DAVID O’REILLY has just made a big bet — big not only by Las Vegas standards, but also by the standards of the swashbuckling oil industry. The Chevron chief executive bet more than $18 billion (£10 billion) that oil supplies will stay tight and prices high when he bought Unocal, after the Chinese authorities yielded to political pressure and withdrew CNOOC’s higher, competing bid.

He is betting that the fabulously successful boss of Exxon Mobil, Lee Raymond, is wrong to believe that the world’s supply of oil will rise. In O’Reilly’s corner are some experts who say we have discovered just about all the big fields that exist. In Raymond’s corner is the International Energy Agency, which reminds us that demand might slow and prices drop.

Little wonder that my colleague, David Smith, says this is “a nervy time for the global oil market”. One reason is that economists can make informed guesses about future demand for oil, and experts can make equally good (or bad) guesses about supply prospects, but nobody can accurately appraise the risks of supply interruptions. Those risks are adding a premium to the current price of oil.

Start with Saudi Arabia, where a medieval regime sits on the world’s largest oil reserves. Authorities in Washington once believed there was a 50:50 chance that the regime would survive the next 10 years. They have now shortened that to five years. The Saudis say they have stamped out the domestic terrorists who went on a bombing rampage, but they would say that, wouldn’t they? Saudi Arabia’s unemployment rate among young men is 25%, real income per capita has fallen by between half and two-thirds in the past decade, thousands of profligate princes keep the budget in chronic deficit, dissent means an extended visit to an unpleasant prison, and Wahabbi preachers favour Osama Bin Laden’s brand of Islam. This does not sound like a country that is a risk-free supplier.

Then there is Venezuela, which is as important as Saudi Arabia as a source of oil for America. Its president, Hugo Chávez, is spouting a particularly virulent form of anti-Americanism. He calls the US the most evil empire in the history of the world and is preparing to repel an invasion. He is using his oil revenues to fund leftist movements from Cuba to Colombia, and attempting to divert supplies from America to China and his Latin American neighbours. Worse still, he has stuffed the national oil company with political cronies, with the inevitable result of huge inefficiencies that have kept Venezuelan production below potential levels.

And there are problems with other important sources of oil. Russia has stifled much-needed investment in its industry by confiscating Yukos and jailing the company’s executives. Iran is heading towards a confrontation with the European Union and America that might result in sanctions that will inhibit its ability to produce and sell oil. Iraq remains in turmoil, unable to protect the pipelines needed to get even its terror-restricted output to market.

Possible political or terror- induced disruptions to the smooth flow of crude to market are not the only source of worry. Underinvestment has left refineries short of capacity, and greater reliance on offshore fields makes production vulnerable to bad weather.

Despite these uncertainties, America’s politicians have been unwilling to develop policies to reduce the nation’s dependence on imported oil, preferring to pass an energy bill that is long on gifts to a variety of special interests but short on any measures that will reduce petrol consumption.

All in all, it is not a pretty picture — and one that Alan Greenspan, Federal Reserve Board chairman, has very much in mind as he shapes America’s monetary policy. Greenspan knows that despite high oil prices, consumers have been disinclined to abandon the malls or car showrooms. He knows, too, that business investment is picking up: business outlays for equipment rose by 11% in the last quarter. So, despite high oil and petrol prices, the Goldilocks economy seems to be getting a bit too hot for a central banker’s comfort.

Until now, most analysts were pleased that the growing economy and high oil prices had not triggered inflation. But revisions to the price measure most relied on by the Fed now show that inflation last year was higher than the 1.6% originally reported. It was, instead, 2.2%, a bit above Greenspan’s ideal, primarily because prices in the service sector are rising at an annual rate of about 3%. Unlike manufactured goods (clothes, cars), services (haircuts, dry-cleaning) are not subject to international competition.

So as Greenspan prepares to quit the scene, he sees an economy that is growing rapidly, a labour market that is tightening, an intractable trade deficit and a dollar that is weakening, house prices that are in his view “frothy” in some areas, and fiscal policy that is loose and getting looser. He also faces his now-famous “conundrum” — the failure of long-term interest rates to keep pace with the increases he has mandated in short-term rates.

So he will want to continue raising interest rates, not only to the “neutral” level that neither heats nor cools the economy, but to a level that will actually cool things down. But high oil prices make it more difficult to decide just what to do, since they can act as a drag on economic growth as well as a source of inflationary pressure. That’s called stagflation — not the legacy that Greenspan cares to leave as he gives up life at the Fed.

Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute

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