Continued: Half-priced oil by end of year?

The sharp drop in energy prices since the beginning of the month is turning into a rare bright spot in a bleak economic landscape.

For the moment, at least, fears of a prolonged energy shock seem to have subsided a bit.

Oil has fallen more than $23 a barrel, or 16 percent, since peaking July 3. Gasoline has slipped below $4 a gallon and is dropping fast as Americans drive less. Natural gas prices, which had risen the fastest this year as traders anticipated a hot summer, have shed 33 percent since the beginning of the month.

Crude oil prices extended their decline, falling 2.5 percent, to $122.19 a barrel, their lowest level since the beginning of May. This helped spur a rally in the stock market, with all major indexes rising more than 2 percent. But stock markets still remain close to the lows of earlier this month.

It comes after an equally sharp correction in the prices of many agricultural commodities such as corn, wheat and rice, which took place a few weeks ago. These moves suggest to economists that global markets, in a near-panic early this year to find prices high enough to allocate scarce supplies, overshot and bid prices too high.

Commodity prices remain extraordinarily high by historical standards. But with the economy weakening amid a housing crisis and a credit crunch that show few signs of improving, many traders have begun to believe demand for oil and other commodities will soften worldwide.

Investors became net sellers in the oil market last week for the first time since mid-February 2007, according to Barclays Capital.

"The market's expectations have changed very rapidly and unexpectedly," said Edward Morse, the chief energy economist at Lehman Brothers. "The market went out of control on the upside. But market participants realized there was much more demand destruction than had been thought even a month ago, that inventories are building up quickly, and that, in fact, more supplies are coming onto the market."

As a result of looser market fundamentals, many analysts believe energy prices could keep falling through the end of the year. The president of the OPEC oil cartel, Chakib Khelil, said Tuesday that oil might drop as low as $70 a barrel.

Will that actually happen?

Whether that happens will depend on the course of the U.S. economy and its effect on the rest of the world. How long will the American slowdown last and what effect will it have on emerging markets like China, which have accounted for the bulk of the growth in oil demand?

Many experts warn that a hurricane hitting the oil-producing region of the Gulf Coast or renewed tensions in the Persian Gulf could easily push prices back up again, quickly.

Only a few weeks ago, Israel conducted war games and Iran tested new missiles, renewing fears of a flare-up in the Middle East, and pushing oil prices to a record of $145.29 a barrel. The recent shift in U.S. policy regarding Iran, with an emphasis on diplomacy, helped deflate some of the geopolitical risk premium that had been built into oil prices.

"The one piece of good news we've had recently has been the drop in oil prices," said Bernard Baumohl, the chief global economist at the Economic Outlook Group. "But there is nothing that tells us with any certainty that this decline can be sustained. Just as abruptly as they have fallen, oil prices can rebound because of geopolitical factors."

Gasoline peaked at a nationwide average of $4.11 a gallon on July 17. Since then, retail gasoline prices have been falling briskly, to a nationwide average of $3.94 on Tuesday, according to AAA, the automobile group. Still, that is $1.05 a gallon higher than at the same time last year, when gasoline sold for $2.89 a gallon.

Natural gas settled at $9.22 a thousand cubic feet on Tuesday, down from a high of about $13.58 at the beginning of the month, as a cooler-than-expected summer helped curb the use of gas to generate electricity. That has led to a build-up of commercial inventories.

'People are waking up'

The drop in oil prices has come as gasoline demand in the United States fell sharply in recent months, thanks to Americans cutting back on their driving.

Gasoline consumption fell 3.6 percent in the week ending July 18, compared with the year-earlier period, the Energy Department said. Americans drove 9.6 billion fewer miles in May compared with the same period last year, a 3.7 percent decline and the biggest-ever drop at that time of year, the Transportation Department said on Monday.

"People are waking up to the fact that prices have an impact on demand and that what happens in the U.S. gasoline market has a worldwide impact," said Daniel Yergin, the chairman of Cambridge Energy Research Associates, a consulting firm. The United States is the world's largest oil consumer, and its gasoline market alone is bigger than the entire Chinese oil market, Yergin said.

"As a result of the economic slowdown and high prices, we've probably seen the peak in American gasoline demand, at least for some years," he said.

Americans remain unhappy about the state of the economy. But consumer confidence rose slightly this month compared with last, according to a report released on Tuesday by the Conference Board, a private research group.

That was mainly because of the declining gasoline prices, said Ian Shepherdson, the chief United States economist at High Frequency Economics.

One big question is what will happen to Chinese oil demand.

Slowdown ahead for China?

China has been the biggest driver of global energy demand in recent years, experts said. From 2000 to 2007, China's energy demand grew by 65 percent, contributing to a 12 percent jump in global oil demand. In that period, China accounted for a third of the total increase in oil consumption around the world.

This year, Chinese oil demand is expected to grow by 5.6 percent, thanks mostly to increases in gasoline and diesel consumption.

This growth would account for nearly half of the rise in oil consumption worldwide, which is expected to reach nearly 900,000 barrels a day, according to the International Energy Agency.

But that too may be changing, some economists said.

"We have seen the economies of emerging countries, like China, India, and Brazil begin to slow down," Baumohl said. "That should begin to soften the price of oil."