Will oil prices double this summer?

Over the past 30 years the world has been through several major oil shocks, or oil crises in which the cost of a barrel of oil suddenly shot up causing consumer and asset price inflation, higher interest rates, and then an economic downturn or outright recession.

Is that where we are suddenly heading in this optimistic summer of 2004 when all the world's economies are growing again after a major post-Millennium slowdown?

Certainly capital markets voted with their feet last week, and investors headed to the exit doors. But this may just a sign of things to come.

One statement earlier last week from Opec sent a chill down the spine of market watchers. This was a declaration from the oil cartels' president that there was nothing Opec could do about rising prices in current circumstances.

For those who respect the Saudi Arabians as the great swing producers of the oil market this is very sobering. If Opec can not release enough oil to satisfy the thirst of an expanding world economy led by China and perhaps India, then who can?

Russia? We got the answer on Friday last week. The Russians are up to 9.3 million barrels per day, and can add no more supply. They are at their physical limit.

Add in very real threats of supply disruption in the Middle East - and we saw Iraq exports dip by 500,000 barrels per day last week due to another sabotage incident, albeit just for a few days - and you have a very precarious supply and demand equation.

Now what can happen to reduce demand to meet available supply? Answer: higher oil prices.

Oil prices will therefore rise to such a level that the global economy contracts and the supply and demand equation is in balance. The mechanism involved in depressing global oil demand is consumer and asset price inflation caused by high oil prices which will necessitate higher interest rates.

In the interim period the question of how high oil prices go actually depends on how long the Federal Reserve keeps interest rates at their present ridiculously low levels. It was, after all, excessively low interest rates that sent demand for oil to present unsustainable levels in the first place.

Given that this is a US Presidential election year, and the Fed has no desire to dampen this year's economic success story, we might see oil prices surge a lot higher before the inevitable medicine of high interest rates is taken. And the higher oil prices rise the more aggressive those interest rate rises will have to be.

On the other hand, in order for the oil producers to invest in new capacity to meet rising real global demand for oil then we will probably continue to see oil prices well above the depressed levels of the 1990s. Otherwise, there will just be another supply and demand crunch, and another business slowdown or recession.

So higher oil prices are probably here to stay, and today's shock headline might be tomorrow's planning baseline. In the meantime, oil prices could double this summer.