Hamish McRae: The last laugh over a barrel

Oil at $10 a barrel – that at least is the fear of Kuwait's oil minister Adel Khalid al-Sabeeh, as OPEC and Russia have tussled over production cuts and the oil price has tumbled to the lowest level for more than two years. But wait a minute. A few weeks ago many people thought that there was a danger of a surge in the oil price and that this surge might tip a fragile world economy into recession. The Middle East, politically one of the most volatile regions of the world, has 70 per cent of the world's oil reserves and Saudi Arabia remains the largest producer. What has happened to change the mood? And is this good news or bad?

There are at least three answers to the first question. Most obviously the Middle East region looks a little less unstable now that it did six weeks ago. Countries that were uncomfortably backing the US-led offensive will feel a little more comfortable now. Whatever the long-term political future of regimes such as the Saudi one, stability has been bought for the time being.

The second change is that NOPEC – the non-OPEC oil producers – has proved less inclined to follow any proposed OPEC cut in production, with Russia in particular pumping as much as it can.

Over the years there has been a big shift in power away from OPEC, with the development of the North Sea and, more particularly, Russia. The technical problems that have bugged the Russian fields and pipelines have gradually been solved with Western help, so its production capacity has improved. The immediate change, though, is Russia's relationship with the US. It sees little political advantage in antagonising its new friends in the West at a time like this, when all sorts of other opportunities are in store. We will see what emerges from the meeting this coming week between Russia and Norway, the two most important NOPEC countries, but neither is likely to push for aggressive cuts in production.

The third shift is in the world economy. The relationship between the oil price and the economy works both ways: the oil price affects the economy and the economy affects the oil price. So while before 11 September there was a genuine concern that higher prices might push the world economy into recession, now the concern is that a world economy in recession will lead to a plunge in the oil price. This downturn probably affects oil demand more than previous ones because one big user, air transport, is particularly hard hit. It seems to be a downturn more evident in manufacturing than services, a further reason to expect falling demand for energy.

Nevertheless, the $10-a-barrel oil price is not expected by most observers. In recent years the oil price has been all over the place (see left-hand graph) but it seems to keep reverting to the $17-$22 range. Most expect it to stay around there. Interestingly, Merrill Lynch is more bullish (or bearish depending on your point of view). It has adjusted down its forecast for the average price next year, but only to $23 from $25. It believes that the risks are on the upside rather than the down because of the dangers to an interruption to supply.

The right-hand graph shows supply and demand, the grey area being the range from 1994 to 2000. If, according to estimates by Merrill Lynch, there is no quota cut by OPEC the US has plenty of stocks through next year – indeed rather more than the average in recent times. If there were a one- million-barrel-a-day cut, the sort of cut being discussed, then US oil stocks would still be well within the range. If, however, something happened to supply, like Iraq stopping its 2.2-million-barrel-a-day exports, then US stocks would fall off fast.

This is not to predict such an outcome, but Merrill ranks supply disruption as a high probability and to warn of that must be sensible. Were it to happen the mid-$20s price seems extremely plausible.

But is cheaper oil good or bad? Obviously the cheaper the price the less of a drag on the world economy, so in the short-term it is extremely helpful to have low energy costs. We probably do not drive about any more because petrol at the pumps is only three-quarters of its peak price, but we do have more money to spend on other things.

But, in the longer term, it must be strategically dangerous, as well as environmentally disturbing, to rely on fossil fuels from a unstable part of the world. Indeed the lower the oil price the more unstable the world becomes. Saudi Arabia needs a price in the mid-$20s to balance its budget, so a lower price will mean the government cannot indefinitely supply the services that its citizens have come to regard as normal. Russia, too, needs high oil prices. More than half its foreign earnings are from oil, gas and related products, while the oil and gas industry contributes about half the country's tax revenues.

The point is often made that whatever happens in Middle East politics, the countries there will need to continue producing oil to give them revenues. The same goes for Russia. But that ignores both the dangers of disruption to supply and the complex and ill-understood interconnections of the world economy.

Saudi Arabia has played an important role in the past as the "swing producer" of OPEC: it has actually been very responsible, using its own production to try and maintain stable prices. That it has not entirely succeeded is not its fault. A period of $10 oil might be very helpful for the world economy in the short run – but at a high cost in the future.