Economic View: We're in bed with the bear

Britain will become more and more dependent on Russia for gas. We will also have an incentive to help it increase its oil production

Vladimir Putin's visit to Britain last week gave a partial answer to the question, "What do we do when North Sea oil runs out?"

It is: "Buy it from Russia." The pipeline deal signed last week will bring Russian gas supplies here to replace North Sea gas, rather than oil. Still, it gives a clear signal why the UK and Russia are likely to be bound together commercially for many years to come.

It is true that North Sea oil and gas won't run out completely for many years. While it seems unlikely that there will be any huge new discoveries, extraction technology is advancing all the time, with the result that companies are finding ways of getting more out of existing fields. So what will happen is a slow decline rather than a sudden stop. We are, however, reaching the start of that decline for both gas and oil.

Last year the UK still ranked as one of the top 10 oil producers in the world - just. More remarkably, it was also number four in the world gas league (see the graphs above). But at present production levels, as the new BP Statistical Review of World Energy shows, Britain has just 5.8 years of proven oil reserves left. In gas, the ratio of reserves to production is not much larger: 6.8 to one. Russia, by contrast, has 22 years of oil and more than 80 years of gas at present production levels.

So you can see the way things will go. Britain, like the rest of Europe, will become more and more dependent on Russia for its gas. We will also have a powerful incentive to help Russia increase its oil production, so it can become an alternative source of oil should the Middle East become even more unstable than it is now.

This prospect raises at least three big questions. First, and most obvious, is there a general energy crisis looming?

I think the answer to that is no, or at least not yet. The ratio of production to reserves both of oil and of gas has been remarkably stable in recent years. Oil remains at about 40 years' supply, gas at 60 (see the graph on the right). We are finding both oil and gas at roughly the rate we are using them up. At some stage in the next 20 years we may well become really worried about the shrinking reserves, and I think we should be worried about the environmental costs of excessive energy use right now. But the world does have some time.

The next question is: what does it mean for us? We have been lucky. The North Sea discoveries enabled the UK to help fund its transition from a manufacturing economy to a service one. It provided a buffer, softening the blow both by boosting government tax revenues and by creating employment, particularly in the North-east and Scotland, at a time when both were needed. But that transition is largely over. Proportionately, energy is a much smaller component of GDP now that it was 20 years ago. We have lost a comparative advantage but one that is no longer material either to the health of the economy or even to government tax revenues. Not only will the decline be spread over many years but a year or so of decent growth more than replaces the losses both to GDP and tax.

So provided the UK can maintain decent overall growth - and that, of course, is a completely different issue - we should not be overly concerned about the gradual decline of oil and gas production.

Question three: what impact will this have on Russia? Here, I suggest, the answer is: huge.

At the moment, Russia is actually overly dependent on its natural resources for export earnings, in the sense that it gets too high a proportion of its hard currency from such exports. As a result it is overly dependent on the oil price, which, of course, it cannot control. Gradually the country will build up alternative revenues, but that will take years. Meanwhile, the lack of a competitive manufacturing sector, coupled with very limited exports of services, will leave the country with a profound need to export its oil and gas.

What it has to do is use these revenues to underwrite the cost of restructuring the rest of the Russian economy. In short, it has to perform, on a much larger scale, the sort of exercise we did in the 1980s, using oil (and gas) money to ease the transition. In this case, though, the transition is not so much from manufacturing to services but rather from a centrally controlled economy to a market one.

A lot of progress has already been made. Russia is the fastest-growing large economy in Europe at the moment. (Well, most of its population is in Europe, even if most of its land area is in Asia.) It will benefit greatly from the rapid growth of the accession countries to the EU, and I would imagine the EU welcoming Russia as an associate member within the next 20 years. It would be worth creating a new form of associate membership to get it in. Look at those oil and gas graphs: Russia has a powerful card in that membership would secure Europe's energy supplies.

Indeed, such a development would in a way mark a return to the relationship that western Europe had with Russia a century ago, when it was the principal supplier of raw materials to the more sophisticated west - though in those days it was timber rather than energy. And in return, the west sold finished goods but also helped Russia build up its own industries.

All that was interrupted for 80 years. Now the visit of Mr Putin reminds us not just of the historical relationship between Russia and the rest of Europe; it should also remind us of the pull of history.