COLUMN-UK government over-estimating future fuel prices: Kemp

Wed Jul 17, 2013 9:12am EDT

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, July 17 (Reuters) - Britain's government is basing its policy recommendations on outdated and unrealistically high projections of future fossil fuel prices - which could be causing it to over-estimate the cost of imports and threatening to skew cost-benefit analyses of alternative policies.

The Department of Energy and Climate Change's (DECC) central projection for oil prices in 2020, at $123.50 per barrel, is almost 17 percent higher than the baseline scenario employed by the U.S. Energy Information Administration (EIA), which puts them at $105.57. It is also 45 percent higher than futures prices for Brent at the end of decade based on the current forward price curve (link.reuters.com/nax69t).

Fuel-price projections are employed across government to assess the costs and benefits of various policy options and benchmark them against continuing with business as usual. If the projections turn out to be incorrect, they could result in costly errors, so it is important that they are as realistic as possible.

Part of the problem stems from different vintages. DECC's projections were published in October 2012 and benchmarked against other forecasts published earlier in the year or in 2011, while the EIA's latest projections are newer, dating from early 2013. Futures prices are even more recent.

DECC's most recent projections were published before the full impact of the shale revolution were appreciated by forecasters and policymakers.

Other forecasters and investors have already begun to adjust their scenarios to reflect views about a possible structural break in oil prices as a result of horizontal drilling and hydraulic fracturing.

DECC updates its energy projections annually, typically in the second half of the year, so the current projections still take little account of changed views about the outlook for crude oil prices. The next set, due to be published in the next few months, should see sharp reductions in projected prices.

Even so, DECC's projections seem on the high side. They appear to be locked in to an earlier period when fears about peaking oil and gas supplies were prevalent, and not yet to have adapted to the effects of the U.S. shale boom.

PROJECTING OIL PRICES

The department explained its methodology in the most recent version of its fossil fuel projections, available on DECC's website.

"A supply and demand model is used to estimate our central and high oil price projections. The results are then sense-checked against external forecasts. For the low scenario, an assumption is made about the minimum cost of extracting oil and this is used as an indication of the minimum price, then this is sense-checked against the supply and demand model," according to DECC.

DECC explicitly compares its results with projections produced by the EIA in 2012 and the International Energy Agency (IEA) in 2011.

The problem is that DECC's price projections have risen relentlessly in recent years - even as global oil prices have appeared to peak.

In 2010, the department's low, central and high projections for 2020 stood at $61, $82 and $123 respectively. By 2011, these had been revised up to $91/$118/$134. In 2012, the projections hit $93/$124/$150.

The initial jump is easy to explain because average Brent oil prices rose from $80 to $111 between 2010 and 2011. But the continued rise in the projections in 2012 is harder to comprehend, because average oil prices in 2011 and 2012 were little changed.

In 2010/11, DECC's supply-demand model appeared to track market prices. In 2012, it continued to show higher prices, even though the market had levelled off.

It will be interesting to see what happens to DECC's projections in 2013. So far this year, spot and forward oil prices have been about $6 below the 2012 level, so the projections should come down modestly.

DECC's worst-case high-price scenario appears to have risen particularly rapidly. In recent years, the department has become increasingly concerned about oil shortages and escalating prices, even as many outside observers have become less worried about future scarcity owing to the North American shale oil boom.

GAS AND COAL, TOO

DECC's projected prices for gas and coal are partially linked to its projections for oil.

On gas, DECC explains: "the projections reflect varying outlooks for gas market fundamentals, the degree of gas market liberalisation and contracting/pricing arrangements between buyers and sellers. They assume UK hub prices are linked or de-linked from oil-indexed gas prices at various times, depending on European gas market supply and demand fundamentals."

In turn, projected coal prices are partly based on natural gas, according to DECC, reflecting historical relationships.

Like oil prices, DECC's projected gas and coal prices in 2020 have escalated rapidly over the last couple of years (link.reuters.com/nex69t).

DECC has raised its low-central-high projections for 2020 wholesale gas prices from 35/69/99 pence per therm in 2010 to 35/68/92 pence in 2011 and 41/72/102 pence in 2012.

Projected coal prices have risen from 32/51/64 pounds per tonne in 2010 to 51/70/97 pounds in 2011 and 48/75/102 pounds in 2012.

The crucial question is whether these projections remain realistic, or need to be revised.

Futures market prices for natural gas delivered towards the end of the decade have generally been trending lower, after peaking in early 2011 .

Far-forward coal prices, too, have been falling.

Until DECC revisits its price projections to take account of new developments, particularly the global impact of U.S. shale, it may be over-estimating future costs for oil, gas and coal. (Editing by David Evans)

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