Economic View: Running on empty: peak oil production is in sight, global supplies will dwindle - and the US, for one, is ill-prepared

China's rapid growth in consumption could suck up all the extra crude pumped next year, leaving other countries to get by with less
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The Independent Online

The oil price will go through $100 a barrel at some stage in the next few months, maybe in the next few days. One consequence, petrol at £1 a litre, is already with us. The climb is surprising, at least to the oil companies, who a couple of years ago were still expecting an oil price of below $50 a barrel, and doing all their planning on that basis. But, in a way, it is more surprising that the world economy has managed to carry on growing strongly despite this rise. For the oil price affects not only energy prices; oil also is the feedstock for plastics and other products we use every day.

This has been a continuing story, really, ever since the oil price started to climb at the end of 2004, but this year has brought three further twists to it. The first is a growing appreciation of the finite limits to global oil production. Not only is production running pretty much at full bore, but there are also doubts about the ability to increase production in the medium-term. The second is the surge in demand from the emerging economies, principally China. And the third is the growing evidence of an economic slowdown in the US and the relationship between the higher oil price and that slowdown. A word about each.

The fundamental availability of mineral oil in the world has not changed much in recent years. No big new discoveries have been made, though a steady stream of smaller ones has been seen and interest in non-conventional sources of oil, including tar-sands, is rising. What has changed is the awareness of the pressure. The principal organisation warning of a lack of supply, the Association for the Study of Peak Oil, was seen by the main oil producers as maverick and wrong four years ago; now its views are seriously debated, even if most geologists feel they are too pessimistic. ASPO is talking of peak production being reached within the next five years.

This change in perception is important in a number of ways. It has spurred the hunt for alternatives, including oil crops – sometimes with unexpected consequences. The worldwide rise in food prices is, in part, the result of using maize for fuel rather than for food. It also changes the sense of power: Russia and the Middle East have become more important; Western Europe and the US less so.

This shift in power is immediately evident in the size of the cash balances that have become available for investment: the rise of the Sovereign Wealth Funds. If oil supplies remain tight far into the future, which they will, these balances will grow and grow. That changes investment perceptions. Countries that have cash will want to deploy that cash to their national advantage.

The second issue, the surge in demand, is the other side of the equation. Not only will supply be tight far into the future; demand will be strong far into the future too. You can argue that the world's largest oil consumer at present, the US, could make changes to its economy that would result in it using less of the stuff. It could, for example, have a much more fuel-efficient vehicle fleet. The price mechanism is already making that happen. But increased efficiency in the developed world is not going to balance increasing demand from China.

The present climb in the oil price has coincided with rising demand from China. Put it this way: China used about three-quarters of the additional supply of oil in the world last year. The economic team at ING Bank notes that China may account for all the additional production this year. If China is to go on using all the additional oil that is available, or more, the rest of the world will have to get by with less. This makes the present surge in the oil price different from all previous oil shocks: it is caused by rising demand rather than restricted supply.

That leads to the third point. The US economy is slowing but it is hard to distinguish between the various reasons for this. One is the sharp fall in house prices now happening in most states. Another is the financial meltdown partly as a result of that: "sub-prime" mortgages being worth much less than the banks had thought, and the financial disruption this has caused. But consumption in the US has remained quite strong given what has happened to house prices and the question is whether, at some point, higher fuel prices will make people feel they have to cut back on other things.

The oil price has shot up in the US and the price of imported capital goods has risen sharply too. But the price of imported consumer goods has been remarkably flat. That may just be the result of different time-lags: the oil price hits immediately, whereas importers of consumer goods take a while to increase their prices. Or it may simply be that China (for that is where most of the imports come from) is such a cheap producer that it can still make money exporting at low prices.

It is hard to attribute much of the US slowdown to more-expensive energy. That raises a big question. Eventually, higher energy and raw material costs must feed through into US inflation. The weak dollar will exacerbate this trend. So can the US Federal Reserve credibly cut interest rates further in the face of this inflationary pressure? Quite a few sceptics have questioned the wisdom of its most recent cut, and neither the Bank of England nor the European Central Bank has sought to follow – the ECB may even increase rates later this year. While the world has coped with oil prices approaching $100 a barrel surprising well so far, the US at least will find it harder to do so.

The surge in the oil price is just one element of pressure on the world economy. Countries that are growing strongly can cope. Countries that are already under pressure, such as the US, are finding it harder to do so. And countries in the middle, such as the UK? Well, higher energy prices will be one more headwind against the economy, resulting in slower growth next year. Money spent at the petrol pump is money not available to spend on something else.

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