Here is the "real" price curve to supply. I have a slightly updated curve that I have not published yet and it has not changed the nature of the curve.

For a larger image us the following link:

http://farm4.static.flickr.com/3186/2968324434_7bd464740b_o.jpg

But where is the evidence for a collapse in consumption? All the public figures (e.g. from the EIA and IEA) seem to suggest that the decline has been small, of the order of 1% or less. So I keep reading about collapsing consumption but I can't find data to support that notion. It seems to be a case of argument from incredulity; it can't be anything else!

Do you think the price drop is due to drop in demand or not?

Yes - I don't believe it can be anything else. Supply does not respond to small changes in price, so when demand drops even a little it takes a huge price drop to have any impact on supply.

All the way to zero ... or five dollars!

There is another factor. I'll keep it brief;

What prices are measuring is production capacity rather than product.

For many years there was a consistent increase in demand - and leaving out inflation - this demand increased prices for crude resulting in more funds being available to further increase production. Consequently production increased, yet it lagged the increase in demand. Production increases never caught up with demand to the point where prices would fall.

Part of this was on account of inflation, but that is not central. Production itself - not the capital cost of it - is what matters.

By 2008 there was a very high level of production. Keep in mind this production is a non- economic activity; unlike banking, drilling wells and pumping oil does not require money (or credit), money facilitates the process but steel, geologists, pipe fitters and other industrial hardware are needed for production. Production takes place on its own account with resources that are inherent to it; out of cash flow. Oil production is basically self- propelled.

By Summer of 2008, the world was pricing a perceived production shortfall. This perception was reinforced by a continuation of the preceding many- years' trend. Also, it was stoked by the media and reflected in parallel bull markets in all other commodities. Yet, perception was false. Even when prices were over $120 dollars a barrel there were other stories in the same media of surplus oil being 'stored' in tankers in the Gulf of Arabia. At the highest price levels, there was sufficient oil available for all users. In other words, there was never a shortage of product, only a perception of a shortage of production.

When the surplus of oil became obvious, and could not be rationalized away the high price for product became unsupportable. The idea followed that high prices were causing 'demand destruction'. However, what was happening was a secular supply/demand imbalance. There was structural overproduction relative to demand. Demand was indeed declining because of the recession, but neither the decline in demand nor the accelerating shortage of credit affected the level of production capacity. That level is an outcome of the process; the large investment in it having already been made. Even with the depletion of the world's oil fields, there is still a great amount of production capacity, and there is an accompanying perception of a high level of capacity.

Consequently, any 'surplus' no matter how small is an indicator of excess capacity; of the continuing secular supply/demand imbalance. OPEC can announce cuts, they can actually shut some valves on pipes and reduce the flow, and some big fields can deplete dramatically, but geopolitics and the need for a constant revenue stream leaves the producers able to put a large fraction of available production onto the market - at any time. In other words, the oil available to produce is both absolutely and relatively very great, even if it is temporarily suspended there is no 'production destruction'.

As Phil indicated, the industry is very large with a large investment base. This capacity functions even at low product prices. Product can even be made available even at an economic 'loss' if only for a producer to maintain market share.

Against this background, any surplus on the market has the effect of continually forcing sales; product is sold at whatever price ... in order to clear the market. The perception is that tomorrow will bring increased supply OR that reduction in demand will have the same relative effect. As demand falls, the structural imbalance between capacity and demand increses; less oil sold and burned is oil that remains on the 'supply' side of the balance. It becomes reserve - or excess - capacity. Going forward, the less consumption the greater the imbalance.

Until there is an actual structural reduction of oil production capacity, not temporary cuts ... prices will drop. As demand continues to fall, the forcing mechanism of marginal oil surpluses - real or perceived - will become more and more powerful ultimagely pressing prices downward ... all the way to zero.

New ... there are other non- energy feedback mechanisms that come into play, but the short version has all these loops amplifying declines in price - making the forcing mechanism stronger still! Higher prices, to paraphrase Ronald Reagan lift all boats. Falling prices eventually leave all the boats aground. After this grounding point is reached, there is little that can raise the prices as only small amounts of money will be risked (or be available to risk) for higher, but still very small returns. Even if there are actual shortages, the price will only rise a little as higher prices will deter consumption. There might be long term $8 dollar oil.

The same mechanism is at play in other sectors of the world's economy. Deflation is a bitch ... I will leave to others the amount of economic activity which $8 oil reflects. It may be substantial or may be very reduced, but it will certainly be much less than in 2008.