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What a commodity bust would mean for Canada’s economy

Given that we’re already in a slow-growth environment, the risk is stagnation in the economy, or something worse


 
Ken James/Getty Images

Ken James/Getty Images

Back in the 1980s, Ron Carey was sitting in a Calgary bar with a fellow oilman, reflecting on the great oil bust that had levelled Alberta’s economy, when he came up with the idea for a bumper sticker that would capture the grim mood in the province: “Please God, let there be another oil boom. I promise not to piss it all away next time.” It wasn’t as pithy as that other famous Alberta decal, “Let the eastern bastards freeze in the dark,” but a cultural phenomenon was born as the sticker’s popularity spread. Three decades later, Carey, now 75, has watched another boom grip the province and is ready to print another run of those stickers if need be. That’s because he sees worrying signs of another bust on the horizon: soaring wages, “ridiculous” house prices and people living “high on the hog” because they assume the good times will go on forever. Carey knows better. “You have to keep people mindful that these things can happen,” he warns. “I’ve been forecasting this could happen again for the past two years, and it damn near did last week.”
The past few months have brought shock and upheaval to energy markets, as well as angst to many corners of the Canadian economy. Since June, the U.S. price of oil has plunged more than 20 per cent, briefly tumbling below US$80 a barrel last week. The decline has weighed heavily on Canadian stocks, which were already caught in the downdraft of a global stock market correction. Even after several days of recovery, the S&P/TSX index was, as of Tuesday, still below the peak it reached just before the Great Recession six years ago.

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The collapse in oil has been all the more stunning, though, because it has thrown into question a lot of what Canadians have come to believe about the energy sector and its role as the country’s reliable economic engine. Doug Porter, chief economist at BMO Capital Markets, calls the collapse the “single most important development for the Canadian economy.”

More than a decade ago, when Alberta’s oil boom began, the outlook was promisingly simple: oil supplies were drying up at a time when the world couldn’t get enough. Now both of those fundamental beliefs are being challenged. The so-called end of the age of oil is being replaced by an age in which there’s more crude sloshing around than there is demand for it—the non-technical term for it would be a big, fat oil glut.

The textbook explanation for this shift is that, during the past decade, the market has responded to the imbalance in supply and demand the way it always has—companies invest in new projects and push the limits of technology to unlock reserves, while high prices force customers to curb demand. But that scarcely captures the paradigm shift now unfolding, as American oil production skyrockets to levels not seen in a generation, even as China’s massive economy shows signs of slipping into a long-term lower-growth funk.

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And while falling oil prices have grabbed the headlines, crude is far from alone in enduring a steep decline. The agricultural fertilizer potash, another commodity that has underpinned the Canadian economy and briefly made Potash Corp. of Saskatchewan the country’s most valuable company, is plagued by oversupply. Shares in Potash Corp.—once a top holding for many Canadian mutual funds—have shed half their value since 2011. Metallurgical coal, used in steelmaking, has lost two-thirds of its value since 2011, falling to US$119 per ton from US$330 amid a coal glut. Uranium and nickel, of which Canada is one of the world’s largest producers, have shed 45 per cent of their value since 2011. Copper, a metal that at its height spawned a bizarre crime wave of thieves stealing wires from phone companies, is down 35 per cent. So too is gold.

The effects on Canada’s economy are already showing. Aside from our stagnant stock market, which has dramatically underperformed the U.S. S&P 500 since 2011, the slowdown is showing up in the jobs sector. Whereas two years ago miners were hollering about a shortage of skilled labour, the job vacancy rate for the mining, oil and gas sector has since fallen to its lowest level since Statistics Canada began tracking it in 2011. At least one multi-billion-dollar oil sands project, proposed by Norway’s Statoil, has been shelved. Others look tenuous. Earlier this month two Asian firms that had paid $1 billion to buy Calgary-based Grande Cache Coal in 2011 ended up unloading the company to a Chinese coal producer in return for assuming the company’s debt. The selling price: a toonie.

In other words, the 15-year commodity boom—which gave Canada its Teflon-like strength during the deep global recession and helped make us the envy of the world—has run its course.

What comes next if oil prices continue to collapse is a question that, not very long ago, would have garnered incredulous laughter. No one’s laughing now. David Madani of Capital Economics is hopeful prices will remain above US$80 a barrel over the next few years. But he’s also considered the repercussions if the bottom continues to drop out of the market. “The energy sector is the bright spot for the Canadian economy. If that were to turn sour, where’s the growth going to come from?” asks Madani. Others warn of an impact on Canada’s bubbly housing market, a slowdown in income growth—which would make it harder for Canadians to manage their massive debt loads—and, as the resource sector cools, a painful readjustment for those workers who have flooded to the West from other parts of the country in recent years.

It would leave Canada’s economy in the most precarious position it’s been in since the financial crisis. “Given that we’re already in a slow-growth environment, I’d be concerned about stagnation in the economy,” says Madani. “Or something worse.”

. . .

It was around the turn of the millennium when an old idea, “peak oil,” was revived and repackaged with a new one, the rise of China, with its bottomless appetite for energy. Books like 2001’s Hubbert’s Peak: The Impending World Oil Shortage by geologist and Princeton University professor emeritus Kenneth Deffeyes, channelled M. King Hubbert’s 1970s argument that the world would soon reach its maximum ability to extract petroleum, before a steep drop-off in production. Hubbert’s disciples offered a singular message: the end of cheap oil, and of our wasteful way of life, is predictable and utterly inevitable. As oil prices marched higher in the ensuing years, spiking in 2008 and then, after a sharp drop and recovery during the global recession, climbed further still, it only emboldened those who saw oil shortages as a permanent fixture in the economy. Talk of $200 oil as something imminent became common. (Confession: yours truly was there, too, as co-author of a Maclean’s cover story on the prospect of “Life at $200 a barrel.”)

Instead, U.S. petroleum production has shot up by four million barrels a day in just four years, thanks to innovations that have allowed companies to tap oil locked within shale formations deep underground. It’s not an exaggeration to say almost no one saw America’s oil revolution coming. As recently as 2007, the U.S. Energy Information Administration, in its 230-page annual energy outlook, included only scattered references to shale, or tight oil, as it’s also known, admitting that shale might, might, help stem the decline in America’s petroleum output. The authors wrote that if the rate of technological innovation in the petroleum industry climbed 50 per cent higher than its historical average, maybe then U.S. production might hit 6.5 million barrels a day by 2015. This year the U.S. is on track to produce nine million.

Not surprisingly, the EIA has dramatically revamped its outlook for 2014, and if its forecast holds true, it could have serious implications for Canada. Its base case scenario still predicts production will start to taper off next year. But the agency also offers a forecast of what might happen if U.S. output continues to surprise. In that more optimistic scenario, within six years the U.S. will come to rely on net imports of oil for just 15 per cent of its petroleum needs, down from 40 per cent in 2012. Over the next two decades, America could essentially transform into a net exporter. Presumably by then Canada will finally have the Keystone XL, Northern Gateway, or some other pipeline built, but it’s not obvious what demand will exist in the U.S., currently our largest customer, for Canadian oil.

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Then there are the surges in oil output from the likes of Iraq and Libya, where production had been curtailed by war and unrest, not to mention the prospect of more oil flowing from Iran if sanctions are lifted. Suddenly the world looks like it will be swimming in crude for some time to come.

Undaunted, Canadian oil producers have no plans to reduce production, even if a few big proposed projects get shelved. Quite the opposite. The oil sands have already boosted Canada’s total oil production by one million barrels a day over the past decade, and the Canadian Association of Petroleum Producers, in its latest forecast (PDF), predicts the country’s oil output will grow another 80 per cent over the next 15 years.

This is all taking place against the backdrop of a global economy that is dramatically gearing down. The Paris-based International Energy Agency cut its forecast for world oil demand growth by 500,000 barrels a day over the next two years. The prolonged slump in Europe’s economy is partly to blame, but the bigger problem is concern about the slowdown in China. On Tuesday, the country reported GDP growth of 7.3 per cent in the third quarter, the slowest rate in five years.

China’s slowdown matters, because it was the industrial revolution in the Middle Kingdom that spurred the explosion in commodity prices in the first place. Year in, year out throughout the mid-2000s and then again after the financial crisis, China’s GDP posted double-digit gains as Western analysts outdid each other with stories of the country’s economic achievements. They’re building 20 new cities a year! They’re building more high-speed rail in a year than the rest of the world combined! They’re building 50 airports a year! Instead, China’s investment-driven growth model led to massive waste, overcapacity and dangerously high debt levels. One IMF study estimates as much as 10 per cent of China’s annual growth has been driven by “excessive” or wasteful investment spending.

That hasn’t stopped some observers, including the Bank of Canada, from predicting China will continue to keep oil and other commodities afloat. In the bank’s January monetary policy report, it stated, “China’s solid growth outlook and the size of its economy mean that the demand for commodities should continue to be robust.” As evidence, it pointed to a doubling in the size of China’s economy over the past five years. But in a new paper, Larry Summers, the former economic adviser to the White House, cautions against that type of thinking, warning that investors have succumbed to what he calls “Asiaphoria.” “Abnormally rapid growth is rarely persistent, even though economic forecasts invariably extrapolate recent growth,” Summers wrote. In other words, because China’s growth rate was so spectacular in the past, forecasters believe it must go on being spectacular. Instead, by looking at half a century of growth miracles in other countries, Summers makes the case that China’s annual growth will average just 3.9 per cent over the next two decades.

It’s the fading of China’s miracle growth that has led David Rosenberg, the chief economist at Gluskin Sheff and Associates in Toronto, to openly muse about a return to US$40 oil. In a recent report, he noted that China’s pace of growth is back to early 1990s levels, “when $40 was generally the high end of the range for the oil price.” He didn’t make an outright prediction that oil would fall back to US$40, but that Rosenberg even raised the possibility is a remarkable sign of how much and how fast things have changed. (It’s worth noting that the average price of oil in real, or inflation-adjusted, terms, has been US$40 for the last half-century, through booms that saw prices above US$100 in the late 1970s and 2008 and subsequent busts.)

In the short term, oil prices will depend a lot on what comes out of a late November meeting of the members of OPEC, the oil cartel. The group faces two choices: to prevent prices from falling any further, it may cut back on production to limit the supply of oil. On the other hand, because non-OPEC countries like the U.S. have been stealing market share from Saudi Arabia, the world’s largest producer, it may opt to slash prices further. In theory, if it can drive prices low enough, U.S. shale oil production will cease to be viable. This has touched off a debate as analysts try to determine the point at which U.S. oil becomes unprofitable, with one oil and gas research firm, London-based GlobalData Ltd., suggesting prices could fall much further before threatening production. A similar discussion is taking place in the oil sands, where the break-even point is seen as ranging from $50 to $80 a barrel.

For those who take a very long view of commodity prices—not just one or two quarters, but decades and centuries—like David Jacks, a professor of economics at Simon Fraser University, what we’re experiencing now was entirely foreseeable. In a paper he released last year looking at 160 years of price movements for 30 commodities, he found that in the long run, commodity prices have gradually risen. But, over time, there’s a regular pattern of “super-cycles,” during which commodities experience big upswings in price in 10- to 35-year periods before peaking and falling back. In the paper, he argued that “accumulated historical evidence” suggests the current super-cycle has reached its peak.

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Jacks doesn’t envision an outright crash in prices—more of a slow erosion through inflation. But, he explains, the end of the boom and a return to a more normal commodity market will leave a deep and lasting mark on this country. “This is going to have large effects on Canada’s terms of trade, on exchange rates and on the general growth of the Canadian economy,” he says. “We’ve experienced a tremendous and wonderful 15 years, and with the backdrop of a very large leverage and mortgage cycle, we’ve had a tripling of home prices. But the upswing is behind us. Now we’re on the downward side of the cycle.”

. . .

To see what’s at risk if the resource sector falls into a recession, it helps to step back and appreciate the extent to which Alberta has driven Canada’s economy in recent years. Because when it comes to matters of demographics, spending and jobs, Alberta is Canada’s real distinct society (sorry, Quebec), a place that has become statistically unrecognizable to those outside its borders.

Sure, steadily rising prices for oil and other commodities helped make Canadians richer overall during the last 15 years. It’s one of the key reasons Canada can now boast a wealthier middle class than the U.S. But consider this: in Alberta, more than seven per cent of workers pocketed more than $100,000 after tax last year. In Wood Buffalo, the region that is home to Fort McMurray and the oil sands, one in four workers earned that much. The next highest province is Ontario, where just three per cent of workers took home that kind of pay.Not surprisingly, a recent TD Economics report said Alberta’s per capita GDP is set to hit $88,000 next year, $35,000 more than the Canadian average.

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That imbalance in Canada’s two-track economy, as Bank of Canada governor Stephen Poloz calls it, is apparent everywhere. Drawn by an unemployment rate that, at 4.4 per cent, is about as close to zero as a province can get, Alberta has been the destination for virtually all net interprovincial migration over the last decade and a half. Meanwhile, Ontario and Quebec have been net exporters of people.

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Since 2000, the number of births in Alberta has grown three times faster than the Canadian average. And since 2004, Alberta has accounted for more than a quarter of all the net new jobs created in Canada. Ontario still added more jobs—about 33 per cent of the Canadian total—but, of course, 40 per cent of Canadians live there, while Alberta’s share of the total population is just 11 per cent. With better jobs and higher incomes, Albertans also spend way more—as a sample, since 2000 their spending on new cars and trucks (OK, mostly trucks) has grown at nearly five times the average of the rest of Canada, while the increase in their pace of spending on alcohol, games and jewellery has also left everyone else behind. Alberta’s economy has punched far above its weight, doing much of the heavy lifting for Canada’s overall employment and income figures.

But a commodity bust will have a far wider impact than just in Alberta. Close to half of all Canada’s exports are tied to commodities, while oil and gas alone account for roughly 20 per cent. At the same time, the natural resources sector makes up about 15 per cent of Canada’s GDP. Any slowdown in Alberta would also have a ripple effect across the country, particularly in the Maritime provinces, which have supplied so many of the young workers in the oil patch.

Of course, lower oil prices are not all bad news for Canada. The country owes its lower dollar largely to the slump in commodities. That’s good for our oil producers—Canadian crude has actually held up well in recent months, partly because the weaker loonie has cushioned it against the decline in oil, which is priced in U.S. dollars. (Crude from Canada’s oil sands has also long suffered steep price discounts because it’s more expensive to get out of the country, but that gap has been narrowing, helping to keep the price of oil sands crude from sliding.) The lower dollar is even better for non-commodity exporters, like manufacturers in central Canada that have struggled to compete. But most importantly, lower oil prices benefit consumers. Given that Canadian drivers pumped 41 billion litres of gasoline into their vehicles last year according to Statistics Canada, even the 20-cent-per-litre average saving at the pump that’s come with lower prices would leave an additional $8 billion free to be spent on other things. That’s more than Ottawa spent in a year on infrastructure under the 2009 stimulus plan.

And to some extent, a slowdown in Alberta from falling prices will bring relief for an economy that’s been pushed to the limit. Labour shortages in Alberta will ease. Public services like schools and hospitals that have strained to keep pace with the province’s booming population will catch their breath. But as with those Albertans who affixed Ron Carey’s prayerful bumper sticker to their cars after the 1980s oil collapse, falling petroleum prices will invariably lead to recriminations—that Alberta overspent during the boom years, and that the province, while debt-free, could still have done more to save for the next bust. The Alberta Heritage Fund has barely grown since 2001—its assets amount to $17.5 billion, which is just a 14 per cent increase over 13 years after adjusting for inflation. “I keep telling people, it’s not boom and boom, it’s boom and bust,” says Michael Lynch, a Massachusetts-based energy analyst who is bearish on the outlook for oil prices. “People complain about short-termism in the private sector, but short-term thinking is also in government. Prices go up, and people think this is how it’s going to stay, that they can keep spending money the way they had. But the good times don’t always last.”

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The coming months will give an indication about what commodity markets have in store for Canada. But with so much out of our control—will the U.S. oil boom continue unabated? Will China’s growth deteriorate further?—the best we can do is prepare for the worst.

As for Carey, whose company, J&L Supply Co., sells drill bits to the oil patch, he says he’s prepared to slash jobs if oil prices tumble further. But he believes most people in the industry will be caught off-guard by how far and how fast oil prices drop—just like last time. “There’s not many people out there today who even remember,” he says. “It’s 34 years ago. Most of the people who went through that mess are either retired or close to retiring. So you have a younger generation that doesn’t even know what a real recession is.”

—with Chris Sorensen


 
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