Peter Jones: Slump exposes frailty of Yes fantasy

Oil prices may rise again soon, but to nowhere near the levels anticipated by the Yes Scotland camp. Picture: Getty

AS THE price of oil continues to hover at around $60 a barrel, almost half the $110 confidently predicted by Alex Salmond during the referendum, it becomes more and more clear that Scots are very fortunate that there was not a Yes vote in September. But are we also looking at something much bigger and potentially more serious – the bursting of what environmentalists call the “carbon bubble” – and which threatens a financial crisis?

According to the Financial Times, analysis by the Office of Budget Responsibility suggests that, at $60, Scotland’s oil revenues in 2016-17, the mooted first year of independence, would have been just £1.25 billion. This is about a quarter of the most modest yield of £4.7bn predicted by the Scottish Government in May, and a sixth of its most bullish prediction of £7.8bn.

If we take the mid-range prediction of £6.9bn, which was the figure used in independence campaigning, a newly independent Scotland would, at $60 oil, have found itself £5.7bn short on tax revenues, and looking at a public spending deficit equivalent to 6 per cent of national income.

If it had also become an EU member, it would also be facing EU demands to reduce that deficit by at least 3 per cent of national income, or by about £5bn. All the campaign fantasies of higher pension and welfare benefits, and lower tax bills, would have been exposed for the fantasies they always were, and the country would instead be looking at much worse austerity, not the promised escape from it.

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And these numbers don’t even factor in the cuts in offshore tax rates which are now vital to keep the North Sea industry alive, nor do they include the reduced tax revenues that will come from the industry’s employment cuts, or the increased welfare bill caused by rising unemployment.

All of the above are not Unionist scares, or Britnat lies, or establishment biases, but cold, hard facts. Why on earth some people think that there ought to be another referendum soon – and that this time Yes would prevail – is utterly beyond me.

Well, I suppose it might be argued that the oil price will rise again at some point, and perhaps soon. Maybe it will – the monthly Reuters poll of forecasters, published yesterday, found that the average of 30 predictions for 2015 was $74 and the average for 2016 was $80 – but that’s still some way short of $110.

All I would point out is that, in historical terms and in today’s prices, oil at more than $100 is the exception, having occurred in only eight of the last 40 years. High prices cause a massive inflow of investment built on hopes of cashing in on the high prices, but they also cause a big increase in supply which then depresses the price again, precisely what we are seeing now.

All that investment, however, might well be the cause of another looming problem. In recent years, environmentalists have been championing the idea that a “carbon bubble” has developed. The argument is that oil, gas, and coal-producing companies are valued according to the worth of the reserves they own and expect to produce. But if the world is to avoid catastrophic climate change, we cannot afford to extract and burn more than a third of these reserves.

Since world governments are becoming increasingly committed to meeting these climate change targets, it means that the current value of hydrocarbon producers is inflated, because two-thirds of their resources may not ever be produced. This is the carbon bubble. The question is if, and when, it might burst. If it does, then a great deal of value tied up in, for example, pension funds invested in oil company shares, is going to disappear.

A lot of increasingly sophisticated work has been done on developing this concept, which is being taken very seriously by some big investment funds. A very useful report on the work to date has been compiled by Scottish Environment Link and is available on its website.

I have some quibbles about some of the thinking, which I’ll explore in a future column. But I commend the report to readers; it is intended to stimulate a discussion which Scotland, especially those who work in investment management, needs to have.

In the meantime, it is entirely possible that the current oil price slump could provoke a mini-version of the carbon bubble burst that environmentalists are forecasting. A lot of the current oil supply glut has occurred because of the big increase in US shale oil production, to the point where US output now rivals that of Saudi Arabia.

Most shale oil production is not by the big majors, but by small independent companies. They have borrowed heavily, mostly by means of what are called junk bonds which pay high levels of interest because they are high risk. Some $90bn has been borrowed this way and is now at risk of turning into junk, hence the name.

Opinions vary about the risk of oil shale companies defaulting on those bonds and going bankrupt. The current price of US-produced oil is about $56, below the $65 threshold reckoned to be the break-even point for about half of shale oil production, but price isn’t everything that determines a company’s ability to repay debt.

Even so, some default looks certain and as a lot of these junk bonds have been leveraged with bank finance, some banks will develop balance sheet holes that could sink them in the same way that sub-prime mortgage lending turning sour did.

Most of these will be US banks, but, depending on the extent to which these loans have been securitised and sold on, the effect could be global. The Scottish Environment Link report notes that our own Royal Bank of Scotland is involved in financing a lot of unconventional oil projects, particularly those to do with Canadian tar sands which are just as vulnerable as shale to the oil price collapse.

Next year will see the extent to which these worries about defaults in high-yield energy bonds, which are about 15 per cent of the corporate junk bond market, become real – and the extent to which that impacts on the financial system.

Meantime, whether you are a Scottish voter or a billionaire investor, the lesson of 2014 is the same – dependency on high oil prices is complete folly.

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