What goes up must come down
It is amazing how short our memories can be. Just last summer, crude oil was trading at $77 a barrel. In five short months, the price has fallen more than 30%, and it now sits near two-year lows. Being heavily invested in the oil patch, I decided it was time to dig into the market fundamentals to find out if the oil boom is really over, or if the current weakness has created some blue-light specials in the oil patch.

Supply and demand
Pundits, politicians, and prognosticators have been talking about the tight supply and demand situation for the past several years. With the recent fall in prices, are we suddenly facing a supply glut? According to the International Energy Agency (IEA), the situation remains tight. The agency claims current world crude supply stands at 85.4 mb/d (million barrels per day), only 0.9 mb/d above demand, which is 84.5 mb/d. The IEA also projects demand growth of 1.7% in 2007, following slower demand growth of 1.1% in 2006. The American counterpart to the IEA, the Energy Information Administration (EIA), claims that world demand is running slightly ahead of supply.

One thing that has changed in the market is that spare production capacity has increased. Saudi Arabia recently announced that when it implements production cuts on Feb. 1, its spare capacity will have risen to 3 mb/d. This is up from the roughly 2 mb/d a year ago that the Saudis claimed as spare capacity. However, spare capacity in the remainder of the world is very limited, and even 3 mb/d represents only 3.5% of global demand.

For now, it appears that the Peak Oil folks will have to wait. Companies like ExxonMobil (NYSE:XOM) have been claiming there is no supply shortage, and that high prices would lead to increased production. Companies have expanded their drilling efforts in tough regions like the deep-water Gulf of Mexico, using drilling companies like Transocean (NYSE:RIG) and Global Santa Fe (NYSE:GSF). In the Gulf during the summer of 2006, Chevron (NYSE:CVX), along with partners Statoil and Devon, announced one of the largest discoveries in American history, perhaps as much as 15 billion barrels of oil.

Increases to crude and product inventories have been capturing plenty of headlines. The latest inventory report from the EIA sent oil prices toward 20-month lows. Crude inventories increased by 6.8 million barrels to 321.5 million barrels, and gasoline inventories increased by 3.2 million barrels to 216.8 million barrels. While the increases in inventory might suggest weakening demand or large production increases, the inventory levels themselves are roughly in line with historical averages for the past two decades.

Furthermore, I seriously doubt there is a significant correlation between inventory levels and pricing. The average domestic crude inventory from 1982 to 2006 has been 325 million barrels. All through the 1980s, when crude prices were all over the map, inventories went back and forth between 320 million and 350 million barrels. During the early '90s, when prices went upward during the first Gulf War, inventories remained above 340 million barrels. In 1998, when oil prices fell dramatically, inventories held above 340 million barrels. Only from the end of 1999 through 2004 were inventories significantly lower than the long-term average, staying in the range of 280 million-300 million barrels. With gasoline, the pattern is similar. From 1990 to 2006, inventories have stayed in a range of 190 million to 220 million barrels. During that time, we've seen prices per gallon fluctuate from less than $1 to more than $3.

Beyond the historical averages, it is important to note how insignificant these inventory levels are -- they represent about 15 days of supply. In other words, any disruption to crude supplies or refinery capacity will send inventories down in a hurry.

Global uncertainty
Geopolitical uncertainty in several key oil-producing regions has added a "fear premium" to the price of oil in the past few years. There is little reason to be optimistic that this situation will change in the near future. Iran has increased its power and influence within the Middle East region, and agitations over its nuclear program, its support for insurgents in Iraq, and its support of Hezbollah could impact oil markets at any time. Iraq continues to produce oil at less than prewar levels, and its oil infrastructure remains a soft target for those parties who wish to disrupt the reconstruction effort. Russia has begun imposing its will on foreign oil investment partners and trying to control the former member states of the old Soviet Union. These strong-arm tactics will likely cause foreign oil executives to think twice about increasing investment in the region. Ongoing problems in Venezuela and Nigeria have kept production levels down in those countries.

Of all the problems out there, Iran and Iraq appear as though they will remain lingering issues for the next several years. However, were either country to become stable, allow foreign investment in its oil industry, and achieve full production capacity, the world would again be swimming in oil, and we could all go back to driving SUVs. For example, it is estimated that Iraq should have a production rate of 6 mb/d; instead, it languishes at about 2 mb/d. Likewise, despite some large discoveries in the past 30 years, Iran's production rate remains 2 mb/d below its peak production of 6 mb/d in 1974. Production declined dramatically after the revolution of 1978-79 and has not yet recovered. The Iranians intend to increase capacity to 8 mb/d by 2015, but the EIA suggests that billions of dollars in foreign investment will be required to achieve this goal. Given Iran's dubious foreign policy and heavy protection of its domestic oil industry, one has to wonder where this foreign investment will come from.

Yet all of this uncertainty has been in place for several years. It seems that the world has just learned to live with it. Furthermore, ever since the hurricanes of 2005, the weather has been extremely cooperative for the oil industry. The winter of 2005-06 was warm; the summer of 2006 was cool. Through the hurricane season of 2006, despite dire predictions, there was nary a tropical storm in the Gulf of Mexico to cut production or hinder rebuilding efforts. To follow it all, the winter of 2006-07 didn't even begin until this week.

Foolish bottom line
For the time being, the oil boom has cooled significantly. Inventories, spare capacity, and production are up, and demand growth is slowing. This, logically, has caused prices to fall. Will oil prices fall all the way to their historical averages near $20 a barrel? I doubt it. Supply and demand remain tight, and world demand continues to grow. Spare capacity remains a very small percentage of overall supply, and it is held almost entirely by one country. Inventories will likely fall right back to their recent averages with continued cold weather and the approaching maintenance period for U.S. refineries. The aforementioned geopolitical issues could flare up at any moment, meaning oil prices would head higher again.

Have oil prices dropped enough to create a buying opportunity? If the global economy stays on track, I think prices are near their bottom. Refinery maintenance in February and March will cut product supplies. This will be followed by the changeover to summer gasoline formulations, followed by summer driving season, followed by hurricane season. I doubt we can run that gauntlet again without disruption. The biggest downside I can see is a possible global recession, and even in that situation, oil is something people cannot live without, so the oil patch will survive much better than most sectors.

For related Foolishness:

From dividend payers to small caps, the Fool has a newsletter for every investing focus. You can check out any of them with a 30-day free trial.

Fool contributor Robert Aronen owns shares of Transocean. He has been adding several companies in the oil patch to his Motley Fool CAPS portfolio. Please feel free to share your comments with him. The Fool has a disclosure policy.