Oil at $9 a barrel is a trigger for economic instability

We have a reverse oil shock - a halving of the price. An upward shock could follow, at precisely the wrong point in the cycle

TOMORROW the ministers of Opec, the Organisation of Petroleum Exporting Countries, meet in Vienna to try to agree on a cut in oil production in an effort to push up the oil price.

A couple of decades ago this would be a source of profound worry for oil companies and producers alike. Hoards of journalists would converge on the meeting and the oil companies would nervously await the Opec decision. It's not like that now, is it? The event will be reported, of course, but without the same excitement.

And, while the oil companies will be watching nervously, their fears will be almost exactly the opposite of those 20 years ago. Then the companies were frightened that Opec would be able to push the oil price up in a dramatic way: they feared the meeting would be successful. Now they are frightened that the oil ministers will not be able to agree: they fear the meeting will fail.

Look at the price in dollars per barrel of Arab light crude back to 1973, just before the first oil shock. Arab light is usually a couple of dollars lower than the Brent price we usually use nowadays as the main marker. I have taken the Arab price for the simple reason that there was no Brent price then.

The oil price is now lower in money terms than it was in January 1974, immediately after the first oil shock. Not only that, it is lower than at any stage since. The most striking thing is the way the price on the Arab light measure has halved since the autumn. Last October it was over $19 a barrel: last week it was below $9 a barrel. If the oil price had doubled, think what a story that would have been. But it has halved, and most of us have hardly noticed. Remember, too, that in real terms the oil price is lower than it was before the first oil crisis.

What's up? The story comes, I think, in three parts. There is a "supply must equal demand" story, a "so what?" story and a "what if?" story.

The first is straightforward. We know why the oil price is so weak. There has been a combination of unusually low demand and a rise in supply. BP's annual "Statistical Review of World Energy", published last week, showed how last year total demand for energy rose by only 1.6 per cent, half the rate of the three previous years. Apart from the effects of the Asian crisis, Japan, Europe and the US all had relatively warm winters, which cut energy demand. Gas consumption actually fell for the first time since 1975.

Meanwhile oil production rose by 3.1 per cent, and Opec production grew faster than at any time since the Gulf War. Opec members produced 41.5 per cent of the world's oil, the highest proportion for 10 years.

But nothing is for ever. A common-sense response is to say that as we are now at the absolute bottom of the post-1973 range, we must be at some sort of floor. True, Opec no longer controls the oil price, for there are too many outside producers. It is also true that the present price would have been thought inconceivable six months ago, but at some stage in all markets there is a turning point. We adjust.

Looking ahead, you can see changes on supply and demand which ought to bring the price back into its trading range of the past decade of between $15 and $20 a barrel. Most movement will have to be on the demand side.

On supply, Opec will presumably agree to cut production. The talked-of figure is a cut of 1 million barrels a day. That is quite big, for total world consumption last year was 72 million barrels a day. But the agreement would have to stick; one of the reasons for the recent fall seems to be the usual one of countries cheating on their production quotas. A cut is very much in Opec's long-term interests, but the temptation for a country to produce a bit more is very strong.

You cannot, however, control the oil price if you have only 40 per cent of the production. You can be a major influence on it, but no more. So on the demand side, there are two things to watch. One will be the level of economic activity in the US and Europe, the two main areas likely to increase demand. If the US falters or the European recovery slows, expect demand for energy to be flat. Only a perishingly cold winter will help.

The other demand element will be the ability of consumers to switch energy sources. This does not happen suddenly, and for transport there is in any case no real substitute: oil utterly dominates. But if it seems likely that oil (and gas) will remain cheap for several years, there is a powerful incentive to switch out of other fuels, in particular coal, for power generation. The pressure on coal producers comes principally from ever- cheaper gas.

That leads to story two: what are the implications of oil remaining very cheap? There is an obvious conservation issue. On any long-term view the world ought to be conserving energy and switching to renewable sources. But the market mechanism cannot help. So the burden of nudging the world towards containing energy use will have to be done by other means, principally taxation and regulation.

Both need to be crafted carefully to be effective, for bad regulation may be worse than none at all. While energy taxation ought to become an even more important source of revenue for developed country governments, building political support for that is extremely difficult, as this country found over VAT on fuel. New energy sources will also need to be explored without the straight financial incentive to do so. And we have to assume that the world will remain a fossil-fuel economy for at least another generation.

Beyond conservation lies a political issue. While there is plenty of oil, most of the world's reserves lie in politically unstable regions. There are political and strategic reasons for not being too dependent on a single source of energy.

And "what if?" The key point is that very low oil and gas prices are a source of instability, not stability. You can see this in macro-economic terms: for now, cheap energy helps economic growth, but it also makes growth vulnerable to an energy shock. Where that shock might come from is not predictable, just as no-one predicted the Gulf War.

Anyone can round up the usual suspects, but the shock need not be a war. At present we are benefiting from a reverse oil shock, the halving of the price. A series of factors could come together and there could be an upward shock, too, and just at the wrong time in the economic cycle.

In most cases, cheaper is better. In the case of the oil price that only holds up to a point. We are at that point. If Opec does get its act together in Vienna, welcome the news. It is in our interests that it should.