Oil prices: take a fresh look at market fundamentals

Commodity prices move according to the dictates of supply and demand, and to a lesser extent speculation. But the argument that an increase in supply automatically reduces prices was stood on its head last week.

Opec's release of 500,000 barrels per day into the market impressed nobody. US light crude shot above $57 a barrel for the first time in history. In truth this action just served to highlight how little room for maneuver the once-powerful oil cartel has these days.

For the oil market is now looking at next winter, and noting that fourth quarter demand is likely to be 3.5 million barrels per day higher than in 2004. Where will that oil come from? Observers reckon Opec can deliver about 500,000 barrels per day more, so we are left with a deficit of three million barrels per day.

And that is without the kind of 'supply shocks' that have become not so very shocking in recent years. Even Saudi Arabia is down to its last 1-1.5 million barrels per day in spare capacity. But most of this is heavy crude oil while the demand is for sweet grades.

Now speculators love a one-way position which is increasingly what the oil market looks to be. Prices have ramped up 25-30% since the start of the year - easily the best performing major asset class - and the upside looks very secure.

However, the traditional end of an oil price boom does not come from an increase in Opec's output but a recession in the oil consuming world. High oil prices will cause inflation in due course which will cause interest rates to rise and profits to fall and stock markets to crash along with house prices.

That would cause an economic collapse in China and slash oil demand reducing prices to something more in line with what consumers can handle.

The real wild card is guessing how long it will be before this logical progression of events occurs. We have seen it many times before.

Indeed, no oil price boom has ever ended without causing a recession in the oil consumer countries. Only unrealistic optimism suggests that it will be any different this time. Tempus fugit.