Peter Jones: The hazards of going with the flow

External factors combined with costs based on 2012 figures have pumped up oil figures. Picture: Getty

REGARDLESS of whatever horror story the nasty unionists might hurl at the independence seekers – no sterling union, spending black holes, pensions time-bombs, etc – Scotland will still be sitting on a comfy nest-egg of £1.5 trillion worth of oil, so no worries. Right? No, wrong.

Oil, and its value, has become extremely important to the independence project. A recent Centre for Public Policy for Regions projection which, while it was disputed by the Scottish Government, was not challenged with alternative numbers, used recent UK and Scottish Government data and Office of Budget Responsibility forecasts to set out Scotland’s likely fiscal position in the years up to 2018-19.

It predicted that in 2016-17, Scotland would have an onshore fiscal deficit of £12.2 billion, or 8 per cent of GDP. This compared to a projected UK deficit of £48bn or 2.6 per cent of GDP. This much worse onshore Scottish deficit has been a historic fact of life.

In the years up to 2011-12, the addition of Scotland’s likely share of North Sea revenues reversed this difference so that Scotland’s likely deficit was better than the UK’s. Now it is worse. But won’t the £1.5tn asset make it better?

Assuming that Scotland takes a share of UK debt, and not one single serious commentator has doubted that, neither does the Scottish Government dispute it, then Scotland’s onshore deficit in the independence year would have to be reduced by about £8bn to match the UK deficit.

Can oil revenues do that? If there really was £1.5tn of oil wealth waiting to be scooped up, then it would be no problem. This figure is, however, end-of-the-rainbow stuff from Oil and Gas UK, the industry’s trade body. The organisation has stated that “there is still a significant resource of some 15bn-24bn boe (barrels of oil equivalent) left to be developed”.

If you take the 24bn, multiply it by $100 (which as Alex Salmond likes to say is a “conservative” estimate of the likely price per barrel) and then assume an exchange rate of $1=63p, then you come up with £1.51tn.

The first thing to note is that this does depend on a favourable $/£ exchange rate. Yesterday’s rate on the foreign exchanges was $1=60p, which reduces the final sum to £1.44tn. If the rate was to slump to $1=50p, which is what it was six years ago, then the final sum drops to £1.2tn.

Incidentally, inside Mr Salmond’s desired sterling monetary union, Scotland would have no control over this exchange rate. So if the UK government mismanaged it badly, it could have a calamitous effect on Scotland’s public finances.

Well, you might say, so what, it is still a huge number. Indeed it is, but it is also a number for the entire UK Continental Shelf. About 10 per cent of the resource lies in English and Welsh waters. Deducting that brings £1.5tn down to £1.35tn, or £1.2tn down to £1.1tn.

Still big numbers, but they assume that the black stuff comes out of the ground at no cost. Of course it doesn’t. The costs are not just big, but escalating at a rate far outpacing onshore inflation. Oil & Gas UK said in the February activity report that costs had escalated by 15.5 per cent during 2013, but production was 8 per cent lower than in 2012.

In 2013, the trade body reckoned that adding up existing oilfield production, sanctioned new oilfield projects, and plans which have some prospect of going ahead including some deemed to have a less than 50 per cent chance, then the total resource which is likely to be developed is 11.4bn boe.

If you do the above sums on this figure, then the total gross value that will be extracted is between £513bn (at $1=50p) and £650bn (at $1=63p). Of course, said Oil & Gas UK: “If the 11.4 boe in companies’ current plans are to be realised, around £300bn (in today’s money) will be required.”

This is made up of £100bn of capital spending, £160bn of operating expenditure, and between £35bn-40bn in decommissioning costs. This was estimated last summer, before the current rate of offshore inflation had become known.

Its latest activity report also says that cost rises will continue in 2014. So it is quite reasonable to assume a further 20 per cent inflation to reckon that in 2015 costs, the extraction cost of 11.4bn boe will be more like £360bn, or £32 per barrel. If we subtract that from the gross values, then the net value to be gained ranges between £150bn and £290bn.

Sure, there are another 12.6bn barrels that might be produced. Believing that they will, however, is more an act of faith than rational economic expectation. The oil lies mostly in fields which have yet to be discovered, and which are reckoned to be small and therefore expensive to develop.

Oil & Gas UK thinks that to get all the 24bn boe out will cost between £600bn-1,000bn, which was estimated in 2012 money and costs, and therefore now looks conservative.

Rapidly rising costs plus oil price and exchange rate uncertainties are already making some prospects, which seemed good a few years ago, now highly marginal.

Last November, Chevron and Statoil postponed for a year decisions to invest a combined £10bn in fields with a total 490 million boe recoverable. At a cost of £32/boe, these fields could yield a handsome-looking net taxable value of £14bn.

But the companies said they needed to reduce the costs. That’s because for the value of their investment, they can get better returns elsewhere in the world where there are easier and less expensive conventional fields to exploit, never mind US unconventional oil in which both companies are investing.

Oil companies will put their investment where they get the best return because that minimises price and exchange rate uncertainties and hence maximises profits, which is what they are in business to make.

The lesson is clear. The idea that an independent Scotland would have a £1.5tn asset is a dangerously misleading fantasy. What matters for Scotland’s public finances is the net value, because that is what taxes are levied on, and the net value could be as low as a tenth of that figure.