?

    Rest assured, if they feel the need, they will buy Bakken product at top dollar and put it in the SPR, or whatever.

    The oil “market” is no more operating on fundamentals than are the equity and security “markets” under this Central Bank Monopoly of “money” creation (discount pricing?)

    Supply and demand are secondary factors in this Brave New Economy.

    For certain, though, the printing induced “supply shocks” of the 70’s gave the Fed Carte Blanche on continued new money creation, in the aftermath, furthering double digit price inflation in the process. Humm?

    Euan Mearns

    ninjin, if demand and price does not recover in 2016, then we are looking at widespread destruction of non-OPEC high cost supply. The world would then settle on a lower supply of low cost oil commensurate with a significantly reduced global GDP. Its likely that we see nationalisation of energy industries and a new world order that is impossible to forecast.


    I’d take anything written at Energy Matters with a great amount of skepticism as that site often publishes posts that play down the climate change predicament, often sailing very close to denial. Doesn’t seem like they examine subjects dispassionately.

    Euan Mearns


    I know that Roel disagrees with me when it comes to CC, but we mange to live with that. But your comment has really, really pissed me off.

    The link between sunshine and temperature based on UK climate records since 1933

    UK temperatures since 1956 – physical models and interpretation of temperature change

    The Vostok Ice Core: Temperature, CO2 and CH4

    I expect you to come with a substantial critique of these three articles highlighting where my analysis is dispassionate.

    Euan Mearns
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