We're not yet running on empty

The upward movement in the price of oil has far more to do with speculation than with a shortage of

Quite recently I had lunch with the chairman of one of the world's largest oil companies. He has a simple test that tells him whether the surge in the world oil price is the result of supply or refining difficulties, or can be explained by other factors such as geopolitical uncertainty or financial transactions such as hedging - a polite word for speculation.

If, as he drives past the huge gauges at the oil-storage silos in Rotterdam, headquarters of the free market in oil, the dial registers close to full, he knows the upward movement in the oil price has little to do with supply. If the gauge is low, he knows that there is a potential production or refining problem and a genuine shortage.

Throughout the present oil crisis, a critical concern as Group of Eight leaders met in Japan, the tanks/silos have been adequately supplied, even as the price of Brent crude soared close to $150 a barrel. The shortages have not been the result of fighting in the Niger Delta, explosions or tornados in the Gulf of Mexico, or strong demand as a result of the American driving season - all quoted as factors in stories about the surging oil price. But when a multitude of reasons is given in any market for a surprising movement it normally means that the writers and their sources don't have a clue.

The price of oil is critical to all our lives. The worst economic crises of the late 20th century were associated with oil-price bubbles of the kind we face now. In 1973, a temporary blockage of the Strait of Hormuz following the Yom Kippur War and an Opec embargo led to a period of double-digit inflation and recession. The same thing happened in 1979, following the Iranian Revolution, and again in 1990-91 after the first Gulf war.

The apparent difference this time around is that the constraints in supply have not, so far, been directly caused by a conflagration in the Middle East, though it is no coincidence that the most recent upsurge is associated with intense speculation that diplomacy with Tehran has failed and that an attack on its nuclear facilities is imminent.

Speculators' paradise

Just as importantly, the Bush administration has been tightening the intelligence and operational screws on Iran and might even welcome an Israeli attack. Were the Iranians to strike back by putting the Saudi and Gulf oilfields out of action, the stocks in the Rotterdam silos would vanish overnight.

Two factors appear to have turned the free market in oil - up to 80 per cent of oil is delivered on the basis of long-term contracts between suppliers and users - into a speculators' paradise. The first is the idea that the world is at peak oil production and that it is downhill from now on, as the Chinese make ever more demands on limited supplies. All the indications are that there are between five and six decades of known oil supplies, from the slopes of Alaska to the oceans off the Philippines. Moreover, sources such as the tar sands of northern Canada - once thought too costly to exploit - are now economical.

The second factor is oil security. Much of the supply is in difficult places such as Iraq, Iran and Russia. Some of these would be affected directly by an attack on Tehran. This has given a new stimulus to the speculators, supported by some of the world's largest hedge funds.

In much the same way as the credit crisis was generated by bankers and hedge funds dealing in "securitised assets" - US trailer-park mortgages dressed up as high-quality debt - so the oil market has become a playground for the financiers. The pattern, according to Robert Mabro of the Oxford Institute for Energy Studies, is clear.

Each week, two of the large investment banks, Goldman Sachs in New York and Barclays Capital (part of Barclays Bank), assess the energy market. On the basis of their assessment, which invariably points to higher prices, investors buy oil futures on the global markets, driving the price ever upward. Since January 2007, when the present climb in the oil price from $60 a barrel towards $150 a barrel began, the number of commercial contracts for real delivery of oil has been remarkably steady. But the number of open financial contracts, driven by hedge funds, investment banks and other traders, has risen sharply.

Such speculation is not all unfounded. There is robust demand for oil and concern about supply. But these underlying factors have been swamped by the financial transactions that have accompanied them. Some are purely commercial, with companies such as British Airways sensibly hedging against future price changes. Commercial hedging, however, is now outpaced by the speculative dealings of mysterious hedge funds.

Markets always overshoot, and some time the oil price will start to return to reality. But there may be a global recession before that happens.

Alex Brummer is City editor of the Daily Mail