Hamish McRae: We have learned to live with $100, and cheap oil is not in our interest

Might the present oil shock dissipate as it did in the 1970s and we head back to cheap oil again? The working assumption of most people is that it won't and that the age of cheap oil will never return – not just in our lifetimes but never, ever. But the oil price has dipped below $100 a barrel and the fact that Opec plans production cuts does suggest that some producers at least feel that cheaper, if not cheap oil, is on the cards.

What is expensive and what is cheap? It is a measure of the battering that oil-users have taken that oil at $100 should be a relief. Go back 18 months and such a price would have been almost unthinkable and the consequences horrendous. As it has turned out the prices have been higher, yet the consequences less grave. Oil at $100 is the same in real terms as it was at the early 1980s peak and far higher than after the 1970s oil shock. Yet the world economy has continued to grow. The United States has kept growing; China and India have kept growing. True, the eurozone economy fell back in the second quarter and the European Commission is now predicting recession in the UK and Germany. But even assuming these forecasts are right (and I think that having been far too optimistic in the past the commission may now be being a touch too pessimistic) the recession it suggests will occur is far less serious that that of the 1970s or 1980s.

So the world has learnt to live with oil at $100, or so it seems. How it has done so matters a lot because it goes some way to explaining how future growth might be sustained in the face of undoubtedly tight oil supplies and the inescapable truth that oil supplies are finite.

The explanation is partly one of substitution and partly one of efficiency. The developed world has become good at using oil principally for the things where there is no easy substitute, such as transport, and figuring out alternatives for non-transport needs. Now it is true that up to now the two principal non-oil sources of energy have been other fossil fuels, gas and coal, so this not a long-term solution by any means. But in the 1970s and 1980s, and again today, the developed world has managed to economise on oil.. Developing countries have been less adaptive in the past and one of the big determinants of the oil price in the future will be whether they become more nimble in their energy use in the future. Within the next couple of years the overall oil demand from developing countries will exceed that from the developed world.

Then after each oil shock, the developed world went back to its profligate ways. Why? Because oil became very cheap again. In real terms it was almost as cheap in the 1990s as it has been in the 1960s, so there was no particular incentive to hold back oil use. The very long-term trend in the oil price may be upwards but that was not at all evident in the 1990s.

How far might the price come back the time? Some work by Charles Dumas at Lombard Street Research suggests that barring a major war the price could be down to $50-$70 a barrel within two years. If it were to follow the pattern of the 1970s (next graph) the fall would be even greater but there does seem to be a real long-term increase in the price of 1.5-2 per cent a year. But that is in the very long term, and he argues that, short term, the market is determined by US demand and Saudi production – not "peak oil" and demand from China. The US, he argues, has big swings in demand, with imports from the rest of the world down 5 per cent this year. And Saudi Arabia has long been the swing producer of Opec. It cut supplies sharply in the summer of last year (see final chart) but now has increased production again.

That price range of $50-70 a barrel feels a bit low to me but that is from the perspective of now. Three years ago, when the price was still below $50, it would have seemed very reasonable. It does, however, raise a fundamental question about the very long-term price of oil, which will turn surely not on what the US, China or Saudi Arabia does but the price of acceptable substitutes for conventional mineral oil.

Here there are as many answers as there are experts but the big message that comes over is that at present price levels, or even a bit less, all sorts of technologies that would otherwise be uneconomic become competitive. These include gasification of coal, the next generation of bio-fuels, maybe wind-power if the price of the kit continues to fall, and solar power as the price of that is falling fast as China ramps up production. Assuming that this time the oil price will not fall back to the extent it did in the 1990s, these technologies will continue to be competitive.

There is a further issue: security of supply. The pattern of the past has been for there to be a supply scare, prices to rocket, everyone to vow to end dependence on imported energy – and then after things had gradually returned to normal to forget about it. It may be different this time. The US has had a scare and it is fascinating that Barack Obama has pledged that the US will end its dependence on oil from the Middle East within the next 10 years. That is significant not because the US might achieve that, nor because he may be in a position to set the country on that path. It matters because a clever politician has identified something that the US electorate wants. This is pretty universal.

Here Gordon Brown says we must end our oil dependency too, though without a timescale. And the one favour that Russia has done Western Europe in recent weeks is to remind all of us that we are unwise to rely too much on Russian energy supplies. So Europe will figure out how to use less gas.

That brings us to the perhaps the most important point of all. The drive to improve energy efficiency is absolutely at the centre of every business in the world. A 3 per cent gain in the efficiency of a truck engine is the difference between a profit and a loss for a haulier. At a home level progress seems to have been slower but there are cumulative improvements in efficiency all the time. New fridges are more economical than old ones; new cars the same; the present UK drive to improve insulation will have a continuing effect. The greater the energy efficiency of a country the less demand for the marginal fuel (i.e. the fuel for which demand is most sensitive), which is oil.

So not cheap oil. That is neither realistic nor actually in our self-interest. Rather it is reasonable to think of acceptably priced oil – and as the price falls in the months ahead that will be of great benefit to our economies, which need every bit of help they can get right now.

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