Somebody make it stop

With each passing day, the price of oil increases further. On Thursday, prices jumped by four dollars in a single day, to $135 a barrel. Here in the UK, the average price of a litre of unleaded petrol is now approaching ₤1.14.

What would it take to bring the price of oil down? In order to answer that question, we need to understand why it is rising in the first place. Under normal circumstances, the price of any good will rise when either demand increases, supply falls, or some combination of the two. Over the last decade or so, demand for oil has risen dramatically, as many developing countries have industrialized.

However, this increase in demand can hardly explain why the price of oil rose from around $90 a barrel in December last year to $135 today. If anything, the growth in demand is slackening off, as advanced countries begin to slow down. In turn, this slowdown reduces demand for goods produced by emerging market economies.

Can we find an explanation on the supply side? There has been the odd disruption here and there, but nothing that can explain the magnitude of the recent surge in prices. In fact, most oil-producing countries have maintained production levels.

If the conventional explanations for a price increase are lacking credibility, where do we look for an answer? We have to go back to demand, but not the usual demand for oil as inputs to production or as a source of energy for transportation. We have to see oil as an asset price, traded in financial markets.

Oil prices are merely responding to interest rates. As short-term rates have come crashing down, and investors have suddenly realized that most asset classes are much more risky than previously thought, commodity prices, particularly oil, have been the only asset class offering significant rates of return. Lower interest rates also drastically reduced storage costs of oil, which has encouraged many suppliers to store oil rather than sell it. In other words, as interest rates have fallen, speculative activity in the oil markets has taken off.

Ironically. Central Banks in advanced countries could bring the price of oil crashing down in just 24 hours. All that it would need is one massive hike in rates. Although central banks would like to burst the oil bubble, they fear something more than inflation. It is a systemic banking crisis.

Banks in the US, the UK, and many parts of Europe are hopelessly exposed to one horrifically overvalued asset class - real estate. Although property prices are falling, a large increase in interest rates threatens to send property prices into a double-digit slide into the abyss.

This collapse would unleash an unstoppable chain reaction. As house prices go down, so does the value of collateral. Default rates on mortgages would also rise, banking losses would accumulate, and bank capital would be wiped out. In other words, higher interest rates threaten to bankrupt financial systems on both sides of the Atlantic.

Can oil prices just keep on going upwards? Oil is the last great bubble, and in the fullness of time, it will burst. The adjustment mechanism will come through long-term interest rates. The oil price bubble is pushing up inflation across the world. Gradually long-term interest rates are beginning to reflect that fact.

So far, the yield curve has only steepened marginally. Nevertheless, give it time, and it will fully reflect higher inflationary expectations. Long-term interest rates will rise further, and as they do, the world economy will slow. The oil market will be faced with declining demand, which will eventually put a brake on this speculative behaviour.

However, that day could be some way off. In the meantime, prices could keep on rising for months to come. The day of $200 oil could shortly be upon us. It is doubtful whether it would be with us for long, but by the time it shuffles off, it will leave the world economy in a deep recession.