(I first examined the falling price of oil in August. The price of oil has dropped further, so it's time for another look.)

Someone told me with relief recently that gasoline is $2.99 a gallon. I was reminded of an editorial cartoon in late 2005 or early 2006, showing someone filling up before and after hurricane Katrina. In both pictures, a guy holding a gas nozzle is looking at the pump and exclaiming, "Gas is $2.50 a gallon!" Before Katrina, he has a look of outrage on his face. After Katrina, he wears a broad grin.

Lower gas prices aren't enough to produce many broad grins these days, against the current economic turmoil and the widespread predictions that the economic downturn is likely to get worse and last years. Still, the drop in oil prices is reinforcing some people's beliefs that oil price rises were a speculative bubble.

As with bubbles, the price of oil has gone up and then back down, though only back down a bit. It looks to me like supply and demand are sufficient to explain the price fluctuations.

First, let's look at the big picture: The price of oil is still high. It's selling for six times more per barrel than it was ten years ago at this time, when oil sold for around $15 a barrel.

Last week, oil dipped under $70 a barrel. In nominal terms, oil did not hit that price until last year. In real terms, adjusted for inflation, the record oil price before this year was set around 1980 at just over $100 per barrel.

If you look at daily closing prices this year, oil prices reached a maximum at $145 a barrel this summer and dropped to under $70, a drop of more than half. Hourly or daily prices are too volatile to show meaningful trends, however. Looking at monthly averages, the price drop was only about a third.*

So, oil is under its record high around 1980 and earlier this year, but why is it rising so much in price over the last ten years, and why is the price dropping now?

Let's look at supply and demand.

Demand for oil has increased significantly in the last ten years, and supply has remained rather flat since 2005. In aggregate, for the last three years, the world has used more oil than has been produced. Drawing down stockpiles made up the difference.

The pinch of flat supply and increasing demand can explain the steep price rises. In the short term, the demand curve for oil products is very steep: People don't reduce their use of oil before prices jump a lot. There is little spare pumping capacity in the world, so the demand could not be met by increasing production. Prices rose steeply, and slowly, people started using less oil.

Demand reached a trough as prices reached their highest point this summer. Prices dropped, perhaps in response to reduced demand. And, for the first time in two years, production exceeded consumption.

WTI

What does this tell us about the likelihood of future trends? That's hard to say. Economics 101 arguments miss a lot in these dynamic times. Both supply curves and demand curves are shifting in ways that are hard to predict exactly.

The economic downturn means people in countries that use a lot of oil can afford to spend less on fuel. That pushes prices downward.

On the other hand, both the US Department of Energy and the International Energy Agency [Oct. 10, 2008 Oil Market Report; the linked material will change as the current OMR is updated] think that worldwide consumption of oil is likely to continue growing in the next couple years, though at a slower pace than they had thought before. This pushes prices upwards.

Meanwhile, production is likely to drop. For existing oil fields, the decrease is 4-5% per year or more, worldwide. New oil projects are necessary just to keep production constant, and their cost is increasing. I expect it's harder to finance the new oil projects. It's hard to borrow money for anything these days. And now, with oil prices so volatile, who's willing to say that a project that is profitable at $100 or $120 a barrel will be a good investment? Decreased production would push prices upwards.

Finally, OPEC is scheduled to meet this month to discuss reducing their production even more than they would have to because of depletion. If they do make the cuts, the short-term effect would also be to push prices higher.

Oil prices are six times higher than they were ten years ago, and it looks to me like there are more forces pushing them upwards over the next year than pushing prices lower. Whether the reduced demand from an economic downturn is enough to keep prices under $100 a barrel, we will see.

And what about the alternative hypothesis, that speculators drove up a bubble, and prices have come down as financially troubled speculators unwound their positions? I still think the best argument against much impact from speculation is Paul Krugman's argument that speculation would lead to increased inventories, which were never observed. I explored the topic in more depth in June, and I haven't seen anything that leads me to revise my conclusions.

UPDATE: Richard Heinberg is more bearish for oil demand and therefore for prices. He makes some good points.

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* Data used are generally from the US Department of Energy.