Managing Volatility in Oil and Gas Revenues Presentation to the Revenue Stabilization and Tax Policy Committee September 12, 2008 Thomas Clifford, PhD Research Director New Mexico Tax Research Institute
Overview Economic analysis of energy markets: Economic theory Fundamentals Futures markets and the role of speculation Trends in New Mexico s oil and gas revenues: Historical production volumes and prices Current futures market outlook for prices General Fund revenue from oil and gas production Managing revenue volatility: Consequences of revenue volatility Tools for managing volatility: Hedging Revenue forecast Recurring/Non recurring revenue distinction Reserves NM Tax Research Institute 2
Economics of Energy Markets Demand for oil and gas is inelastic i.e. purchases do not respond quickly to changes in price: Gasoline consumption depends on kind of cars we drive and the amount we drive them. Both are hard to change quickly. Supply of oil is subject to large disruptions: Hurricanes Political turmoil in producing countries Demand for natural gas can fluctuate sharply due to weather causing large price spikes because there is so little excess gas capacity. Pipeline constraints can cause huge price blowouts as producers lower prices in an attempt to gain needed pipeline space. Excess capacity in both oil and gas markets is limited, so large price changes may be needed to clear the market when demand increases. NM Tax Research Institute 3
Energy Market Fundamentals: 2003 2008 World economic growth since 2004 averaged 5% per year best in 20 years; Global oil consumption increased almost 4% per year 2004 2007; China, India, Middle East subsidize energy, increasing demand; still use far less oil per dollar of output than U.S. Non OPEC supply growth stagnated in 2000 s; OPEC supply increased, but less than consumption Surplus capacity is now less than 2% of total consumption Lack of surplus capacity means that when demand increase, prices must increase by enough to reduce demand to bring supply and demand back into balance; E.g. gasoline demand did not respond until price hit $4.00 NM Tax Research Institute 4
Geopolitical Risk Top World Oil Net Exporters: 2006 Country Net Exports (1,000 bpd) Saudi Arabia 8,525 Russia 6,866 United Arab Emirates 2,564 Norway 2,546 Iran 2,469 Kuwait 2,340 Venezuela 2,134 Nigeria 2,131 Algeria 1,842 Mexico 1,710 Libya 1,530 Iraq 1,438 Angola 1,379 Kazakhstan 1,145 Qatar 1,033 Total 39,652 Total world consumption 84,700 Source: U.S. Energy Information Administration Most of world oil exports come from unstable regions or countries. NM Tax Research Institute 5
Futures Markets: General Principles Standardized terms of contracts make futures markets an ideal forum for discovering opinions about future prices. Margin requirements are typically less than 10%; Low margins imply high risk/return because price changes can easily exceed the total margin. Price volatility is usually even greater in markets without futures exchanges, e.g. coal, fertilizers, tea. Distinction between hedgers and speculators is not always clear, it reflects motives, not individuals. Commercial and non commercial classification by CFTC is self reported. NM Tax Research Institute 6
What Factors May Cause a Pricing Bubble? Bubble = prices are above the level needed to match supply and demand based on fundamentals (actual use and production). Manipulation : Companies with enough market power to move prices through their behavior, i.e. cornering the market. CFTC tracks through large trader reports. Increased role of institutional investors in commodity futures markets although motivated by legitimate desire to diversify may have added to demand enough to push prices higher independent of market fundamentals. Speculators may misinterpret trends resulting from sharp changes in fundamentals. The result may be a sharp increase in futures market price volatility. NM Tax Research Institute 7
Futures Market Activity: 2004 2008 Number of crude oil futures contracts traded tripled between 2004 and 2008; Number of large traders doubled Fastest growth was in non commercial traders speculators Institutional investors (e.g. pension funds) have increased their purchases of futures contracts in recent years, adding to demand and possibly pushing up prices Most position changes by speculative traders followed rather than preceded price changes CFTC argues that any bubble should be short lived. If prices are too high relative to fundamentals, we should see a significant increase in inventories high prices reduce demand and increase supply have not seen a dramatic increase this year: Problem is there is little excess capacity in the market that inventories can t build until demand decreases, which takes time; Inventory data are not very accurate; Floating stock problem. Source: Report of the Interagency Task Force on Commodity Markets NM Tax Research Institute 8
Summary: Speculation vs. Fundamentals: 2004 2008 Fundamental factors account for rising prices in 2004 2008. Speculation added to steep price increases in 2008. Diminishing speculative activity and slowing worldwide economic growth will push prices down in the next year or two. Fundamentals will keep prices above their averages during the 1990 s. Volatility will also be higher than during the 1990 s. NM Tax Research Institute 9
Historical Production and Prices for New Mexico Oil and Gas Crude oil volume stabilized around 60 million barrels per year in the last two years. Drilling in response to high prices has offset the rapid natural decline rate of production. Prices received by New Mexico producers climbed dramatically in the latter part of FY 2008. Data from NM TRD ONGARD system. NM Tax Research Institute 10
Total natural gas volume is falling by 1% to 2% per year. Permian production appears to be falling a little more quickly than San Juan. Natural gas prices have been more volatile than oil prices though they have followed the same general upward trend. Gas prices fell by 73% in 2001 2002 (CA energy crisis) and by 60% in 2005 2006 (post Katrina) Data from NM Taxation and Revenue Department ONGARD system. NM Tax Research Institute 11
Current Futures Market Outlook: Crude Oil After rising by $50 per barrel from January to July, futures prices have fallen by $30 NM producers receive a few dollars less per barrel than the WTI Spot price NM Tax Research Institute 12
Current Futures Market Outlook: Natural Gas After rising from $8 to $13 in January to July, NYMEX prices have fallen by $6 NM producers have been receiving prices similar to the Henry Hub spot price But significantly higher than posted spot prices at NM hubs NM Tax Research Institute 13
Aug. 2008 Forecast Forecast O&G revenue is at all time high in dollars and share of General Fund Gradual decline is expected NM Tax Research Institute 14
State and Local Revenue Sensitivity to Oil and Gas Prices Using Projected FY 2009 Volume and Deduction Values Crude Oil Natural Gas Total Change in Price $1.00 $0.10 Annual Production Volume* 60.0 1,474.0 Deductions as percent of gross value 10.0% 20.0% Taxable Value (million dollars) $54 $118 State General Fund: (Million dollars) O&G School Tax 1.7 4.7 6.4 O&G Conservation Tax 0.1 0.2 0.3 Natural Gas Processors Tax 0.4 0.4 Subtotal: General Fund Taxes 1.8 5.3 7.1 Federal mineral leasing royalties 1.4 5.1 6.6 State land office bonuses and rents 0.3 0.4 0.7 Subtotal: rents and royalties 1.7 5.5 7.2 Total General Fund Revenue 3.5 10.8 14.3 Other State Funds: O&G Severance Tax 2.0 4.4 6.4 State Land Royalties 2.7 2.9 5.6 Subtotal: Other State Funds 4.7 7.4 12.1 Total State Revenue 8.3 18.2 26.4 Local Government Revenues: Ad Valorem Production Tax 0.6 1.2 1.8 Production Equipment tax 0.1 0.2 0.3 Total: Local Government revenue 0.7 1.5 2.1 Grand Total State & Local Revenues 8.9 19.6 28.5 *Million barrels of oil and billion cubic feet of gas. NM Tax Research Institute 15
Revenue volatility has increased significantly since 1999. O & G revenues can change total revenue by up to 10% in one year. Other revenues move in tandem with O&G revenues, increasing volatility. NM Tax Research Institute 16
Consequences of Revenue Volatility If forecast revenue is less than actual revenue: Recurring revenue is underestimated Recurring appropriations may be less and non recurring appropriations more than otherwise. If forecast revenue is more than actual revenue: Recurring appropriations may have to be reduced, or General Fund reserves will end the year below the forecast level. NM Tax Research Institute 17
Tools for Managing Revenue Volatility Hedging Revenue forecast Reserves Recurring/Non recurring revenue distinction NM Tax Research Institute 18
Hedging State could lock in a future revenue stream and eliminate uncertainty. Cost would be foregone revenue if prices exceed hedged level. Benefits would be higher revenues is prices fall below the hedged level. Revenues would still be subject to volatility after contract expires. Transactions costs could be significant. NM Tax Research Institute 19
Revenue Forecast Consensus estimates can be adjusted to reduce the likelihood of a revenue shortfall: Criticism: Estimates are too conservative Without guidance from the Legislature and Executive, estimators have no explicit authority to make these adjustments. Current estimates appear to contain more risk than in the past. Portfolio effect is not helping to reduce the State s exposure: O&G revenue a high share of total General Fund Other revenues move in the same direction Range estimates could be used to highlight the uncertainty in the forecast. The State could invite an expert panel to help assess the risk associated with the consensus forecast. NM Tax Research Institute 20
Revenue Forecast (continued) FY 2009 Price Outlook as of September 8, 2008 NYMEX (9/8/2008) Consensus Forecast Natural Gas $8.45 $9.60 Crude Oil $111.21 $122.00 Consensus forecast oil and gas prices are above the current NYMEX futures. This outlook appears to contain less insurance against price decreases than was typical in past forecasts. Legislature should be aware they are working with a different level of risk. NM Tax Research Institute 21
Revenue Forecast (continued) 2004 to 2007 forecasts underestimated revenue by as much as 15% of General Fund. Oil and gas was the largest component with average error of 6% of General Fund. Other revenue forecasts tend to miss in the same direction as oil and gas. NM Tax Research Institute 22
Revenue Forecast (continued) Range could reflect uncertainty in all revenue or be limited to uncertainty in the oil and gas revenue forecast. Showing uncertainty in terms of new revenue shows the impacts on future budgets of decisions made in the current year. NM Tax Research Institute 23
Reserves as a Risk Management Tool Appropriate reserve level depends on whether the revenue forecast includes any risk insurance against price volatility. O&G revenue volatility means 5% is too low, 10% may be a prudent minimum level if the state hopes to avoid mid year budget curtailment. NM Tax Research Institute 24
Dividing O&G Revenue Into Recurring/Non recurring Currently no effort is made to distinguish recurring oil and gas revenue from non recurring in the forecast: Any distinction is bound to appear arbitrary to some extent. Distinction would be hard to maintain as revenue is tracked through the year. Classifying some oil and gas revenue as non recurring would avoid the potential need to cut payroll in the future, while making funds available for non recurring appropriation immediately: Example: In the current consensus forecast, oil prices are expected to reach $116 in FY 2010 and then decline to $100 over time. Gas prices will be $9.20, declining to $9.00. If the excess over $100 and over $9.00 were treated as nonrecurring, a total of about $43 million would be shifted from recurring revenue to non recurring revenue. Although recurring spending would be lower in the current year, it would be the same in the out years, the difference would be that there would not be a reduction in the budget (or lower growth) from one year to the next. NM Tax Research Institute 25
Conclusions Oil and gas revenue volatility has increased significantly in the last 4 years. Energy prices are volatile because supply and demand are both unpredictable. Also, surplus capacity is almost non existent, so prices must adjust to clear markets. Futures markets bring transparency and liquidity to energy pricing, but they also attract speculation. The State needs an explicit policy for managing revenue volatility. Possible components of the policy include: Consensus forecast prices can be adjusted downward to insure against risk. Range estimates can be used to highlight uncertainty. Reserves can be maintained at higher levels 10% is probably a prudent minimum Oil and gas revenue can be broken into a recurring and a non recurring component The State could invite a panel of experts to help assess the degree of risk in the consensus forecast. NM Tax Research Institute 26