Sunday, 21 December 2014

Oil & Gas: Will We Ever Learn?

That the current oil price crash exposes the weakness of the Yes camp’s economic case is undeniable, but those of us who argued against independence on the grounds of economic rationality would do well to avoid gloating. If we were currently experiencing a short-term price driven boom, the economically literate and rational among us would be arguing that we shouldn't make long-term judgments on the basis of short-term price fluctuations.

So instead of over-reacting to today's oil price, let's instead take this as an opportunity to reflect on how the economic case was presented by the Scottish Government and whether the electorate were suitably informed when votes were cast.

First of all it's worth noting that neither side of the Yes/No debate is celebrating the oil price decline. Even if we discount some of the more sensationalist headlines (North Sea Oil Industry Close to Collapse), measured voices such as Sir Ian Wood (North Sea Oil Collapse Fears 'Too Dramatic') and Oil & Gas UK (Oil & Gas UK have warned of up to 35,000) are warning of 18,000 - 37,000 job losses. Whilst the ever excellent David Smith argued in the Sunday Times (Relax: Lower Oil Prices Will Be Good For Growth) that the oil price slump may benefit the UK economy (because the UK is a net importer of Oil & Gas), nobody who cares for those employed in the industry will be celebrating the current market conditions.

Looking back to referendum debate I recall plenty of us complaining about the oil & gas forecasts in the White Paper (alongside many other complaints about the lack of a credible economic case) but hindsight can play tricks on us - so I have revisited the question using contemporaneous data sources.

The first and most obvious point worth making is that nobody predicted a price crash to today's levels. There are a lot of data points on the chart below but the overall message is simple - the price levels used in the White Paper (blue line) were at the high end of available forecasts at the time but no forecasts were as low as the prices we are now experiencing and expecting (the black line).

Full sources and explanations are given at the foot of this post.

Of course there is a very efficient market in oil price futures so we can look back to the time of the White Paper publication and see if the price assumptions used were consistent with market expectation back then.  The chart below shows the expected market price for a barrel of oil in December 2017 based on the Futures Market Price over time.  The blue lines show the $113 assumption used in the White Paper and the White Paper publication date; it shows us that the price assumption used in the White Paper did indeed fairly reflect market expectations at that time.

Of course revenue is a function of both price and production volume, so let's look at revenue forecasts produced at the time of the referendum debate.

In the chart below, blue lines are Scottish Government Scenarios (as per the Oil & Gas Analytical Bulletins in March 2013 and May 2014)  red lines are OBR forecasts, the black line is the actual outcome.  The dotted lines represent forecasts as of 03/13 and the solid lines as of 05/14 (i.e. periods bridging the publication of the White Paper).  The two highlighted data points in 2016-17 are the two scenarios the Scottish Government chose for the economic forecast used in the White Paper.

You can see how these forecasts evolved over time here (> 2 min video blog)

It's a pretty graph, isn't it?  But let's consider what it is illustrating.
  • The dotted lines show how dramatically optimistic the Scottish Government scenarios were compared to the OBR at the time - they appear to have simply ignored the OBR forecasts (despite the fact that they have a consistent track record of being overly optimistic) and used a low case that was 60% higher than the OBR forecast
  • The solid lines show that when the OBR revised down their forecasts the Scottish Government simply assumed away the downward trend. In fact the Scottish Government introduced a 6th scenario, presumably so that the higher of the two figures used in the White Paper could still be justified
Now let us pause and reflect on this.  The White Paper was produced by the Scottish Government; this means civil servants should have ensured that it didn't become an SNP manifesto or a case weighted unrealistically in favour of independence. Similarly the Oil & Gas bulletins should surely be impartial assessments of the economic outlook we face? It's hard to look at the graph above and not conclude that the scenarios presented in May 2014 were manipulated to try and support the White Paper scenarios.

This civil service failing has been covered by others (notably John McTernan: White Paper Damns Civil Service) and extends well beyond the issue of North Sea tax revenue forecasts - but this graph alone is surely a compelling illustration of the need for an OBR equivalent independent fiscal watchdog in Scotland. Maybe we could call it the Scottish Office for Budget and Economic responsibility and task it with providing SOBER assessments to inform policy makers and votes?

It gets worse; even if we take the Oil & Gas scenarios as objective forecasts produced in good faith, how can the two scenarios chosen for the White Paper be justified? Any business person will tell you that scenarios should be used to provide an illustration of the range of likely outcomes, to stress test the plan and ensure that the a downside scenario can be weathered.

During the Independence referendum the Alex Salmond claimed "There can be little doubt that Scotland is moving into a second oil boom" and there were forecasters who shared at least some their optimism (e.g. the OECD The Price of Oil - Will it Start Rising Again?) so it is perhaps understandable that yes camp pushed for a bullish scenario in the White Paper.

But what about a conservative scenario?  If you produce six scenarios in the Bulletin you should surely include at least one that reflects a worse case than the OBR forecast?  Given the credibility of the OBR within the UK surely at the very least that forecast should be used as a base case?

In effect the Scottish Government White Paper presented two scenarios for North Sea tax receipts: "Optimistic" and "Hopelessly Optimistic".

Look again at the graph above.  The White Paper "low" scenario for 2016-17 is £3.9bn higher than the OBR forecast that existed 6 months before the referendum.  That's more than double, that's £734 per person or (to use the "over 5 years" methodology Alex Salmond used when propounding his Shameless £8bn Lie) that's £19.5bn over 5 years or £3,700 for every man woman and child in Scotland.

Remember: this is not hindsight. There were voices of reason at the time counselling that the Scottish Government’s forecasts were extremely optimistic (e.g. in the FT The Scottish Government is Misleading Scots about Oil) and the figures I'm using above are simply the OBR forecasts that were available at the time - the shortfall between the White Paper "low" scenario and current OBR forecast is even greater.

Some of us argued against independence in part on the basis that an independent Scotland's economy would be over-exposed to this volatile commodity, we argued that the White Paper failed to make an economic case and that the economic risks were not being honestly presented to the Scottish voters. There were many other warnings being offered (e.g. around employment, currency, uncosted White Paper promises etc.) but the current oil price shock certainly provides a dramatic illustration of the point some of us were trying to make.

More thoughtful Yes voters might consider whether countering those rational observations made at the time with the simplistic, projected opinion that we were in some way suggesting Scotland was "too wee, too poor, too stupid" might not have been the most intelligent way to debate the issue. We weren't "talking Scotland down" or suggesting oil was somehow not an asset; we were simply trying to ensure that referendum votes were cast knowing the very real economic risks an independent Scotland would face.

Maybe next time (if there is a next time) we will succeed in having a more rational and informed debate, that those who counsel for rational economic assessments will not simply be shouted down and accused of negative campaigning.


Oil Price Chart Data Sources
The black line on the chart below shows the current market expectation based on the Brent Crude Futures market (Futures markets are of course not infallible, but they do provide a truly independent, market based 'Wisdom of the Crowd' forecast as of today).


Anonymous said...

On a detail point, oil futures prices do not reflect the market's expectation of the price in the future. They are the price now for delivery in the future.

Anonymous said...

I did notice you fail to mention the at the revenues currently collected go straight into England's tax figures... Seeing how the big oil companies all have their headquarters in England there forever the revenues go towards England's figures instesad of Scotland's. It is the same with exports tax revenue. One fifth of Scotland's exports leave Scottish ports therefore the tax revenues are not counted towards the figures for SCOTLAND... The tax figures are extremely misleading...

Kevin Hague said...

"Anonymous" 2: please read some of the many posts on this blog about GERS stats. They are summarised at the foot of This article.

Your point is completely irrelevant to this post and incorrect when considering the GERS figures which have been used consistently throughout this blog and the debate.

The GERS figures allocate all relevant revenues to Scotland (as per Scottish Government's methodology and including geographic (=90%) share of oil to Scotland). Similarly corporate tax is allocated based on activity not hq (an estimate, HMRC estimate Scotland's share at £1bn less that SG).

On that basis - before the dramatic oil slump - Scotland runs a similar (worse last year) deficit/cap as rest of UK. Tee White Paper extrapolated those figures to 2017 using the forecasts described in this post (relying on the 90% coming to Scotland to try and create an economic case which even then didn't stack up.

So your comment is - to say the least- very wide of the mark