Hamish McRae: Two big reasons why we need peace in the Middle East: oil and oil money

Economic View
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The Independent Online

It is premature to speculate about the economic consequences of the political strife in the Middle East, and in a way almost improper to do so.

The clashes continue, people are dying and we do not know where this will end. But the threat of sustained unrest in this region is real and does have economic consequences. The world very much needs a stable and successful Middle East.

The most obvious reason for this is oil. Ever since the first oil shock – the quadrupling of its price in 1973-74 – the developed countries have sought to cut their dependence on Opec and especially on the group's largest producers in the Middle East. This region produced "easy oil" – it just came out of the ground – and the world was then forced to discover and develop "difficult oil" in places such as the North Sea, Alaska and the Gulf of Mexico. The higher oil price justified the higher costs of extraction.

As a result, despite the world's growing thirst for oil, it became less dependent on Opec and the Middle East, and further, it became less dependent on oil as opposed to other energy sources, particularly gas. Oil's share of the world supply of primary energy has declined from around 48 per cent in the early 1970s to about 32 per cent now. Oil is increasingly used for things with few substitutes, notably transport, and used much less for things where other energy sources are practicable, notably electricity generation.

But we will still need more of it, even with improved conservation and further development of biofuels. Or at least if the world economy grows as projected over the next 20 years, we will need more of it and most of the increase will come from the Middle East. According to the BP Energy Outlook 2030, some three-quarters of the additional supply will be from Opec, and of that, largely from Saudi Arabia and Iraq. You can see this growing reliance on the Middle East in the right-hand chart.

If you look at oil reserves, as opposed to production, the importance of the region is even more dramatic. We don't yet have figures for 2010, but at the end of 2009, the Middle East accounted for 56.6 per cent of the world's proven reserves. The largest of those, in order of size, are Saudi Arabia, with nearly 20 per cent, Iran with more than 10 per cent, Iraq, Kuwait and the UAE. Add in the main North African producers – Libya, Algeria, Sudan and Egypt – and the total rises to nearly 62 per cent.

You see the point? The tighter global oil supplies become the more the world depends on the region and hence the more it needs political stability. It may be that in another generation we will have found ways to become less dependent on oil and it would be a very good thing, for all sorts of reasons, were we to be able to do so. But meanwhile there is no getting away from this harsh arithmetic.

You then have to try to think through what might happen to energy supplies were the regional instability to persist for a lengthy period. There is no reason to suppose that new regimes, of whatever political nature, would wish to cut oil production – or at least not by any substantial amount. We have the experience of Iran after the ejection of the Shah in 1979, when oil production initially declined but subsequently recovered. We have theexperience of the first Gulf War and the serious damage to the Kuwait fields. And we have the experience of Iraq now. Iraq's present production is currently running at about two-thirds of its historic peak in 1979, but is projected to more than double over the next 20 years.

It is all very well to say that political change may cause a temporary fall in supply, but it can be extremely disruptive if it hits a market that is already tight. The present price of oil suggests that the market is quite tight now. There may be a bit of speculative froth in there but remember that we are still in the early stages of the global expansion. The price makes me uneasy: it is uncomfortably high for this stage of the cycle.

But this is not just about oil. It is also about oil money. The other main way in which the region affects the world economy is the way it deploys its sovereign wealth funds and other assets. The Middle East is a large net saver and looks set to continue to be so. It has in general been an extremely responsible steward of its assets – able to take swift decisions but keeping a long-term perspective. It is worth noting that it was Middle East money that enabled Barclays to avoid going to the British government for capital. You might say that when push came to shove, Abu Dhabi and Qatar were more trusted than Her Majesty's Government.

It would make no sense at all for this responsible stewardship to shift in any way, whatever regime changes take place in the Middle East. Money is curiously apolitical. But it would equally be silly to ignore the possibility that, in the short term at least, there is another source of potential instability that might influence financial markets.

The saddest thing would be were unrest to encourage capital flight. It is all very well for surplus funds to be invested abroad but there is great potential for local investment. Bahrain, the current focus of unrest, is a case in point: a communications and financial hub that has to some extent lost ground to its flashier neighbours and which has been striving to invest in its infrastructure to catch up. It would be silly not to acknowledge that huge harm has been done to its economic prospects, whatever the political outcome.

There is, I suppose, a wider message here. We talk and write about the economic boom of the emerging markets and the balance of power in the world is indeed changing. This weekend brought a meeting in Paris of the Group of 20, where the emerging world is represented, as it should be, along with the old Group of Seven developed nations. But there are fragilities and tensions in the emerging countries that we ignore at our peril and we should all hope that these are resolved in an orderly and peaceful way.

Hello to the new FPC, the PRA and the FCA. Alphabet soup, anyone?

A welcome to the Bank of England's new Financial Policy Committee, set up as a sibling to the Monetary Policy Committee, and whose job it will be to avoid systemic risks in the banking system. The discredited Financial Services Authority will be replaced by two bodies, one called the the Prudential Regulation Authority, the other the Financial Conduct Authority.

There is a danger that we get bogged down in alphabet soup, so the main thing to remember is that the policy committee is in overall charge, the prudential regulation one is a slimmed-down FSA but under the wing of the Bank, and the conduct one is supposed to protect consumers. Let's hope the new Financial Policy Committee avoids the trap that the MPC has fallen into by becoming so politicised.

One member, US professor Adam Posen, recently attacked Mervyn King for supporting the coalition's fiscal programme. Posen, plus David Blanchflower, formerly of the MPC, and US economist Paul Krugman, have been attacking the governor for months. Now Ed Balls, the Shadow Chancellor, has joined them, arguing that the deficit is being cut too fast.

There is no need to go into the rights and wrongs of his argument, except perhaps to note that John Smith, when Labour leader, spent years trying to fight against his party's reputation for fiscal mismanagement and that Gordon Brown's golden rule was designed to show that Labour would not make the macro-economic errors of both parties in the past. But whatever you think about the policy, by attacking King, Balls plays straight into the hands of those who believe Labour cannot be trusted with financial matters – thereby undermining the legacy of Smith and Brown. The governor has to give general support to the government of the day, of course, just as, in broad terms, he supported the previous government – even when the rest of us saw it was going off the rails.