Economic View: Get ready for the big switch

Tony Blair says it isn't and I happen to believe him. But whether or not you think that the war is principally about oil, the fact remains that the developed world has become overwhelmingly dependent on petroleum. Two thirds of the world's oil reserves are in the Middle East – and, of those reserves, Iraq is second only to Saudi Arabia.

Anyone trying to pick his or her way through the rhetoric about the significance of Iraq's oil might like to start with the following three propositions. First, in the short term what happens to Iraq's oil is not very important. Second, stability in the Middle East and in particular Saudi Arabia matters hugely. And third, Russia is a more important long-term player in the petroleum game than even Saudi Arabia.

To explain. Iraq has enormous oil reserves but produces relatively little. It has 11 per cent of the world's proven reserves (Saudi Arabia has 25 per cent), yet in 2001 pumped only 3.3 per cent of its production. That is actually slightly less than the UK, though we have only 0.5 per cent of the world's reserves. The pattern applies more generally to the Middle East, as you can see in the first two pie charts: the Middle East utterly dominates reserves. But while it is still very important, it is much less so in terms of current supply.

It follows that swings in Iraq's oil production are not that important in world terms. But establishing a greater degree of political stability in the Middle East is, for the region will become even more important as the alternative sources of oil dry up. Britain's production peaked in 1999 and in theory we have only about five years' reserves left at present production levels. The US has only 10 years' reserves. By contrast the Middle East has nearly 90 years.

Now we won't suddenly find in 2008 that there is no oil left in the North Sea. The US won't suddenly find it has no domestic oil production in 2013. The oil companies will find more of the stuff and the geologists always like to squirrel away some slack in their estimates. Probable reserves are much larger than proven ones. For those reasons, too, we should not be too alarmed by the fact that there is only 40 years' global supply at present production rates. But gradually, inexorably, year after year, we in the West will become more dependent on the Middle East for our oil. That is why we have a profound and increasing interest in its economic and political stability.

Gas will matter more too, which is where Russia comes into the equation. There are some 80 years of supply of natural gas in the world, ie double that of oil. Gas is an effective substitute for oil in many applications: home heating of course, but also power generation and vehicle use.

Britain has already switched much of its electricity generation more swiftly to gas than any other country in the world. Now, thanks to the lower tax and the exemption from Ken Livingstone's congestion charge, expect many more cars and vans in London to switch to liquid petro- leum gas (LPG) in the months ahead.

The distribution of gas is rather different to that of oil, as the third and fourth pie charts show. Russia, plus the other former USSR countries, has slightly larger reserves than the Middle East. And in gas production the Middle East is much less important than it is in oil: less than 10 per cent of the world supplies.

So as oil becomes tighter, expect a gradual switch to gas. It is a less convenient fuel because it has to be kept under pressure and by weight it has lower calorific value. So it will never fuel aircraft. But it is cleaner and it can be fitted into the oil economy without massive additional investment.

This benefits Russia. It is closer to the main market of Europe so the gas can be transported by pipeline rather than ship. And it has 80 years of supply against Europe's 16 years, so it can offer long-term security. Getting the future relationship with Russia right is important to the US from a strategic point of view. Getting it right is even more important to Europe from an economic point of view.

Still, this is all pretty unsatisfactory. In an ideal world, neither the US nor Europe ought really to be too dependent on the Middle East or even Russia for their energy. Is there an alternative? I was intrigued by the final chart, which comes like the others from BP's excellent annual review of the petroleum market and which, as you can see, shows the oil price since 1861 in both current dollars and present-day dollars, ie adjusted for inflation.

In real terms oil was very expensive in the middle of the 19th century, became progressively cheaper until the two oil shocks of the 1970s and has now settled into its late 19th-century range of $10-$30 a barrel.

So during the period when the world gradually switched from a coal economy to an oil one, oil became progressively cheaper. You could look at that the other way round and say it was because oil became cheaper that the world made the switch, and to some extent that must be true. But oil was more suitable for those two key 20th-century technologies, the car and the aeroplane.

Looking ahead, it is easy to see the switch from oil to gas noted above, but that only buys some time. The really interesting question is what technology will come along next and replace petroleum. It won't be nuclear or the currently fashionable idea of wind power (a medieval technology). Hydrogen-powered fuel cells? Maybe, but not for a while. My own favourite candidate would be conservation: wait, for example, for LEDs to replace the regular light bulb. But that too will take a generation.

Meanwhile we need stability in the Middle East – and we had better be nice to Russia.