Oil Prices Are Likely to Drop Before They Rally Again

Just as investors were beginning to gain confidence that lower oil prices would add to the momentum propelling the U.S. economy toward better-than-expected growth in 2011, crude prices began rising again on Friday. Despite the shift in direction, however, oil prices are likely to decline again next month before rallying back toward the $100 a barrel level later this year.

Oil futures had fallen about 3.9% this week, closing on Thursday below the $86 a barrel level for the first time since November. However, oil futures jumped more than 4% on Friday, fueled by fears over violent street protests in Egypt. With all of this week's losses erased, analysts are now debating whether oil will continue its trend lower toward the $83 a barrel range as we enter February or resume its climb above $100 a barrel, which many analysts predict will happen by the summer.

Evidence supporting an oil price drop started emerging last week, when OPEC members began hinting that the cartel might increase the supply of oil in the marketplace. This week, analysts at JPMorgan said those comments helped move crude prices lower as investors reacted. Higher prices could choke off demand in the U.S., the largest user of crude oil in the world, which would affect demand globally.

"We take that as a strong indication that the producer group does not want oil prices to rise too high, too quickly," JPMorgan's analysts wrote this week in a report to investors.

"Flight to Safety" Trades

Additionally, there are indications that worldwide oil consumption during the first quarter of 2011 may not be as strong as was predicted. Standard & Poor's downgrade of Japan's long-term sovereign credit rating and Fitch's downgrade of Taiwan's local currency credit rating this week "could signal softness in [oil] demand and could cool off red hot product prices," according to PFGBEST energy industry analyst Phil Flynn.

In addition, fears that China will soon take steps to cool down its red-hot economic growth rate -- which will also affect oil demand -- helped fuel concerns about a short-term oversupply of oil.

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Finally, many speculators decided to take some money off the table while oil prices were on the high side in the wake of the U.S. Energy Information Administration's report that crude oil inventories increased by 4.8 million barrels from the previous week. Flynn says U.S. crude oil inventories are above their upper limit for this time of year, suggesting an oversupply and an imminent price correction.

Even with such strong evidence suggesting a downward move in oil prices is due, oil futures prices jumped more than 4% on Friday as investors used "flight to safety" trades to minimize the uncertainty surrounding the turmoil brewing in Egypt. If Egypt is locked in political unrest for some time and if that unrest spreads to other Arab nations, it would definitely have a negative affect on the global oil supply, driving prices higher.

Next week, oil prices are expected to reflect pressure from an expected drop in demand -- many oil refineries are expected to begin shutting down temporarily as the demand for winter heating oil levels off. U.S. crude oil inventories are also expected to show an increase for the second week in a row. It's not clear whether those factors will deter the oil bulls from pushing oil prices into the mid-$90s.

Since September, oil has rallied from $75 a barrel to that mid-$90 range. Sustaining the rally at those prices may hurt economic growth, as corporations again delay expansion and hiring plans out of fear that their margins will be eroded by escalating oil prices. Given the length of oil's upward trend, Deutsche Bank Global Head of Rates Research Dominic Konstam, says a corrective move lower is likely before oil can move higher.

Says Konstam: "I'm not comfortable that it will keep on rallying."