Who would have thought oil stocks would have led the early 2006 market rally? Warm weather, slowing growth in key markets, high levels of natural gas inventories,and a gradual recovery from hurricane-induced supply disruptions surely should have cooled investor ardor for the energy story.

Notwithstanding these trends, oil markets remain tight. Consequently, according to one industry analyst, Steve Terry, prices likely will remain high and may exceed last year’s peak levels in the coming months. Any disruption, such as one that might arise from a political confrontation with Iran or violence in Nigeria, will cause another spike up. “I’ve always tended to be dismissive of supply security as an issue,” Mr. Terry admits. “Now it is the big issue.”

Mr. Terry was for many years a part-owner and top executive with Britain-based Petroleum Economics, which was sold a few years ago to KBC Process Technology. Recently, he and former PEL colleagues have started up Citac Global, a consultancy providing in-depth energy research to companies and governments. He was in New York last week speaking at Burnham & Company to energy specialists in the financial community.

One bright spot in his presentation is the longer-term outlook. Mr. Terry thinks the Saudis will be the world’s swing oil producer for many years to come.That is, he does not buy Matthew Simmons’s argument, put forward in his widely read book, “Twilight in the Desert: The Coming Oil Shock and the World Economy,” that Saudi production is nearing its zenith, and that many of their important fields will start to decline in a few years. Why? Mr. Terry’s knowledgeable contacts in the Middle East have convinced him that Saudi production can grow significantly from current levels.

That’s the good news. The bad news is that in the short run, he sees no break in oil prices. Though both OPEC and non-OPEC production are expected to increase, giving markets a little breathing room and lifting OPEC’s spare capacity, there are a number of wild cards that prevent Mr.Terry from being complacent. Last year, a number of producers fell short of expectations, especially the North Sea countries and Russia. It could happen again, and the margin for error is small.

Another concern is the possibility of exceptionally tight gasoline markets. Changing regulations on sulfur emissions and on liability for MBTE spills in America could cause a reduction of imports and lead to a spike in prices. Mr. Terry is concerned that inventories could sink below five-year lows, causing a scramble for supplies and once again leading to a steep hike in the cost of oil.

A major variable for crude prices is the role of speculators, aka hedge funds, in the market. While it is impossible to know how much of last year’s price rise can be traced to speculative trading, there are indications that the funds have been huge participants in the markets. Mr. Terry cites reports that as much as $50 billion has flowed into funds that track the Goldman Sachs Commodity Index (75% of which is made up of energy contracts) and another $20 billion into other commodity indices.

Another indicator is the so-called “contango market” in oil futures. This is a reference to the fact that prices for future deliveries of oil are above current price levels. This is unusual given that today’s prices are so high relative to historical norms. The explanation, according to Mr.Terry, is that the funds don’t want to face the expense of rolling contracts forward and therefore are willing to pay higher prices for future deliveries.

Using mainstream economic forecasts for 2006 world growth of 3.4%, Mr. Terry estimates that worldwide demand for petroleum products will rise 1.7 million barrels a day (mb/d). Non-OPEC supplies are projected to increase 1.42 mb/d ahead of last year’s levels, with gains expected from America, Canada, Brazil, and Angola. Citac also is projecting a gain for Russia, which had disappointing output last year, and which may be starving the industry of resources necessary for maintaining output longer term.

Overall, the need for OPEC production, which Mr. Terry estimates at 30 mb/d, or about the same as last year’s level, will leave OPEC producers with spare capacity of 2.7 mb/d.That’s a considerable improvement over last year’s narrower surplus capacity of 1.4 mb/d.

As a result, Mr. Terry expects OPEC to regain control over prices this year – control that was noticeably absent last year as supply disruptions combined with increased speculative activity to drive prices above economic levels. Assuming he’s correct, where do OPEC leaders want to see prices? In his view, $50 a barrel is the new floor.”I can’t see too much downside to the price of oil” Mr. Terry says. “Except, if speculators start to dump contracts.”

Longer term, or beyond mid-year, most analysts expect the run-up in oil prices during 2005 to cause some drop in demand. An energy analyst at ISI Group, Mike Rothman, points out that the spike in oil prices in the late 1970s caused oil demand in America to drop for five consecutive years in the early 1980s. Such a response takes a year or two, but is inevitable.

Motorists in America have already responded to the hike in gasoline prices. The number of miles driven in America from January through November grew at the slowest rate recorded since the Department of Transportation began collecting data in 1980. In California, legislators are encouraging through tax rebates the use of solar panels to produce electricity. In China, a source of a major increase in the demand for oil, authorities have embarked on a project to build 40 nuclear power plants – the largest program of its kind ever undertaken.

All over the world, governments are pushing the use of alternatives to crude oil. As prices rise, substitute sources such as tar sands become viable. Meanwhile, the logistical issues of transporting natural gas are becoming surmountable. LNG projects are building and, according to Mr. Terry, there is beginning to be a world price for natural gas.

Though there is no doubt that a sharp rise in oil prices shifts the demand curve lower (a reality that undoubtedly influences pricing decisions made by OPEC leaders), there is a delay. Consumers may cut back on driving or may choose more fuel-efficient hybrid cars, but the impact of such measures will likely not be felt this year. Instead, high oil prices, according to Mr. Terry, will likely continue to plague consumers, and reward investors in oil stocks. Just when you thought the story was over.