The 2014 Oil Price Crash Explained

  • In February 2009 Phil Hart published on The Oil Drum a simple supply demand model that explained then the action in the oil price. In this post I update Phil’s model to July 2014 using monthly oil supply (crude+condensate) and price data from the Energy Information Agency (EIA).
  • This model explains how a drop in demand for oil of only 1 million barrels per day can account for the fall in price from $110 to below $80 per barrel.
  • The future price will be determined by demand, production capacity and OPEC production constraint. A further fall in demand of the order 1 Mbpd may see the price fall below $60. Conversely, at current demand, an OPEC production cut of the order 1 Mbpd may send the oil price back up towards $100. It seems that volatility has returned to the oil market.

Figure 1 An adaptation of Phil Hart’s oil supply demand model. The blue supply line is constrained by data (see Figure 4). The red demand lines are conceptual. Prior to 2004, oil supply was fairly elastic to changes in price, i.e. a small rise in price led to a large rise in production. This is explained by OPEC opening and closing the taps. Post 2004, oil supply became inelastic to price, i.e. a large change in price led to marginal increase in supply. This is explained by the world pumping flat out. Demand tends to be fairly inelastic and inversely correlated with price in that high price suppresses demand a little. Supply and price at any point in time is defined by the intersection of the supply and demand curves. 72 Mbpd and $40 / bbl in 2004 became 76 Mbpd and $120 / bbl in 2008 as demand for oil soared against inelastic supply.

Figure 2

Followers of the oil market will be familiar with the recent evolution of oil supply and price shown in Figure 2.

Figure 3

What is less widely appreciated is that a cross plot of the data shown in Figure 2 results in the well-ordered relationship shown in Figure 3. Oil supply and price are clearly following some well established rules. This relationship led to Phil Hart developing his model shown as Figure 1.

Figure 4

Separating the data into two time periods brings more clarity to the process at work. The data define a fairly well-ordered time series beginning at January 1994 at the bottom left rising slowly to January 2004 and then steeply to the Olympic Peak of July 2008. The financial crash then caused the oil price to give up all of its gains returning to 2004 levels by December 2008.

Figure 5

The second time period from January 2009 to the present shows some different forces at work. Starting in 2009 some new production capacity was built. This was not in OPEC and is concentrated in N America where the light tight oil (LTO) boom took off supplemented by steady expansion of tar sands production. Prior to 2009, the production peaks were of the order 74 Mbpd. Post 2009 peaks of the order 77 Mbpd were achieved. About 3 Mbpd new capacity has been added. In May 2011 there is a significant and curious excursion to lower production not accompanied by a fall in price. This coincides with Libya coming off line for the first time and the loss of 1.6 Mbpd production. It seems possible that this coincided with weak demand and the fortuitous loss of production cancelling weak demand leaving price unchanged.

The EIA are always running a few months behind with their statistics these days, not ideal in a rapidly changing world. Thus we do not yet have the data to see the recent crash in the oil price. But we know the price has fallen below $80 and production is unlikely to be significantly changed. So, how do we explain production of roughly 77 Mbpd and a price below $80?

Figure 6

Figure 6 updates Phil Hart’s model (Figure 1) to take account of the oil supply and price movements of the last 5 years. Capacity expansion is achieved by adding 3 Mbpd to the former, well-defined supply-price curve (blue arrow). There is no a-priori reason that this curve should hold in the new supply-price regime, but for the time being that is all I have to work with. The red lines, as described in the caption to Figure 1, conceptually represent inelastic demand where high price marginally suppresses demand for oil. The recent past has seen oil priced at $110 with supply running at about 77 Mbpd as defined by the right hand red coloured demand curve. Reducing demand by about 1 Mbpd brings the price below $80 / bbl (red arrow).

The Recent Past and the Future

Old hands will know that it is virtually impossible to forecast the oil price. The anomalous recent price stability of $110±10 I believe reflects great skill on the part of Saudi Arabia balancing the market at a price high enough to keep Saudi Arabia solvent and low enough to keep the world economy afloat. The reason Saudi Arabia has not cut production now, when faced with weak global demand for oil, probably comes down to their desire to maintain market share which means hobbling the N American LTO bonanza. Alternatively, they could be conspiring with the USA to wreck the Russian economy? But Saudi Arabia is not the only member of OPEC and the economies of many of the member countries will be suffering badly at these prices and that ultimately leads to elevated risk of civil unrest. It is not possible to predict the actions of the main players but it is easier to predict what the outcome may be of certain actions.

  1. If demand for oil weakens by about a further 1 Mbpd this may send the price down below $60 / bbl.
  2. If OPEC cuts supply by about 1 Mbpd at constant demand this may send the price back up towards $100 / bbl.
  3. Prolonged low price may see LTO production fall in N America and other non-OPEC projects shelved resulting in attrition of non-OPEC capacity. This may take one to two years to work through but with constant demand, this will inevitably send prices higher again.
  4. Prolonged low price may see many specialist LTO producers default on loans, risking a new credit crunch and reduced LTO production. This would likely lead to a major consolidation of operators in the LTO patch where the larger companies (the IOCs) pick up the best assets at knock down prices. That is the way it has always been.
  5. Black Swans and elephants in the room – with conflict escalation in Ukraine and / or Syria-Iraq and a new credit crunch, all bets will be off.
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52 Responses to The 2014 Oil Price Crash Explained

  1. Hi Euan:

    I put this XY plot of the data together from the data links you supplied. It shows the same trends as your Figures except that I’ve plotted all the points on one graph and segregated them into five periods, with trend lines and arrows showing the overall “direction of travel” for each (arrows in both directions for October 2004-May 2009, which as you noted goes zooming up and then comes right back down again).

    I’ve also projected production data for the missing months since May 2014 (shouldn’t be too far off) so that we can at least get an idea of how the latest trend might compare with the old ones. We seem to be in uncharted territory.

  2. Hugh Sharman says:

    Practically speaking, of course, high cost oil extraction can and will close down soon, especially tight shale oil, possibly along with some pretty horrific debt defaults.

  3. Naimals says:

    Roger’s graph is very interesting and informative because it indicates that the latest change in oil price were probably supply driven rather than demand driven:

    With a change in demand (defined as an increase in quantity demanded at every price level), the price and quantity always shift along the supply curve (shifting along a positively sloping curve). This has been the case for the red, orange and green dots.

    For the blue and grey dots, however, the points are shifting down a negatively slopping curve (i.e. the demand curve), which indicates an increase of supply (which is defined as the quantity supplied by all producers at every price level). While the blue dots may be explained by the tight oil boom in the US, the grey dots are certainly peculiar and beyond scientific / economic explanations if you look at the face of it: who on earth is willing to sell his products at $80 in November whereas he was selling it at $110 just a few months before? (This is equivalent of an increase in supply in the economic definition) Who is the marginal producer @ $110 and who is the marginal producer @ $80? Which producers are still able to make money @ $80?

    • Euan Mearns says:

      the grey dots are certainly peculiar and beyond scientific / economic explanations if you look at the face of it:

      Yes, well you need to remember that we do not yet have the data for August to November 2014 and Roger has simply made the grey dots up to illustrate a point 😉

      But its true that the price crash could be caused by an increase of supply of the order 1 Mbpd at constant demand. But the last time the price crashed like this was post finance crash of 2008 when a couple of million bbls per day demand was wiped out. There are a multitude of stories out there of parts of the global economy slowing, especially China, Euro Zone, maybe Russia and so for the time being I will stick with a demand based interpretation. Adding supply is a slow process. But the main point is the 1 Mbpd sensitivity of the system.

      • Maybe we’re in another recession?

        • Naimals says:

          Didn’t catch that the production volume for the last few months are not yet confirmed but that will make a difference in the analysis:

          If it was a recession like 2008, then we would expect a reduction in the volume as the drop in price would be induced by a reduction in demand (fear, less consumption, etc.) corresponding to a shift of the demand curve to the left.

          If the temporary data for the last few months of 2014 are indeed correct, it is indicative of an expansion of supply (not in the physical sense, but in the economic sense, which only requires a few major suppliers lowering the price they sell to the market), supply curve shifting to the right, volume increases and price drop.

          This, in other goods market, will be equivalent to one key vendor lowering the marked price on the price list every month. More of the goods get sold and other suppliers has to follow since they are price-takers. (However, I don’t know enough of the crude market to tell whether its behaviour is indeed similar)

          • Changes in consumption won’t change the basic picture. The graph will still show a near-vertical line heading downwards, and the only parallel event since 1994 was the oil price collapse during the 2008 global recession. The 2008 price collapse was, however, a lot more severe than the current one, suggesting that we may be seeing the impacts of a global economic slowdown rather than a full-blown global recession (there’s no accepted definition of a global recession anyway). There seems to be general agreement that the global economy is indeed now in slowdown mode.

        • dcoyne1984 says:

          A major difference between the two periods is the response of OPEC. In the first period they cut production, in this case they did not. It is possible the World is in a recession, the low oil prices may tend to increase World GDP and shift oil demand to the right, this may happen more quickly than 1 or two years, possibly in as little as 6 months, though very difficult to predict depending upon what happens in the middle east and Ukraine, South China sea, Iran, Pakistan, etc.

    • Javier says:

      For a precedent of the grey dots behaviour you have the oil glut of 1980-1983. An increase in supply at a time of a decrease in demand. The oil producers are forced to sell their product once extracted and the main expense is pre-extraction. Not a great place to be when prices go down, since they cannot set the price of their product.

      We are living a demand/supply mismatch since 2002, due to peak-oil lack of supply until 2009 and a probable tight-oil induced excess supply since 2011. Between 2002 and 2004 spare capacity took care of the mismatch (Sam Foucher showed that). This article is a fantastic way of showing the demand/supply dynamics since 2004, once spare capacity got depleted, until 2013. For 2014 we need to wait for the data, but there is evidence that indicates a slowing of non-OECD demand starting in 2011, that would lead to a current glut.

      • Euan Mearns says:

        For good measure, here are my most recent plots of OPEC spare capacity to Aug 2014. In the wake of the 2008 financial crash OPEC trimmed over 4 Mbpd from production, most of which was brought back on in a couple of years. There is no sign of this being repeated. The latest IEA OMR (to Sep 14) actually shows Iraq and Libya up on August.

        The black band of Ecuador marks the top of actual OPEC production, the grey band at top denotes spare production capacity (see Figure 5)

        • Javier says:

          Crystal clear Euan, nice job with the graphs and thank you.

          I remember those articles on “expensive oil is here to stay”. Now we will get articles on (not so) “cheap oil is here to stay”. I am betting for those that predicted price volatility swings coming down peak-oil as periods of demand destruction alternate with periods of insufficient supply.

          • I think these price reductions are temporary, and expensive oil is here to stay. Prices may be subdued for a few years but they will return to $85+/bbl fairly soon.

            The price for the marginal barrel of non-OPEC oil in 2013 was $85+. Regardless of recent demand destruction, China and India are growing fast enough that the marginal barrel of non-OPEC oil will need to be exploited again.

            -Tom S

  4. Sam Taylor says:


    For all the focus on LTO, I think that older conventional production has got plenty of potential downside in the short term. I was at Petex last week, and went to a presentation by Apache on how they’ve managed to arrest the Forties field’s decline through an absolutely massive drilling effort, as they attempt to sweep the field clean. Generally only chasing targets of maybe 1 million barrels or so. I expect that we’ll see lots of smaller projects like this stop on lower prices, and older field production probably returning back to its decline trend fairly rapidly. And despite Oonagh Werngrehns exhortations, few people seemed that excited at the prospect of trying to wring out every last drop from the north sea.

    However I agree that shale debt is a real worry. Energy companies make up something like 15% of the US high yield bond market, up from 5% in 2005. What scares me is the potential of falling oil prices having the effect of both stimulating the US economy and leading to higher interest rates, while at the same time hitting the shale drillers pocketbook. It’ll be a test of whether or not the banks have really shored up their capital holdings or not. Frankly the new COCOs securities that they created in the wake of 2009 to accomplish this just look like a time bomb to me.

    • Euan Mearns says:

      From what I recall The Industry did not react significantly to the price rout of 2008, but uncharacteristically carried on, leading to the false boom Aberdeen has enjoyed for the last 5 years. This time the knives are out with rates being cut and redundancies everywhere. Has to have a negative impact on production. What are the chances of Osborne reversing tax hikes?

      • Sam Taylor says:

        The price in 2008 went down and then back up in the space of 12 months, perhaps the somewhat rapid return to $100 helped mitigate things somewhat? Economics within the industry seem to have changed since then, though. Capex is up and production is down, and I think a large amount of the cash pile that companies were sat on has evaporated.

        The industry would seem to need tax breaks to sustain its health going forward, but one has to wonder how that would play with the electorate, or indeed a government which seems intent of deficit slashing no matter the cost.

  5. David says:

    I skimmed an article in the Telegraph last week that said a lot of the US shale oil production was hedged well into 2015 and even beyond. Who is hedged and for how long will impact the change in supply with weaker prices.

    • Euan Mearns says:

      I guess it is important to know what “a lot” means. Any company that hedged at $100 will appear to be sitting pretty right now. Of course there are those on the other side of those bets sitting on gigantic losses that will appear somewhere in the system someday. The LTO / shale industry has momentum and it will take many months / years for the drilling action to be wound down – pouring gasoline on the fire as they say.

  6. A C Osborn says:

    With 6 million new cars a year being sold in just China alone requiring Fuel I can see those surpluses being eaten in to quite quickly.
    I don’t have a figure for India, but that also has to be pretty high as well.

  7. derek louden says:

    There are a number of other issues worth considering. For George Osborne the possibility of reduced borrowing has vanished. He faces a number of problems, a decline in petroleum taxes, corporation taxes, excise duty, VAT and license fees from the fall in oil prices. He also faces a nightmare scenario in terms of infrastructure with the decline in prices accelerating the de-commissioning of old fields which are no longer profitable. The infrastructure losses place satellite developments at risk as there’ll be nothing left to tie back to. He’s faced with a much faster pace of de-commissioning than he’d thought likely when agreeing to part-fund these costs and finally he’s being lobbied forcefully to provide tax breaks at a time when a collapse in tax receipts leaves him no lee-way to provide them. As an aside, he’s allowed Mark Carney to assume liability for “market maker” shadow banks when they are unable to meet their liabilities on forex, interest rate or commodity exchange contracts. Taxpayers will, as a last resort, bail out banks if they’re unable to honour purchases of oil at $110 a barrel in June 2015. Exactly how this will be paid for is difficult to ascertain at this stage. Ideas anyone?

  8. Willem Post says:

    “76 Mbpd and $120 / bbl”

    74+ Mbpd appears more correct.

  9. Alister Hamilton says:

    There’s another explanation for the recent oil price decline proposed in this report:

    in particular on this commentary page (you have to pay for the full report)

    One of the report’s authors is taking questions over at

    Very interesting!

    • Tom S says:

      I doubt very much that analysis is correct. I haven’t read the hills group report because it costs money. However, I have read the comments which the hills group author posts to, and they often seem badly mistaken to me.

      I think there should be a strict division between serious articles (like this one) and the musings of the doomsday crowd. The doomsday crowd gets it wrong, very badly, over and over again, and then just issues new predictions which fail in turn. This has been going on for many years now, and it’s an extreme embarrassment.

      IMO, it’s best to keep a strict separation between serious analysis and the doomsday movement.

      -Tom S

  10. Teo says:

    I have noticed that people have problems grasping just how very large China has become.
    Total vehicle sales ( private and commercial) in 2013, in China have been 21,984 mil.
    We have the numbers for the first half oh 2014. This year, the total sales will be over 23 mil.

    2013, India : 3.24 mil
    Brazil : 3.8 mil
    Russia : 2.95 mil

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  12. Mushalik says:

    I am working on a series of articles describing the impact of US tight oil. These are the first 2 articles:

    US oil dependency on Middle East has hardly changed since 2007

    US oil consumption did not increase as result of US tight oil boom

    • Euan Mearns says:

      Abiotic methane may exist, but if it does, this does not mean that all methane is abiotic. The formation of methane from organic matter is well understood by either thermal or biogenic processes. Take coal bed methane for example – there is no doubt that methane came from the coal.

      Organic carbon gets subducted at subduction zones and can then re-eemerge in volcanos.

  13. Jacob says:

    I think that what is missing in the above explanation is the factor of time-lag in demand and supply reaction to price signals.
    When prices go up, the initial drop in demand is small (inflexible demand) but over time demand adjusts. Eg. people buy smaller cars, or install gas heaters replacing oil heaters, or move to reduce their commute, or use more public transport, etc. So, demand drop as reaction to price increase takes two-three years to materialize.
    The same with supply. When prices go up, new exploration and drilling start, but it takes years until new production (supply) comes on-line.
    So, it might happen that a couple of years or so after a price hike the demand drops and supply picks up, coincidentally, at the same time. This produces a price drop, and the cycle starts anew.

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  19. I didn’t see where the supply side boost is coming from? Sorry if I missed iot

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  27. kublikhan says:

    Why do you say demand has fallen when the IEA reports demand has risen? Growth is reported at a five year low, but it’s still growth. Are you only looking at the decline in demand in the OECD? This was more than offset by rising demand in the non-OECD.

    “Global oil demand estimates for 2014 and 2015 are unchanged since last month’s Report, at 92.4 mb/d and 93.6 mb/d, respectively. Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.”

    “[Global oil demand estimate for 2013: 91.2 mb/d]”

    • Euan Mearns says:

      The IEA suffers from optimistic bias. Have you ever heard them say they expect the global economy to enter a tail spin and demand for oil to plummet?

      And you need to read my post carefully. I said the oil price action can be explained by a fall in demand for oil of 1 Mbpd that is not the same as saying that demand for oil fell by that amount. The main point is that ±1 Mbpd translates to ± $30 on the oil price.

      I do happen to believe that with euro Zone, China and Japan all back in trouble that the movement is more likely to be 1 Mbpd less demand short term than 1 Mbpd new supply suddenly arriving. Although we do have Kurdistan and ISIS as new players in the supply market.

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