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A spike in prices, a peak to output - will oil be the downfall of global growth?

Oil worries are back, with the oil price this week nudging towards $58 a barrel. From a worm's eye viewpoint here in Britain, the fact that diesel is going to over £4 a barrel will be a worry for many. From an eagle's eye view surveying the global picture, the issue is less how this might hit our pockets but rather whether an oil shock will be the event than ends the current expansion of the world economy.

The investment bank Goldman Sachs caused a stir last week when it put out a paper warning that a "super spike" in the oil price might already be upon us. This could drive the price towards $105 a barrel. Worse, it opined that its new range for the price of $50-$105 a barrel could be conservative, especially if there were disruption to supplies.

If these fears were to prove correct, it would mean that the real price of oil - in today's money - would peak at a higher level than it did in the last great oil squeeze, in the early 1980s. Then the peak was about $85 a barrel in 2005 dollars (see left-hand graph). The world survived, of course, and the price subsequently fell back. But it was at the cost of a serious global recession, more serious than the recessions of the early 1990s and the early 2000s.

How seriously should we take this view? Most of the oil companies are still using a price of around $25 a barrel for their internal assessments of investment projects. Since that is less than half the current price, it suggests that they are either ultra-cautious, know something the rest of us don't, or are making the same mistake as the professionals made in the late 1970s, when they failed to spot the second oil shock.

For the conventional wisdom seems to be that oil supplies will not be a serious problem for the world economy for another decade at least. While there is pressure at the moment on supplies, methods of extracting oil are improving all the time, enabling a higher rate of recovery from existing fields and a lower cost of developing new ones. Demand will continue to increase, so this conventional view acknowledges, particularly from China. Nevertheless, prices at their present level are high enough to encourage some shift at the margin away from oil as a basic fuel and a switch towards other forms of energy, in particular gas, where supplies are greater. So it is all right.

Ranged against this conventional view is a clutch of people arguing the contrarian position. Some are geologists, some conservationists, some professional contrarian investors (not to be dismissed - they can make a lot of money that way) and some are professional advisers to the energy industry.

One of the most interesting of the last category is Matt Simmons, who runs a specialist investment bank. His basic thesis is that the world is closer to its peak oil output than most people realise. He points out that 1.2 billion people use nearly all the energy used in the world and the remaining 5.3 billion use hardly any. But as prosperity spreads more of those people will wish to have the lifestyles of the 1.2 billion. Result: rising demand for energy for the foreseeable future. India and China are already on this course.

Now look at the supply side. Some 70 per cent of the world's oil supplies come from fields that are between 30 and 70 years old. There are known fields still to be exploited, of course, but they are small in relation to the ones already discovered. You can use better technology to extract oil faster but ultimately there is a finite amount of the stuff, so the faster you take it out, the less there is left. So technology may increase the production peak but if it does so, it is at the costs of steepening the decline thereafter.

Mr Simmons shows the chart on the right. This assumes two different amounts of oil that might ultimately be produced in the world and shows the implications were the increase in production and decrease to follow a similar even pattern. On the more optimistic of the two assumptions, production of oil ought now to be starting to decline if the path of decline is to match the profile of the rise in production. On the more pessimistic, it ought to have started to fall some years ago.

This is just a conceptual way of looking at when the world might reach its peak production. The conventional view is that we are not yet at the peak and that production can carry on rising for some years yet. However, it clearly cannot go on rising forever. When it starts to fall, economic growth will have to be supported by other forms of energy.

Given human ingenuity, that should be possible. Here in Britain we are just starting to be able to buy a form of bio-diesel - that is diesel fuel with a proportion of vegetable oil added to it. At some price - and you can have a debate as to where that price is - it is perfectly possible to grow crops that can be converted into fuel for vehicles. And while around 75 per cent of the world's installed electricity-generating capacity comes from fossil fuels, there are renewable alternatives.

At a price, the world can generate the energy it needs, and the more the price rises, the more our ingenuity will be devoted to finding ways of using less of it. The market will ultimately manage to marry supply and demand.

But the Goldman Sachs argument is not that the world is facing an energy catastrophe. Rather it is that it is facing a price spike. In other words, the oil price is likely to rise above its long-term trend level. It then looked at the consequences in terms of attractive investments in the energy industry, which is fine because that is what investment banks do. But there is another way of looking at this prospect: what might it do to the world economy?

The one word answer is "recession". But that assumes a number of other things going wrong, or at least an inadequate policy response. For example, were the oil price to shoot up, quite a lot of the damage could be offset by a crash programme to boost energy efficiency. Japan did that in the 1970s, after the first oil shock. China and the United States could do it now. Indeed since we have a lot of experience in energy shocks leading to recession, we start with some models of what not to do. Besides, the underlying inflationary situation now is much less serious than it was in the 1970s, 1980s or even the early 1990s.

Nevertheless, it would be astounding, were the oil price to hit $100, for the world economy to escape unscathed. At best it would experience two or three years of very slow growth and that is not something that any economic policy-makers have factored into their calculations. Everyone, including Gordon Brown, assumes that growth will continue steadily for the foreseeable future. It can't and it won't.

What we cannot see is whether this expansionary phase is stifled by an oil squeeze, by a more general burst of inflation, by a loss of confidence in the markets, or conceivably by a trade war. What we can see is that oil at over $50 a barrel is an amber light, and were it to rise to over $100, the light would flip to red.

Editorial Notes: According to a short bio from a speaker's bureau:
Hamish McRae is the business and finance editor of The Independent, one of Britain's leading newspapers. He is also the author of The World in 2020: Power, Culture, & Prosperity. McRae shows audiences not only where we will be in the next twenty-five years but how we will get there.
-BA

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