That Falling Feeling; As the myth of endless Chinese demand is exposed and heavy investment boosts supply, prices at the pump could plummet further.

Byline: Leonardo Maugeri (Maugeri is senior vice president of strategies and development at Eni SpA and author of the book "The Age of Oil: The Mythology, History, and Future of the World's Most Controversial Resource.")

Understanding the oil market is difficult. making reasonable forecasts is almost impossible. That's why most analysts were surprised by the dip in prices from the Aug. 8 historic high of $79 per barrel to below $60 in recent days. Suddenly the alarmists who foresaw an imminent era of oil scarcity are silent, OPEC is again discussing supply cuts, oil share prices are down. And new conspiracy theories are flowing, like the one about the Republicans' pushing down gas prices before the U.S. midterm elections.

What's going on? Over the last few years the public has been bombarded by pessimistic warnings about a world inexorably running out of oil, in the midst of growing instability in oil states from Iran to Nigeria, and rising demand--particularly from China, India and other emerging economies. As this bleak scenario gained acceptance, it became easy to assume that the price of oil would defy the laws of gravity and break the barrier of $100 per barrel.

In fact, the current oil crisis has nothing to do with a catastrophic shrinking of global oil resources, while the specter of rising Asian demand is largely a myth--China has huge potential to reduce its oil consumption. Supply is tight because two decades of low prices discouraged the exploration and development of new fields in the world's most oil-rich areas. That has cut spare production capacity--the critical cushion needed to cope with crises--to just 2 to 3 percent of global consumption. This makes the price of oil a hostage to political and climatic events. There has been no objective rise in oil-state instability, only in the market's vulnerability to speculation--gloomy or not.

What has happened recently is a global-market mood swing, in the face of evidence that consumption growth is slowing while production is still rising. U.S. oil inventories--and even reserves--have turned out to be higher than had been previously thought. Forecasts for the hurricane season in the Gulf of Mexico switched from severe to mild. Temporary shocks, particularly the BP spill and shutdown in Prudhoe Bay, Alaska, proved less disruptive than expected. And geopolitical risks seemed to recede, as confrontations involving Iran and Lebanon eased, at least for now.

In a situation where fleeting news can move markets, almost anything can happen next, from a new spike to a further drop in the oil price. Right now, the spike is the most likely scenario in the medium term--say, one year or two. But a bit farther out, between roughly 2010 and 2012, there is a good chance that supply trends will overtake demand, raising spare production capacity to a range between 7 to 10 percent of demand. That large a cushion would drive down both the price of oil and the market's major vulnerability to minor rumors. Let's try to understand why.

Essentially, the underlying causes of the new century's first oil crisis are in the process of being solved. Since 2002, the major producing countries and oil companies have gained the confidence to invest in exploration, development and refining. We are in the midst of a real investment boom, although it needs time to bear fruit. Oilfield development takes several years, and there is now a serious shortage of equipment and qualified personnel.