Hamish McRae: We must learn to live with expensive oil

Unless there is some economic collapse of China and India, global demand will go on growing

How would we cope with oil at $100 a barrel? And - even bigger question - how is the prospect of years of expensive energy going to change the balance of power in the world?

You can hear the rumble of drums around the world as energy-producing nations feel their power growing. Russia, which has the world's largest gas reserves, has reminded Western Europe that it will increasingly become its main gas supplier and can turn off the taps if it is not treated with respect. Venezuela, the world's fourth largest oil exporter, has annoyed the Americans by declaring that China is its preferred customer. And now Bolivia has told its military forces to seize control of foreign-run gas fields, a process that is now taking place.

All this is uncomfortably reminiscent of the oil shocks of the 1970s, when the acronym Opec - the Organisation of the Petroleum Exporting Countries - entered popular language. It exerted its power by agreeing quotas for oil production, leading to a quadrupling of the oil price and two global recessions within seven years.

After the most uncomfortable decade, in economic terms at least, since the Second World War, the world recovered. Other sources of oil, including the North Sea, were developed. Tough monetary policies squeezed down inflation. The oil price fell back, growth was resumed, inflation fell and the foundations for the long boom that we are still enjoying now were established. That experience should remain a warning, but historical parallels are rarely exact. Our situation now is in some ways more hopeful and in some ways more disturbing.

It is more hopeful in that global energy supplies are much more widely dispersed. The spate of exploration and investment that took place led to a surge in supplies of both oil and gas, from which we are still benefiting. The world is using energy more efficiently. It may not look like that when you see the four-wheel-drives and the budget airlines. But actually we have learnt how to increase output with only a small rise in energy consumption, at least in developed countries such as Britain.

More generally, global inflation is pretty much beaten, the Cold War is over, financial markets are more robust and globalisation has integrated the twin giants of China and India into the world economy. All this helps to explain why the recent rise in the oil price has so far failed to dent global growth.

At least so far. If, from a overall economic perspective, we seem to have coped pretty well with rising energy prices, and certainly much better than in the 1970s, there are less comforting aspects to the outlook.

First, the overall supply of oil is much tighter than it has ever been before. It is constrained not by Opec members agreeing to cut output but by physical limits to production. In the past, whenever the price rose, Saudi Arabia would pump more. It took a very responsible attitude in that it recognised that the long-term economic stability of the world economy depended on reasonably stable energy supplies.

Now it does not seem to be able to increase output. There are rumours that the geological state of its giant fields has deteriorated and that it has failed to discover new ones. Kuwait also seems to be in some difficulty maintaining its output. The oil markets are awash with other rumours of production difficulties, and here the plain fact is that the North Sea is now in decline.

True, there is still a lot of oil in the world, and at present prices these additional sources become economic to recover. Still, the fact remains that the amount of oil in the world is finite and, while most developed countries could manage without increasing their demand that much, China and India will need to import more of it as they continue to grow and improve the living standards of their people. Unless there is some economic collapse of China and India, which would have the gravest consequences, global oil demand will go on growing relentlessly.

For some uses there are substitutes. You can use gas and coal (and nuclear) to generate electricity. We can build wind turbines, though I am afraid that counts pretty much as tokenism. Every five weeks, China builds new power stations equivalent to the entire British wind electricity programme, and 80 per cent of them are coal-fired. And for vehicles and aircraft, oil is the fuel.

Eventually, of course, some new sources of energy will be developed. Meanwhile we can learn to conserve more at every level. But the overall picture is unlikely to change much. The only safe assumption, therefore, is that energy will remain expensive, maybe quite a bit more expensive, for the foreseeable future. The consequences for climate change will continue to disturb us too.

Meanwhile we have to face two things: the possibility of $100 a barrel oil, and the shift in the power balance to the energy producing nations.

As far as the first is concerned, Goldman Sachs has just done some sums about the possible consequences for continental Europe. If prices rise to $100, and that in turn leads to a slowdown of the US economy and a fall in the dollar, that would knock 0.3 of a percentage point off European growth this year and 1 percentage point of growth in 2007. The US, under this projection, would only grow by 1 per cent next year. Goldman thinks that the US is actually more vulnerable than Europe.

So oil at that price would not mean a world recession, and that is encouraging. We are not back to the 1970s. But it won't be easy, even for an oil-producing nation such as the UK.

The political consequences will run on. There are some huge gainers. Within the developed world the biggest one is Canada, already a net exporter and with vast recoverable reserves. The Middle East would appear to be a gainer, and at the practical level of it experiencing a surge in wealth that is already evident. Thus there has been a sharp rise in Middle Eastern money coming into property in London. But of course that region is and will remain unstable.

Russia and Latin America will become more important, as will the oil-rich countries of Africa. All have smarted from being marginalised amid the surge of Western interest in China and India. The US will have to learn to deal with Latin America on a more equal basis, and we in Europe will have to do the same with Russia. And everyone will have to deal with oil-rich Africa with great sensitivity. None of this will be easy.

I suppose my main political concern is that something unpredictable will take place: for example, that either the United States or Russia will make some mistake. Don't ask me what that might be, for the very nature of such shocks is that they cannot be predicted. In one sense, expensive energy should be welcomed, for it will teach us to use less of it. But it is clear that we have worrying, touchy times ahead.