When It Comes to Oil Prices, Demand Is the Key

To understand sliding crude oil prices, follow the demand trail.

While there is undoubtedly some risk to crude supply from potential U.S. action in the Middle East, OPEC appears ready to stand by current production levels, absent a large-scale regional conflict.

And while U.S. military response to the recent domestic terror may send crude prices higher, any rally -- as we have argued recently -- should be viewed as a chance to lighten up on energy, especially for shorter-term investors.

Why?

Before the Sept. 11 terror, the economy was already teetering close to recession and energy prices were beginning to feel the pinch. And with consumer discretionary spending hibernating after the attacks, there is little chance we can avoid additional economic contraction. That means an even further drop in energy demand. Plus, there's the direct impact of the air travel slowdown on energy demand, since nearly 10% of all crude demand is directly related to aircraft travel.

Concerns over an economic slowdown and the resulting decline in energy demand have energy investors anxious. "The crude markets are scared to death of a soft economy" says Dan Pickering, director of research at Simmons & Co., a Houston energy investment boutique.

So scared, in fact, that oil demand forecasts and target prices for the coming year are coming down fast. Simmons recently lowered its fourth-quarter 2001 and 2002 annual price target to $21 from $25 for West Texas crude oil, noting "we believe that a cautious approach with respect to crude oil demand and prices is warranted in the near-term."

Sure, crude prices may rise with tensions in the Middle East, but history suggests that reaction won't last and, longer term, it's the economy that dictates crude price direction. "History says whatever spikes you get are very short-lived," said Petrie Parkman's Tom Petrie in the wake of the terror. "Typically, in the aftermath, demand craters, and you usually get lower lows."

However, as prices close in on $20, many investors may think crude prices can't go much lower. Yet that is exactly what natural gas investors said as prices went from $8 to $5 this summer only to see prices continue to plummet. Currently, natural gas trades at around $2 per million British Thermal Unit.

So, how low can oil go? It all depends on the economy and demand. "It's hard to dial in an 'OK' price," says Pickering.

At some point, the economy recovers, demand returns and prices firm. And for long-term investors, a beginning glance at energy stocks at today's depressed prices may be prudent.

But, with so much economic uncertainty, caution -- in both oil prices and oil stocks -- seems to be warranted.