Hamish McRae: Greater efficiency, not a new wonder fuel, is the answer to higher oil prices

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The Independent Online

Higher oil prices have helped push up both UK and eurozone inflation: the UK is now at 1.5 per cent and the eurozone 2.5 per cent. So it comes as some relief that Opec is seeking to get its members to boost production and hold down the price. And not just its members. Purnomo Yugiantoro, Opec's president, said he is writing to non-members Angola, Mexico, Oman and Russia to request that they produce more oil as well.

Higher oil prices have helped push up both UK and eurozone inflation: the UK is now at 1.5 per cent and the eurozone 2.5 per cent. So it comes as some relief that Opec is seeking to get its members to boost production and hold down the price. And not just its members. Purnomo Yugiantoro, Opec's president, said he is writing to non-members Angola, Mexico, Oman and Russia to request that they produce more oil as well.

What's this? Opec trying to get non-members pump more? Surely the whole point of Opec is to try to maximise its members' own revenues. To do that they need to hold the price at a reasonably high level and to discourage other producers from undermining this strategy.

Actually the Opec strategy makes huge sense. The key objective is price stability and at the moment Opec is failing to achieve that. If the price goes too high the world is encouraged to hunt for other sources of oil and for substitutes. That goes against the long-term interests of Opec. Normally the Opec members, and in particular Saudi Arabia, have enough spare pumping capacity to increase output when a price spike occurs. On this occasion they clearly feel they haven't, hence the request to non-members.

To all of us who have been brought up to think of oil as a finite resource that will some day run out, it might come as a bit of a shock to see Opec worrying about the price being too high rather than too low. But the experience of the 1970s and early 1980s hangs over Opec. In real terms the oil price then was even higher than now, for the peak was around $80 a barrel. But Opec saw how higher prices spurred the hunt for oil, made oil that was hard to get out profitable (eg the North Sea) and encouraged the development of alternative sources of energy. As a result Opec's hold on world oil supplies is much weaker now than it was a generation ago.

To see how the supply/demand equation is developing I have been looking at the new BP Statistical Review of World Energy, out yesterday, from which the graphs are taken. Last year saw a modest reduction in oil reserves in the sense that the world did use slightly more oil than it found but there are still 41 years' of supply left at present consumption levels.

You have to qualify this a little, partly because consumption is rising and partly because the line is a muzzy one between proven reserves and reserves that are probably there but cannot be proven. (Shell's recent reserve débâcle was over this distinction.) In the past the general tendency has been to underdeclare reserves for tax and other reasons. In the 1980s, Opec members suddenly increased their declared reserves because their production quotas were related to the amount of stuff they said they had in the ground.

Still, the general picture holds true: there are 41 years of oil left and about double that of gas, as shown in the bottom left hand chart. There are also (not shown) a couple of hundred years of coal. The location of oil and gas reserves is shown in the two pie charts: nearly two-thirds of oil is in the Middle East but only 40 per cent of natural gas. Europe and Eurasia (the latter is mostly the Asian region of the former USSR) have almost as much gas as the Middle East and of course gas is a close substitute for oil. That 35 per cent will give huge clout to Russia in the future. It will be almost as important for Europe's future energy needs as the Middle East is now.

Now look at what forms of energy are being used and where. The middle chart on the bottom shows how the three fossil fuels - oil, gas and coal - dominate world primary energy production. Nuclear and hydro power are significant (though proportionately less so than they were a generation ago). Nuclear power output actually fell last year and hydro output was static. And the fashionable forms of alternative energy, such as wind power, are negligible. That is not to say they are not worthwhile; that is a separate matter. The point is simply they are too small to change the global picture.

You can see why if you look at energy consumption by region, the bottom right-hand chart. Hydro and nuclear power are tiny in the Asia Pacific region, which happens to be the place where energy demand is growing fastest. World coal demand, thanks largely to China, rose by nearly 7 per cent. China can to some extent, and at the cost of flooding large chunks of the country, increase its hydro-electric output. But basically it is a fossil fuel economy. If it continues to grow at 7-8 per cent a year, expect demand for fossil fuels to carry on growing pretty fast too.

This suggests that oil and gas will tend to remain expensive. (Coal won't so much because it is awkward to ship around and creates more pollution than oil and particularly gas.) From the narrow perspective of the UK that may seem not too bad news. We are still a net exporter of oil, last year producing just under 3 per cent of world output and using just over 2 per cent. But even with improved extraction techniques, the British side of the North Sea will decline. There is officially only 5.4 years' supply. That does not mean that oil will run out in 2009 - after all in 1993 the official reserves were at the same level they are now and we did not run out in 1999. But production last year was down nearly 10 per cent on 2002.

This is a very narrow perspective. Higher priced energy will slow global economic growth and that damages living standards everywhere, including the UK. No, I think the big issue is the extent to which high-priced fossil fuels stimulate the quest both for greater efficiency in energy use and the development of alternative sources. And the great unknown is whether there is a radical alternative out there, already in some laboratory, that will change everything. It has to be out there now, for it typically takes 30 years for a development to get from the initial invention to widespread global application. The safety-first assumption, I fear, is that while there are lots of hopeful technologies, there isn't anything that is likely to change the world.

If that is right, then the only way forward is the quest for greater efficiency. Here the lesson of the 1980s may be helpful if the world did curb indeed its energy needs. Simply applying best practice would help greatly and present prices are already high enough to be encouraging - for example - US drivers to buy more efficient vehicle models. Indeed higher prices are really the only weapon that works. The only way to tilt the Chinese car boom towards the economical end of the spectrum is to make petrol expensive. The only way to encourage new factories there to adopt the most energy-efficient techniques is to price energy high enough.

So in the short term we should hope that Russia and the other non-Opec producers heed the Opec call and pump more. But in the medium-term we should hope that the oil price does not fall back too far and the complacency of the 1990s sets in again.

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