Blogs & Comment

Budget 2015 is highly optimistic about oil prices. The market disagrees: Mike Moffatt

The budget implies that oil prices will rise around 40% in the next two years. The options market says something else

Much has been made of the manoeuvres in Budget 2015 needed to ensure a small surplus. Through a combination of $1 billion from the sale of GM shares, a $2 billion reduction in the contingency fund and $1.8 billion taken out of Employment Insurance (a holdover from Budget 2014), the federal government was able to turn a modest deficit into a $1.4 billion surplus.  But even with those changes, ensuring the next few budgets are balanced may prove challenging, thanks to some overly optimistic economic projections.

The forecasted surpluses in the next three years are very modest, ranging from $1.4 to $2.7 billion; coupled with $1 billion per year in contingency reserve, there is very little margin for error if deficits are not an option. If the economy underperforms the assumptions built into the budget, the government’s fiscal position could deteriorate rapidly; we have already seen expected revenues for 2015-16 and 2016-17 decline by $6-7 billion per year since the Fall Economic Update (with some offset in reduced expenses), largely due to low oil prices. In a low margin-of-error environment, it would be prudent to make relatively conservative assumptions about future state of the economy.

However, based on feedback from some private sector economists, Budget 2015 assumes that oil prices will increase by nearly 40% over the next two years—a prediction not shared by the futures market:

Could oil prices increase at-or-above the rate projected by the government? Absolutely. But it is far from guaranteed. Furthermore, it is relatively easy to come up with plausible scenarios where oil prices stay flat or even fall, usually involving some combination of a slowdown in China’s economy and state-owned enterprises increasing oil production to make up lost revenue through increased volumes. If oil prices do not escalate, the government’s budget outlook will deteriorate in the billions of dollars, through a combination of slow economic growth and lower than anticipated inflation. And, unlike the government, the market is not predicting a substantial increase in oil prices—though there is no guarantee they are accurately predicting the future either. Speaking of which, if the government believes the market is dramatically mis-pricing the future price of oil, should they not be buying up oil futures to provide windfall profits to taxpayers?

If oil prices do not rise at the rapid rate predicted by the federal government, the spectre of deficits will return. This does not necessarily mean that low oil prices would guarantee a deficit, a government committed to balancing the books can ensure surpluses through spending deferrals or further raiding of Employment Insurance premiums, though those create their own problems. Given the optimistic oil price predictions in the budget, further tough decisions may be necessary in the future if the budget is to stay balanced.