The price of oil has dropped rapidly in recent weeks. What's going on? And what do falling oil prices tell us about whether the world has passed its peak in oil production?

The short answer to what's going on is that it could well be random variation in a long-term trend of rising prices. And yes, volatile oil markets are exactly what we'd expect when global oil production has passed its peak.

Let's begin by looking at the fundamentals of supply and demand.

Tom Whipple reported in the weekly Peak Oil Review on August 11:

There has been very little change in the fundamentals of supply and demand during the last few weeks. OPEC production for July was up a bit, but this was more than offset by declines in non-OPEC production. US demand for oil products remains about 2-3 percent lower than last year. Chinese imports, which are more volatile than those of other countries, were significantly lower in July than in the spring...

Since China has reduced driving and industrial activity to lower air pollution during the Olympics, we may well see increased Chinese oil imports after the Olympics are over.

On a percentage basis, the current bear market in oil is something we see a lot of in recent history. In a European Tribune article late last week, Jerome Guillet noted that the oil price drop at that time was a mere 14% from the record closing price. (As of posting time, the drop is 23%.) Drops 14% or more have occurred roughly once a year since the beginning of 2003, while overall prices have ratcheted upwards by around $100 a barrel. Drops of more than 23% have occurred three times during that same time period.

Oil price volatility (via Jerome a Paris, European Tribune)

Peak Oil writer Kurt Cobb points out that geologist Kenneth Deffeyes predicted in 2003 that we would see great price volatility at the time of peak oil. He drew on the mathematical field called queuing theory to explain why. As Cobb explains it:

There has been a very slim margin of spare oil production capacity worldwide for perhaps the last three years. This, along with robust oil demand has almost certainly contributed to rising prices. As users and speculators crowd together on the 'buy' side of the market waiting to be serviced by the producers on the 'sell' side of the market, they create a bottleneck. The surest way to get to the head of the line is to offer a higher price. That, of course, begins the bidding as each buyer weighs how important it is to gain access to oil immediately or at least to lock in a price at the current level. This is classic crowd psychology.

Naturally, the whole process can work in reverse. As everyone who wants to bid on oil gets satisfied by the sellers ...the line on the buy side dwindles. Now the sellers are a bit panicked and offer lower prices as the few buyers left wait to see who can offer the best price. The price moves quickly and wildly up and down, but the system remains near capacity...

If the spare capacity in the market were large, then sudden increases in demand could more easily be accommodated and prices would not be nearly as jumpy. But with spare capacity razor thin...the only short-term rationing mechanism is price.

What does this mean for prices in the medium term? Jerome Guillet is writing a series called Countdown to $200 oil, and he is undaunted in his view that oil prices are headed upward. While the US has decreased its demand, demand growth overall is continuing in China, India, and, most significantly, oil-producing countries. The decline in exports from oil-producing countries is likely to continue, which spells bad news for countries like the US, where two thirds of the oil used is imported.

Guillet says, "Our energy policies should focus on one thing first and foremost: demand reduction... And the smartest demand destruction is the permanent kind, that brings savings every month and every year rather than one-offs like giving up a trip."

If governments plan public policy, and you plan your life as if $200 or higher oil is just around the corner, they and you are unlikely to be wrong. And we're all likely to be better prepared for whatever developments occur.

Epilogue: I originally wrote this piece on Monday, as script for my weekly Peak Oil Check-In syndicated radio commentary. Yesterday, Tom Whipple wrote in an intra-week update to the Peak Oil Review, "There appears to be a consensus among oil traders that...prices still have further to decline. For now, they cite technical factors in the oil market, their conviction that demand will continue to fall, and brush off falling stockpiles and supply disruptions."