Iran is flexing its muscles and muscles it indeed has. It has the world's second-largest oil reserves at a time when in the short term, global oil supplies are tight and in the long, they will get ever tighter. If it wants to pick a fight with the West, and there is every indication that it inclines in that direction, then this is not a bad time to get going. So should we worry about the consequences and if so, what should we do about this?

Some perspective. Iran may have huge oil resources for, at more than 11 per cent of the world's proven reserves, it is second only to Saudi Arabia and has more than the US and Russia combined, but in production it is smaller: only 5 per cent in the world, less than the UK and Norway produce from the North Sea. Because global oil supplies are stretched at the moment, that 5 per cent matters. This is why the recent tension over Iran's nuclear programme, with the possibility of UN sanctions, has driven the oil price back towards a new peak.

On the other hand, while Iran is a giant of the oil world, it is a minnow in the world economy as a whole. If you strip out its oil output it would have a GDP about the size of Surrey. It also lacks the technology not just to develop its nuclear capacity but simply to get the best out of its oil resources. We do not have direct evidence of that yet but Kuwait, with a broadly similar scale of production in not so different geological conditions, is now inviting foreign companies back. It feels it does not have the expertise to maintain production as fields age and their output starts to deteriorate.

So at one level Iran matters enormously: its oil reserves are huge. But at two other levels it barely matters: its economy is small and its technology weak.

In a rational world this would be the basis for a wonderful friendship: the West has the demand and the technology, while Iran has the resources. We could march along together, using the time gained to develop the successor to a global economy driven by oil. But, of course, the realities are different. Iran is a scratchy, difficult partner, while the Western, developed world is becoming increasingly alarmed and, because it is frightened, may also behave in an irrational way.

There is athird partner in the relationship that will further confuse the situation: the rising importance of non-Western consumers of oil. China is now the second-largest consumer of oil in the world after the US, while India is number six. (The UK by the way is not even in the top 10.) So China and India are understandably seekingto ensure their own energy supplies, and hence cement their relations with any oil producer that is having little local difficulties with the established developed countries.

At a global level that might not seem to matter: oil sold by Iran to China is oil that China is not buying on the world market so there is no overall impact either on supply or on prices. But were there a sudden squeeze it might matter for a short period. You could envisage a situation where countries with secure long-term contracts might find themselves with an assured supply while countries that simply bought on the world market would be scrambling for stuff at any price.

So I don't think we need to worry about the blanket "if you are nasty to us we will sell our oil to someone else" threat. But we should be aware of the more measured threat: "if you are nasty we will cut supply to the world market but carry on providing our friends with oil at a long-term stable price".

In any case, it makes no sense for sophisticated, Western economies to rely for its most valuable form of energy on parts of the world that are inherently unstable. Russia did Western Europe a great favour by cutting off gas supplies to Ukraine and thereby lead to a grand reappraisal of Europe's energy needs. Iran's blustering should have a similar effect, not just on Europe but on the US, as evidenced by the George Bush's State of the Union speech last night. The need for energy independence has been one of his most consistent themes.

That leads into what seems to me to be the core issue here. We are nearing the end of the oil age and we don't know what will follow it. The world will have to patch its global energy needs until it can develop an alternative to oil. Oil proved a much more convenient fuel than coal and was able to take over from the fuel that had fired the first century of the Industrial Revolution. The 20th century was the century of oil. The third century will progressively be driven by something else but we don't know what it will be. So we patch. The better we patch, the better we will serve the environment and the better we will contain the power of Iran, Russia, Saudi Arabia and other unstable states.

So how do we know what to do? It is difficult given the disappointments of nuclear power and the minute scale of the present array of alternative sources of power. There is, however, one proven, though imperfect, guide. It is called the market.

The most interesting aspect of the current squeeze on global energy supplies is not only the search for not-very-efficient alternative supplies but also the impact of higher prices on energy demand.

The magic of the market is that it works on both sides of the equation. On the supply side, higher fossil fuel prices not only encourage more efficient development of resources' they also make near-substitutes more viable. At $50 a barrel, oil from agricultural products becomes an effective substitute for mineral oil. That is not without environmental costs: land that is put to growing oil may be land that would otherwise be habitat for wild creatures. But it is a useful patch.

On the demand side is where the greatest potential lies. Bill Clinton pointed out recently that were the US to adopt global best practice in energy use it could chop a huge amount off its energy needs. We know that politics don't reduce energy use in the US' give the market a shot. Similarly, expensive energy will persuade China to adopt good energy practice in a way that external political pressure will fail. In practical terms, the market is our best hope.

Here in the UK you can see the way the market is respected whereas political pressure is rejected. The Government's policy of squeezing up petrol duty let to riots and was stopped. But subsequent increases, driven by the world oil price, not the Chancellor, have been meekly accepted - and the sales of more efficient diesel cars have duly soared.

This is win, win. I think we should welcome every squawk from Iran and every growl from Russia. Every reminder that it is intolerable to rely on them for the world's energy supplies should be music to our ears -even if we do need to keep them onside a bit longer.

Higher fossil fuel prices encourage more efficient use of resources, and make substitutes viable