Financial Reflections: Oil forecasting and the referendum debate

ESRC Fellow David Bell reflects on the oil prediction disagreements between the Scottish Government and the HM Treasury in their respective papers published on May 28th.  Professor Bell says  it would be useful for undecided voters in the referendum debate to know how forecasts are being made and how accurate they’ve been.

North Sea oil plays an important part in the referendum debate. In the latest fiscal projections issued by the Scottish and UK Governments, there was yet again a major disagreement about the size of future North Sea Oil revenues and therefore about their effect on the government balance sheet in an independent Scotland.

The volume of oil and gas production in the North Sea has been falling. Figure 1 shows the decline in oil and gas production between 1998 and 2013. It also shows the DECC forecast for production between 2014 and 2028. There has been a very rapid decline over the last 15 years. A more gradual decline is expected over the next fifteen years.

Fig 1: Actual and Forecast Oil Production

Source: DECC

Figure 2 shows the price of crude oil acquired by refineries based on an index of 2005 = 100. It shows the nominal price of oil growing strongly over the early years of this century before levelling off since 2011.

Fig 2: Index of Price of Crude Oil Acquired by Refineries (2005=100)

Source: DECC

Though neither government suggests there will be a sudden substantial increase in production or the oil price, the protagonists in the referendum debate have come up with quite different scenarios for future oil revenues. These have a dramatic effect on Scotland’s projected fiscal balance. The difference between the estimates is shown in Figure 3. It reaches a maximum of £4.5bn in 2014-15. To put this in perspective, this difference exceeds the annual revenue from council tax and non-domestic rates combined. It is also equivalent to 4 per cent of Scottish GDP, which means that a budget deficit of 2 per cent of GDP would be transformed into a surplus of 2 per cent of GDP depending which of the forecast assumptions is correct.

Figure 3: Forecasts of Oil Revenues, Scottish and UK Governments May 2014

The UK Government has not derived its own projections of revenues. Instead it has used the latest forecast produced by the Office for Budget Responsibility. The OBR projections are based on the DECC production forecasts (as in Fig 1) and the OBR projection of the oil price (largely flat over the forecast horizon). The Scottish Government also assumes no significant change in the oil price, but does envisage a small increase in production, based on industry forecasts.

These differences cannot fully explain such marked differences in projected revenues. Another possible explanation is that the Scottish Government are taking a more optimistic view of the evolution of costs. Cost inflation has been a particular problem for operators in recent years. Oil and Gas UK summarised these pressures as follows:

“While investment in 2013 is expected to be the highest for more than three decades, the development costs per barrel have risen rapidly and are five time what they were a decade ago”
Oil and Gas UK Activity Survey 2013

This does not bode well for revenues, since operators are allowed to cover their costs before taxes are levied. How the Scottish Government has accounted for the effects of cost pressures on future revenues is not clear. Neither is it clear how OBR take account of this issue. What is clear, however is that past OBR forecasts of oil revenues have tended to be optimistic relative to the outcome (See Fig4). It would be helpful for the uncommitted observer to be able to similarly assess the Scottish Government’s forecasting record in respect of oil revenues. Although no-one can know before the referendum which forecast of oil revenues will be correct, the forecasting record of the respective governments (or the agencies that they use) could provide a useful pointer.

Figure 4: OBR Economic and Fiscal Outlook (EFO) and UK Budget Oil Revenue Forecasts


CC header image courtesy of Sten Dueland on Flickr.

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post by David Bell
University of Stirling
28th May 2014
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