Sunday, 30 October 2016

Balances and North Sea Exports

Two things bugged me about the last post and, as with many important points made in writing, they received attention only in the two footnotes. After a bit of reading around I've managed to assemble some data on exports of oil and gas from the North Sea industry and outflows from the Scottish economy to the foreign sector. I'd recommend reading the previous post if you're not acquainted with the concept of sector balances.

About 80% of North Sea production is currently in waters that are closest to the Scottish coast and it's thought by most commentators that this geographical share would belong to Scotland if independent. So it's interesting to consider how the balances presented previously change if this geographical share is included.

With the caveat that there are significant uncertainties involved — and it could be several billion pounds either way* — here is my attempt to construct these balances.

Balances with North Sea (wNS)
To save flicking back and forth, here's the onshore version of this graph from the previous post. For brevity, I'll refer to the one above as wNS (with North Sea) and the one below as onshore.

Balances - onshore only

The two graphs are obviously quite different. The main difference is that the onshore version shows a large but fairly constant trade deficit (the blue foreign sector balance is positive), whereas the wNS one has a smaller and more volatile trade surplus. This is because North Sea exports have historically been very large and variable.

The public balances in the wNS graph are smaller than those in the onshore graph because of North Sea tax revenues which are (mostly) levied as a percentage of profits. In the boom years this led to wNS public balances being improved by £10 billion or more over onshore balances. Following the oil price drop in 2014/15, profits and so tax revenue sunk to almost zero. For 2015-16, the wNS public balance was improved by a miniscule £0.06 billion over the onshore balance.

A crucial point to appreciate is that although exports have also fallen with oil price to about half of their 2008-09 peak, they remain substantial and nowhere near zero.

The bulk of the flows into the Scottish economy from North Sea exports are into the private sector, and so the wNS private balance is large and highly variable. Note though that both graphs show the private balance expanding in response to the 2008 financial crisis due to a desire to save money when faced with an uncertain future.

The wNS private sector balance is overstated because some of it is sent to the foreign (private) sector to pay foreign employees and owners of North Sea companies (called factor income). For 2010 this amount was estimated to be £7.8 billion, of which £5.4 billion was related to North Sea activity. Unfortunately this is rather uncertain and estimates are not available for any other year.

The result of removing this from the private sector and adding it to the foreign sector balance is shown in the 2010-11* column at the right of the wNS graph. This makes the foreign sector balance zero and so according to the identity introduced in the last post, the private and public sector balances must be equal and opposite. (Another way of stating this would be to say that the current account balance of Scotland is zero.)

Although we can only correct the graph for 2010-11, we can use that correction to make a rough prediction for following years. North Sea exports have decreased since 2014 due to the fall in oil price. So if the actual wNS foreign balance was about zero a few years ago, it is almost certainly positive now, meaning that it constitutes a net outflow from the Scottish economy (i.e. a current account deficit).

In other words, in recent years, and likely for years ahead, we would see the wNS graph looking more like the onshore one with blue and green bars being positive and the red bar negative. Although the red bars would be about the same length on both graphs (North Sea revenues are near zero), the wNS graph would have shorter blue bars than the onshore graph but larger green bars meaning a larger private sector balance.

The last post concluded by pointing out that trying to reduce a fiscal deficit must entail reducing one or both of the private balance and trade deficit. This conclusion still holds true but as the trade deficit would now be relatively small (perhaps a few billion), it seems more likely that the private sector would bear the brunt.

Currency conundrum

A fascinating (and concerning) conundrum arises if Scotland were independent. It would be composed of two interlocked economies:
  • an onshore economy closely tied to rUK with a trade deficit (net importer)
  • an offshore petro-economy that's a net exporter.
And these two economies pull the currency choice in two different directions.

The onshore economy that's tied to rUK would benefit from using the pound, but an exporting oil economy would require Scotland to have its own currency that could respond to the volatile oil price and perhaps also fluctuations in the exchange rate with the US dollar in which oil is priced.

Quite how that square could be circled is a subject for another post, but if you've a thirst for more detail I recommend reading what Angus Armstrong wrote in 2013 and Ronald MacDonald's 2014 paper (full of typos I'm afraid).

Both these articles were written before the 2014/15 fall in the oil price and the Brexit vote. Rather than render their arguments out of date, these events make them seem all the more vivid as they highlight the importance of currency.

There's a fundamental reason why I think considering sector balances is important, but I'll leave that to a third and final (and shorter!) post.

*Uncertainty, complexity and technical details

The easy, or at least easier part is the net fiscal balance. Data on this including a geographic share of North Sea revenue is given in GERS.

Firstly, all the trade data, even with the onshore economy, should be regarded as quite uncertain. In the worst cases I've noticed revisions between quarterly publications of the Scottish National Accounts of as much as several billion pounds (e.g. compare imports-exports between 2015Q4 and 2016Q1 editions).

Unfortunately, the data on trade of North Sea oil and gas is both more complex and even more uncertain. In 2013, the Scottish Government published an experimental analysis of this for 2012 (though the news article about it on the Scottish Government website was deleted in the last five days for reasons unknown), and has since provided an updated report that gives data for the years 2000 to 2014. Although very interesting, it's not possible to simply add the North Sea trade data to the trade data from the onshore quarterly national accounts because the latter includes imports and exports between the North Sea region and onshore Scotland (see pages 18 and 19 of the report for more detail).

However, drawing on a graph given in Armstrong and McCarthy (2014), with a sense check against the Scottish Government updated report, I was able to estimate the trade balance as shown in the blue bars of the wNS graph. Unfortunately, this data set was by calendar year whereas the GERS net fiscal balance is by financial year. Ideally this should be corrected if quarterly data is available, but given that calendar and financial years differ by only one quarter, the error involved (about 5%) is probably dwarfed by the larger uncertainties.

The net factor income adjustment comes from the Scottish Government's attempt to estimate Scotland's Gross National Income or GNI for 2010. The GNI is similar to GDP except cash flows to foreign employees and owners are included. This work tells us that GNI is about £7.4 billion less than GDP for Scotland because that amount is flowing out as what's called a net factor outflow. Armstrong and McCarthy (2014) also estimate a further transfer overseas of £0.4 billion which gives the £7.8 billion figure mentioned above.

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