21 March 2008

Toward a future that works: What goes up, must come down

The current increases in provincial government spending on built almost entirely on the phenomenal crude oil prices of the past few years.

Inflation is running at an average of 2% annually.  Provincial government spending will jump about 12 to 14% from this year to next (effective 01 April 2008), if the interim supply bill is any real indication and that is on top of similar increases in each of the past three years.

To illustrate this, look at the simple chart of revenues and expenses from the 2007 provincial budget speech.
Bear in mind that each of these columns represent projections only.  The experience in 2007 - the first column - has shown revenues significantly above forecast.  We'll know the actual expenditures in a couple of weeks when the budget for 2008 is tabled in the legislature.

The chart does indicate a general policy of government to keep its spending only slightly below anticipated revenues.

Before you click to another page because this is all old hat, consider that in 2003, oil was around US$25 per barrel.  The only people who predicted that within five years oil would hit US$100 a barrel within five years were either in an insane asylum, considered candidates for a straightjacket or part of a very small group of oil pundits who had been faithfully predicting predicting hundred dollar a barrel since the 1970s.  Eventually they had to be right, just like a psychic.

Ask around today and you'd have a hard time finding anyone who will tell you that we will see oil below US$50 a barrel in the near future either.

Odds are better, though, that oil will drop to US$50 and lower within the next decade.

Look around and you'll find plenty of oil experts who will tell you that the current price of crude oil is inflated by a number of factors, each or all of which will adjust  to usual trends.  There's a security premium in the price of as much as 20%.  There's a percentage attributable to the relatively weak American dollar. 

No one expects the American dollar to remain at its current value for too much longer.  Once the Americans come out of their recession, the dollar is likely to rebound, Alongside that will be a drop in oil prices.

As for the security premium, we are likely to see some changes there after the November presidential elections. No matter which of the current candidates wins, the change in administration will affect the markets.  If the new administration moves on security issues or looks like it will move to defuse some of the Middle East tensions, the price of oil will settle down to a price much lower than today.

Already, we've got oil heading towards US$70 a barrel and that didn't take much effort.

And already someone is nodding that $70 is bigger than $25 and so everything is fine.

Well, it might be fine, if the local oil supply was infinite.  The provincial government could take a boost and even a substantive hit if there were Saudi-type or even Alberta-type oil supplies offshore.

There aren't.

The chart at left is taken from a Wade Locke presentation on Equalization changes in the 2007 federal budget.  There are other versions of the slide but this one is readily available.

Notice that for the three working offshore projects, oil production hits a couple of peaks within a few years of each other and then gradually declines. Find 2008 on the timeline along the bottom.

This chart assumes no Hebron, but that really isn't important.  Even if White Rose cranks up in the fall of 2008, oil production won't start until some time after 2015.  It may even be closer than not to 2020.
Hebron won't add to production that is already booming;  it will simply fill in some of the white space - representing no production - that grows larger on the right hand side of the table.

At the same time, additional White Rose and Hibernia production fattens up and lengthens out the right hand side of he chart a bit, but it certainly doesn't keep production up at the peak levels.

The impact of those peaks on provincial revenues can be seen more readily in another Locke slide, right, from the same presentation. 

Again, Wade Locke has produced several similar versions of this chart but it all comes down to the same basic point. There's another set of slides in a 2006 presentation at Memorial University's Harris Centre.

Again, we have a sharp increase in revenues, a couple of peaks and then a drop off the back end.

Changing the assumed price of oil changes the height of the peaks but it doesn't change the overall picture. Even if we assumed some floating price at any given point in time - which doesn't change the perspective of using an assumed average oil price over time, as Locke does - the only way provincial revenue would continue at current levels, hit the anticipated peaks or actually grow would be if oil prices didn't fluctuate but grew steadily out beyond current levels.

It's a pretty simple idea.  If you make a given amount of money from a given  amount of oil, as the amount of oil drops, the only way to keep revenue up is to see prices increase for oil at the same pace as the oil quantities drop.

Sure, we could find lots more oil and gas and exploration may yield more large discoveries, but let's take a more conservative approach.  Let's work within the framework of what is commercially viable and either in production or coming into production within the next decade.

To get a sense of why current oil prices are out of the ordinary, take a look at this chart, left.  It compares prices, historically both in current dollar terms and in terms of constant December 2007 dollars.

In the first part of 2008, crude prices have already exceeded the historic peak oil prices from the 1970s. However, that doesn't mean that the historic trending must now go out the window.  Rather we should anticipate a drop in oil prices both in constant and current terms.

And just to really drive it home, bear in mind that Locke and others typically talk in terms of average pricing over time.  That's a reasonable, conservative approach.  Bear in mind though that if one assumes an average price of US$70 per barrel and oil hits US$100, then at some period, oil would have to drop below $70 by a proportionate amount - i.e. to something around US$40  - to make the average work. Averaging assumes price fluctuation and it is an historically sound approach.

The new provincial budget will be tabled in the House of Assembly within the next few weeks. That document will tell us the actual government performance in 2007 and it will forecast for the next year or three years.  If the past three years hold, the provincial government will likely boost program spending and other spending based on current oil windfalls.

That's a shaky foundation of course.

NAPE and other public sector unions may be looking for significant wage increases, along the lines of growth in overall government spending. The problem will come, as it likely will, since the wage increases are not one-off expenditures.  Adding another $100 million or more to the wage costs will come every year after.  That doesn't sound like much against a surplus of a billion dollars, but drop that billion dollars by 30% and add other increased costs and pretty soon, the annual spending could exceed revenues.

Increasing spending by something approximating the steep increase in revenues coming from one source and one can reasonably expect that the revenue and spending tumble down the other side will be just as sharp. 
The difficulty facing the current administration is that they have heralded their successes to such an extent that public expectation is for increased spending.  Public sector unions have been promised significant wage increases. Even prospective parents have been promised cash for producing children. 

Politically, they have painted themselves into a very tight spot.  How tight a spot depends entirely on the price of oil.

After all, what has gone up will, almost inevitably, come down.

[Techie note:  There are several charts mentioned in the text.  The links work, but for some reason the pictures cannot be uploaded (21 Mar 08).  We'll work to fix those as quickly as possible.]
Next: Toward a future that works:  Hebron and old people (coming).  The equity positions in two offshore oil projects significantly alter government's cash flows over a time when unavoidable spending pressures hit.
SoonToward a future that works:  a fiscal policy for responsible government.