Oil & Gas revenues – separating truth from fiction

Oil & Gas revenues – separating truth from fiction

by Greg Williams
article from Tuesday 10, June, 2014

OIL REVENUES are a fickle, vacillatory thing. They go up, they go down, and a lot of the time you can’t control why. There’s a reason why the companies who produce it are called explorers. 

Sometimes you spend £100m drilling a well and you find oil, sometimes you don’t. You can build a new, multi-billion dollar platform, but a six inch pipe plumbed incorrectly can bring your platform to the point of capsizing. It can take months to fix things because you’re hundreds of miles away from dry land. Sometimes a war breaks out and the price of your commodity doubles. A couple of years later the world economy falls into recession and your value of your livelihood halves. Oil revenues are whimsical and as such notoriously hard to forecast.

This variability is of critical importance in the independence debate. Scotland is currently dependent on oil and gas for approximately 10% of its tax revenue.[Footnote 1] In relative terms, that’s about the size of the education budget, or twice the schools budget. It matters to both the Scottish Government, observers and perhaps more than few voters in terms of how Scotland’s financial accounts look – it’s the different between having a budget deficit of 7 per cent of GDP, or running a surplus. As a reference point, one would need to have a deficit of below 3 per cent of GDP to be deemed sufficiently stable to join the Euro.

Recently the Scottish Government released their most recent forecast: The Oil and Gas Analytical Bulletin – May 2014. This document went on to underpin the First Minister’s big reveal, in a fiscal paper entitled Outlook for Scotland’s Public Finances, a claim that Scotland will be in a better fiscal position than the UK as a whole in the first year of independence. Here I’ll examine the Bulletin’s forecasts and consequently the validity of the overall claim in Outlook.

The Bulletin comprises six different scenarios as below, each incrementally more ambitious in terms of revenue generated. The Scottish Government’s Outlook paper utilises Scenario 4, so we will consider the build up to that point.[2]

Scenario 1

“Scenario 1 applies the assumption that Scotland accounts for 90% of future North Sea tax revenue to the North Sea projections published by the Office of Budget Responsibility (OBR). This is Scotland’s average geographical share of tax receipts over the last five years. Cumulative Scottish North Sea receipts between 2014-15 and 2018-19 under this scenario are projected to be £15.8 billion.”[3]

Straight away we have to consider the veracity of the 90 per cent figure. It’s the average of the last five years, but not in line with the recent historical trend, as the Government Expenditure and Revenue 2012-13 demonstrates:

It is also more generous than the share of oil revenue in the previous decade. Professor Kemp of Aberdeen University, whom the First Minister regularly likes to quote in hydrocarbon matters, points out in a previous analysis that the range of 80 to 88 per cent was the norm in the first decade of the 21st century.[4] It would therefore by more prudent to say that a share of 86 per cent is an appropriate estimate on which to base one’s finances. This gives a revenue forecast of £15.1bn over the period 2014-15 to 2018-19, a reduction of £700m from the Scottish Government’s estimate.

Scenario 2

Building on Scenario 1,

“Scenario 2 assumes that oil prices remain at $110 in cash terms in future years. It also assumes that future production follows the central path projected by Oil and Gas UK. This would result in output rising by around 14% by 2018. All costs are assumed to increase, relative to the levels forecast in Scenario 1, in proportion to the increase in production. Under this scenario, North Sea production in Scottish waters could generate approximately £24.0 billion in tax revenue between 2014-15 and 2018-19.”[5]

This scenario is tricky to examine, because unless I have missed it, we don’t know what costs per barrel of oil extracted the Scottish Government is using – the first critical component of tax revenue per barrel. The second element is of course the price of the product. Much has been written on how valid a target of $110 a barrel is already, so here I will just draw attention to the forecasts of the World Bank at $97/ barrel and the IMF at $87/ barrel by the end of the decade.[6] The Bulletin’s Scenario 2 stands out for its optimism.

We must also test the statement that ‘all costs are assumed to increase…in proportion to the increase in production.’ Earlier this month, the Scottish Government released an update in its oil and gas statistics as part of the Scottish National Accounts Project (SNAP).[7] Their own data proves the assumption not to be the case, as per graph below:

So rather than costs increasing in proportion with production, they do the inverse. Considering this is the Scottish Government’s own data, and they are quoting Oil and Gas UK (OGUK) forecasts that production is to increase over the next five years, I am surprised they haven’t claimed that production costs will decrease going forward, rather than increase.  Again, without seeing the Scottish Government’s workings we can’t truly understand this or recalculate a more realistic revenue forecast. However the credibility of their figures is undermined if their own data contradicts a core assumption that underpins it and belies a misunderstanding of the key issue the oil industry is currently grappling with. Only in an Orwellian dystopia can an empirically proven inverse relationship be construed down the corridor of St Andrew’s House as a directly proportional one.

Scenario 3

Scenario 3 recognises that exploration, appraisal, and investment costs may not directly relate to the level of production in a given year. If these costs were not affected by the increase in production assumed in scenario 2 (but production costs still increased in line with output) then this would increase profits and in turn tax receipts. Under this scenario Scottish North Sea receipts between 2014-15 and 2018-19 are forecast to be £31.4 billion.[8]

In layman’s terms, the Scottish Government are saying here that the costs of finding the oil (exploration and appraisal, or E&A in oil tycoon speak) do not necessarily increase in line with the number of barrels produced, as they asserted happens to production costs in Scenario 2. That, in my opinion, is a fair judgement. E&A activity is mainly conducted off mobile drilling rigs, whereas production is off fixed platforms. The two activities have different cost bases.

We can assume when it is claimed the E&A costs do not increase with production the Scottish Government held them flat. Is this tenable?

Unfortunately for the Nationalists, the data in same publication from OGUK which they rely upon for the more optimistic production estimates paint a picture of rising E&A costs [9]:

It is no surprise that we have seen a marked increase in E&A costs, as rates for the rigs doing the E&A activity are reaching historical highs at the $400,000/day mark. Even if they decrease in two or three years times as some analysts are starting to forecast, it is very unlikely that E&A costs will be flat or move downwards over the next couple of years, as there is normally a year plus lag between a rig being contracted with the rate reported, and the rig then drilling the E&A wells at that rate. E&A costs are thus likely to increase further as the rigs in the North Sea roll onto more expensive contracts in 2014-16, and since E&A costs are tax deductible, tax revenues will be eroded as a result, drawing the £32.4bn projection in Scenario 3 into considerable doubt.The data show us that E&A costs are on an upwards trajectory, not a flat or downwards one. The costs of finding more oil are increasing, and the reason for this lies in the market rates for those drilling rigs. Again, OGUK provide the data [10]:

Scenario 4

“Scenario 4 combines the assumptions about oil prices and production outlined in Scenario 3 with the projections for future investment published by Oil and Gas UK. Under this scenario Scottish North Sea receipts are forecast to be £34.3 billion between 2014-15 and 2018-19.”[11]

What are these projections for future investment? We can see from the Bulletin’s own graph that OGUK forecasts lower investment over the period in question than the OBR:[12]

And as year one capital investment is tax deductible in oil and gas production, lower investment should yield higher tax revenues, all other things being equal. Indeed, the Scottish Government state that the lower investment expected by OGUK rather than that predicted by the OBR over the five year period would yield an additional £2.9bn in revenue. Again the full calculations are not disclosed, so we cannot directly challenge the math, but we can interrogate the logic.

Basically speaking, a high oil price attracts high levels of investment, because a high oil price means higher profits. So if one is forecasting oil and gas investment, one would expect a forecaster to either predict high prices and high investment, or low prices and low investment. It would be rather innumerate and illogical for a forecast to hold a pessimistic view of the oil price yet an optimistic view of investment expenditure.

Yet this is exactly what the Scottish Government are accusing the OBR of doing. At the start of the Bulletin, in Scenario 2, the OBR are held as a bunch of pessimists: too negative in terms of the oil price assumptions. In Scenario 4 however, the OBR are too optimistic: too positive in terms of the amount of money oil and gas companies want to invest in Scottish waters. Well, which one is it? Have the OBR mastered sub-conscious cognitive dissonance, or are perhaps the Scottish Government picking and choosing whichever the particular projections suit their argument? Given what we’ve seen here, and especially if you’ve read the sister paper to Bulletin as well, the macro-economic Outlook, one would be inclined to think the latter.

Summary

We can conclude by stepping back and looking at what the SNP are asking the people of Scotland to believe concerning the oil forecasts which underpin their overall fiscal projections. They assert that:

  • Scotland’s share of UK oil revenues will be at a relative historical highs rather than norms, and
  • The oil price will be higher than oil companies and other governments plan for, and
  • Exploration and Appraisal costs will reverse their historical trend, and
  • The statistics produced by a couple of desks down in St Andrews House are wrong, and
  • The OBR’s forecasts are wrong because the body is engaged in a classic piece of double-think, holding both excessively positive and negative views in the same breath.

The amount of logical leaps required here feels like a cross between the Krypton Factor and Total Wipeout. Much more believable is that the Scottish Government has comprehensively over-estimated the revenue it can expect from oil and gas to suit its political purposes Again, without the disclosure of the spreadsheets that sit behind their forecasts, it is difficult to pin down the monetary impact of their over-exuberance. However for argument’s sake, let’s assume that the more conservative Scenario 2 is a realistic assessment of oil and gas revenues. As per the table at the top of this article, that would yield £10bn lower oil revenues than the Scottish Government has banked with Scenario 4 over the period 2014-15 to 2018-19.

In the first year of independence 2016-17, the more realistic Scenario 2 revenues are £2.2bn lower, which would drive up Scotland’s net fiscal balance to -£7.8bn, or 4.9% of GDP:[13] critically for the Nationalists, worse than the UK’s position, no matter whether you apportion debt on a population or since-we-found-oil share. And the oil revenues being excessively optimistic if we are being generous, or manipulated if not, makes Outlook for Scotland’s Public Finances wrong by the time one gets to the third paragraph.

The assertion ‘we’re better off on our own’ becomes the empirical ‘we’re better off in the UK.’

Greg Williams works in the oil and gas industry in Aberdeen. His views are his own.

 

1 Government Expenditure and Revenue: Scotland, 2012-13.

2 Table taken from Oil and Gas Analytical Bulletin – May 2014, p. 13.

3 Bulletin, p. 12. 

4 http://www.scotland.gov.uk/Resource/Doc/133434/0061924.pdf, p. 34. 

5 Bulletin, p. 12.

6 http://knoema.com/yxptpab/crude-oil-price-forecast-long-term-to-2025-data-and-charts 

7 http://www.scotland.gov.uk/Topics/Statistics/Browse/Economy/SNAP/expstats/oilandgas/OGM2013Q4

8 Bulletin, p. 12. 

9 OGUK Activity Survey 2014, p. 40. 

10 Ibid, p. 22.

11 Bulletin, p. 12.

12 Bulletin, p. 12.

13 Calculation for the year 2016-17 based on: 9.3% share of total UK expenditure, as forecast by the OBR, = £69.8bn. Total Scottish revenues excluding Oil and Gas of £57.3bn (Forecast, p. 17). Scenario 2 oil revenues of £4.7bn Net deficit of £7.8bn Scottish GDP estimate of £158.6bn

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