Oil market in a repeat of the 1970s

What does this mean? Answer: even higher oil prices, and we will probably see $50 per barrel and higher this summer.

The background that led to present $40 per barrel oil prices is quick to sketch. The US led invasion of Iraq in March 2003 destabilized an already unstable Middle East, and put a war premium on crude oil of $5-8 per barrel which remains today due to continuing violence in Iraq and the new phenomenon of terrorism in Saudi Arabia.

At the same time artificially low US interest rates have overheated the world economy in the run up to a US presidential election this year. This has caused a surge in oil demand from China and the US at a moment when the oil supply and demand equation was in precarious balance.

Add in the fact that the US gasoline market has been split up by new environmental legislation making it difficult to move the stuff around; and the massive positions taken by hedge funds in the oil market, and you have today's huge price spike, and not much to stop it.

Opec can raise its production quotas but it is not clear that this will help to calm market fears. As Opec ministers have commented in recent days this time the oil price is largely out of their control.

So where are we heading? In order for oil prices to match their previous high of October 1990 in real terms - that is fully adjusted for inflation - then we are talking of $60 per barrel and not $40.

Oil markets are extremely nervous about the possibility of a major terrorist strike on oil installations this summer. That would indeed trigger another upward price spike, although the International Energy Agency holds sufficient reserves to guarantee that the world can not run out of oil, of which the US Strategic Reserve is an important contributor.

One more reason - and there are a lot of them - for a high oil price this summer is that the US Strategic Reserve has been buying oil despite the high prices and is now full to the brim with crude oil.

What could unwind this cocktail of factors supporting higher oil prices? A recession in the Western countries induced by high oil prices, renewed consumer price inflation and higher interest rates? Or could we see serious efforts to calm tensions in the Middle East and to promote peace? Or may be a combination of the two?

However, if we look back to historical precedent then the Middle East war of 1973 was followed by the oil price hikes of 1974 and then high oil prices until 1980 when oil was twice the price that it is today in real terms.

Now it is true that the political situation is very different now, and Arab nations are not punishing the West deliberately as in 1974. But the economics could play out in very much the same fashion.

This would be good news for revenues in the Oil States but very costly for Western countries in terms of lower growth and higher inflation.