(Updates with closing prices, adds background, details)
NEW YORK, April 4 (Reuters) - U.S. raw sugar futures rocketed to their strongest weekly gain in 3-1/2 years on Friday as an escalating trade dispute with Mexico kindled concerns about tighter supplies, breathing fresh life into the niche, thinly traded market.
Prices for domestic sugar notched a 10-percent weekly gain on hefty volume as traders continued to fret that Mexican mills could curb sales into the United States, one of the world's top sweetener consumers, in retaliation for any action the U.S. government might take following allegations that the mills were dumping sugar on the U.S. market.
U.S. sugar groups petitioned the U.S. International Trade Commission and the U.S. Department of Commerce last week for relief from alleged dumping of cheap, subsidized sugar from Mexico.
While traders waited for an official response from Mexican mills, concerns mounted about the impact of the dispute on the U.S. domestic market even as the global industry struggles with a massive surplus.
"The reality is setting in. People think there's a real chance (anti-dumping) duties could come into play," said Jerry Kramer of Kramer Sugar Co, a brokerage in Wellesley, Massachusetts.
Fears that trade flows between the two countries will be roiled was further fueled by statements from Mexico's economy minister this week that Mexican farmers could seek an investigation into U.S. high-fructose production in retaliation.
The second-month U.S. domestic raw sugar contract on ICE Futures U.S. catapulted to an 18-month high of 25.07 cents, before closing up 1.02 cents, or 4.3 percent, at 24.87 cents per pound.
Volumes were hefty for a second day with almost 2,000 lots of futures changing hands on the day, according to Reuters calculations.
While tiny compared with the 130,500 lots traded in ICE's international sugar contract, that is almost five times the average daily volume of the past three months.
Turnover was heavy along the whole forward curve - volume in the front-month matched that of March 2016 - reflecting frenetic buying by distributors and sweetener users to secure supplies and short-covering by those caught out by the sudden change in supply outlook.
"People are just now realizing the significance of this and wondering how they will get sugar so they are looking to put on extra positions," Kramer said.
Booking far forward among domestic producers and traders, the main users of the niche contract, is not unusual, but high volumes over the past two days suggest a brisker-than-usual level of interest.
Output in Mexico and the United States reached record levels last season, leaving the market awash in supplies and prices under pressure.
The dispute has brought fresh interest to the ICE No. 16 contract, which is used by only a small portion of the 10.5-million-tonne U.S. market but is critical for U.S. government sugar policy.
The U.S. Agriculture Department (USDA) used the contract as a reference price as it weighed whether to intervene to boost prices and stave off defaults on government-backed loans by U.S. producers last year.
A ballooning surplus sent second-month domestic prices as low as 18.70 cents a lb in July, prompting U.S. sugar producers and processors to forfeit hundreds of millions of dollars worth of loans, backed by sugar, for the first time in nearly a decade.
Many in the market were bracing for similar defaults later this season, but the recovery in prices may reduce that likelihood.
Low liquidity in the contract, which was launched in 2009, has been "problematic" for years, Patrick Henneberry, senior vice president at Louis Dreyfus Commodities' Imperial Sugar refinery operations, said at an industry dinner this week.
Even before this week, open interest, a measure of a market's liquidity, has picked up. It has hit record highs since the end of January, when the total breached 14,800 lots for the first time.
The record high of 17,680 lots was recorded in mid-March, equal to almost 1 million tonnes of sugar. That is a fraction of the 40 million tonnes in ICE's more widely used global contract.
Still, the potential loss of a neighboring trade partner has "renewed" interest in the market, Kramer said. (Reporting by Chris Prentice, Editing by Franklin Paul; and Peter Galloway)