Budget 2015: delayed by the drop in oil prices, so let's examine oil prices!

Ted Hsu
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wti_jan_15Finance Minister Joe Oliver delayed the 2015 budget for two months until April 2015 because of the sharp drop in world oil prices. Every $1 decrease in oil price means $150 million in revenue lost to the federal government. So you’d think that, to be careful, the Conservatives would want to use a solid estimate of future oil prices.

Here are the future oil prices (West Texas Intermediate,US$ per barrel) that the Conservative government is using in Budget 2015 as it forecasts rising surpluses in the next few years:

2015: $54, 2016: $67, 2016: $75, 2018: $78, 2019: $78

Now, in the past, Scott Clark and Peter DeVries say that the Finance Ministry used to assume flat oil prices over the five year planning horizon. Clearly, the Conservatives have chosen to use more optimistic prices (supplied by a survey of private sector economists).

Now, there is some sense to this. One reason for the low spot price of oil is that facilities available to store oil are in short supply. People would rather not have crude oil right now becauses there’s nowhere to put it. But, there is a place to find out what effect storage has and what a reasonable future price for oil is. That is the in the global futures market for crude oil which is determined by producers and consumers of oil around the world. Here are the June futures prices as observed at the close on April 21, 2015, budget day (I grabbed them from the Chicago Mercantile Exchange web page):

2015: $56, 2016: $62, 2017: $64, 2018: $66, 2019: $66.

A couple of years out, they are significantly lower than the private sector economist forecast used in the budget.

Now why should we use market prices for crude oil instead of private economist forecasts? Well, first of all they are lower, and therefore it is more prudent to use them (remember the Finance Ministry used to assume flat, not rising, oil prices). But much more importantly, those economists do not have to put their money where their mouth is. They don’t have to buy if the market price is lower than their prediction. By contrast, the futures market is the place where real business risks are hedged by buyers and sellers of oil, where supply and demand figure out what price they are willing to meet at.

If there’s one thing you learn right away from working in the financial and commodity markets it is this rule: “You are not smarter than the market”. Joe Oliver, former investment banker, should know that!

Budget 2015’s projections of surpluses out the next five years are therefore not on solid ground. Remember that the Conservatives are relying on these surpluses to trigger  and pay for tax cuts such as doubled Tax Free Savings Account contribution limits, and new income splitting for couples with children (which by the way, tend to benefit wealthier people a lot more than everybody else).

As a final note, I draw the reader’s attention to table 2.4 at the end of chapter 2 of the budget, in a section called Planning Assumptions. The risk adjustment to estimated future GDP was decreased relative to the fall 2014 economic update — further reason to have less confidence in the government’s fiscal prediction (a.k.a. hopes).

Update April 23: Mike Moffat, UWO economist, has written the same thing in MacLean’s:

http://www.macleans.ca/economy/economicanalysis/joe-oliver-is-more-bullish-than-energy-traders-about-oil-prices/

Update May 8: I asked a panel of top bank economists whether this problem was a big deal. These folks would have been amongst the “experts” consulted by the federal government. The answer I got was pretty interesting. I was told that if the government overspent, trying to balance the budget on overly optimistic oil prices, that would be not so dangerous. The reason is that, if oil prices indeed went up, that would agree with the budget assumptions. If they did not go up, then presumably our economy overall would have slowed, and then running a small deficit would not be so bad for the economy! Clever, but I would bet that the government did not plan it that way!