Hamish McRae: Hurricane Katrina gives us a taste of things to come in an oil-hungry world

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The Independent Online

When there is a global catastrophe the human tragedy should always take precedence over the economic damage. So far, we can only guess at the death toll of Hurricane Katrina. But we can see that this toll may have run into the thousands and that the blow to the human community will be felt far beyond the cities and states that have been devastated.

We know even less about the scale of the physical damage to New Orleans, and to others cities and the region, so it is really too early to gauge with much confidence the long-term economic impact. There are some precedents of great disasters striking giant American cities - the Chicago fire of 1871, the San Francisco earthquake of 1906 - and there are of course a string of hurricane strikes on the US every year. But mercifully there has been nothing on this scale in recent years. No great city has had to be evacuated in living memory.

We do, however, know quite a lot about the way economies recover from natural disasters. For example we know that physical reconstruction, once it gets going, creates economic activity. We know too that such is the size of the American economy as a whole, even a city of a million or so people is quite small. And to put into context the $30bn (£16.6bn) or so that has been quoted as the cost of reconstruction, it is worth remembering that last year four hurricanes caused total damage of nearly $30bn. Yes, the costs of Katrina are going to be huge, but they will not be of a different order of magnitude from the costs of previous storms. Further, the costs are small in relation to the total size of the US economy. Capital Economics, which has made a quick assessment of the costs, points out that if the bill does end up at $30bn that would be equivalent to 0.2 per cent of US GDP. At the present strong US growth rates, that in turn would be equivalent to about a fortnight's growth. But if in macroeconomic terms the impact of the hurricane is quite small, there is one aspect of the damage it has caused that may turn out to have global significance. That is the damage to US oil production.

The Gulf of Mexico produces about one quarter of US output and most of this is currently shut down, hence the surge in oil prices to more than $70 a barrel. In the short term the US can release part of its strategic reserve and the likelihood of that has pulled back prices a bit. It may be, too, that the damage to the oil production installations is limited and there will not be any long-term shortfall. That we will not know for some days, maybe weeks. But if there is, this will make a tight oil market even tighter.

If so, the damage to these installations will give us a taste of what it is like to live with shortfalls in production in an increasingly tight global oil market. In other words, it will give us a feeling for the sort of conditions that are likely to prevail in the medium term.

There are three main reasons for this tight market, two on the demand side, one on the supply side. On the demand side, there has been the surge in demand from China, which has now passed Japan as the world's second-largest user of oil. This year, the rise in demand has actually been quite modest but comes on top of several years of rapid increase (see top graph). The second demand side-effect has been the steady rise in US demand, which has climbed alongside the growth of the economy as a whole. There is a particular problem in the shortage of refining capacity in the US, for there has been little new investment in this during the past quarter century. Hence petrol and aircraft fuel prices have risen by even more than the rise in the price of crude. But even had the oil companies put in more capacity and US consumers had cheaper pump prices, this would not of course have affected the price of crude.

Everyone accepts the importance of the demand from China and the US. The third influence is the most contentious because it opens up the great debate as to whether the world is close to peak oil production.

The world's oil reserves are finite and sooner or later oil production will start to decline. The debate is whether that peak is five or 10 years away or whether it is now. The view of the oil majors is that it is some way off, the view also of the world's largest oil producer, Saudi Arabia. The opposing view is more radical and is made by a few independent geologists and oil consultants, including Matt Simmons, who has recently been advising President George Bush.

The idea that oil will at some stage peak goes back to 1956, when the geophysicist King Hubbard published a paper suggesting oil production would take the shape of a bell curve and predicting that US production would peak between 1965 and 1970. It actually peaked in 1971.

This work was carried on and applied to the world, with calculations suggesting the peak will be reached sometime between 2005 and 2008. A version of the Hubbard curve, published by the Worldwatch Institute, is shown in the bottom graph.

We already know that this is the first oil shock caused by a rise in demand rather than restrictions on supply. If this line of argument proves right, we face the possibility that prices will not fall back from their present level but continue to rise, or at least plateau. Eventually the Gulf of Mexico will resume production but whatever it produces will be swiftly snapped up by an oil-hungry world. Katrina gives us a taste of what - in the oil market at least - is to come.

More expensive oil is not of itself a catastrophe. It is perfectly possible to live well and use less energy. Australians use roughly half as much energy as Canadians and still do pretty well on that - the climate may make things a bit easier but would not account for all the difference. But there will be an adjustment process as more efficient kit is put into homes and factories, and we learn to use less fuel for transport.

What we do not know is what substitutes will be most effectively developed if oil stays at its present price. It is easy to imagine that farming will be more for energy than for food but we don't know whether the future will be with biodiesel or with ethanol. But if all this is in the future we should recognise that Katrina, amid all its devastation, may carry a silver lining in its cloud.

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