The world's great energy companies still plan exploration for crude oil and investment in refineries on the basis of oil prices far below USD 50-60 a barrel. Therefore, the price signals from the demand side are nowhere near feeding through fully into a supply response, suggesting that high energy prices are likely to persist for many years.

One possible explanation for this anomaly is that the global energy sector is one of the world's most oligopolistic. Substantial market power in production and exploration, and processing and distribution is concentrated in the hands of a very small number of companies. Oligopolies in commodity sectors tend to have a bias to under-investment because they face asymmetric incentives. If they keep investments low and demand is then unexpectedly strong, their profits from the resulting high prices will likely be almost as good as if they'd foreseen the boom and done more capital spending. However, if they invest heavily and demand is surprisingly weak, then their profits can fall sharply as prices collapse in the glut.

Compare this with the global manufacturing sector. It also contains many very large oligopolistic companies, but unlike the energy and commodity sectors, they must compete on innovation, product design, marketing and distribution in their core businesses. It is essential that they keep investing in innovative new products, or they will risk losing market share when their competitors get a new design to market ahead of them. In contrast to the energy sector, there is a bias toward over-investment. Since 1980, total private investment in the USA more than doubled, but investment in the commodity area still lags behind those levels.

So it seems likely that, in the long term, short-term cycles aside, investment will continue to be buoyant in manufacturing and relatively restrained in the energy and commodities complex. With limited spare capacity, this relatively modest investment rate implies that energy prices are set to remain elevated. Getting the oil price down to USD 40 per barrel at current demand levels would mean that global oil production would have to rise about 20 percent from the current 85 million barrels a day, according to our analysis. This would be over and above the growth of about 2 percent a year needed to keep up with rising demand, and this seems unlikely even on a five-year-plus time horizon.

Nor does it seem plausible to compare the current situation to the 1970s, when high oil prices caused a recession and undermined energy demand. At that time, the price hikes reflected a politically motivated cut in supply. This time, they are the result of strong demand from a buoyant global economy, which has become much less energy intensive and seems well able to keep growing in the face of high energy costs.

We therefore believe that the biggest reaction to high energy prices will come from innovation by manufacturers, rather than from a large rise in supply of conventional energy, or a short-term decline in demand. Since innovation is part of the core business model of large modern manufacturers, it will be natural for them to develop new products that minimize the use of energy and materials inputs - or that harness unconventional energy sources. And, while much of this innovation will initially be relatively modest and incremental, over time, we are likely to see more radical change.

New inventions can reverse the relative price shift
The explosion of interest in petrol-electric hybrid cars is an early indication of this trend, and perhaps will be followed by diesel-electric hybrids offering another quantum leap in efficiency. More radical steps lie beyond this, such as the development of the current embryonic market in pure electric vehicles into a mass market for lightweight urban transport, car-shaped but barely using more materials than a powered bicycle, and made safe by restrictions on the use of conventional heavyweight vehicles in towns. Another example is the development of improved solar energy systems, much of which is being done by the general manufacturing sector, rather than by the large integrated energy companies. One of the exciting developments here is the linkage with other emerging technologies, such as the use of light-emitting diodes (LEDs), which require far less electricity than corresponding conventional filament bulbs. As a result, widespread adoption of solar-powered residential and office lighting - and to a more limited extent heating - is not a silly projection to make for ten years from now.

Our vision is that entrepreneurial manufacturers, competing on innovation, will respond to the enormous shift in current relative prices with new products. The emergence of these products will eventually erode demand for conventional energy and raw materials, and ultimately reverse the relative price shift. That will likely take well over a decade to play out.

The 1970s experience: move up the value chain or die
What was the common denominator of the industrial casualties in the 1970s?

Excess capacities
High dependence on raw materials prices
High labor costs
Weak competitive position
No pricing power

Who escaped, who suffered?
German companies were the best example of management of the oil shock. Thyssen moved from commodities steel to stainless steel and escalators, BMW became an international brand of quality, Daimler-Benz entered aerospace after purchasing Dornier, Siemens entered electronics in 1981 through big joint ventures, for example with Philips and Intel. Conversely, UK companies were hit by unyielding trade unions, lack of research and development (R&D) and inflexibility, mostly on the back of government control. As a result, some companies making a loss survived with subsidies and several private companies fell into bankruptcy. Only with Thatcher's revolution was England able to recover its competitiveness.

What will happen this time?
Countries unable to adapt to the shock of higher energy costs and companies lacking flexibility and competitive positions could meet the same fate as their ancestors, British Leyland or Manufrance. Export-oriented companies with market-share growth, the ability to outsource, and a strong record of cost control will survive. In the long term, some experts fear that European companies might have difficulty competing due to lower R&D investments, which makes it hard for them to move into high-end products.