Iraq may be doing us a favour by raising oil prices

The world oil price climbs, threatening to push up inflation and undermine the economic recovery. Potential disaster, useful warning or welcome relief?

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Actually all of the above.

The potential disaster is that some interruption in supply would have the gravest consequences for the world economy. The immediate reason for the climb in recent days was the shutting down of exports by Iraq. Such swings in price are acutely political: yesterday the price fell by $2 to $26.65 a barrel on reports that Israel would pull back its troops. But that could very easily be reversed.

The Iraqi threat was not in itself a particularly serious blow. It has been limited in the scale of its exports, for UN economic sanctions allow it to sell only limited qualities to pay for essential imports. Though Iran has voiced support for cutbacks, Iraq has not gained any general support. The largest oil producers, Saudi Arabia and Kuwait, have both explicitly rejected the Iraqi action and Saudi Arabia has said that it will offset the shortfall caused by Iraq. While oil has become expensive by the standards of recent years, in real terms it is much lower than it was in the late 1970s. The bottom line is that as long as the present regime remains in power in Saudi Arabia, the oil weapon against the West is unlikely to be effective.

Nevertheless there are several reasons to believe that oil will remain a relatively expensive commodity in the coming months. Demand will be boosted by the greater economic activity that we are already seeing. Supply will be contained as long as Opec maintains reasonable discipline in sticking to production quotas. Though it only produces about 40 per cent of world output, its Middle East members are the swing producers, able to increase or cut production reasonably easily. Non-Opec producers, by contrast, are unable or unwilling to increase production much: Russia, one of the few non-Opec producers that could increase production, confirmed yesterday that it would not do so to offset the Iraqi shortfall.

You do not need to be a whiz at economics to appreciate that restrained supply and rising demand is likely to lead to higher prices. As oil affects all energy prices, this will add to inflation. For the time being the US and to a less extent the UK are protected by reasonably strong currencies. For those with weak currencies, the inflationary impact is a real worry. Expect rising concern about inflation to drive up interest rates around the world in the coming months.

So whatever happens in the Middle East, energy prices will be a serious constraint on growth. Were there to be a more general interruption to production – for example as a result of unrest in Saudi Arabia – then the impact would be much more serious. A disaster in the Middle East would be a disaster for all of us: there is no reason why, in the short-termat least, the oil price could not double again.

This present increase should therefore serve as a useful warning. We have created an oil-driven global economy, in a world where 70 per cent of known reserves are in its most politically fragile region. That is not very bright. The only way we can, in the short and medium term, dig our way out of this dangerous situation is to become better at energy conservation. That means harnessing the power of the market to wean us off oil.

A reasonably high oil price is therefore a blessing in disguise. If oil is too cheap, we will waste it. It is a welcome relief to have the market pushing in the right direction rather than the wrong.

In theory, it might be possible to construct taxes and subsidies to encourage the world to use energy more efficiently. Everything has been tried, from grants for home insulation through to legislation to compel motor manufacturers to improve the fuel consumption of their fleet. But such measures are often ineffective. For example, taxing energy use by British china tableware makers has tended to push their production offshore, where factories are less energy efficient. Britain uses less energy, sure, but the world uses more. In the US, requiring better fuel consumption in cars has encouraged customers to shift to four-wheel-drive vehicles and light trucks, which use more fuel. The fuel efficiency of the car fleet has improved but overall fuel efficiency has deteriorated. Nuts.

What we do know works is the price mechanism. There are huge strategic and environmental reasons why the world should try to use less oil. Sadly, however, the environmental lobby that has made this point has frequently overstated its case. The most famous environmental warning, that of the Club of Rome 1972 book The Limits to Growth, has been discredited by 30 years of increasing prosperity. There are limits to growth, but these are much more elastic than the Club of Rome authors believed.

But where lobbyists fail, the market can succeed. If more expensive oil leads our societies both to economise and to develop alternatives to oil, then the clouds of the Middle East conflict could have a silver lining. Put brutally, we need to be taught a lesson. More expensive oil now would undoubtedly slow the world recovery, and any interruption to supplies would jeopardise it. But reasonably expensive oil would also help us to learn to grow more securely in the future.