What drives oil prices and where are they headed? According to one analyst, traditional institutional funds and hedge funds are the big drivers today of oil prices, and unfortunately for the industry, those prices may be headed for the mid-$50s at best.

In a recent report, Doug Leggate, integrated oils analyst for Citigroup in New York, says the increased dominance of funds as the incremental buyer of oil futures-accounting for more than 50% of the market-has introduced greater technical traits to the market.

"We therefore contend that if funds are technically driven, technical analysis (which charts previous long-term market trends to predict future market patterns) will become a key leading indicator of oil prices."

To support this thesis, Leggate makes use of a proprietary, multi-factor correlation model that dissects the relative influence of the four main variables that have affected oil prices during the past decade: inventory levels, spare OPEC production capacity, refining margins, and open-contract interest in the futures market.

Leggate found that this regression model replicates almost every major oil-price move of the past 10 years and leads to some surprising conclusions.

In the Citigroup model, fund open interest emerges as a critical oil-price driver. Meanwhile, although oil-inventory levels are confirmed as key, they are seen as having only a secondary influence on oil-price movements. Surprisingly, OPEC spare capacity, long seen as the catalyst for rising oil prices, is a negligible factor, the analyst contends.

Given these conclusions, "the challenge is to identify where funds move next, which brings us full circle back to technical analysis," explains Leggate. "That analysis suggests that a critical inflection point has been breached, with the next oil-price support level for West Texas Intermediate (WTI) crude in the mid-$50s."

This view comes with a healthy dose of skepticism from most analysts focused on market fundamentals, the analyst concedes. Also, he allows that OPEC remains a wild card, in terms of the oil-price level it may act to defend. "We continue to believe this level lies in a range of $45 to $55 for WTI-but may very likely be at the upper end of this range."

While this outlook may appear gloomy, Leggate nonetheless continues to see value in U.S. oils-which have recently been discounting long-term oil prices in the $32 to $37 range-even though these stocks will struggle against falling crude prices.

"With technical risks seemingly on the downside, we retain a defensive stance," the analyst says. "Preferred stocks remain those with less commodity exposure and at the low end of implied oil-price valuations."

Chevron and ExxonMobil screen well, he says. "Also, at the higher-beta end of the sector, Hess Corp. and Occidental Petroleum retain the potential for meaningful upside from operational catalysts in the coming months."

At press time, Citigroup's technical analysts were predicting substantial near-term oil-price risk, with a move to as low as $50 likely during the next few months.

In the short term, Leggate's oil-price outlook is likely to be at least directionally right. But when it comes to the longer-term outlook for that commodity, supply/demand fundamentals, a still unstable Middle East and the vagaries of OPEC also need to be scrutinized closely.

As the Citigroup analyst points out, the cartel is something of a wild card in the oil-price forecasting game and, having witnessed how resilient the U.S. economy was even at $77 oil, it might well be emboldened to defend an oil price much higher than $45 to $55. Indeed, one could reasonably postulate-seeing the long caravans of SUVs along every major highway in the U.S.-that OPEC might be tempted to set a $60 to $65 floor for oil.

Moreover, with the dynamic growth in the economies of China and India, it's hard to see annual world oil demand rising at a rate anything less than 2%. Meanwhile, major oils continue to struggle with replacing reserves.

This sort of imbalance, which doesn't factor in supply disruptions arising from further geopolitical tensions in the Middle East, leads to one inescapable conclusion: in the long term, we're much more likely headed for continued high, not lower, oil prices.

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