Fundamentals point toward market balance but pessimism is dragging oil prices down. IEA has apparently succumbed to this negativity but their data suggests that things are getting better, not worse.

In a business-as-usual world in which nothing unusual happens, the world will be close to market balance some time in 2016. If anything unusual happens, all bets are off and oil prices could rebound much faster than anyone imagines.

Just to be clear, I continue to believe that oil prices must fall further in order to modify producer and capital-provider behavior and thus prepare the way for some kind of meaningful market balance to occur and I don’t see that happening any time soon.

Fundamentals are moving slowly in the right direction toward market balance. Imbalance will persist for some time and a meaningful price rally—that is not taken away when reality forces its way back upon the markets—cannot occur unless/until supply and demand are approaching balance.

A Year of Extreme Price Cycles

NYMEX WTI futures prices have fallen 34% since October 2015, and are below $30.00 per barrel for the first time since 2003. Prices have gone through four cycles of 30-40% increases and decreases over the past year (Figure 1).



Figure 1. NYMEX WTI futures prices and price cycles in 2015. Source: EIA, Bloomberg & Labyrinth Consulting Services, Inc.

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The two price rallies from March-to-June and from August-to-October were based largely on hope and the price decline from June-to-August represented a return to the reality of supply and demand fundamentals.

The most recent price decline that began in October is a bit different. Here, confirmation bias has replaced critical thinking about the oil market. The ruling paradigm is that prices are likely to stay low for years or even for decades and evidence is easily found that favors and confirms this bias. I believe that this paradigm is incorrect.

Despite troubling signals of structural weakness in the global economy, data suggests that the oil market is stumbling toward balance. Although I have said that prices must go lower in order to flush out the zombie producers, IEA’s statement in the January Oil Market Report that the world could drown in over-supply is based more on sentiment and pessimism than on data.

Stumbling Toward Market Balance

The best way to show this is by using both IEA (International Energy Agency) and EIA (U.S. Energy Information Administration) data. Each has its advantages and disadvantages. IEA data estimates demand—oil use (consumption) plus stock increases—whereas EIA only estimates consumption, a proxy for demand. EIA presents monthly global liquids data while IEA only presents quarterly data. EIA forecasts both supply and consumption a year forward whereas IEA only forecasts demand. Together, the two provide a reasonably full view given the difficulties and uncertainties involved.

IEA data shows that global over-supply (supply minus demand) of liquids was 1.83 mmbpd (million barrels per day) in the 4th quarter of 2015 (Figure 2). Although that is an increase of 250,000 bpd over the 3rd quarter, it represents a 530,000 bpd decrease compared with the second quarter, the highest level of over-supply since the price collapse began in mid-2014. Furthermore, the 6-month moving average (1H MA in Figure 2) of market balance shows that the production surplus is decreasing.

Figure 2. IEA World liquids market balance (supply minus demand) and Brent crude oil price. Source: IEA & Labyrinth Consulting Services, Inc.

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Total supply actually decreased somewhat in the 4th quarter, and it was the seasonal decline in demand that increased market balance. I am not trying to make a case that things are great but simply that the data indicates that things are moving slowly in the right direction.

EIA’s monthly data shows that market balance is clearly improving with a decline of almost 1 mmbpd in supply surplus from August (2.51 mmbpd) to December (1.55 mmbpd) (Figure 3). The 4-month moving average (4 MMA in Figure 3) reinforces the observation that the over-supply is decreasing.

Figure 3. EIA Market balance vs. Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.

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Much of IEA’s negativity is because of lower forecasted demand growth of 1.2 mmbpd in 2016 (Figure 4). This is based largely on pessimism about China’s unstable economy and declining oil demand, discouraging economic expectations in the developing world, and renewed Iranian production.

Figure 4. IEA annual liquids demand growth and 2016 forecast. Source: IEA & Labyrinth Consulting Services, Inc.

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Let’s put this in context. 1.2 mmbpd is disappointing only compared with 1.7 mmpbd in 2015 but that was the highest demand growth in 5 years. 2016 demand growth is more than the average for 2011 through 2013 when oil prices were more than $100 per barrel, and is one-third higher than in 2014 when the oil-price collapse began.

Annual consumption growth data from EIA (Figure 5) offers a somewhat different perspective suggesting a progressive increase since 2013.

Figure 5. Annual demand growth and 2016 forecast, and Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.

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What conclusions might we reach from this? If we assume that supply remains flat and IEA’s forecast of a 1.2 mmbpd increase in demand is reasonable, the supply surplus should fall to approximately 350,000 bpd. That does not include the wild card of Iranian production.

That is where EIA’s forward estimate of both production and consumption is helpful because Iranian production is included (correctly or incorrectly). Figure 6 shows improving market balance using a 6-month moving average of supply minus consumption to smooth through the month-to-month variations that have characterized market balance since the oil-price collapse began.

Figure 6. EIA market balance (6-month moving average) and Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.

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Using this approach, the world liquids supply surplus should decline to approximately 730,000 bpd by the end of 2016 (Figure 7). That would be a decrease in supply surplus of about 1 mmbpd from year-end 2015. This suggests that Iran may add an average of 400,000 bpd in 2016 which seems reasonable although it exceeds EIA’s recent reference case estimate of approximately 300,000 bpd.



Figure 7. EIA market balance (supply minus consumption) vs. Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.

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Finally, the Oil and Gas Journal has provided an analysis and forecast of world liquids production that is more optimistic than either EIA or IEA (Figure 8).



Figure 8. Oil and Gas Journal world liquids supply and demand and 2016 forecast. Source: Oil and Gas Journal & Labyrinth Consulting Services, Inc.

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Their forecast calls for world liquids market balance by mid-year 2016.

The World Is Not Drowning In Oil

The analysis that I have presented assumes the improbable namely, that nothing unusual happens in 2016. In a business-as-usual world, the oil market will be close to balance this year. The liquids surplus will be about a million barrels per day less than it is today. The world will not be drowning in oil a year from now.

What might happen to complicate this outcome? A supply interruption in the Middle East is likely based on current events in that region. The failure of some large producing nation or a group of smaller nations to maintain production at current prices or because of lack of capital investment is possible. Greater decline in U.S. production than assumed is probable especially after the disastrous full-year financial data is released beginning next month. OPEC and Russia will probably cut production in 2016.

Any of these scenarios or combination of scenarios would affect the oil-market and would probably accelerate movement toward market balance and higher oil prices.

Opinion suggests that little progress has been made in reducing the over-supply of oil in the world and the momentum of pessimism points toward low prices for years to come. Data points toward a different outcome in the relatively near-term.