Since August of last year, the oil price has nearly doubled. Whereas the first part of the rise in energy prices (2002-2006) occurred during a period of - and was partly a symptom of - strength in the world economy, the recent increase comes at a time of slowing growth in many countries. It could lead to an environment of global stagflation and therefore poses a serious risk for equity markets.

There certainly are a number of fundamental reasons to explain why the price of oil is much higher than in the last 2 decades:

• strong economic growth in the developing world has increased demand for oil. China's impact on global demand is often overstated in that regard: more than half of non-OECD demand growth comes from the Middle East, Latin America, Africa and the former Soviet Union;
  
• global oil production may have reached its peak 3 years ago; - in April of this year, Russia announced that its oil production for the first quarter 2008 had declined for the first time in a decade;
  
• at the same time, countries with large reserves feel less pressure to increase production in light of the surge in revenues from the current high price of oil;
  
• supply disruptions in countries like Venezuela, Nigeria and Iraq have built an important security premium into the price of oil;
  
• rising costs for equipment, people and skills have made it much more expensive to develop new fields;
  
• fears of a financial crisis, the fall in equity markets since October of last year and the weakening dollar have attracted a new class of buyers into the oil market. These financial (as opposed tocommercial) investors look at commodities as a new 'asset class', supposedly uncorrelated with traditional asset classes like equities or bonds. They are thus seeking exposure to the commodity markets as a way to diversify their portfolios. (As I'll explain below, the impact of these investors/speculators is however vastly exaggerated.)

All these factors provide valid explanations for why oil prices should be higher than the $22/barrel price that was the average for most of the 1980's and 1990's. However, with the possible exception of the last, none of these fundamental factors has changed that much since August of last year, when the oil price was at $67 compared to $133 today.

People used to say that as far as commodities were concerned, "the best cure for a high price was a high price". The idea being that a high price would ultimately lead to a drop in demand and/or an increase in supply which over time would lead to a lower price. The seemingly relentless rise in the oil price therefore leads to the question of whether this law of economics has been abolished. It certainly still seems valid for commodities such as wheat. After rising 150% between May, 2007 and March, 2008, the price of wheat has since fallen by 40%. However, unlike oil, wheat is renewable and has easy substitutes.

The first thing to note about oil is that this economic law is not really allowed to work. On the demand side, the price signal is muted because in some of the regions where demand is the strongest, oil is heavily subsidised. On the supply side, oil-producing countries have no incentive to increase production and are increasingly diverting exportable oil towards domestic uses. While there is a lot of talk abouth 'peak oil' (at least in the financial markets), the latter point is not often talked about. Given their strong economic growth, oil-producing countries are increasingly keeping their oil for their own needs, which leads to a kind of resource nationalism. According to some experts, Mexico, which currently provides around 15% of US oil imports, could thus cease to be a net oil exporter by 2014. Indonesia this week announced that is quitting OPEC, accepting its shift from an oil exporter to a consumer.

The second important point is that in the short term, supply and demand for oil are relatively price inelastic. Such inelasticity has even increased in the last years for the following reasons:

• on the demand side : new demand coming from the developing world where government price controls in many cases protect consumers from the full impact of higher prices;
  
• on the supply side:
  
  a) a higher risk premium given that the countries where new oil is being discovered are often not very stable and prone to corruption;
  
  b) rising exploration and production costs;
  
  c) environmental concerns;
  
  d) massive underinvestment in the last 2 decades;
  
  e) shareholder activism and short-termism which make public companies reluctant to undertake the long lead-time investments needed to increase the supply of oil.

What all this means is that the oil price must rise much more sharply than in the past to have a meaningful impact on supply or demand.

It has become fashionable to blame the latest increase in the oil price on speculators/financial investors. By putting large amounts of money into oil futures contracts, these investors are supposedly driving up the oil price. While this explanation seems appealing, it does not hold water. In the case of oil (and most commodities), the futures price does not drive the cash price which is set by supply and demand (to consume oil). Contracts traded in commodity markets are essentially bets on where prices will go but the final buyers of commodities are consumers not investors. To illustrate the inaccuracy of the theory that the rise in outstanding futures contracts (and thus speculation) can be directly linked to the rise in the oil price, consider the following:

• between 2002 and 2004 the oil price nearly tripled, yet futures prices were generally lower than spot prices;
  
• many non-exchange traded commodities (for which there is no futures market) have seen prices increase faster than exchange-traded commodities;
  
• in February of last year, the government of India banned futures trading in wheat. Studying that ban, a group of economists now came to the conclusion that there was no conclusive evidence connecting futures trading and spot price increases;
  
• the recent crude oil price increases have occurred with no significant change in net speculative positions.

This is not to say that there is no speculation in the oil market.

One example of speculation is oil that is artificially withheld from the market in anticipation of higher prices. Such practices are driven by the fact that the opportunity cost of not selling oil is currently low. The pricing unit for oil is the dollar which has been weakening against most other currencies. And the Federal Reserve Bank has sharply reduced its interest rates. Some experts cite the current tanker shortage and high lease rates as evidence that speculators are leasing tankers to keep oil on the seas while waiting for higher prices. This would suggest that if the oil price drops, much supply might suddenly appear. The more so since in its May report, the International Energy Agency noted that " (...)annual supply recovery recommenced in 4Q07 after three quarters of weak-to-negative growth and 1Q08growth was the strongest since early 2005".

On the demand side too, recent events seem to suggest that demand is beginning to respond to high prices:

• demand is slowing in the United States as high prices are finally changing American addiction to oil;
  
• according to a headline in last week's Financial Times, several Asian countries are getting ready to cut energy subsidies which have become very expensive;
  
• China's oil imports have been very strong in the first quarter because of the reconstruction work following the snowstorms of early 2008 and because Beijing wanted to ensure that the domestic market is well supplied in the run-up to the Olympic Games.
  
• while the logic linking the rise in the price of oil to increasing structural demand from developing countries makes sense, some forecasts seem to implicitly assume that these countries will turn into big and wasteful consumers like the US. Fortunately, the experience of Europe since the oil shocks of the 1970s shows that there need not be a strong correlation between GDP growth and oil demand. Japan's demand today is well below its peak of 1979 despite its' GDP being much higher. Even if it takes time, higher oil prices will lead to greater energy efficiency and use of alternative energy sources.

The fundamental arguments about lasting changes in global supply and demand in the oil sector are certainly valid. However, they tell us little about whether the oil price should be at $50 or $500. They are currently used by oil bulls to justify ever-rising prices. Bears seem to have capitulated and last week's rise in the oil price was due to a large degree to short covering. Oil thus shows many signs of being in a bubble. While $200 oil might be in the cards at some point in the future, I think the next big move in the oil price will be down.