How can we explain such an extraordinary rally in oil prices? Is the answer as simple as supply and demand imbalances as many in the oil industry would have us believe? Or, is there something more sinister at play, such as speculation or, as some have accused, outright manipulation?

Much to our own surprise, the underlying economic fundamentals of the market (i.e., supply and demand) go a long way in explaining the run-up in oil prices in recent years, but cannot alone account for the excessive rise we have seen this year," says Adolfo Laurenti, senior economist of Mesirow Financial Demand for oil outstripped its supply much of the last decade, with the biggest shortfalls occurring in 1999, 2002, and 2007. This forced economies around the world to dip into existing reserves to satisfy their needs, and ultimately bid up the price of oil.

The global demand for oil should stabilize and could even weaken slightly, but is not likely to contract dramatically in the near-term. This means that production rather than consumption will have to drive a correction in prices.

The real responsibilities for insufficient supply are squarely in the camp of the developed economies. Indeed, between 2003 and 2007 production dropped by 0.7 million barrels per day (mbd) in Norway, 0.4 mbd in the United Kingdom, and 0.3 mbd in the U.S. Production in OPEC, on the other hand, was on the rise, increasing by 1 mbd in 2007 alone.

Reasons for supply shortfalls include: nationally-owned oil companies, which lack the market incentives to increase investment (e.g., Venezuela); systemically low oil prices in the 1990s - $20 per barrel on average - caused a serious shortfall in investment on exploration and new equipment across the developed world; concerns about global warming; and, political instability has interrupted supply routes.

"Oil prices should fall from their recent highs, and stabilize somewhere in the $90 to $100 per barrel range by the end of the year. The timing is tricky, however, and prices could easily top $150 per barrel before correcting. Consumers have begun to react to higher prices, however, and if they do stay that high, demand will fall further in the U.S. than is currently forecast, and prices will come down more aggressively next year," concluded Laurenti.