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We've found out this week just how fast the market can turn bullish on oil. The mere thought that Europe wasn't going to collapse has sent oil from $77.50 per barrel to nearly $85 per barrel in two days.
As the market tanked over the last two months, the one reprieve has been the falling price of oil and lower burden on drivers and businesses. But if Europe is able to figure out its messy financial situation, the U.S. stumbles through the next year or so, and emerging markets such as China and Brazil continue to grow, the relief will be short-lived.
Demand isn't going anywhere
Smaller, more fuel efficient cars and SUVs may be back in style, but that doesn't mean Americans don't still love to drive, and that isn't about to change.
Consumption fell in 2008 and 2009 during the depths of the recession when employees were laid off, product (and therefore trucking) demand fell, and plants were idled, but demand started to return in 2010. Unless the economy takes another complete nosedive, our oil consumption will likely remain flat or rise slightly in coming years.
And that's just a view of the United States. China is probably a bigger driver of oil prices, and with the economy growing around 10%, oil demand is growing rapidly as well. After growing 12% in 2010, crude oil consumption is expected to grow another 6% this year, a big leap for the world's second largest economy.
And Beijing has started restricting the number of private vehicles allowed on its roads, so the demand could be even higher. Similar dynamics are playing out in Brazil and India where growing economies are translating into more consumption of oil. Overall, emerging economies will likely drive oil consumption higher over the next five to 10 years, putting pressure on the price of oil.
Oil prices will drive supply
On the supply side, there are barriers to lower oil prices simply based on economics. Wells are no longer in easy-to-drill places in the middle of Texas, where a well at Spindletop blew oil 100 feet in the air in 1900, or in the Middle East where oil has been abundant.
Instead we're drilling offshore in deeper and deeper water that is more and more expensive. Drillers like DryShips (Nasdaq: DRYS ) , Seadrill (NYSE: SDRL ) , and Transocean (NYSE: RIG ) are building ultra-deepwater rigs as fast as they can to keep up with the demand in the Gulf of Mexico, Brazil, and off the coast of Africa.
Oil shale has also changed the dynamics of oil prices. Kodiak Oil & Gas (NYSE: KOG ) , Continental Resources (NYSE: CLR ) , and Range Resources (NYSE: RRC ) have made tremendous progress bringing down the cost of extracting oil from rocks, but there are still financial limits.
Drilling in deep water and oil shale is only attractive if the price of oil remains relatively high. Andrew Gould, the recently retired CEO of Schlumberger, estimated that the economic cutoff for ultra-deepwater, oil shale, and arctic oil drilling was around $70 per barrel. That's not a large margin of error with oil currently just over $80 per barrel. The higher oil prices go, the more incentive we'll have to keep up with growing demand. But if prices remain where they are or fall further, supply will start to be cut off.
There's also the elephant in the room, OPEC, to consider. OPEC can flip a switch (figuratively) and send worldwide supply lower and prices higher. They're very unlikely to increase supply and send prices lower.
Call me a cynic, but I don't think unrest is over in the Middle East either. Syria is still a mess, Total (NYSE: TOT ) has just recently started to begin production in Libya, and Iran has its own problems. The Arab Spring is great for the freedom of citizens, but it is almost sure to have a continued negative effect on the price of oil.
Foolish bottom line
The perfect storm of a slow economic recovery, low investor confidence, and new sources of oil production has put downward pressure on oil prices recently. But once confidence returns and the economy begins to grow again, investors will be back on the oil bandwagon.
The last time oil prices fell this dramatically was in 2008, before the economy hit rock bottom. By mid-2009 when unemployment peaked, oil prices were already starting a steady rise.
Rising oil prices aren't all bad, as I pointed out earlier this month. It creates U.S. jobs, reduces our dependence on foreign oil, and makes alternative energy sources more economically viable. In the mean time, enjoy cheap oil prices while you can. This Fool doesn't think the party will last long.
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