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The news has been filled with stories of the climbing price of oil. Oil has broken $100/barrel, prices not seen since oil spiked in 2007-2008.

What is driving the price of oil? It’s a very complicated question, and the answer is filled with stereotypes and false assumptions. This article explores what really drives long-term oil price trends.

A common economic assumption is that as demand for oil rises, prices will rise as well. The chart below shows global oil demand for the last 25 years, which has been rising at a steady rate from 62.8 to 86.7 million barrels a day, an increase of 40% through the end of 2010.

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In contrast, U.S. oil demand, shown in the dark grey, has grown from 16.3 to 19.1 million barrels a day, a much smaller increase of only 18%. In fact, 2010 showed an increase in U.S. oil demand for the first time in 5 years. While the U.S. still guzzles more oil than any other country (we consume more than the next highest four countries, China, Japan, India and Russia, combined), there is no doubt that the developing world is driving increases in demand for oil. This is in no small part being driven by China.

Oil supplies since 1986 have increased in a similar fashion as demand, shown by the black line in the graph. Global oil supply has grown fairly steadily to a 44% increase since 1986. The price of oil, shown by the white line, has increased a staggering 211% in the same time period. Also, the gain has not been steady, but has had many peaks and valleys, as can be clearly seen in the chart. So what has made the price of oil go so wild?

Part of the answer, at least in the short-term, are price rises in reaction to regional tensions, which may upset important production facilities or supply lines. Witness the jump in oil prices due to the recent unrest in Libya and the Gulf.

Another partial answer is that profits by large oil companies have grown to unprecedented levels. For example, Exxon/Mobil (NYSE:XOM) has seen net income, or profits, increase exponentially from $1.5 billion in 1986 to $30.5 billion in 2010. That’s more than a 20-fold increase! No doubt XOM is a very well run business, and I congratulate its management in increasing shareholder value, but the issue of oil company profits is a topic for another article.

The main driver of oil prices started to change in the early part of the last decade. Oil prices started becoming less about supply and demand of oil itself, and became more of a proxy for the world economy through the stock market. Oil as a commodity became oil as an investment.

The reasoning behind this phenomenon is that if the economy will pick up, then there will be more demand for oil, which should make it a more valuable commodity. What happens, though, is that short-term investors start chasing gains, which can inflate prices past anything grounded in reality.

So what is the reality? The charts below show the value of the S&P 500 (blue line) as compared to the price of crude oil (black line) over various time periods. The correlation coefficient between stock and oil prices is shown on each graph (a value of 1.00 would be a perfect match). From 1986-1993, little correlation existed between stocks and oil. The spike in oil in 1990, caused by the Iraqi invasion of Kuwait, actually corresponded to a decrease in the stock market. After that oil prices showed a steady decline, while stocks posted steady gains.

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From 1994-2002, the two prices became more in line, but obvious differences still appear. It was not until 2003-2010 that a strong correlation, greater that 50%, occurred between the price of oil and the price of stocks. Note that advances and declines almost exactly match each other. At this point, oil became a proxy for the global economy.

What has happened so far this year? Oil has actually begun to disconnect from stock prices, showing a negative correlation since the beginning of 2011. Fears of Libyan oil being cut from European markets, or disruptions spreading to other key suppliers, are spiking oil prices higher. It is hard to say whether this disconnect will continue or if oil prices will remain a playground for investors.

Either way energy prices will remain high, and may go higher. Unless the foment in the Gulf states froths up to truly disruptive levels, I believe in the mid-term (1-3 years) the correlation between the stock market and oil prices will remain in tact. So if you believe in the economic recovery, which I do, energy prices will stay at these high levels. If oil supplies from the Gulf deteriorate, then energy prices also go up (I estimate oil to close out 2011 around $110/barrel). In the longer term, there is risk that the sovereign debt crisis could pan out into another global recession or worse, which would likely drive down the price of oil. I consider this unlikely, though.

While I believe you would do well to invest in a basket of big international oil stocks for the short to mid-term (XOM, PBR, RDS.A, CVX), longer term I am very bullish on the alternative energy sector. I prefer a diversified portfolio of clean energy companies in a variety of sectors (solar, wind, smart grid, alternative fuels, efficiency). Some of my favorite at current prices include POWR, NEE, and FSLR.

Source: What Is Driving Oil Prices and How Can Investors Benefit?