With news of oil reaching record highs daily, many people are wondering will it ever come down again.  The basic economics of oil are driven by supply and demand and for the past couple of years a doubling effect has been in action.  As demand rose, driven by China and India's economic growth, supply was being constricted by the war in Iraq, instability in Venezuela, regulatory issues in Russia and the mothballing of wells with high costs of operation by oil companies.  The combined effect was a steady rise in crude oil prices.

Since most crude oil is traded on a futures basis, that is lock price now and get delivery later (much like locking in a mortgage rate), buyers and sellers factor into the price an expectation of the future.  Lately that expectation is for some form of disruption in delivery due to war or civil unrest and is frequently called a “war premium.”  The basic supply and demand price is commonly referred to as the fundamental price.  In this CNNMoney article Mark Gongloff cites Lawrence Goldstein, president of the Petroleum Industry Research Foundation, an industry research firm as saying

"Fundamentals would suggest prices in the low-to-mid-30s.” 

Based on that analysis, the current war premium is approximately $20 a barrel or 57% of the fundamental price.  At that level, it begins to look less like a premium and more like speculation.

When Mr. Gongloff wrote his article in August, 2004, global inventories were dangerously low and all indications were supply was not likely to change much.  That does not appear to be true any longer.  This article in the Wall Street Journal Indicates major oil companies are bringing online mothballed wells as fast as possible.  And this article indicates a rapid rise in global inventories.  (It also discounts that the increase will lower prices, but I believe it is because of the focus on supply.) The combination of these events has changed the equation and will put downward pressure on prices if they continue.

Demand, the other side of the equation, is being driven by China and India.  However, the bloom appears to be fading as reported here and here.  Expect this to continue.  China is restricted by lack of raw materials, rising labor costs, and a general flattening of the growth curve because all the good facilities are utilized and adding new ones is proving much more difficult than expected.  For India, it is much the same.  Exports slow as disposable income in other countries moves from Chinese and Indian imports to energy.   Longer term demand is also at risk. According to this article, hybrid cars are selling much better than anticipated. 

If buyers demand hybrid technology at the same pace they did when air bags and anti-lock brakes were first introduced, cars equipped with hybrid engines could make up 20% of the overall car market by 2010 and 80% by 2015.

The study said oil refiners could face a significant drop in demand for gas, and should plan for a potential downturn. Automakers as well should start planning for a changing marketplace.

Based on the above analysis, I expect oil to fall.  The rate it falls will depend on the market herd that is speculating on higher prices.  If speculators start exiting now in a slow and controlled manner the drop will not be precipitous.  If they stay in and continue to drive up the price to $60 a barrel and no major changes occur, the drop will be sudden and far.  As they are forced to cover their bets, the sell stampede will accelerate with prices falling into the high teens.