Cheaper oil: What are the chances?

By U.S. News & World Report

Oil is up 30% in three months and topped $135 on Wednesday after this week's ho-hum report on U.S. supplies. The general sentiment among investors, even in commodity pits, is that there may still be room to rise, with analysts predicting oil could top $200 a barrel over the next couple of years -- if not earlier.

But just as there is a seller for every buyer, there is a bear case for every bull case. So here are a few scenarios that could push prices back down:

Investors pull back

Institutional investors -- pension funds, hedge funds, sovereign wealth funds -- could decide commodities are a less attractive proposition and take profits after a year of record-breaking price increases.

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"The market could fall under its own weight in the near term," says Eric Wittenauer, an energy futures analyst at A.G. Edwards. "You've got to question how much more money can come into these markets at this point in time."

Probability: Unconvincing. The argument could have been made at $100 a barrel too, Wittenauer says. Or at $110, or $120 . . .

The dollar gains

The greenback recovery is far from assured, though it has managed to bounce off mid-March lows. The U.S. Dollar Index hit a yearly low of 70.96 on March 14 and has since recovered to a bit above 72, in part on speculation that the Federal Reserve is about to end two years of rate cutting.

But that improvement hasn't been enough to stop crude's rise.

It might take a move by the Group of Seven industrial countries to support the dollar. G-7 officials "talked up" the currency a bit following the blowup of Bear Stearns (BSC, news, msgs). It's not clear they'll do more talking soon.

"We're going to have to see some strength in the dollar to pull some of this investment money out of oil," says Darin Newsom, a commodity analyst at DTN.

Probability: Possible.

Chinese demand drops as Summer Olympics end

This may sound strange, but once the torch is extinguished after the Beijing games, crude could get a break.

That's because in the run-up to the games, China has demanded an ever-growing flow of diesel fuel. That in turn puts upward pressure on the cost of other distillates like heating oil and jet fuel.

"The most important thing we could see is foreign diesel demand begins to slow," Newsom says. "If that happens, it'll kick out one of the major supports underneath the crude market."

Probability: Moderate. There are signs the superheated Chinese economy may be cooling ever so slightly, though its long-term expansion probably means more competition for almost all commodities.

Production increases

The Organization of Petroleum Exporting Countries could boost production, but not by much. OPEC blames the surge in crude prices on the falling dollar and speculators.

President Bush urged OPEC production increases in his recent visit to the Middle East, but analysts warn that opening the tap wider would provide only a short-term fix and wouldn't help on the demand side of the equation.

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Saudi Arabia, home to the world's largest reserves, is pumping at full capacity. Big new discoveries like the one off the coast of Brazil could help, but billions of dollars in investment will have to be made before a single barrel of oil is extracted.

Probability: Unlikely.

Domestic demand declines

As Americans head into the summer driving season, high gasoline prices have had an impact on demand, which is down 1.4% this year from the comparable period in 2007.

But that's not enough to bring costs down, according to a weekly consumption survey by MasterCard Advisors, a unit of MasterCard (MA, news, msgs). There could be a seasonal pullback in pump prices after a normal two-week rally leading into the Memorial Day weekend, but prices would likely rebound ahead of the July 4 holiday.

Conservation efforts -- rather than gas tax holiday schemes proposed by Sens. John McCain and Hillary Clinton -- would have to be substantially stepped up to really dampen crude prices.

Probability: Unlikely.

Other markets calm down

Right now, most analysts agree oil is out of sync with supply-and-demand fundamentals (though they disagree on just how much). The reason is that investors are scouring the globe for yield at a time when stocks are floundering, bond yields are paltry and the American economy is uncertain at best.

In times like these, everything from gold to oil looks attractive and safe. To be coaxed back into the broader market, traders will have to see an end to the credit crunch and regain confidence in the global financial system and the American consumer.

Probability: Moderate. Markets seem to believe that the Federal Reserve has headed off the worst of the financial crisis. Equities have recovered a bit, though slower consumer spending and falling home prices continue to weigh on investor confidence.

Even if some of these scenarios play out, the pullback in prices could be modest: 15% to 20% at most. That would still leave crude oil at well over $100 a barrel.

Most analysts remain solidly bullish on the price of crude through what could be a long summer for American motorists.

This article was reported and written by Kirk Shinkle for U.S. News & World Report.