Oil’s a Drag on the Economy: Energy Boost Needed

Once it was common to think of Britain’s economy as being comprised of two distinct parts. There was the onshore, or non-oil economy, and often – I am talking about three decades ago here – its performance was underwhelming.

Then there was the oil economy, booming as a result of the opening up of the North Sea as one of the world’s most important sources of oil and gas from the 1970s. Combine the two and you got a healthy growth picture. Exclude oil and things were not nearly as strong.

Today, the picture is reversed. The non-oil economy is far from strong but it is growing. Output in the oil economy, by contrast, is falling fast.

A few days ago we had another instalment of the economic puzzle. There was a big, 82,000 fall in unemployment over the latest three months and, official figures showed, a net rise in employment of 499,000 over the past 12 months.

At a time when the economy has not grown at all, according to the gross domestic product figures, employment has risen by nearly half a million – to its highest ever number of 29.6m – and hours worked and vacancies have both increases sharply.

Some of this puzzle will be resolved in the fullness of time by data revisions. Some of it reflects the fact that pay has been, and continues to be, very subdued: it is currently rising by just 1.8% annually.

Part of the story, however, is to do with oil. Britain’s onshore economy is doing a lot better than its offshore economy. The decline in North Sea oil and gas output, a trend that began in the late 1990s, is striking.

Britain’s recovery began in the middle of 2009. For the North Sea, however, that was the start of an acclerated decline in output. In October, North Sea production stood at just 51% of its June 2009 level. The overall economy has grown, though not as much as anybody would have hoped, but North Sea output has halved.

In the old days, such a development would have been devastating, because North Sea oil had a bigger weight in the economy. These days the effects are smaller but still significant. So, instead of shrinking by 0.1% over the past year, as the overall GDP figures suggest, the non-oil economy has grown by 0.2%.

Compared with 2009, overall GDP has risen by 3.3%, its non-oil equivalent by 4.1%. Simon Ward, an economist with Henderson Global Investors, notes that this recovery is less of an outlier when adjusted in this way: the profile of non-oil GDP becomes more like the late 1970s and early 1980s.

This does not, I emphasise, solve all the puzzle. If you take the non-oil figures at face value, this is still a much weaker recovery than we would like. It points to an economy that has averaged only 1% to 1.5% growth in the recovery phase, and that growth has slowed the longer the recovery has gone on.

But it is part of the explanation and it has a couple of other interesting aspects. The first concerns Scotland. The debate about Scotland’s fiscal future under independence rests mainly on the proportion of North Sea revenues it would be allocated.

Fast-falling North Sea output suggests this is a shaky foundation on which to build an independent country. The Institute for Fiscal Studies recently concluded that if Scotland were assigned North Sea revenues on a so-called geographical basis – something that would have to be debated – its budget deficit would be proportionately smaller than the rest of Britain, thogh it warned about the volatility of such revenues.

For every swing, however, there is a roundabout. If Scotland were to get most of the oil revenues, its economy would also be more oil-dependent in general. The oil/non-oil distinction, important for Britain as a whole, would be hugely significant.

The IFS calculations suggest that North Sea oil and gas would account for 18% of the Scottish economy. What this means, by my calculations, is that Scotland would have had no recovery at all over the past three years.

It would, in fact, be rather worse than that. Assuming Scotland had the same 4.1% non-oil GDP rise as the rest of the country, this would be more than outweighed by the near-halving of output from a sector that makes nearly a fifth of its economy. Scotland’s GDP would be 4% to 5% below its mid-2009 levels and even further below pre-crisis levels.

The other interesting question is whether we can look to a future in which energy once more drives the economy rather than acts as a drag on it.

On Thursday the government gave its approval to Cuadrilla, an energy firm, for the resumption of “fracking” – hydraulic fracturing – for the exploitation of shale gas reserves. Shale gas is environmentally problematical and most of the evidence suggests that recoverable reserves do not approach those of the North Sea.

The British Geological Survey, however, which is the most reliable independent source, says “UK potential is as yet untested” and that there are “abundant shales at depth”. It has identified significant accumulations, including Widmerpool Gulf near Nottingham and the Elswick Gasfield, near Blackpool.

Caution is justified. Shale gas may never have the transformative effect on Britain it is having in America. But even an echo of those early North Sea days, when oil and gas helped mend Britain’s damaged public finances and helped the balance of payments, would be very welcome.

On both counts, we need all the help we can get.

This piece is cross-posted from David Smith’s EconomicsUK with permission.