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How to live with lower oil prices

How the collapse of oil prices is impacting the Canadian economy, and what policy makers at the federal and provincial level should do to ease the pain


 
Hand Full of Oil.  Getty Images

Getty Images

The large and persistent drop in oil prices has been a major hit to Canada’s economy. In this Maclean’s article, many analysts (including me) suggested that this economic development was one of the most important things to watch in 2016. While there are lots of other interesting and important stories unfolding, such as:

  • gravity-defying house prices in Toronto and Vancouver;
  • the response of financial markets to the normalization of monetary policy in the U.S.; and
  • whether companies will regain an appetite to invest in Canada

I keep coming back to lower oil prices and the massive terms of trade shock they’ve delivered. The result has been a significant loss in our international purchasing power—just ask any Canadian on vacation in the U.S.

When oil prices first fell in the summer of 2014, we knew it would be a significant economic challenge for Canada, but we didn’t know big the shock would be and how long it would last. As time has passed, long-term expectations for oil prices are down by more than a third (H/T Luke Kawa).

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Of course these forecasts are notoriously bad and there’s evidence that using them might be worse than just assuming that oil prices won’t change. But the low prices we’ve lived through over the last year and a half, combined with technological improvements that have fundamentally increased oil supply and changed production strategies, should be a clear signal to policy-makers (and to oil producers) that they would be wise to exercise caution and make their decisions based on longer-run plans that don’t assume a quick rebound in prices.

Back when the severity of the oil price shock was beginning to dawn on us, the Bank of Canada surprised financial markets by cutting interest rates. In its January 2015 Monetary Policy Report (MPR) the Bank quantified the potential fallout if oil stayed at $60 a barrel for a few years, relative to there being no decline in prices. The news wasn’t good.

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The Bank’s next MPR in April shed light on the massive regional disparities from the shock. Not surprisingly, Alberta is the hardest hit by far.

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These estimates are also relative to an optimistic counterfactual where oil prices don’t fall (and assume no monetary policy response, whereas the Bank cut rates by 50 bps in 2015). To get another perspective on this shock, compare the paths expected for Canada’s nominal GDP in the federal government’s fall economic and fiscal updates, about one year apart based on surveys of private sector forecasters (in September 2014 and October 2015).

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Evidently, lower oil prices are expected to permanently lower Canadian output over the projection. By 2016, the level of nominal GDP is about $80 billion lower, a hit of almost four per cent. The shock to real gross domestic income is even larger because GDI accounts for the drop in our international purchasing power.

As expected, repeating this exercise for the epicentre of the shock in Alberta shows proportionately worse impacts. Nominal GDP is expected to fall by about 10 per cent in 2015 alone (and even this may prove to be optimistic). Moreover, there’s a mark-down of about $40 billion, or a 10 per cent permanent hit, to the level of Alberta’s nominal GDP expected over the next few years.

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In sum, we’re clearly experiencing a big shock. One that has several important dimensions, some are direct and straight-forward, and others are more obscure.

One obvious impact is that investment in the oil patch has fallen abruptly. It’s down about one-third throughout in the first three quarters of 2015 (though despite a big drop, this level of oil investment could be considered relatively healthy from a longer-term perspective).

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Alberta’s labour market has weakened significantly, and the unemployment rate in the commodity-producing provinces as a whole (Alberta, Saskatchewan and Newfoundland and Labrador) is now higher than in the rest of the country for the first time in over a decade. Job losses have been concentrated in younger workers and men (H/T Trevor Tombe).

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Government finances are weaker. At the federal level, the budget balance is somewhere around $15-20 billion lower over the next five years, possibly more. The proportionate impact on those commodity provinces should be larger.

But there are also other impacts from the oil shock that are less obvious. The fall in investment in Canada means there’s less capital deepening (particularly in the energy sector, but possibly more broadly because the resulting weaker Canadian dollar makes imported capital more expensive). This will likely slow our potential output growth going forward.

There’s also been slowdown in the net in-migration to Alberta from the rest of Canada that has occurred over the past two decades (H/T Jock Finlayson)

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Though there hasn’t yet been an outright reversal (H/T Trevor Tombe again).

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Finally, there may also be impacts on federal-provincial transfers that could reverberate across the federation. For example, with much lower nominal GDP, it’s now possible that health transfers (CHT) may actually need to honour the three per cent funding floor guarantee — something that few would have predicted necessary when changes to the funding formula were announced in 2012.

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Similarly, because the total equalization budget is tied to nominal GDP growth, it too will slow down significantly for transfers that are tied to the 2015 outcome.

Policy responses

Despite all of this wreckage, arguably the biggest macroeconomic policy response in Canada so far has been to reduce the monetary policy rate by half a percentage point in 2015. On its own, this minor reduction in borrowing costs will have only modest direct effects on the aggregate economy.

However, I suspect that the indirect effects of looser monetary policy, and more generally, the associated depreciation of our exchange rate—which is related to our monetary policy stance, as well as that in the U.S., which is moving in the opposite direction, and other factors—is the most promising way to facilitate our economic adjustment.

The loonie is currently on pace for its second-largest annual decline in recent memory, down 17 per cent versus the U.S. dollar so far this year. (H/T Doug Porter)

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I expect the Canadian dollar will (need to) fall further. I wouldn’t be surprised if it drops below 70 cents as the U.S. starts down its path to raising its policy rate (at the same time Canada’s central bank openly discusses the option of negative interest rates if needed).

Indeed, empirical evidence for a wide range of countries (particularly developing ones) suggests that after large terms of trade shocks—such as Canada is experiencing now—economies with flexible exchange rates do better than those with fixed exchange rates: output falls by less, and the recoveries are faster. Basically, the exchange rate depreciates more. The makes the country’s exports more internationally competitive and helps reinforce the effect that the country’s exports already command fewer imports.

While this sound fine in theory, and for other countries, the big worry is that Canada’s export performance has been extremely disappointing over the past decade—particularly our trade with the U.S. Maybe a sixtysomething-cent loonie is just what the doctor ordered for our ailing exporters. But maybe our export sector—particularly our manufacturers—have lost some of their production capacity in recent years, which means that we won’t be able to bounce back and fully take advantage of the lower Canadian dollar. At any rate, expect our non-commodity-exports to increase their contribution to our overall export growth, but we will have to wait and see what happens in 2016. In the meantime, I’ll be far less annoyed than usual by attempts to “talk down our dollar.”

As Glen Hodgson has pointed out, we should be encouraging provincial policy responses in the three resource-producing provinces to these primarily localized regional shocks that have national spillovers.

This means that fiscal policy, especially in Alberta, should be quite aggressive and expansionary in the near-term to try to cushion some of the blow from this big negative shock, while at the same time, have longer-term discipline. The adoption of new debt targets in the last budget makes sense from this perspective.

Finding the right balance is tricky between short-term stimulus and long-term fiscal sustainability, as we still need to encourage the internal reallocation of capital and labour to other parts of the Canadian economy. But at its core, learning to live with lower oil prices requires a fundamental rethink of how government programs are funded in these provinces. They shouldn’t be overly reliant on resource royalties, which leaves them overly exposed to abrupt commodity price swings.

Quite aside for the issue of the level of taxes, the tax mix should improve by relying proportionately more on taxing consumption to fund current government programs, which provides a much more stable revenue source (as advocated by Jack Mintz and others). Adopting a provincial sales tax at a rate similar to that of its provincial neighbours (or substituting the sales tax for other more distortionary forms of taxes) makes economic sense, even if it is sure to generate political opposition.

Finally, because we simply don’t know where energy prices are going over the long-term, it is far better for our policy-makers, at both the federal level and provincially, to adopt conservative budgeting assumptions for commodity prices and government revenues. If they did, our biggest economic, policy and planning surprises might also be happy ones.

Update


 
Filed under:

How to live with lower oil prices

  1. Having already decided to divest from fossil fuels and having committed at the Paris conference to adhere to the same time table for carbon foot print reduction as other world governments that are less dependent on commodities for their existence, there is no use now for fretting about leading a normal life in an economy so devastatingly impacted by the global oil glut. Thus far it has been highly fashionable pastime for us to invest our energy in vilifying the big oil. Very often, we also forgot that big oil and big banks are owned by the small man through his mutual fund portfolios. Academic institutions divested and encouraged others to divest from oil exploration investments. Interest groups had a field day blocking all the marketing outlets for the oil produced. Yet they were being financed by the oil royalties. Governments (both Provincial and Federal) and interest groups forgot that they were gradually but deliberately bleeding to death, their cash cow without so much as a clue as to where they were going to get their next meal.
    It is not wrong to shift away from a controversial energy source. But the attempt to shift has been so drastic like moving from Sahara to Tundra. What was the effort taken to temper the shock? Where was the effort to develop alternate sources of income and/or alternate sources of employment? Can we name one interest group or one Provincial government which has studied the issue or come up with any concrete ideas worth exploring? Did we really believe that David Suzuki and Elizabeth May were more interested in our lives than their own? It was fashionable to grandstand against all the governments of the world on the matter of seal hunt because it affected the livelihood of a limited number of people who could have been compensated or found alternatives within our limited means. We talked about a lot of principles then. No one bothered to think that we could at the minimum ask for a different time table in the emission reduction talks so as not to disrupt the lives of so many of our fellow citizens. Was it because we considered it to be beneath our dignity?
    The current commodity price shock will be very drastic to very hands that fed the nation. It will shatter the lifestyle of more than 90% of the population in those very vital regions of the country that provided for almost all of our transfer payments. It would be too much to expect the Provinces now to handle the resuscitation business singlehandedly. The Federal Government should direct its infrastructure dollars in greater proportion to the three provinces, namely Alberta, Saskatchewan and Newfoundland and Labrador. Home Renovation Tax Credits and Infrastructure building may be more appropriate for regions that are normally affected by the current recession, because there is no evidence yet of economic activity slackening there. Development activity in the three provinces most affected by the recession will need a drastically different and innovative approach. Ideas to make the most use of the skills that have been laid redundant should be combined with infusion of capital for investment in new labor intensive industries most suited for the locales concerned. Massive amount of federal amounts should be handled at the provincial level but that handling should not be further decentralized to the level of municipal governments. If the recent talks of our PM are any indication that simply isn’t going to happen!

    • Well put. The simple question to be asked: Having advocated for a shift from oil, and the tax dollars that it provides, are those same advocates now willing to advocate just as hard for governments and their employees to do as much with far fewer resources made available to them?
      In the same vein, how is it that it was a nationally existential crisis for GM or Chrysler (and their unionized workers) to face an economic peril with a far smaller impact than it it is to suddenly find tens of thousands of oilfield workers facing a much tougher situation? Why is it okay for any government to advocate against a major industry in one province, while relying on the taxes of that very industry to support automakers and airplane manufacturers?
      Again, if the climate crisis is a real thing, why would we support the energy intensive manufacture of cars, and the building of greenhouse gas spewing jets?

      • Oil prices will rise again for sure. The next OPEC meeting will be much different that the last. The Saudis have run their treasury down and are now borrowing. That will devalue their local currency and, since Saudi Arabia imports everything, the price of those importedgoods will rise and put tremendous pressure on the government for the first time in 40 years to address this. As well, when Saudi Arabia couldn’t get cooperation from the other OPEC countries to restrain production in 1998, they dropped the price by 50% and held it there for a year until the other members agreed to cooperate. Iran and Iraq will both come around net time.

      • The actual cash flow is just worse: prior to the price crash, the WTO calculated a net benefit to the oil and gas industry of $34B while CRA reported net revenues of $22B; in other words, Canadians were subsidizing this industry to the tune of $12B. Now it’s just worse, especially when one adds in all of the looked for government support to all the persons and companies no longer supported by the oil and gas industry on top of declining tax revenue from these disemployed entities as well as the industry itself. The money pit just got deeper.

        • You’re interpreting that wrong. Laughably wrong, in fact. The total financial benefit to the industry (according to your WTO figures) would be $56 billion, of which $22 billion is then siphoned off in the form of taxes and royalties. If your first statement were true, then your second would have to be false. If we are subsidizing the energy industry, then replacing the wages and benefits of energy industry workers with EI and other social welfare payments that are much lower would reduce the strain on the public treasury.
          Like it or not, the energy industry is a massive job and revenue creator, yet many of the people most active in attacking the energy industry- activist groups supported by funds donated by public sector unions, for example- are direct beneficiaries of the industry even though they do not contribute one iota to it.
          We have multiple governments in this country who are direct recipients of tax dollars generated in the energy sector actively opposed to two separate initiatives that directly benefit their spending ambitions. One is the opposition to the Energy East pipeline, which will create jobs on multiple levels here in Canada at every level of production from well head to refinery. Instead, by opposing the pipeline, political leaders ensure that those jobs remain outside of Canada, and the money used to purchase offshore oil also stays outside of Canada. That’s fine, but it requires an Olympic level of stupidity to be a politician in a “have not” province and be opposed to Energy East.
          Then there’s the opposition to Gateway, and Trans-Mountain, and Keystone. Again, these projects would bring billions of dollars annually into the Canadian economy, even with low prices. With that influx, there comes a flow of taxes and royalties to various governments, including those who merely sit on the sidelines and say “Gimme, gimme.” Again, the stupidity that accompanies such opposition is of such gargantuan proportions as to defy proper definition. The only plausible explanation is outright malice.
          That brings us full circle. Given the new fiscal reality, I merely ask a simple question: What steps are going to be taken to reduce expenditures to match the reduced income to governments from the cash cow they love to hate? Many of you wanted it gone, so what’s your next step?

  2. “One obvious impact is that investment in the oil patch has fallen abruptly. It’s down about one-third throughout in the first three quarters of 2015 (though despite a big drop, this level of oil investment could be considered relatively healthy from a longer-term perspective).” This investment has never been a good deal for Canadians: job creation per $ invested is 50% of that for the electricity sector and 22% of that of the manufacturing sector. If a single sector produces 11% of GDP while absorbing over 25% of investment, that’s a poor leverage of available capital (except for the foreign owners of oil and gas companies). Going further, one should consider where a large portion of that investment ends up i.e. large purchases of heavy equipment and materials from China and South Korea; arguably, this huge application of capital has done nothing for the Canadian steel industry, nor for heavy equipment manufacturers.

    • The “What have they done for me? Why do they still exist” kind of arguments can only come from a socialist, a trade unionist or a member of any one of the interest groups living off from hand-outs from the Government. Despite the current incumbency in Alberta and at Ottawa, of socialist governments that cater 100% to the interests of the trade unions, our economy is still a market oriented one. The capital moves around always looking for the safe investment that pays most dividends. There is nothing we can do about it. The argument that investment in the oil sector now benefits only the foreign investors is nonsense. What is good for gander has to be good for the goose too. Unless we assume that the our governments grab by way of taxes, an unfairly large portion of the income derived by local investors, this kind of argument takes us nowhere.
      Again, to expect all industries to be composed in the same proportion of capital, technological intensity, automation and labor participation would be nonsense. The argument that electricity production uses more labour than oil exploration is so bland and generalized. The power generation operation could be a hydroelectric plant, a plant that burns coal or oil, a plant that uses windmills, solar panels or even ocean waves, it could be a nuclear reactor or it could be even a geothermal plant. Depending on the inputs required, labour participation and capital efficiency will differ in those operations too. It is well known that the modern day extraction of oil or ore from the ground employs cutting edge technology and automation very intensely. Obviously the capital outlay therein will be heavy. It would be good to remember that the activity still brings in lots and lots of free money to coffers at two levels of government. “Gimme more” kind of argument will only result in cutting open the goose that lays golden eggs. When it comes to heavy machinery, again it is a matter of looking for the best quality from the cheapest source. In an internationalized market place, to argue that we should sell them our wheat but they shouldn’t expect us to buy their machinery will not wash very well either.
      It is a bothersome problem to have the machinery manufactured in a foreign land to our specification, bring it here in parts and again have them reassembled here. If our labour can rise to the occasion, there would be huge savings all around and there would even be a trade surplus for the government. Why go that far? If our labour can be competitive enough as against our next-door neighbours, they won’t, go through the trouble to disassemble huge auto assembly plants only to haul them away as far as Texas and then reassemble there. The nonsensical voices of protectionism have already done us enough harm, and deprived us of many things in life. Now, the only way to make the oil exploration industry bring in more money to the coffers of the trade union by way of member subscriptions is to act like the socialist government of North Korea. Convince the governments to nationalize all oil exploration and mothball all the rigs. Then the government can give the trade unionists shovels, pickaxes and crowbars and tell them to keep digging for oil. We could even compel all union leaders to participate in the venture and call it a reeducation camp.

      • GeraldR- How could something that drew Canadians from every province, and provided them with good paying jobs that did not exist in their home province not be a good thing? The oil industry is one that expends great effort to extract from the earth a product that is without value where it exists in its’ natural form and state. It retrieves that product, and then refines it into products of unimaginable scope that are then used to add value to the personal economies of everyone who uses those products down the line.
        Oil is as close to a magical chemical as mankind is ever likely to experience, given the multitude of uses we find for it every day, yet we can still find people who look down their noses at the energy industry.

        • Bill,
          You are absolutely right. We are surrounded by products derived from processing crude oil.
          I worked for a large Canadian based oil company. Our company produced over 700 different products from gasoline, jet and rocket fuels to lubricants and greases, plastics, solvents, etc. Without the availability and use of crude oil derived products, humankind would not have advanced nearly to the degree we have enjoyed.

          • Jerome/Bill
            You might be interested to know that the actual number of products distilled from petroleum exceeds 6000. Out of a barrel of oil, only 19.5 litres are distilled into global warming gasoline and related products. Even out of that, almost half goes into unavoidable burning such as jet fuel and bunkering oil. The balance 23.5 litres of a barrel are turned into more than 6,000 items counting everything from Aspirin, Glycerin,Diapers, life-saving medications including cancer drugs, clothes, shoes, slippers, paints, machinery parts and whatever else you name it. The consumers of all these products become paupers by paying taxes through their nose just because of 10 litres of fuel. Out of that 10 litres, how much is used by emergency services and essential services for transportation – God only knows! This carbon tax debate is just a money grab debate. The dirty oil debate won’t do any thing to make life less miserable – not today, not in a 1000 years!

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