NORTH SEA OIL REVENUE FORECASTING - A CAUTIONARY NOTE...

Fancy a career in the Scottish government’s economics department? Take a tip. When tempted to forecast the price of oil, go into a darkened room and lie down till the mood passes.

The world of energy price forecasting, like that of predicting the price of gold or the stock market or the behaviour of currencies, is littered with the corpses of the clever, the meretricious and the outright chancers.

Were the world of commodity or asset price forecasting in any way robust and reliable, the experts would be emailing us from their villas on Seven Mile Beach Grand Cayman with their yachts bobbing happily on the cloudless azure horizon.  Strangely, or all too predictably, Mr Swinney’s economic advisers are still chained to their desks and having to trudge daily into the grim 1930s monolith that is St Andrews House.

Bear this in mind in appraising the recent exchanges on how an oil-rich independent Scotland would order its finances.

This caveat will not, of course, staunch the understandable desire to forecast the future or set some framework around the price behaviour of a commodity on which the revenue and spending ambitions of an independent Scotland will critically rest.

But you don’t have to be a disciple of Nicolas Taleb or a keen follower of Black Swan economics – the capacity of unforeseen, unpredictable events to burn the Rational Expectations School to the ground – to treat the best researched predictions with circumspection.

Unfortunately, such forecasts have been catapulted centre stage in the argument over independence.

Because it is North Sea oil revenues – deeply variable as these are on the uncertainties of production, investment, taxation and underlying oil price - that transform the argument.

We move instantly from an economy that would be persistently and chronically in deficit to one in which an independent Scotland would have a sharply lower budget deficit compared with the UK overall and indeed on some assumptions would be enjoying a budget surplus.

But which will it be? How can we make sense of the claim and counter claim?

One of the most comprehensive – and independent – assessments has come today from John McLaren at the Centre for Public Policy Research.

Its latest briefing note draws on a variety of recently released UK and Scottish government related documents to review Scotland’s future fiscal balance – public sector revenues minus expenditures - both in absolute terms and relative to the UK.

First it sets out what Scotland’s fiscal balance would be excluding revenues from North Sea oil & gas. It cites the conclusion of the recent Fiscal Commission report that “a long-run objective should still be to achieve as close to an overall onshore budget balance, and to use at least a proportion of North Sea revenues to invest for the long-term balance.”

Scotland’s mainland, or onshore, fiscal balance ex North Sea oil has been in deficit since at least 1980. Over the period 2007-08 to 2011-12, this deficit was between 10-18 per cent of GDP.

Scotland on its own would thus have a noticeably higher fiscal deficit than the UK, by around an extra 5½ - 6½ per cent of GDP.

This picture is transformed once a geographic share of North Sea oil and gas revenues is included. In previous years Scotland would have had a very large absolute fiscal surplus throughout the 1980s – though a much smaller one in 2000-01.

More recently, (i.e. in the last four years), whilst Scotland has continued to run a fiscal deficit, it has been smaller than that of the UK. In 2011-12, the latest year available, the Holyrood administration’s Government Expenditure and Revenue Scotland (GERS) shows this relatively better Scottish position to be equivalent to 2.9 per cent of GDP.

However, latest projections for North Sea revenues by the Office for Budget Responsibility (OBR) suggest that all of the Scottish advantage seen in 2011-12 disappears by 2012-13, as oil revenues are projected to fall by more than 40 per cent. 

Thereafter, an initially small, but growing, relative advantage is projected to emerge for the UK. As the CPPR assessment makes clear, this is by no means the only possible outcome...

The Scottish Government recently outlined four additional North Sea revenue scenarios based on varying oil prices and production levels; each of these results in higher North Sea tax revenue projections than those of the OBR.

These scenarios make Scotland’s fiscal deficit relatively smaller (as a percentage of GDP), although in only one scenario does Scotland’s fiscal balance end up being better than the UK’s by 2017-18.

Alternative scenarios are based on a variety of assumptions, many of which are open to debate. They all depend on a variety of challenging North Sea oil and gas assumptions in relation to the future levels of: production; prices; investment and costs. This results in a very complex equation from which to derive the level of North Sea revenues.

Assuming a cautious oil price for public expenditure planning purposes would be consistent with the Fiscal Commission’s view that: “An attractive approach in the short-term would be to plan the government’s spending plans on the basis of a cautious forecast of oil revenues produced by an independent fiscal commission.”

Even if North Sea revenues turn out towards the top of the range projected in the Scottish Government’s Oil & Gas Analytical Bulletin, it would not mean a return to anything like the level of revenues seen in the early 1980s. And many of the key factors determining North Sea revenues will remain outside the control of a future Scottish government, as they are currently for the UK government.

Such is the variability of oil prices, investment, operating costs and production levels, that the projections set out by the CPPR “should”, says McLaren, “be read as indicative only.

However, this only adds to the need for greater analysis of, and clarification of, existing arrangements and any alternatives to these arrangements, in order to help voters assess the pros and cons of independence leading up to the referendum vote.”

As the Fiscal Commission recommends, in the long term Scotland should aim for an onshore budget balance and allow most, or all, oil and gas receipts to be saved in an oil fund. “At present”, McLaren laconically concludes, “we remain some way from understanding how this might be achieved.”

Still fancy a crack at being chief economic adviser to John Swinney in an independent Scottish government? You have to construct revenue and expenditure projections over a rolling give year period to cover such major items as health, education, welfare, defence, police, justice and council spending and, oh, let’s not forget, our share of UK debt and annual debt interest.

Lying down in a darkened room begins to look by far the better option.