Essential Oil

All conversations at the annual meetings of the World Bank and the International Monetary Fund in Washington last weekend led to the subject of oil - and many of those conversations had started there.

Whether ministers, officials bankers and other observers were speaking on or off the record - or in some cases, it has to be said, off the wall - the big issue was how the higher oil price would affect the world economy in the short and longer terms. Graphically illustrating the subject were the reports at one stage during last week's exodus of traffic from the coastal towns of Texas and Louisiana that "Houston has run out of gas."

Fortunately, while Hurricane Rita devastated some rural areas, its impact was less severe than had been feared, and refining capacity in the Gulf of Mexico was spared the worst.

But the effect of the latest "oil shock" is visible immediately to the occasional visitor to the US: not so long ago the price at the the pump of a gallon of petrol was $1 (57p); last weekend it was over $3 in some places, although you could see the market working in front of your eyes, and prices were falling again over the weekend as the panic over Rita's potential impact subsided.

There were also many reports in the press and theories being developed by economists that even in the gas-guzzling US the impact of higher prices has had a noticeable effect on demand.

This year's rises in oil prices, and the hurricanes, have undoubtedly affected oil supplies and industrial production in the US, and third-quarter growth is bound to be well below previous market assumptions. But, other things being equal, official sources in the US are privately sanguine about the medium-term outlook for growth. They do not expect another major rise in the price and are even suggesting there ought to be some easing.

The bad news is that, given problems with refining capacity and mismatches in the quality of "crudes" (as they refer to the different types of oil), the US - which is already running a balance of payments deficit approaching 7% of gross domestic product - will have to import even more oil to fill the gap.

Despite this, and notwithstanding widespread worries about the imbalances in the world economy and the well-founded belief that the US cannot go on for ever increasing its trade deficit, there was remarkable confidence in the short term about the US's ability to go on attracting foreign funds to finance its deficit.

A very senior Asian official pointed out that eastern Asia was still awash with savings, and yields in the US were very attractive, But nobody has any illusions about the longer-term problems.

Back in 1979, the then chairman of the US Federal Reserve, Paul Volcker, had to depart hurriedly from a World Bank/IMF meeting in Belgrade to fly back to Washington and deal with a crisis of confidence in the dollar.

This involved dramatic rises in interest rates and the onset of recession. Given the fragile state of the present so-called European recovery - which has most certainly been hit by the higher oil price - a serious US slowdown would be extremely bad news all round.

But the message I picked up in Washington was that, for all the horrific scenarios that can be constructed around the US deficit, there could be one more lease of life before some almighty crisis hits the international monetary system.

But even the short-term optimists about the US economy are very concerned about the longer term. The big concern is that, with China and India now major consumers of oil, and not showing obvious signs of significant deceleration in their rates of economic growth, the oil price will stay stubbornly high after an expected dip and even go much higher.

The problem worrying officials at the highest level is the gap between known oil resources in the ground (or under the sea) and the rate of extraction. Given the obvious time lags between investment in new extraction facilities and delivery to those great tankers, a serious gap in supply can be envisaged over the next five years.

Of course, there will be those who say, "Fine: it's about time we all faced up to a future world without oil. And why shouldn't these Opec countries invest in extraction facilities at a pace to suit themselves?"

Fair enough. But in a world economy still hooked on oil - even if the ratio of energy use to GDP is now half what it was in the 1970s - there could be trouble ahead.

Meanwhile, it is sad and ironic that after all the sterling efforts by the British chancellor, Gordon Brown, and many others, the debt forgiveness package finally sown up in Washington should be accompanied by cries from many African countries that the financial benefit will be dwarfed by - you've guessed it - higher oil prices.

· William Keegan is the Observer's senior economics correspondent.