Hamish McRae: An oil shock is likely to herald another world recession within the next 10 years

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The Independent Online

The oil concerns won't go away. There is the impact on eurozone inflation - will oil make it impossible for the European Central Bank to cut rates even if it wanted to? There is the further deterioration higher prices put on the US trade account, with consequent pressure on the dollar. That in turn would push up the oil price still further, for though it is denominated in dollars, the price does to some extent reflect dollar strength or weakness. There is the pressure on China's inflation and balance of payments. Did you know that China's trade account has suddenly slipped deeply into the red? And so on.

The oil concerns won't go away. There is the impact on eurozone inflation - will oil make it impossible for the European Central Bank to cut rates even if it wanted to? There is the further deterioration higher prices put on the US trade account, with consequent pressure on the dollar. That in turn would push up the oil price still further, for though it is denominated in dollars, the price does to some extent reflect dollar strength or weakness. There is the pressure on China's inflation and balance of payments. Did you know that China's trade account has suddenly slipped deeply into the red? And so on.

In a direct sense the UK would be the least affected of the Group of Seven countries: we are still just a net exporter, though we won't remain so for much longer, so there is no significant impact on the current account. As for inflation, yes, naturally energy prices affect that, but while sterling is no longer an oil currency, it is likely to remain strong in a world of expensive oil, and that to some extent insulates us from inflationary pressures.

But looking at the energy market through the prism of the UK economy gives a rather narrow view. To try to get this oil cycle into perspective, I have been looking through the best source on the world energy position, BP's annual Statistical Review of World Energy. The 2004 edition won't be out until next month and I have been using the 2003 version. But I don't think this matters too much because the long view remains much the same.

The first thing to be clear about is the extent to which the world is dependent on the Middle East for its reserves, as you can see in the pie chart. A lot of people suspect that Russian reserves are much larger than at present appreciated, largely because Russian companies have up to now had little incentive to play up their reserves - unlike a certain Anglo-Dutch oil company. But even if Russian reserves are bigger than stated, even if new fields are discovered, and even if techniques for extracting a higher proportion of the oil continue to improve, the fact remains that most of the stuff is in the Middle East. There is really no getting around that.

The next thing to focus on is what has been happening to consumption by region. The next two charts show the pattern both for petrol and for the middle distillates, that is to say diesel fuel, heating oil and the like but not the heavy stuff they burn in power stations. As you can see, in both North America and Europe demand for both types of product was trimmed a bit by the oil shock in the early 1980s, but since then demand has risen slowly.

But look what has happened to demand in the Asia Pacific region. It has shot up. A generation ago that region used much less oil product than Europe. Now it uses much more. This is largely the China boom - China has now become the second-biggest user of oil, passing Japan - but expect India to chip in with some pretty meaty increases in demand too. The world's largest single highway project is in India, not China.

Unless you think the China and India booms are going to collapse, petroleum demand from the Asia Pacific region will continue to rise for the foreseeable future. There is real possibility that either or both might falter, though for quite different reasons. Nevertheless, the underlying demand seems certain to continue climbing in the medium term.

I have not found any data on China or India's projected demand for petroleum over the next 15 to 20 years but there are some good ones for the US to 2020 and these are shown in the next chart. If that top line turns out to be right, the US will continue to add to the demand from China and India for another generation at least. You start to think: wait a minute, given where the oil is located, is this sort of straight-line projection for demand really credible and if so, what are the medium-term implications for the oil price?

Well, the history of the oil price, both in money of the day and 2002 dollars, is shown in the final chart. It does not show the latest spike to $40 a barrel but you can see that even now the real price of oil would be lower than it was after the first oil shock of the 1970s and much lower than after the second one of the early 1980s. We scrambled through then, though at the cost of two world recessions. Why should we not scramble through now?

On a two or five-year view the optimistic view seems the most sensible. Yes, the oil price may rise to $50 a barrel but in real terms that is nothing new. We've been there, done that. There are at least two reasons to believe that somewhat more expensive oil will not trigger another world recession. One is that global inflation is under much better control than it has been in any period since the 1950s. The other is that most of the developed world has made big strides in energy efficiency and the parts that have not, essentially North America and Russia, could easily do so if the financial incentives were right.

There are things that could upset that: revolution in Saudi Arabia is the most obvious candidate. Still, there is no direct, immediate reason to panic.

On a 10-year view the picture is rather different. In an ideal world the oil price would remain at or close to its present level, gradually creeping up and putting continuing pressure on energy conservation, development of alternative sources of power, and of course, further oil exploration. Unfortunately demand may increase in a more or less straight line but the price will not. We will get humps and bumps. So while there are decent reasons to believe that we will get through this cycle all right, there are equally good reasons that we won't get through the next one without another true energy crisis.

That is on the balance of probability. My own very rough and ready expectation is that there is only a 30 per cent chance that this economic cycle will be brought to an end by an oil shock. There are other things that will go wrong instead - what these might be is another column. But it is an odds-on chance that the next cycle after this one, when it comes, will indeed be ended by an oil shock. And I am twitchy that the 30 per cent odds noted here may be a touch too low.

Those straight-line projections for US petroleum demand cannot really be right, can they? It is just too dangerous for any country to be so reliant on imports from what is arguably the most volatile region in the world. Something else will happen: maybe a technical advance that we cannot at the moment predict. Meanwhile, remember how bad the world has been at managing its energy needs. We almost need another oil shock to encourage us to be wiser.

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