By the last week of May, the world trade price of oil had increased to nearly $42 per barrel. This was the highest it had reached for some time, and it was increasing despite the onset of summer (which typically implies reduced oil prices). While in real terms this is still well below the peak reached in the mid-1970s, which triggered the famous worldwide stagflation, it is still high enough to cause concern among both policymakers and investors.

It must be noted that much of the increase in the price of oil has occurred quite recently. As Chart 1 shows, from a low of $17.87 a barrel in February 2002, the average monthly price of crude imported into the US rose to around $25 a barrel in May 2002 and fluctuated around that range till December that year. It then rose sharply during the winter months to touch $31.89 in February 2003, only to begin its decline again to reach the $25 level by April-May 2003.

It is only after June 2003 that oil prices have once again been on the rise, with the US import price climbing to around $31 per barrel by February 2004. Even this figure is way below the spot price of $42 recorded at the end of May. Thus most of the increase in price could have occurred only over the last three months. Chart 2 provides the spot price of Brent Crude for the February to April months as reported by the most recent monthly oil market report (dated May 12) of the international energy agency. This shows that Brent Crude prices in spot markets rose from an average of a little less than $31 a barrel in February to $33.8 in March and then fell to $33.3 in April. Examining weekly prices for five weeks up to the week ending 3 May 2004 suggests that the price increase that has taken oil prices to record levels began in the week ending April 26, with price during the week ending May 3 averaging $36.1 per barrel.

Thus clearly there has been a surge in oil prices during May. This sudden surge, coming in the wake of a much slower increase over the previous three months, suggests that trends warranted by supply-demand balances have been significantly amplified by speculative factors. The real issue under debate now is on the relative role of these two factors - supply-demand balances and speculation - in explaining the current high price of oil.

A close examination suggests that demand supply balances could not have contributed to the observed price trends in world oil markets, despite a sharp increase in global demand driven by a rapid rise in consumption in the booming Chinese economy. According to the International Energy Agency demand growth during 2004 is likely to be the highest in 16 years, with global oil demand expected to rise by 3.6 million barrels a day relative to 2004. More than a third of this increase is seen as being due to increased Chinese demand, with another quarter contributed by North America.

At first glance, this rapid rise in demand appears a problem since OPEC producers who are responsible for 38 per cent of global demand, have little spare capacity left. A range of factors have affected OPECs capacity to keep pumping out oil in response to demand increases. These include the Iran-Iraq war, the Gulf war and the attempt by US-backed Venezuelan oil workers in 2002 to topple the Chavez government by paralysing the oil industry. These have not just effected crude extraction but limited refinery capacity.

However, despite these setbacks, OPEC production is estimated to have risen by 3.3 million barrels a day between 2002 and 2004, which together with its recent decision to expand supply by a further 2 million barrels a day (reportedly the production in excess of quotas that was already occurring) should be more than adequate to match the increase in demand. To boot, non-OPEC oil production, is estimated to have risen by 2.3 million barrels a day between 2002 and 2004, led by a 1.7 million barrels per day contribution from the countries of the former Soviet bloc.

In fact, the government of Saudi Arabia, the world's largest oil producer (and the only OPEC country with significant excess capacity at the moment) has actually been trying for several weeks to ease prices downward. It announced that it will pump more oil itself and managed to persuade other OPEC members to raise the group's production quotas by about two million barrels a day, to ease any fears of supply constraints.

In sum, while the fact that OPEC producers are running up against their capacity limits could have generated fears that further rapid increases in demand may not be matched by corresponding increases in supply, as of now the oil market is hardly characterised by a situation of unmet excess demand. However, this has had only a limited impact on the markets. Instead, most observers predict that oil prices will remain high for the next few months at least, and possibly even longer.

The key to understanding oil price increases, therefore, is the role of the speculative factor. Most predictions of where oil prices are headed are based on trends in oil futures or derivative instruments that involve a bet on the likely trend in oil prices. Long positions, involving current access to the commodity held with the intention of selling it later indicate that speculators are betting on a price increase. This implies that available stocks are being held back with future trade at a profit in mind. To the extent that this affects the actual demand-supply balance at any given point of time, these expectations of a price increase tend to get realised. This renders the price volatile as well. For example, on Wednesday June 2, expectations of an OPEC output increase resulted in a fall in US benchmark crude futures of as much as $1.75 per barrel to $40.58, from a record close of $42.33 in the previous session.

A revealing development noted by most observers is the presence of hedge funds and pension funds in the market for oil futures. It must be noted that it is not just what happens in oil markets that determines speculative activity there. Recent months have seen hedge and pension funds seeking new avenues for investment because of losses being suffered in financial markets. Long positions in commodities have increased because of declines in Japanese and emerging market securities prices and indices and the adverse consequences of the dollar's rally. Many fund managers see oil as a saviour in this context because profits from long positions in oil derivatives have offset losses in other markets.

They have been encouraged in this activity by recent developments in Iraq and Saudi Arabia. Naturally, the chief source of concern for some time has been Iraq. It is not just that attacks on the export-oriented oil pipeline in northern Iraq have constrained oil exports from the occupied nation. Even in southern Iraq (which provides around two-thirds of Iraq's oil production) there have been attacks on oil production and transport facilities. If the US military occupation of Iraq was really all about oil, it should come as no surprise to note that the difficulties, and indeed failure of that occupation, will create uncertainty and expectations of oil price rises in world markets.

But the relative success of Iraqi opponents of US occupation, who have continued to disrupt oil supplies from that country, is not the only source of apprehension. In the past months, there have been several attempts by insurgents to attack energy targets inside Saudi Arabia, and some of these have been at least partly successful. There is no reason to believe that these attacks will reduce or be eliminated in the near future. Partly for this reason, Saudi Arabia has not been able to calm the energy markets with promises of more oil output, as it had successfully managed in the past.

Of course, this increase in violent attacks against oil facilities in different parts of the Middle East is no accident, but is related directly to the US military occupation of Iraq and its general geopolitical strategy in the region. The Bush regime sought to establish its control over world oil resources (and to underline thereby its control over the world economy) through aggressive military intervention. Paradoxically (but perhaps predictably), it has succeeded in diminishing its control and creating more uncertainty on the future of the oil economy.

In the event, terrorist attacks in May in Khobar aimed at the facilities of oil firms and at foreign personnel linked to the oil industry (that killed 22 foreign oil workers) spurred rumours that there is a strong possibility that Saudi Arabia's production capabilities may be severely damaged if not crippled. This in turn is expected to affect oil supplies enough to generate shortages. There are three presumptions involved here: first, that security at Saudi oil installations can easily be breached; second, that foreign personnel are crucial to Saudia Arabia's oil industry; and, third, that production elsewhere cannot increase to make up for any shortfall in supply from Saudi Arabia.

As many observers and players have been at pains to point out, none of these is necessarily true. Ali al-Naimi, the Saudi Arabian oil minister, reportedly dismissed negative perceptions about oil supply security in the kingdom after the attack in Khobar when he said: "This paranoia about terrorism in the world that all of the oil establishments are at risk, that is not true. I tell you very confidently that the oil establishments in Saudi Arabia are very, very secure. They are protected very, very strongly to prevent anything from happening to them.''

He also made clear that there is no shortage of local expertise if the need arises: ''when something happens, even when it is not close to the establishment, what happens is that people have the perceptions that this will lead to employees running away. We have the human resources that are capable and educated and we have the best petroleum companies in the world. How to convince those pundits, analysts and traders is the problem," he reportedly said.

But in a market driven by rumour, the herd instinct and a desperate search for profit, the Khobar attack was enough to drive prices to record levels. While estimates of the impact of such speculative activity on the part of financial investors on oil prices vary, some analysts suggest that it could have contributed as much as 10 dollar increase in the price per barrel. That is, almost all of the recent increase in prices is seen as the result of speculative activity.

Needless to say, spokespersons for finance have been quick to deny all this. Hedge fund managers repeatedly dismiss views that speculators have been a leading force in pushing prices to record levels. And, Robert Collins, president of Nymex, the principal exchange for oil futures, said: "While it is true to say there is a great deal of hedge fund activity in the futures exchanges, those markets are ultimately driven by the fundamentals of the cash/spot markets in which (hedge funds) barely operate."

However, the numbers are clear. Price increases are not warranted by the prevailing supply-demand imbalance and hence must be speculative; more so because even the OPEC announcement that output would be increased has not had an adequately calming effect on the oil market.

If oil prices do continue to rule high, this in turn will generate inflationary pressures, which have already been evident in the US. Given the obsession of financial markets with inflation control, it is not surprising that they view this with trepidation. Even in India, the question of how to deal with rising world oil prices, and the extent to which they should be passed on to Indian consumers, has already become an issue for the new government.

But oil prices are especially significant in US politics. The United States is the world's biggest consumer and importer of oil, consuming roughly one-quarter of the world's petroleum. Already by March the US trade deficit rose sharply to a record $46 billion in March, and about half of the increase was accounted for by increased payments for oil imports. The US oil import bill figures for April and May are likely to be much worse.

US consumers are the most pampered in the world, used to low petroleum prices for their cars in particular, and usually there is a direct political fallout when they have to pay more for this item. Petrol prices in the US have gone up by more than 50 per cent this year already, and there are rumblings amongst the electorate about having to pay well above $2 per gallon. President Bush, up for re-election later this year and already taking a battering on his aggressive military and foreign policy, can ill afford this additional source of national discontent.

But the real problem is that price increases driven by speculative activity hits the oil importers hard, without delivering the benefits to oil exporters in full. A conservative estimate by the International Energy Agency suggests that a $10 per barrel increase in oil price (say from $25 to $35) if sustained over a full year, transfers income from oil importers to the beneficiaries of the price to the tune of $150 billion or 0.5 per cent of global product. But with global demand placed at over 81 million barrels per day, the actual transfer could be as much as double that amount.

A large chunk of this transfer would be from developing country oil importers. The impact of such a transfer on their balance of payments cannot but be damaging. In the emerging markets like India and China with large foreign exchange reserves, such a transfer would drain their reserves, making them extremely vulnerable to any decision of foreign financial investors to withdraw their investments. Put otherwise these countries lose both ways: they loose if financial investors choose them as investment destinations, since this results in an increase in reserves, an appreciation of the currency, a worsening balance of trade, and increased external vulnerability. They loose even more if financial investors choose to move out of paper assets into oil in search of better profits, because that both increases their import bill as well as reduces their reserves because of capital outflow, threatening a financial crisis. Speculation in oil does adversely affect richer nations like the US, EU and Japan. But it can have devastating effects on poorer oil-importing economies. In the final analysis it is only the speculators who win in a world of dominant finance.