Today’s column concludes the discussion on fiscal break-even prices for crude oil, introduced three weeks ago on November 13. To recall, that topic was introduced under the rubric of a broader one: on the cost-price relation, which might emerge in Guyana’s coming time of oil and gas production and export (possibly around 2025). Readers should be further reminded that this broader topic was itself introduced as the third of four dynamic considerations, I intend to engage in this series concerning Guyana’s emergent petroleum sector.
The two previous topics already addressed are: firstly the physical/ecological characteristics of the natural gas and oil discovery (on October 9); and secondly, the configuration of ownership – control – organizational responsibility for producing and exporting products based on the Guyana discovery (on October 16). The remaining (fourth) topic is yet to be addressed. And, this will be done next week.
Limitations of fiscal break-even analysis
To complete the appraisal of fiscal break-even price analysis, it would be useful if I were to highlight some major conceptual limitations of this type of financial analysis. This is attempted in this section.
Financial analysts and economists stress the following: first, fiscal break-even price analysis is intrinsically limited, because it focuses exclusively on the supply-side (cost) determination of price; treating demand as a second-order condition for the determination of this price. In truth, the determination of all prices requires both supply and demand factors to be analyzed.
Second, in the treatment of fixed cost, break-even price analysis assumes such cost is completely fixed. That is, it does not change during the period of analysis. However, this holds true only for the very short-run. Beyond this time frame, there is opportunity for the scale of production to change and consequently the shape of the cost function (supply) thereby impacting on both fixed and variable cost.
Third, analysts further argue, break-even analysis assumes a linear cost function. This means variable cost per unit of output is held constant throughout the likely range of crude oil sales, which is utilized for purposes of calculating fiscal break-even prices. This assumed linearity of the variable cost function is quite restrictive.
Fourth, all crude oil suppliers have access to stocks (inventories), which they utilize to smooth imbalances between demand and supply. Fiscal break-even analysis however, ignores stocks (inventories) by holding (implicitly or explicitly) the condition that stocks (inventories) maintain a constant relation to output.
Finally, there is the further assumption that, if other products (typically chemicals) are produced and sold together with crude oil and natural gas, these ‘other’ sales also maintain a constant ratio to sales of crude oil and natural gas for the period when the fiscal break-even price is being determined.
Readers should not conclude from these highlighted limitations that break-even price analyses are worthless. To the contrary, such analyses have value for strategic national planning and budgetary decision-making. The above critique basically advises great caution and prudence in the practical utilization of this analysis.
Following on the observations made above, it should be noted that the literature on this topic also offers several advances which Guyana should seek to apply as the authorities advance fiscal break-even analysis in national and sectoral (natural gas and oil) analysis, planning, and decision-making, going forward. This section identifies a few of these proposals.
One set of these observations speaks to the need for employing greater transparency when estimating and forecasting fiscal break-even prices for Guyana’s petroleum sector. There is considerable criticism today of the way this type of analysis is being conducted. Some analysts go as far as claiming there is deliberate deception with the aim of impacting market outcomes. The frequent revisions of such estimates, with little or no detailed explanations of why these revisions are taking place, give credence to this distrust. And, in turn, this distrust reduces the operational value of such variables in the global energy market. When revisions of target break-even prices are made, detailed explanations of why these have become necessary should be provided, but generally this is not done.
Another concern is that analysts of fiscal break-even prices do not place enough emphasis on related inputs. Thus in countries like Guyana analysts underestimate the following: 1) impacts national exchange rate changes have on the value in domestic currency of the spending power of any given fiscal break-even price; 2) complications generated by national indebtedness (sovereign debt/ GDP ratio); 3) the impact of non-oil revenue yields on the national budget; and 4) the presence of huge phantom or shadow economies when fixing target break-even prices for the petroleum sector.
This list can be readily extended, but sufficient has been identified here, to make clear that the particular structural features of Guyana’s political economy should be central to the determination of its target fiscal break-even price.
Finally, there are intrinsic methodological features that require explicit attention. These include 1) more precise treatment of uncertainty, in what is essentially an exercise in the realm of uncertainty. This means features such as sensitivity analysis and bands have to be incorporated into the traditional exercises; as well as 2) non-macroeconomic indicators, such as the role of state corporations.
Such changes would be best attempted if Guyana, through its international contacts, sought to play a coordinating role in promoting broader international cooperation in pursuing the standardization of the calculation and application of fiscal break-even analysis for the petroleum sector.
This wraps up the discussion of fiscal break-even prices. Next week I address the geo-political issues posed by the Venezuela border threat before moving on to the next topic for consideration within this series. That topic is the movement from Guyana’s ‘discovery’ of oil and natural gas, to their production and export in coming years.