Hamish McRae: The real question is why the price of oil is not even higher

The oil market is the dog that hasn't barked. Oh, there has been a bit of growling, the odd woof. The oil price was until yesterday at a six-month high. But it was only at a six month high. Given the potential for catastrophe in the Middle East, such a relatively muted run up in the oil price is surely a surprise. And now that US oil stocks seem to be heading up again, the talk is of a fall in the price, not a rise. What's up?

The starting point is that this winter saw remarkably low demand for oil. It was the mildest winter in North America for many years; air travel was cut after 11 September; and the recession further reduced demand worldwide. However, as we have moved into this year the market swung the other way, pushing prices back up.

Just as three factors cut the price at the turn of the year so another three have pushed it up more than fundamentals would suggest. These are the fact that Opec countries have stuck more closely than usual to their quotas; the recovery gradually became more secure; and of course the tension in the Middle East.

As you can see from the first graph, stocks of oil in the US moved steadily up until mid-February, when they were towards the top of their historic range. This is a sharp contrast to the early months of 2001, when they were at the bottom of the range.

What happens next depends, amongst other things, on Opec compliance – the extent to which the Opec countries stick or fail to stick to their quotas. True, Opec only accounts for some 40 per cent of world oil production, but it remains very much the swing producer, so its production level has a disproportionate impact on the price.

Merrill Lynch, which has done a great deal of work following the oil market, makes a assumption of 70 per cent compliance as its base case. But it may turn out that compliance continues to be higher, say 85 per cent. The effect of these two different production levels on US oil stocks, as projected by Merrill Lynch, is shown on the graph. The message is clear enough: if Opec countries maintain the higher level of compliance the US will be down below the normal level of oil stocks by November.

What might this mean for prices? Merrill Lynch has a nice little computer model that fits what is happening to US stocks to what is happening to the oil price. As you can see (bottom graph) the price has come up rather more quickly than the model predicted, the result of the factors noted above.

Whatever happens, the stock situation will reinforce this recent upward movement. But whether the model points to an oil price of $26 a barrel this autumn, which would be fine, or $34, which would cause considerable concern, depends very much on the level of compliance.

Computer models are only computer models, so you should not take them too seriously. But they are useful in showing general relationships, which give some guide to the future. One central message here is that Opec does not need to use oil as a weapon to sustain an oil price above $30: all it needs to do is to cheat on quotas less than it has in the past.

This has two longer-term implications. One, pointed out by Merrill Lynch, is that the natural dollar oil price is in the mid-20s region rather than the mid-teens. The other, which it thinks is unlikely, is that oil would be an effective weapon putting pressure on the US.

What can one sensibly say about that? The starting point is that Opec has over the years been extremely restrained in using its power for political ends. Saudi Arabia, the swing producer, believes that it is not in the long term self interest of Opec to allow the price to run at more than the mid-20s. It believes that to do so increases the pressure to hunt for substitutes and would reduce the long-term value of its reserves.

A second point is that Russia's competence in managing its oil and gas production has been greatly enhanced over the past five years. That too will tend to reduce the power of Opec over the next decade at least – though note that some 70 per cent of the world's oil reserves are in the Middle East.

Still, the political situation in the region is so unstable that some interruption to supply must be a serious possibility. Some of the possible outcomes are so alarming as to hardly bear thinking about, but even on fairly measured assumptions of risk, a spike up in the oil price above $40 a barrel must remain a serious possibility.

One of the issues that this possibility raises is the inflationary implication of a surge in energy prices. We know that the world's central banks have started a round of increases in interest rates, though we don't know how far and how fast this trend will run. This is happening against a background of firm but not outrageous oil prices. One of the absolutely central things the central banks will be watching will be the trend in energy prices and if these rise above present projections they will have to lean against them. In fact, low fuel prices, now turning up, have been one of the key features holding down US inflation through the winter.

When one is dealing with profound political uncertainties one has to try and establish a range of outcomes, from the worst that can reasonable be conceived to the best that one can reasonably hope for. Looking at the oil market, all that is priced in at the moment seems to be that Opec will continue to be disciplined in its production, with perhaps a small premium to price in the unlikely possibility of a disruption to supply.

The experience of the Gulf War, when there was only the briefest spike in the oil price, would seem to suggest that the market has got this right. But the dangers are asymmetric. In the very short term the price may well fall back. But it is hard to see any set of circumstances where the underlying supply/demand ratio will become much more favourable and easy to see several where it could be less so.

The conclusion is very simple: quite aside from any moral and political interest, the West in general and the US in particular have a profound economic interest in seeing stability return to the Middle East.