Saturday, March 8, 2014

#AKbudget| Rough seas ahead ...

An article earlier this week in The Wall St. Journal caught my eye -- as it should every eye in both the Administration and the Legislature as they increasingly come to grips with budget issues heading into the second half of this year's session.

Titled Eni CEO Sees Oil Price Falling to $90 a Barrel, the article reports on a speech by the head of Eni -- one of the Top 20 oil companies in the world -- in which he predicts "oil prices are likely to fall to around $90 a barrel [by 2017] as global supply rises and demand falls back thanks to a shift to more natural gas usage and increased fuel efficiency."   A copy of the full speech is here.

That caused me to concentrate more closely on something I hadn't in awhile -- but should more often -- the current NYMEX crude oil futures for the remainder of this year and beyond.  Admittedly, while these futures prices reflect real, live bets on which some traders have invested money, they are merely market (and sometimes, very thin market) predictions of where price may be headed and not definitive assessments.  As with anything else in the market, they are subject to change at a moment's notice as they certainly would, for example, if some catastrophe shut down production in Saudi Arabia for an extended period or the EPA banned fracking in the US.

On the other hand, based on the information available at any given point in time, the futures prices are probably as good an assessment of where oil prices are headed as anything else -- and they are increasingly reflecting the same future ahead as Eni's CEO predicted in his speech.  Glancing at the futures prices as of the close of trading yesterday, these are the current prices (Brent/WTI -- ANS typically falls somewhere in the middle) per barrel for deliveries in December in each of the following years:  2014: $104.34/95.21; 2015: $99.50/87.27; 2016: $95.76/83.20; 2017: $93.47/81.29; 2018: $91.75/80.13; 2019: $90.39/79.24. The usefulness of the prices trails off the farther out in time they go, but absent intervening factors unknown at the time of the trade, the near term (i.e., next 18 - 24 month) price levels usually are reliable indicators of where price is headed.

The reason that the headline and these prices should catch eyes in Juneau is because they differ markedly from those on which the Administration's current 10-year forecast is based -- and which the legislature is currently using to make judgments regarding the Governor's proposed FY 2015 budget and beyond.  The following chart compares the prices used in the Administration's most recent 10-year forecast against the midpoint of the current Brent/WTI futures price for December of the same year.

The consequences of such differences are significant.  In its report on the Governor's budget, the Legislative Finance Division included a chart showing the effects of oil price on FY 2015 budget levels.

The Governor's proposed $5.6 billion (UGF) budget balances at an oil price of $117/bbl.  At the oil price forecast used in preparing the budget ($105), however, the Governor's proposed budget results in a deficit (draw on savings) of $1.04 billion.

At $90/bbl, the deficit rises to in excess of $2 billion, and that assumes that the total UGF budget -- operating and capital combined -- remains at $5.6 billion.  If the budget rises to $6 billion -- as some have speculated it might as a result of legislative-driven earmarks -- the FY 2015 deficit balloons and alone starts approaching $3 billion. At that level (and assuming the legislature agrees with the Governor irrevocably to transfer $3 billion from the CBR to the PERS/TRS account), the state's remaining financial reserves at the end of FY 2015 will be less than $10 billion -- barely enough to scrape through three more years at current spending levels before experiencing the "fiscal crisis" and "economic crash" predicted for the early 2020's last year -- and repeated again this year -- by UAA's Institute of Social and Economic Research.

Admittedly, the Eni CEO's prediction is that the industry will only reach such price levels in 2017, progressively ratcheting down from current levels to those in the meantime.  But that doesn't relieve the urgency with which the Administration and legislature should respond.  In order to be at a spending level that can tolerate a $90/bbl world by 2017, the state needs to make some very significant cuts between now and then, and in addition, retain as much in savings as possible along the way.

In my view, that should mean using every possible means to restrain spending to the $5.6 billion originally proposed by the Governor this year and starting to identify the additional significant cuts that will be required again next year to stay on pace to deal with a lower crude price world by 2017.  Frankly, as I will explain in another piece later this weekend, I am not sure we are there.

As Eni's forecast and the NYMEX futures make clear, the state is headed for some very rough seas ahead.  The second half of this coming legislative session will reveal much about whether we are doing a good job of battening down the hatches.