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.
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 Mbpd. 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 Mbpd 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.
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 4 Mbpd 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 1 Mbpd 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.
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 North 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.