Hamish McRae: The black stuff is being brought to heel but China keeps the engine running

It would be reasonable to expect world inflation to fall
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The Independent Online

The price mechanism does work for the oil market after all - if in a lumpy, uncertain, disjointed way. The huge run-up in the cost of the black stuff has eased and the talk of "on to $100" has faded. Oil slipped a bit further on Friday despite the continuing troubles of BP in Alaska and suggestions that Opec would get an agreement to shade back production.

It seems that the high price through the summer has indeed trimmed demand a little, that the prospect of a global economic slowdown has helped too, and that the quite small increases in production by Opec have helped turn sentiment.

So what does this mean? The first thing is that a fall in the oil price is helpful to the world economy right now: it makes the prospect of a "soft landing" - a gradual slowing of growth rather an a near-recession - much more likely. The scope that the world's central banks will have to cut interest rates, in order to offset any fall in demand next year is greatly increased by the impact of falling oil prices on world inflation.

The second point is that the underlying supply-demand balance remains skewed towards the demand side. So whatever happens in the next few weeks, the medium-term proposition that oil will stay quite expensive still stands. In other words, $50-$100 a barrel remains a more probable range over the next five years than does $25-$50. More about the reasons for this in a moment.

The third point is that, thanks to this experience of high oil costs, we are beginning to understand more about the likely price and availability of alternative sources of energy.

The left-hand chart above shows how the annual change in the oil price, rather than the actual level, affects inflation in the OECD member countries - in effect, the developed world. It would be reasonable on this basis to expect world inflation to fall from its present level of well above 3 per cent to something well below 2.5 per cent. Axa Investment Managers, which put together the chart, notes that this will give the US Federal Reserve the latitude to cut rates by 0.75 per cent next year.

Britain will probably get another rise in rates next month to 5 per cent, but it will become harder to justify increases if inflationary pressures are being reduced by falling global energy prices. The Bank of England needs to raise rates to keep house prices under control, but that is really for prudential reasons: the Bank does not want people to stretch themselves buying assets that might well fall in value, at least in real terms, over the next few years. But its formal remit in fixing rates is to keep inflation between 1.5 and 2.5 per cent. Arguably, it has had to talk up the inflationary dangers in order to justify the recent run-up in rates. Falling oil prices make this talking-up less credible.

However, falling oil prices may not last long. The medium-term outlook has, I think, been clarified by the experience of the past couple of years. Compare what has happened to oil demand in the different regions of the world, as shown in the right-hand graph. In 2003, when prices were stable, demand was up on 2002 in all areas. In 2004, when prices were up a lot, demand in the US rose a bit, and in China by a huge amount. But in Europe and the former Soviet Union it was up only slightly. Then in 2005, another year of rising prices, demand in the US and Europe fell, while in China and the rest of Asia it continued to rise.

My reading of this is that Western developed economies have become sensitive to higher oil prices and can figure out how to trim demand. China, though, is rather less sensitive and ploughs on. That would figure. Big decisions in China about energy use, infrastructure and indeed any investment are shaped to a much lesser extent by the market than they would be in Western Europe and the US. But after a lag, even China has been forced to try to do something about its growing demand for oil. (Actually it was building more coal-fired power stations and cutting back on the output of the oil-fired ones.)

So the price mechanism does eventually work, at least on the demand side. Nevertheless, oil demand in China will continue to rise for there are some applications, notably road and air transport, where there is no immediate substitute. Much the same could be said about India, though at the moment demand there is much lower.

Moreover, demand in Asia has risen despite oil being above $50 a barrel. This suggests that even if oil goes below that level for a few months, it won't stay there for long. China is already the world's third-largest car market behind the Japan and the US, and is expected to have passed both by 2013. The internal combustion rules for a while yet and oil remains the most convenient fuel.

That leads on to the final point: what have we learnt in the past year about the practicability of oil substitutes?

There is no doubt that a period of oil above $50 a barrel has created huge interest in a range of possibilities. The problem is that there is no general agreement on which technologies will be the winners. We can grow bio-diesel but that uses huge amounts of land. We can convert sugar into ethanol but that is a wasteful process. We can convert coal into gas and in turn into liquid fuel, but this is messy. And all these, properly costed, seem to come in at the equivalent of $100 a barrel or more. That will fall, but it will take time.

Some of the best hopes come from bio-engineering. Making bio-diesel or ethanol requires converting food crops - selectively bred over centuries for that purpose - into fuel crops. Suppose instead we breed crops especially for fuel, but use bio-engineering to improve the yield much more swiftly? I am not a scientist but I understand that an oil equivalent of $50-80 a barrel becomes a real possibility.

The big point here is that the experience of the past year has given a huge boost not only to the hunt for mineral oil but also to the search for substitutes. It is, so far, a disorganised response but the world will get better - at the tax and regulatory issues as well as the technology. And the more transient the fall in the oil price, the greater the stimulation for action. The one thing we should not expect, though, is for China to rein back its car production - with all the implications for future oil demand.

Those who stand and serve are made - unlike those who make

Manufacturing in the UK has had a good summer - but services seem to have had a better one. On Friday we got figures for manufacturing output showing it had risen for four consecutive months. Surveys from the CBI and purchasing managers suggest that September will be good, too.

Looking ahead, there are concerns that foreign demand may fall back when global growth slows (though note the impact of cheaper oil, discussed above). For the time being, however, all is cheerful.

But does this matter? Manufacturing is now down to about 15 per cent of the economy. It remains important as a contributor to exports and it still employs many people, but it is dwarfed by services. Nor is it very profitable. The net rate of return on UK manufacturing companies is only 6 per cent, down from a peak of 15 per cent in 1997, whereas the equivalent figure for UK service companies is over 20 per cent - the highest since current records began in 1989.

The simple explanation for this is that manufacturing is more subject to international competition, particularly from lower-cost producers in Eastern Europe and Asia. One response is that if you can't beat 'em, join 'em: Manganese Bronze, maker of the London taxi, announced a deal last week under which it would license its design to be made in China. By contrast, many services produced here, though not all, are not really subject to foreign competition.

But I think it is more complex than that. Demand for services is rising faster than for goods. Quite apart from international competition aspects, services seem to be less price-sensitive. And other changes are taking place in society that require us to buy more services. For example, the increasing complexity of taxation and regulation forces more people to employ advisers to help them cope. The increase in asset prices, particularly of housing, has already increased the revenues of service professionals.

The really interesting question, then, is not what happens to manufacturing. It is whether our services are too profitable.

Too profitable? Well, is there some monopolistic element here that pushes up service industry margins, and if so, what might be done to curb it?

I don't know the answer, but a 20 per cent profit margin sounds a lot to me.

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