With oil prices trading at close to $140 a barrel everybody is wondering if and when oil and other commodities will turn.

With oil prices trading at close to $140 a barrel everybody is wondering if and when oil and other commodities will turn.

In the last few weeks three key elements that have stoked oil’s rise have changed signalling that the relentless move higher is about to come to an end, according to RBS Sempra economist John Kemp. Other commodities such as gold, corn and wheat have travelled higher in part on the coattails of oil and a u-turn here would stop the rally across the asset class.

Apart from supply and demand fundamentals, oil prices being fuelled by price control and subsidy regimes across China, Asia and the Middle East have ensured that regional oil demand continued to surge as rising oil prices did not filter through to households and businesses. Also, a combination of cheap money policies pursued by the Federal Reserve and other central banks helped move prices higher, according to Mr Kemp.

But in recent weeks Malaysia and Indonesia removed their subsidies. Local oil prices spiked 10-30 per cent almost instantly causing a lot of domestic political problems. China, however, has not yet changed its policies because it is the only one in the region that can handle the fiscal burden of subsidies. However, even there the $10 billion per year cost of subsidising crude oil imports at $100 per barrel for China’s large oil refiner Sinopec is a non-trivial amount. This will rise more than proportionately with every dollar that crude moves above $100 and China's government will eventually have to raise controlled prices, even if it does not liberalise them completely.

The second signal is that economies in Europe and the US, both massive consumers of commodities, are beginning to suffer. US policy makers have been deeply jolted by the recent surge of oil prices from $110 to $140 and are terrified by talk of $150 and $200, says RBS Sempra’s Kemp. Federal Reserve Chairman Ben Bernanke said that the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.

The rise in food and energy prices is already cutting real household incomes both in the US and Western Europe, producing a slowdown in consumer spending growth and this is expected to deepen through the latter part of the year, intensifying as housing wealth evaporates. A sufficiently deep and prolonged slowdown in advanced economies would create slack in commodity demand and end the bull run.

Lastly, the global monetary cycle has shifted from pro-growth accommodation to anti-inflation tightening. The shift has been underway for several weeks, triggered by the latest $30 surge in crude oil prices but became inevitable after the ECB President Jean-Claude Trichet signalled the ECB was preparing to lift interest rates across the eurozone to counter an inflation rate almost double the bank's target.

This, at least, is the theory. However, not all depends on fundamentals, says Arturo Rodriguez, chief investment officer of Juno Mother Earth Asset Management, a New York-based commodities hedge fund firm. Part of it is perception, and “you can’t argue with perception. The market wants to go higher. We are not getting close to the end of the market. What needs to happen (in oil) is an exhaustion move like the one we had in wheat earlier this year when prices rose to $13 a bushel.

When that happens in oil, and that exhaustion move will probably be $200, this is when the market will turn,” said Mr Rodriguez.

Goldman Sachs forecasts that oil will trade at $149 in six months' time and at $145 a year from now. Merrill Lynch, however, has a more moderate forecast of oil slipping closer to $120 in the next six months and to $107 next year.

In the meantime, there are additional pressures forming in the oil market. US lawmakers are increasingly pushing for tighter controls as high oil prices create political pressures at home. Proposals on the table include reducing limits on positions that can be held in the market, raising margins and changing the tax treatment on commodity investments by pension funds to make them less attractive. The most drastic one, to be tabled by Senator Joseph Lieberman later this month, includes banning large institutional investors, including index funds, from investing in commodity markets.

This is already causing some funds in London to pull out of commodities. One London banker says “what we will see more of over the summer is funds withdrawing length, going short or reallocating investment, which were destined for commodities into other markets.”