Wishin' don't make it so

Last week oil reached US$96.88/bbl for West Texas Intermediate Crude. The month of October averaged US$86.22/bbl. By the time you read this, it may already have spiked the psychological threshold of $100/bbl. This is a very different from the forecasts of the Treasury, the Reserve Bank and the Ministry of Economic Development (MED), each of which follows a pattern of predicting oil prices have peaked, and will soon fall or at least remain stable.

Treasury forecasts oil prices every half year in the Budget forecasts. In the 2004 budget economic and fiscal update (BEFU), they predicted the price would now be around $26; in December that year they predicted $40 for late 2007. Each half year their predictions have started from a higher actual price and shown a rapid decline from that price to levels which bear no relation to reality today. Just this year, the BEFU expected we would be at $68 now rather than the November average of $95.

So for the past four years the government's budget and financial forecasts, their assumptions about transport costs and demand and the likely effect of import costs on our current account deficit have been based on wildly erroneous predictions of the price of the key input to our economy.

Graphically these predictions shows the actual price of oil in a near vertical slope and each half yearly forecast (except for the last) starting much higher than the previous one, but seemingly learning nothing from reality and after a brief plateau, heading determinedly south.

The Reserve Bank is into this game too, though because they use heavier Dubai crude as their benchmark, which is generally a little cheaper in US dollars, it is hard to compare them with directly with Treasury. However, they too always predict a decline in oil prices going forward, and unlike Treasury, they don't even demonstrate a modest improvement in forecasting.

Their December 2005 forecast for the end of 2007 was $40. The following year they noted it had risen "temporarily" above $70, but predicted that by now it would have fallen to $54-59. Just seven weeks ago, in its September monetary policy statement, the Bank said "we assume oil prices will stabilise around US$68, before trending lower from the beginning of 2008". The graph then shows a drop to $55 in 2010.

During this period monetary policy statements began to comment on rising oil prices as a driver of inflation. Could it be that one reason the bank has had difficulty controlling inflation is their failure to see rising oil prices as anything other than a very short-term phenomenon? Has their expectation that things would quickly return to "normal" prevented them from taking action when they otherwise would have? Of particular concern to the bank should be the effect oil prices have on all other prices, magnifying its inflationary impact.

The MED also forecasts oil prices. These are used for general government policy, and in particular, to inform the energy strategy.

The October 2003 energy outlook stated "the high price scenario assumes a price of US$25/bbl in 2004 that rises to US$30/bbl in 2020".

Unlike the other agencies they do not forecast the price peaking and dropping dramatically. The September 2006 energy outlook suggests in its "mainstream" forecast that oil will be stable at $60 until 2030.

MED's flat line may have influenced Treasury's latest forecast. It also seems likely the Reserve Bank and Treasury have shared notes and converged on $68 - though the bank continues to forecast falling prices. The great mystery remains is why all three of them are so comprehensively and repeatedly wrong.

There is one government forecast which has got it right over the last year but it is devalued as a "minority" view. In fact, in its 2006 outlook the MED produced two forecasts, which they described as follows:

"Specifically we assume a base case oil price of $60 flat to 2030." This is a bit lower than current and futures prices of around $70 as of this writing. However, it is well above the long-term view of most mainstream analysts.

An alternative high oil sensitivity case explores geologist Colin Campbell's prediction that conventional oil production peaks in 2008. In this case oil prices continue to rise steadily to US$120 in 2012.

When we look at the graph showing the "minority" high oil price scenario, we see actual oil prices are right on track for the peak oil scenario. Despite the price of oil showing its usual volatility, the trend line is obvious. It follows Campbell's prediction almost perfectly to date, although only time will tell how stable that trend is.

Campbell is a retired BP oil geologist with a lifetime working in the industry. His "minority" scenario noted by MED in 2006 is from then on ignored in all government planning, and by Treasury and the Reserve Bank. It is clearly the "mainstream" forecast which has informed the New Zealand energy strategy:

"However, while the demand for oil grows, the International Energy Agency (IEA) notes the world's proven reserves (including non- conventional oil) could sustain present production levels for 42 years. Rising prices will spur exploration and make previously uneconomic reservoirs of oil viable. Higher prices and other technologies will also prompt the extraction of liquid fossil fuels from sources such as gas, oil-rich shales and lignite. There are immense quantities of these non-conventional sources of oil, although extracting and using them will produce significant greenhouse gas emissions unless CCS (carbon capture and storage) is available."

There is no space here to explore the arguments that most unconventional sources will yield little energy compared to what must be invested to access them; that world gas production will also peak soon after oil and that if we convert coal to transport fuels even carbon capture and storage will not prevent runaway climate change because it cannot be added to the tailpipe of a vehicle.

It is pertinent, though, to pose some questions:

How much have the bank's erroneous predictions contributed to its expectations of inflation, and therefore its actions?

How much has Treasury's poor forecasting contributed to its repeated understating of the surplus?

If continuously rising oil prices are now structural, how will we manage our already huge current account deficit?

What effect have forecasts of cheap oil in the future had on plans to accelerate spending on new large roads, and on modelling the cost- effectiveness of fuel efficiency standards for new vehicles?

Is the job of government to avoid scaring the markets and the voters, or to start some serious planning for a different kind of world?