Crude Reality: How Long Can Oil Stay Down?

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"The chances of a 'V' forming in the oil price chart ahead are very slim."

Tuesday was a violent day for oil once again. Oil prices fell to near $36 a barrel on the NYMEX setting a new low point for 2008. Of course, many are still betting on a rebound in oil prices.

Goldman Sachs calls for $30 oil due to "weak underlying economic fundamentals." Yet it still expects oil to average $45 a barrel this year and close out 2009 at $65 a barrel. Merrill Lynch is expecting oil to average $50 a barrel and average $70 in 2010.

Oil is volatile and the volatility is causing a lot of uncertainty. But the question remains, how low can oil really go, and how long can it stay there? As usual, it all comes down to fundamentals.

On the demand side, the U.S. Energy Information Administration’s (EIA) latest Short-Term Energy Outlook stated U.S. oil consumption fell 5.7% in 2008. It predicts oil consumption will continue to fall in 2009 by 2.0% and expects a modest uptick of 0.8% in 2010. We all know the demand side of the equation will get pinched—global recession, financial crisis, etc. It's the supply side that the market is reacting to now.

OPEC has announced cutbacks of more than 4 million bpd. Despite OPEC's relative ineffectiveness, Saudi Arabia has confirmed it cut production by 300,000 barrels a day. So far other members have, more or less, stuck to the OPEC quotas.

Meanwhile, U.S. domestic oil production is increasing rapidly. In fact in 2009, domestic oil production will probably increase for the first time since 1991. Domestic production is expected to increase 300,000 bpd to 5.25 million bpd—a 6% increase.

The final thing is the cost of production. So if the cost of production of every new barrel of production is $65 a barrel, it would have to go up. Oil would be an easy win from here, right? Not exactly. At the peak the world was consuming between 85 and 86 million bpd. That included the Canadian oil sands projects (production costs for which are between $60 and $80 depending largely on natural gas prices) and marginal, deepwater offshore projects where the cost of finding and producing a barrel of oil can run as high as $60.

In the past few months, we watched OPEC cut its production faster than any other time in history, Russia engages Ukraine in the latest round of "Gas Wars," a cold December in the Northeastern U.S., and Israel takes a hard line offensive against Hamas. Despite it all, oil prices fell by more than 20%.

The chances of a "V" forming in the oil price chart ahead are very slim. And with every mortgage that falls "under water," each mall shop that shuts its doors, every Chinese factory that closes down and each dollar that is taken away from a profitable business and given to a hopelessly unprofitable one, the odds get lower and lower.

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