A Letter to the First Minister

| 08/08/2014 | 4 Comments
We are delighted to welcome Professor Donald Mackay as a contributor among the distinguished economists who write for WN and explain why Scots should vote Yes on September 18.

This letter is from Professor Sir Donald Mackay, a leading expert on North Sea oil and gas ever since they came onstream in the 1970s.  He was chairman of Scottish Enterprise and an economic adviser to the Secretary of State for Scotland, including the last Unknownfour Conservatives to hold that post, George Younger, Malcolm Rifkind, Michael Forsyth and Ian Lang.  At that time he was a critic of plans to set up a Scottish Parliament, but now he intends to vote Yes in the referendum on September 18.

In this letter, Sir Donald critically examines the various projections for the production and price of oil in the period ahead.  He finds that the figures most used by the British government lie at the extreme lower end of the possible range, whereas the most likely outcomes are those higher up the scale, near to the level estimated by the Scottish government or, on certain assumptions, even above them.  In this case, there would be no danger from the North Sea to the public finances of an independent Scotland.

Dear First Minister

From 1974 I have been arguing that the development of the North Sea province would create substantial direct employment and income in Scotland.  In fact these impacts have been even greater than I anticipated.

The litmus test of public policy is that before these oil and gas reserves are exhausted, some part of the North Sea tax revenues should be used to restructure the supply side of the Scottish economy – particularly industrial, manufacturing and tradable services. This has not happened, but before we rush off to blame Mrs Thatcher again we should recognise that this problem was evident long before her time and that the record of the last Labour administrations was at least as bad, in arguably more favourable circumstances (see the Financial Times, December 24, 2013).

The macroeconomic framework

I begin with the macroeconomic framework which an independent Scottish Government would face and suggest that its fiscal position from 2016 would be very much strengthened by the likely future path of North Sea output and tax revenues. Scotland has operated within a monetary union since 1844, with the Bank of England as the central bank.  Most economists would recognise that the UK is an optimal currency area.   As Anton Muscatelli observed (Financial Times, April 2, 2014), a single currency would benefit both the UK and Scotland: `The most damaging prospect to the rest of the UK from rejecting a sterling currency union is what it would do to its own trade and business activity.’

Fiscal policy within a monetary union would have to be based on symmetric rules for budget deficit and debt sustainability.  Under a Conservative administration in Westminster after 2015 this would require a sustained period of prudence until the UK national debt level had achieved a sustainable level. T he Treasury’s basic premise, that an independent Scotland in 2016 would inherit a chronically weak fiscal position, is unsustainable.  It would be easier for Scotland to live within the fiscal rules, because the likely future direct and indirect impacts of North Sea oil and gas would be much greater than the Treasury suggests.

The forecasts differ

First, the arithmetic. The  table below shows the estimated “geographical share” (90 per cent) of North Sea tax receipts which would accrue to a Scottish government.  There are six forecasts based on differing assumptions of output (o) and prices per barrel( p). The $110 is the price per barrel used by the Scottish government in all its recent estimates.  The other data are taken from the Office of Budget Responsibility, Oil & Gas UK and the Department of Energy and Climate Change.

The first striking thing is the huge difference in the estimated tax revenue between the outliers.  The OBR is the low outlier in both output and price terms, and forecast number 6 is very much an outlier in price terms. The DECC prices are taken from its central scenario, best described as its `best guess’.

OBR forecasts

I begin with the OBR.  Its output forecasts are produced by DECC and assume that output will decline by 3 per cent between 2013-14 and 2014-15, remain static between 2015-16 and 2018-19 at 1.4 million boe (barrels of oil equivalent) before falling further by 10 per cent over 2018-2020. The OBR would have benefited from my statistics lecturer whose favourite dictum was that `extrapolating for a long period without thinking will soon make you look ridiculous’.

We don’t need to do any serious extrapolation to arrive at sensible estimates of what output is likely to be over the period to the end of this decade.  In February 2014, the Wood Review concluded that `production hit a new low …..last year (2013), but  a number of  larger new fields are about to come onstream in the next two or three years, and that could take production back to the level of two to three years ago  where it could be sustained for the remainder of this decade’.  The text tells you that Sir Ian knows which fields will be producing in the forward period and what their production profiles are likely to be, together with similar information about those which are planned to come onstream  or be shut down.  Oil &Gas UK’s central forecast is that output will increase by 14 per cent between 2013-2018 to reach 1.7million boe a day, which I have taken forward, as it arrives in much the same place as the Wood Review.

The OBR is also hopelessly at sea when it comes to forecasting the price of oil.  It started well, in 2012, when a member of its main steering committee admitted that `forecasting oil prices, as anyone knows, is a mug’s game.  It then joined the mugs by explaining that `our oil price forecast moves in line with the average of futures curve over the ten working days to February 27, 2014, for the next two years, and is then held flat at that level for the remainder of the forecast period’.   I confess that 27 February is my birthday and I had to suppress a fit of the giggles. Then I realised that anyone deluded enough to take this seriously was quite capable of inflicting serious damage on an unsuspecting public.

I have a limited understanding of the futures market as a director of a small oil business 30 years ago.  Nobody at that company would ever have thought  that the futures curve could be used to produce accurate forecasts of the price of oil at some future date.  Professor Alex Kemp, the official historian for North Sea oil and gas, has informed me that historically future prices have not been an accurate predictor of subsequent oil prices.  Often, even the price direction indicated by the futures curve has turned out to be wrong.  He has a diagram to prove his point!

A brief search of the internet led me to Liz Bossley, the CEO of Consilience, whose book Trading Crude Oil is regarded as the textbook on the subject. She is an economics graduate of Glasgow University and a living exponent of the robust commonsense which characterises so many of the alumni of that ancient institution.  I have asked her to forward a copy of her book to you and have chosen two quotes from it:

“The forward oil price curve is not a forecast of what oil prices will be at some future date.  Instead it is a snapshot taken at a particular instance of time of the prices at which buyers and sellers are actually prepared to deal at that moment in oil for delivery at different dates  in the future.’

The most compelling reason for not using the OBR approach is that oil companies do not use this methodology for forecasting oil prices. Here Liz added the comment that `the forward curve is only reliable for the instant in time you use it.  The next day it can look completely different.’  Enough said!

DECC forecasts

The second quote from her book is: `Companies exposed to the price of oil have to have a view on likely future oil price movements,  usually spelled out in its  scenario plan as a high, low and base case assumption…’

This is the approach adopted by DECC.  Its central (or best guess) scenario is an oil price of $128 by 2018, this being $29 above the OBR forecast and $18 above the Scottish Government forecast.  I discount the DECC high scenario on the grounds that it seems unduly high and carry the best guess scenario through my calculations. If the high scenario was to come right, please set up a sovereign oil fund to ensure that you do not use the revenues on matters unrelated to the need to restructure the economy.

Oil & Gas UK forecasts

My best guess scenario is based on the Oil & Gas UK forecasts and  I have adopted the Scottish government’s price assumption of $110. This is closer than the other estimates to the average annual price of Brent crude these last three years.  DECC has noted that the annual price of Brent crude has been much more stable than has been the case in many past periods and economists tend to stick with stability rather than indulge in mindless extrapolation!

This approach takes the views of those closest to the industry in estimating output (Oil & Gas UK and Ian Wood) and a future oil price which is appreciably lower than the best guess price of DECC.  On this basis it would yield estimated Scottish Government tax revenues over  2014-15 to 2018-19 which are close to twice those of the OBR.  I would suggest that this scenario is likely to pass the Keynesian test of being `roughly right’, while the OBR’s forecasts are likely to be `precisely wrong’.

On this basis a well prepared Scottish government would be able to implement the main supply side reforms contained in your white paper and fund that process within the fiscal limits which would be imposed by symmetric fiscal rules.  As for Project Fear, I am sure you will make good use of the words of the American president who said, in the depths of the deepest recession ever faced by his people, that `the only thing we have to fear is fear itself’.

Yours aye,
Donald Mackay

220px-AlexSalmond_2007-Cr

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Category: A Vision for Scotland, Independence, Our Economy

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Comments (4)

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  1. Douglas Robertson says:

    We are about to vote on the long term success of a nation. One industry, and a declining one at that, is not the basis for a decision. There are as many questions as answers in Sir Donald Mackay’s comments and that is the problem. Voters need knowledge over a wide range of industries, social issues etc.etc. to have confidence in placing their vote.

  2. Alan Smithee says:

    What about post 2018 oil revenues? This seems a bit short-termist to me

  3. Phillip Rice says:

    Why has no one mentioned shale gas? It offers a case for lower Brent oil prices and a different mix of where production comes from. This extra supply alters all the economic forecasts and has been so significant in restoring medium term US oil and gas self-sufficiency. The recovery in the US oil and gas industry has driven down US oil prices from the European levels. The Brent premium to the US oil price is the critical factor. The scenario is : it could drop 5 $/bbl. Such a collapse occurs when exports from US are free to flow. The shale oil and gas story is many-sided but it does aďd more risk to the North Sea prices forecasts on the downside. Surely a lower price scenario driven by shale ought to be included. Maybe this downside is being ignored by the optimism of the Yes economists.

  4. Gavin Kennedy says:

    At last some sense about toward prices of an internationally credible oil price, all well ‘caveated’ as one expects from Donald.

    The ‘NO’ chorus is ‘validating’ their understatement of a secular declining oil tax revenue from Scottish oil by constant repetition only; this needs as constant a response from the more likely figures shown by Donald.

    ‘No’ bases its figures on quasi-government sources; Donald uses oil experts economists in the field. That oil exploration investment has risen recently suggests that oil companies are far more optimistic.

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