Serious Money:Oil is back in the headlines as prices remain within sight of the record high of more than $78 a barrel set last August. The price of crude is up almost 40 per cent since January as demand continues to exceed expectations while supply disappoints, writes Charlie Fell.

Market experts see no signs of relief in the months ahead and Goldman Sachs recently warned that oil prices could surpass $90 this autumn and reach $95 by the end of the year. Meanwhile, the International Energy Agency (IEA) foresees a supply crunch within five years as incremental demand exceeds capacity increases.

Oil prices would undoubtedly soar from current levels should the IEA's bleak outlook come to pass. It is becoming increasingly clear that the age of cheap oil is well and truly over.

The background to the bull market in oil is well-documented. The spike in oil prices was triggered by insufficient spare capacity to meet higher than expected growth in world oil demand, combined with political instability in key oil-producing regions.

The re-election of Hugo Chavez as president of Venezuela in 2002, the invasion of Iraq in 2003, unrest in the Niger Delta and hurricanes Katrina and Rita in 2005 all disrupted supply.

Simultaneously, the emergence of China and India as major oil consumers and the increase in oil usage in the former Soviet Union following almost a decade of decline caused spare capacity to drop to record lows.

Spare capacity as a percentage of consumption fell from more than 7 per cent in early 2002 to less than 2 per cent and not surprisingly, the price of crude increased sharply.

The IEA forecasts that strong global demand combined with project slippage and geopolitical problems will see annual incremental demand exceed annual supply increases by 2010, which will cause spare capacity to drop to unacceptably low levels by 2012.

The agency's assumption that global economic growth will average 4.5 per cent a year over the forecast period seems too high, but lowering growth to 3.2 per cent postpones the point at which oil demand growth exceeds the growth in global oil capacity by just one year.

Additionally, the analysis caters for a surge in bio-fuels production but the additional supply will have only a marginal impact.

The IEA also warned that a rise in "energy nationalism" could hamper supply as governments in countries such as Russia and Venezuela limit investment and use high oil prices to strengthen their control of domestic production. A supply crunch appears to be inevitable.

The notion that the world is facing an impending energy crisis is gaining broader appeal. The forward curve of futures prices has seen a sharp increase in the price of long-dated contracts in recent months.

The forward curve towards the end of last year peaked for delivery in March 2009 at $76 and dropped by more than $12 for delivery in December 2012. Today, the curve is extraordinarily flat as the price of long- dated and near-dated contracts have converged. The market no longer expects a cyclical downturn in prices.

However, if market participants truly believed that peak oil was imminent, demand for long-dated contracts would be high and the forward curve would edge ever higher across the entire maturity spectrum. Thus, the supply crunch envisaged by the IEA is not reflected in futures prices and consequently, oil looks attractive at current levels.

It has been difficult for oil investors to earn good returns in recent years as futures prices have consistently exceeded spot prices. This situation, known as contango, is unusual in the oil market. Indeed, futures prices have been below spot prices almost 90 per cent of the time over the past two decades.

To appreciate the impact of contango, it is necessary to understand the dynamics of oil investment. Investors typically gain exposure to oil through the futures market as direct physical investment is not practical.

Thus, to gain exposure to oil, an investor will buy futures contracts, which are continually rolled into new contracts to avoid expiries.

The total return earned is determined by the spot yield (the price performance of oil), the roll-over yield (the rolling of contracts into cheaper or more expensive contracts) and the collateral yield (the interest rate earned on the assets underlying the futures contracts).

Historically, the roll-over yield has been the most important component of returns. Typically, futures prices are below spot prices and converge towards the latter over a contract's life. The increase in price accrues to the investor as the exposure is rolled into a cheaper contract.

However, strong demand from end-users and investors has caused futures prices to exceed cash prices. Consequently, despite impressive price performance, roll-over yields have depressed returns.

However, the dramatic flattening of the forward curve of futures prices in recent months has seen the price on near-dated contracts converge with the spot price and consequently, oil investment is looking increasingly attractive. It's time to buy oil.