6 Reasons Why Oil Could Plunge

Price bubbles have a habit of collapsing under their own weight.

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Updated on 05/22/08:An earlier version of this article reported the price of oil to be $133. That figure has been updated to $135.

Oil is up 30 percent in three months after peaking above $135 today following 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:

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

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

2. The dollar gains.

The greenback recovery is far from assured, but for now 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. But that improvement hasn't been enough to stop crude's rise, even as hopes for a bottom to the dollar's decline improve as the Federal Reserve decides to end two years of rate cutting. It might take a move by the G-7 countries to support the dollar. G-7 officials "talked up" the currency a bit after their April 11 meeting following the blowup of Bear Stearns. 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.

3. The Olympics end.

This may sound strange, but once the torch is extinguished following the Beijing games, crude could get a break. That's because in the run-up to the games, China has continued to demand 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. If that happens, it'll kick out one of the major supports underneath the crude market at this time," Newsom says.

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

4. Production increases.

OPEC could boost production, but not by much. It blames the falling dollar and speculators for the surge in prices. President Bush urged production hikes in his recent visit to the Middle East, but analysts warn a short-term fix by turning on the tap won't correct the demand side of the equation. Saudi Arabia, home to the world's largest reserves, is pumping at full capacity. A big new find like the one off the coast of Brazil could help, but those are long-term worries because of billions of necessary investment in order to extract a single barrel. "OPEC is operating with little or no spare capacity," Wittenauer says.

Probability: Unlikely.

5. Domestic demand declines.

Americans are heading into the summer driving season. High prices mean that, compared with a year ago, Americans have pumped 1.4 percent less gasoline in 2008. But that's not enough to bring costs down, according to a weekly consumption survey by MasterCard Advisors. A seasonal pullback could come after a normal two-week rally in prices leading up to Memorial Day, but they'd be likely to rebound ahead of the July 4 holiday. Conservation efforts—rather than gas tax holiday schemes offered by Sens. John McCain and Hillary Clinton—would have to be stepped up substantially to really help dampen crude prices.

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  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.