Oil prices: Buckle up for a wild ride

NEW YORK (CNNMoney.com) -- Expect nothing but volatility for oil prices over the next year or two - with the fate of the global economy largely dictating whether crude will fall to $50 or shoot up to $150 a barrel.

The global economy is teetering on the edge, and no one really knows if it will muscle through this credit crunch or succumb to a pronounced recession.

With crude prices so closely linked to the health of the economy - unemployed people tend to drive a lot less - oil analysts don't really know where oil prices are headed either.

Oil prices have fallen over 40% since July and are currently trading around $86 a barrel, but if the $700 billion government bailout for financial sector doesn't work and the world's economy plunges into a serious recession prices could still fall further - as low as $50 a barrel.

With the U.S. stock market's steep losses following the approval of the economic bailout plan, and bank failures in Europe prompting a $350 billion-plus bailout in Britain and talk of more to come across the Continent, it's a scenario that shouldn't be quickly discounted.

"Should we enter a synchronous global recession...oil prices could fall further to $50 a barrel next year," Francisco Blanch, head of global commodities research for Merrill Lynch, wrote in a recent research report.

Blanch doesn't think such a recession is likely, nor does Citigroup futures analyst Tim Evans.

But in the event of a deep global recession, Evans also said "The market would find value at $50 a barrel."

The global recession scenario only exaggerates the trend of falling demand seen recently.

In the United States it's been quite dramatic. Oil demand fell over 6% in July, according to the Department of Energy. Europe has also witnessed a drop in demand, while in the red hot economies of China and India oil use is growing slower than previously thought.

Evans said the main causes for the U.S. decline weren't the slowing economy, but government policies promoting biofuels and greater fuel efficiency, as well as consumers buying more efficient cars and driving less.

"This is not a token shift," he said. "There is hard work that goes into decreasing demand by that extent."

Plus, this decline in demand is coupled with an expected increase in supply.

Merrill estimates new OPEC investments will boost production capacity by 3 million barrels a day - or nearly 4% of current world output, over the next 18 months.

This picture of falling demand and rising supply - coupled with a strengthening dollar and investor flight from oil futures - has led to oil's rapid decline in price over the last couple months.

Now, if the bailout works and a global recession is averted and the world's economies come roaring back to life, dreams of $50 oil will certainly be dashed.

Crude would once again run into the same supply and demand scenario that helped push it to nearly $150 a barrel this July - namely, growing demand from the billions of people in China and India gaining middle class lifestyles butting against a global oil industry that struggles to produce much more than the current 85 million barrels a day.

It's this scenario that caused oil bulls like Goldman Sachs and Boon Pickens to to declare as recently as July that we'll likely see $150-$200 a barrel oil in the next year.

Even post credit crunch, Goldman is still predicting oil to average $110 a barrel in 2009.

"Investors appear to be placing greater weight on the demand concerns rather than the supply shortfalls," Goldman said in a research note.

If the U.S. goes through a mild recession, but the world economy chugs along and eventually heats up, oil is likely to trade back in the triple digits at some point in the next couple of years, according to Merrill's Blanch.

The bank bailout is likely to cause higher inflation as massive amounts of cash enters the market - pushing up oil prices as investors buy it as a hedge.

But again, analysts turn back to strong demand and tight supplies once economies pick up speed.

"As economic activity starts to recover in the emerging markets, their energy demand will likely start to strengthen again," wrote Blanch. "Energy and commodity demand growth is a secular investment theme that probably has decades to run."

With so much uncertainty, it's not surprising that most analysts are taking a middle-of-the-road approach, predicting prices somewhere in the $70 to $100 range for 2009.

This is predicated on the expectation of a middle-of-the-road performance for the economy.

Most economists see the U.S. economy slumping into an official recession in the later part of 2008 and the first part of 2009 before recovering, and see global growth slowing but not contracting.

Citi's Evans thinks $70 to $80 is a reasonable range for the next year, low enough to not draw the ire of consumers but high enough to satisfy OPEC and encourage new production and alternative sources.

Merrill also lowered its 2009 oil price forecast from $107 a barrel to $90.

Deutsche Bank recently reduced it's late 2008/early 2009 oil price forecast to $85 a barrel, citing a weak global economy.

"We believe crude oil prices have further downside as the fall-out of the financial crisis spreads into the real economy and ultimately global oil demand," Adam Sieminski, the bank's chief energy economist, wrote in a recent research note.

Sieminski also noted how credit-related trouble in Europe, exemplified by this week's sharp selloff in European shares, is boosting the dollar and lowering oil prices.

"For the past few days, European equities have been underperforming their U.S. counterparts," he said, "possibly signaling the markets concerns that European authorities may find it more difficult than the US to coordinate a rescue package in the event of a large-scale banking failure."