Why You Can Expect Oil Prices to Go Lower from Here

For the past few years, the so-called energy "experts" have told us the world is running out of oil.

All the major fields have already been discovered, they said. Meanwhile, global demand – especially from big emerging markets like China and India – keeps rising.

Yet, oil recently sank below $100 a barrel as a jump in unemployment signaled to traders that Americans will be paring back their energy use. This was yet another blow to crude prices. Oil has plunged $40 since hitting $147.27 a barrel in early July.

Let's take a dispassionate look at what's happening with crude prices, beginning with the obvious: No one from Ben Bernanke to T. Boone Pickens can tell you how high or how low oil is headed with any certainty.

If it were possible to forecast supply and demand, we'd all be trading oil futures from out of beachside huts in Bora Bora. However, there is always a sure sign that the price of anything has reached La-La Land: Ordinarily sensible people start spouting nonsense. You know, "The Internet is forever," "They're not making any more real estate," that kind of stuff.

Take "the world is running out of oil" with the same grain of salt.

It's different this time, the oil bulls say. China is growing so fast it's gobbling everything up. Ho hum. This story is old news. Yes, China is growing at roughly 10% a year. But if anyone cares to notice, it has been growing at this rate for over two decades now. It didn't just jump into the world economy when oil was $15 a barrel a few years ago.

Another sign of a mania was the major media, which kept making meaningless statements about oil. For example, a few weeks ago, The Washington Post, in an article explaining why oil had nowhere to go but up, quoted one consumer who said: "If you don't have gas, you can't get to work. And if you can't get to work, you don't get paid. And if you don't get paid, you can't buy food. We're at their mercy."

Is this what passes for economic analysis these days? Come on. We're all dependent on oil. That's a given. And the world will need even more oil in the years ahead.

But this is just the back story. It doesn't tell us where oil should be trading now. Ultimately, that will be decided by supply and demand. And those factors suggest lower prices. The International Energy Agency (IEA), the Paris-based energy watchdog of the world's richest nations, has lowered its forecast for world oil demand growth by 460,000 barrels a day.

The IEA also sees supply from outside OPEC growing by over a million barrels a day, the strongest growth since 2004. Anyone who has taken Economics 101 knows what increasing supply and decreasing demand does to prices. Look out below...

The price of oil always sows the seeds of its own collapse. People say consumers are trapped. But not entirely. We can drive less. We can use mass transit. We can buy more fuel-efficient cars. Consumers will conserve. More money will be invested in alternative energy sources. Producers, too, will search for and bring to market oil that was once too costly to extract. Eventually, supply and demand will come back into balance. Don't get me wrong. You won't see $30 oil or $1.50 gas again anytime soon. And probably never.

Two decades ago, the world could pump 15% more oil than it needed. Today that spare capacity has practically vanished. It's now about 2% beyond the world's total daily consumption of roughly 85.5 million barrels. That makes the oil market exquisitely sensitive to rumors of anything that might endanger existing production.

A terrorist group in Saudi Arabia or insurgents in remote parts of the Niger Delta could turn the world oil market upside down very quickly. (And send oil higher again.) But barring a major supply disruption, fundamentals point to still lower oil prices.

The Energy Information Agency announced recently, "U.S. oil demand during the first half of 2008 fell an average of 800,000 barrels per day compared with the same period a year ago, the biggest drop in 26 years."

So perk up. Lower oil prices are good for the economy and good for the stock market.

And if there is no unexpected disruption in supply, it's reasonable to expect oil will soon be trading well south of $100 a barrel.

Good investing,

Alex Green

Editor's note: Alexander Green is the Investment Director of The Oxford Club. Under his direction, the Club's portfolios have beaten the Wilshire 5000 Index by more than a 3-to-1 margin.

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