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An oil shock would rattle the entire world's economies

The oil price, in dollar terms at least, is now the highest it has been since 1990. It was soaring oil prices that tipped the world into three of the last four world recessions -- the early '70s, the early '80s and the early '90s -- so there is an obvious concern. Add in the fact that the two countries with the largest oil reserves, Saudi Arabia and Iraq, are not in the most stable condition.

Surely there should already be an amber warning light for the world economy. The disturbing question is what might switch it to full red alert?

In some ways the world economy is in better shape to cope with high oil prices than in the past. General inflation is much lower. Goods prices in most developed countries are stable or falling and the price of services is climbing only slowly. Experience of the earlier oil shocks has encouraged exploration and production in other regions. The share of the Middle East's oil reserves remains huge (two-thirds of the world's total) but its annual production is smaller; less than one third. Russian oil production is rising fast and has the potential to rise much further. And finally, part of the surge in oil prices is simply the result of the fall of the dollar. In sterling or in euro terms oil is way below the early '90s peak, and even further below the early '80s one.

But there is also bad news, for in two ways the world is in worse shape to cope. U.S. oil demand is at an all-time high. Coupled with declining local production that means imports are proportionately even higher. And the new kid on the block, China, is importing more and more oil to keep its amazing economic growth booming. China has now replaced Japan as the world's second largest oil consumer.

Between them, the United States and China accounted for two-thirds of the world's incremental growth last year, so anything that hits those two economies would have a devastating impact not just on them but on the entire world. Thus the euro zone may be starting to grow again, thanks to export demand, but European exports ultimately depend on a strong United States and China.

So what will happen? The oil price, like the price of any commodity, depends on supply and demand. Supply first. The key is Saudi Arabia, not just because it is the largest single oil producer in the world but also because it has traditionally behaved as the swing producer. The Saudi view has long been that the safest and most sensible course of action is to try to moderate price swings.

If prices rise too high, it worries that this stimulates exploration in other parts of the world and substitution with other forms of energy. So both it as a country, and the Middle East as a region, would accordingly lose their clout in world affairs.

On the other hand if prices go too low not only does that play havoc with the budget deficits of the oil producers in OPEC, low prices also encourage waste in the consuming countries and that is not in the long-term interest of the world.

So not only has Saudi Arabia taken a "responsible" attitude to oil prices. It also has the capacity to crank up its own production, or cut it back, and so enforce discipline in OPEC. As a result it has a loud voice in the world. Bob Woodward's new book on President Bush reports that the Saudis have told the administration that they will increase production to hold down the oil price in the run-up to the November election. That story has been denied but it would not be hard to see the rationale for the Saudi authorities wanting to support President Bush and the West more generally.

By contrast, the enemies of the Saudi royal family want to see the oil weapon used to destabilize the West. Osama bin Laden has accused the Saudi government of holding the price artificially low to help America and while he acknowledges that it is ultimately set by supply and demand, believes that it would be much higher were Saudi Arabia to withhold supplies.

The unanswerable question is whether the present regime in Saudi Arabia can survive. The terrorist attack in Yanbu on the Red Sea coast, north of Jeddah, the country's petrochemical hub, killed five foreigners and a Saudi police officer. It was the first assault targeted directly against the oil industry, and it has already led the United States to advise its citizens to consider leaving the kingdom.

It is easier to predict what might happen were the country taken over by people less favorably disposed to the United States. It would not disappear as a producer, of course, but instead of exerting a steadying hand on the oil markets it might start to exert a maverick one.

Meanwhile demand continues to climb. There are some signs in the United States that the mood that using oil is a God-given American right is waning. Intriguingly, Bill Ford, the head of the motor company, recently called for higher taxation on gasoline and suggested the United States would move away from the gas-guzzling sports utility vehicles and go back to more efficient cars. Certainly the most fashionable car in Hollywood is the Toyota Prius, a medium-sized car that has a hybrid petrol-electric engine with exceptionally good fuel consumption, as well as being non-polluting at slow speeds.

But any greater efficiency of the U.S. vehicle fleet would take years to come through. In any case China's car boom is only just getting into full swing while India's has hardly begun. It is quite hard for us here in Britain to realize quite how our economic futures are being shaped by events on the other side of the world.

The China story is now at last being recognized though the figures still astound. One that shakes me is that it consumes more than half the world's cement. But we see the India take-off more in terms of British jobs being lost to Bangalore. India's economic take-off will also have a big impact on oil prices. Computers, servers and air conditioning need a lot of power. If the computers are in India that means more oil to fuel the power stations to keep them going.

So while it is fashionable in Britain to call for still higher fuel prices to try to curb demand, what we do or don't do is increasingly irrelevant in world terms. The incremental demand for oil does not come from Britain or indeed Europe. It comes from the United States and the twin giants of Asia.

So: There are obvious threats to supply and the prospect of increasing demand. What gives?

The answer is the price. The market will match supply and demand. That is what it does. The trouble is that the price may have to spike up in the short-term before it settles down, probably at a higher level than it has been in recent months. That is what has happened before and there is no reason why it should not happen again. To some extent the national governments can moderate the rise: The United States, for example, could unload some of its strategic reserve. But an oil shock is an oil shock even if we can to some extent deflect the blow.

My guess would be that the United Kingdom, Europe and Japan could scramble through some further modest increase in the oil price and even some disruption to supplies. But it would be a big shock to America and a bigger one to China. And that is where the growth is. Were supplies to be seriously disrupted, for example by a revolution in Saudi Arabia, then the effect would be extremely serious for the whole world. We would get through it, just as we got through the previous oil shocks, but at the cost of world recession.

Editorial Notes: The author's statement the Saudi Arabia has the capacity to crank up production has been under question lately. See this article for more information: Is Saudi Arabia Still the King of Oil? by Julian Darley

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