Hamish McRae: How can we conserve energy and not ruin the economic recovery?

Economic View
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Opec still has the power to send a shudder around the world.

By failing to agree on an increase in quotas at last week's meeting in Vienna, it reminded us all that its members are the swing producers in the oil market. Some, not all, can increase production at least a bit and on Friday there were reports that, notwithstanding the Opec meeting, the Saudis would do just that. But the the non-Opec producers are running pretty much flat out and cannot increase production.

Surges in energy prices have brought a halt to previous economic expansions – it was one of the factors that brought the 2001-2008 growth period to a halt, at least in most of the developed world. But the strength of the oil market in recent months comes as a surprise. There was a big increase in energy demand last year as growth recovered, but the speed at which this has fed through to prices is disturbing. We are seeing a tight oil market – where demand is outstripping supply – in the very early rather than the later stages of what we hope will be a recovery lasting several years.

That raises a crucial issue: might expensive oil (and commodity and food) prices scupper the entire recovery? There is clearly a danger that this might happen, though my own view would be that the danger is quite small. Nevertheless, this will clearly be an expansion unlike any other since the Second World War in that growth is likely be constrained by physical limits of commodities and energy.

The Opec meeting saw a breakdown in relations between the mostly smaller producers, led by Iran, and the bigger ones led by Saudi Arabia. The small ones, who can't increase their production by much anyway, voted for no change in quotas, overruling the countries that could pump more. In practice, this may matter less than it might seem. As you can see from the graph on the right, production is already running well above the quota limit, and there have been similar periods of dissent in Opec in the 1990s and before. But in recent years the quota system has worked reasonably effectively and Opec has behaved in pretty much a textbook cartel way, increasing production to meet temporary increases in demand and cutting back as demand shades back.

The key aim of the cartel, and particularly of Saudi Arabia, is to maintain prices that are high enough to give a decent return to the producers but not so high as to encourage a shift to other fuels and the development of other oil fields by non-Opec countries. Both those courses of action have happened. Oil is not so much used now for electricity generation as it used to be, with coal and gas taking over. And exploration has continued apace to discover alternative sources of supply, particularly outside the Middle East. Opec members come from all around the world, not just the Middle East, but the region accounts for the bulk of its production.

It also accounts for more than half the world's proven oil reserves, as you can see from the main graph. But as you can also see, that proportion has declined over the past decade, as exploration in other parts of the world have been stepped up. A lot more oil has been found in Latin America, in particular. These figures come from the Statistical Review of World Energy published last week by BP, and anyone interested in the numbers of the global energy market should download it. In case you missed it, the big news story was that China has now passed the US as the world's largest energy consumer. There were others worth noting, including that India is now number four in energy use, behind China, the US and Russia, but ahead of Japan and Germany.

The rise in the oil price so early in this stage of the recovery is worrying as the oil price affects everything else. It affects other energy prices because it encourages switching from oil to other forms of energy. It affects food prices, partly because of higher transport costs but also because oil is a feedstock for fertiliser and as it encourages more use of food crops for conversion into fuel. (Biofuels may count as renewable energy but the excessive use of food crops to produce fuel is not at all "green".)

And if food prices climb, wages tend to rise in line. Result: general inflation and a squeeze on living standards that ripples right around the globe. We feel it here in the UK, as inflation is cutting into our real incomes. Money spent filling up the car is money not available to spend on other things.

So what will happen? I think, in the short term, there may be some shading down of oil prices. There does seem to be some slowdown of growth at the moment, evident just about everywhere, but most importantly in China and the US. That will take a bit of pressure off for a few months. But it does not seem to me to be realistic to expect oil and other energy prices to come back much. Nor indeed should we hope for that to happen because I am afraid that the most powerful way for the world to be forced into conserving resources will be the price mechanism.

The trouble with this is that we need high-ish prices to encourage conservation, but not ruinously high ones with all the catastrophic social and economic consequences that would result. That outcome is and will remain very hard to engineer.

Meanwhile the outcome of the Opec meeting has alarmed the financial markets, as well it might. True, the oil price fell on Friday in response to the stories about Saudi Arabia increasing production, but the Dow Jones index has had its worst six-week run since 2002. Personally, I am more worried about the social consequences of high energy, food and commodity prices than the economic ones, because these hit the poorest hardest.

But the bigger concern – that this recovery will be qualitatively different from previous ones – surely stands. We will just have to use scarce resources more responsibly, and "we" means the whole world.

As growth falters, all eyes are on how the Bank responds to bad inflation news

There was some slightly more upbeat news about UK growth from the National Institute of Economic and Social Research. It reckons in the three months to the end of April output grew by 0.4 per cent, equivalent to an annual rate of 1.6 per cent, not great but something.

It notes that we are unlikely to reach the previous peak in output until 2013. This is disappointing, for were we to follow the trajectory of the early 1980s recession we would be back to peak by end of 2012.

This slow progress, with CPI inflation expected to be stable at 4.5 per cent this week, sharpens the Bank of England's dilemma as to when to start raising rates. Royal Bank of Canada expects that to be November, with a quarter per cent then and another every three months. It expects inflation to peak at 5 per cent in October. Citigroup also expects an autumn peak around 5 per cent but in September. This is the worst time for public spending, because the base for uprating pensions and benefits is the September inflation number.

The contrast between the European Central Bank's action (notwithstanding the difficulties interest rate rises make for the weaker eurozone members) will look very sharp because by then there will have been at least one more rise in eurozone rates. The conventional analysis may be that by maintaining this loose monetary policy the Bank offsets the tightening fiscal policy but there is a counter argument that some small increases in rates might have strengthened sterling, trimmed inflation and boosted demand because people would have higher real incomes. Citigroup believes the UK would benefit from an earlier rise in rates and it is not alone.

There is a growing body of opinion that what is seen as the Bank's relaxed attitude to inflation is damaging the recovery. Stand by for more bad inflation numbers this week and beyond.