Manufacturing at risk from oil supply shock

London Briefing: Two utterly conflicting pieces of news caught the eye at the beginning of the week. First, oil prices once again breached the $70 (€54.50) per barrel level on the back of an overt Iranian threat to supplies. Second, the EEF, the club that represents employers in UK manufacturing, reported that growth is now at its fastest rate in a decade.

UK manufacturing industry? Most people assume that we don't have any companies that actually make anything any more, so news that the widget constructors are doing very nicely will come as a shock.

History teaches us that when oil prices go up, the economy suffers and manufacturing, in particular, gets clobbered. Indeed, the difficulties faced by manufacturing have led many businesses to simply give up. Bankruptcy - or a move to lower cost countries - has taken the sector down to about 15 per cent of the total UK economy from around 50 per cent half a century ago.

This seemingly inexorable trend will come to a halt only when we no longer produce any physical goods. What remains has been called the weightless economy: invevitably, all we will produce will be services, mostly bits and bytes that whiz around the internet.

One of the many reasons why manufacturing has shrunk in this way can be traced to the rise in energy costs throughout the 1970s. We spent the next quarter of a century becoming more energy efficient, partly by becoming smarter but also via the simple expedient of getting rid of the most energy-intensive industries. These, of course, tend to be manufacturing businesses.

Having outsourced most of the dirty and smelly bits of the economy, we can feel virtuous sitting in our energy-efficient offices, marvelling at how little oil we consume compared to only a few decades ago.

We still buy manufactured goods of course, just not ones we make at home. So somebody is still involved in energy-intensive activity. But at least it is not us.

Given all of this, we might have thought the rise on energy prices of the past few years would amount to the final nail in the coffin for the metal bashers. Which is why the news that they are doing well comes as such a surprise. What is going on?

It could be that the latest burst of activity is merely a cyclical affair and that the trend is still very much intact. Come the next global recession, the ascendancy of the service sector will be complete.

There is probably something to this. One of the ways in which some manufacturing has managed to survive in the UK has been by boosting productivity: produce more with less, particularly man hours. We can never compete on wage costs so the only way is to sweat the asset base even more. Even with the bounce in manufacturing output, I wouldn't hold out too much hope of a jobs boom.

Industry is doing well partly because the global economy is booming. Rising tides do, eventually, lift all boats. And here lies the main part of the explanation for the puzzling coincidence of rising oil prices and robust manufacturing growth. The key difference between now and the 1970s is that high oil prices back then came about because Opec restricted crude oil supplies: it was, to use the jargon, a classic supply shock. Industry simply wilted under the assault.

Today, Opec is pumping all that it can. Prices are high because demand for oil has grown rapidly. As economies have expanded, so has the need for oil. Hence, its price has risen.

It's called, inevitably, a demand shock. And the differences between demand and supply shocks go a long way to explaining why our economies, including the most vulnerable bits like manufacturing industry, have managed to hold up so well. Whether this can continue is a moot point: if a supply shock now follows the demand shock, things could go very pear-shaped indeed.

If, say, those Iranian threats turned into a blockade of the Straits of Hormuz, that would get us dusting off our supply shock memories. Indeed, not all of the recent rise in the price of oil is down to demand: a few dollars, at least, is because of the Iranian situation.

Any further rise in the oil price is almost certainly going to be based on supply fears. That's when the consequences for economies - manufacturing in particular - will start to be real and severe.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.