Download No Barrel of Fun: What Weaker Crude Means for Canada

IN FOCUS
December 16, 2014
Peter Buchanan
(416) 594-7354
[email protected]
Warren Lovely
(416) 594-8041
[email protected]
Andrew Grantham
(416) 956-3219
[email protected]
Nick Exarhos
(416) 956-6527
[email protected]
That’s unprecedented since, while we’ve
seen retreats of that magnitude before, the
recent ones were demand-led corrections in
which broader US or global recessions did
much of the economic damage to Canada.
The US economy is instead accelerating
and will benefit from cheaper crude, and
growth disappointments overseas were
only a modest part of the story of oil’s dive.
Instead, this was more of a supply shock,
driven by OPEC’s bombshell decision not to
trim excess output in November and soaring
Chart 1
“Shaling Up” US Oil Production Forecasts
“text text text”
12
Why This Oil Shock Could be More Painful
9
Ratio of crude
production to oil
demand
1.8
1.6
%
6
3
1.4
0
1.2
1
0.8
0.6
80
90
00
10
At time of 1997-8 Asian
C risis
Today
Source: British Petroleum, Statistics Canada
North American, particularly US (Chart 1),
production. It’s also unprecedented since
Canada was not nearly the net oil exporter
it is today during either the supply-side price
correction of the 1980s, or the next decade’s
Asian crisis-inspired jolt (Chart 2), making it
much more exposed now to oil’s story.
mn bbl/day
10
8
6
4
2
Chart 2
Energy Trade
Surplus/GDP
Benjamin Tal
(416) 956-3698
[email protected]
The recent dive in crude oil prices is an
unprecedented development for the
Canadian economy. Even after allowing for
the cushions provided by tighter heavy oil
spreads and a weaker C$, the local currency
value of a weighted index of Canadian
barrels is down over 40% in the last four
months.
Oil & Gas
Capital
Spending/GDP
Avery Shenfeld
(416) 594-7356
[email protected]
Avery Shenfeld, Peter Buchanan and Warren Lovely
Oil Prod./GDP
Economics
No Barrel of Fun:
What Weaker Crude Means for Canada
2011 Fcst
2012 Fcst
2013 Fcst
2014 Fcst
0
08 09 10 11 12 13 14 15 16 17 18 19 20
Source: US Dept. of Energy
Even if improved global demand and some
paring of excess supply restores substantially
higher prices in the last quarter or two of
next year, WTI oil might still average only
$70/bbl in 2015, our base case for this
analysis. Some aggregates, like real GDP,
will see a smaller hit than many who think
of Canada only as North America’s resource
hub might conclude. But within that story
lie major sectoral and geographic wins and
losses, and a much larger terms of trade
hit to nominal GDP, national income and
the fiscal performance of oil-exporting
provinces.
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CIBC WORLD MARKETS INC.
In Focus—December 16, 2014
Scaling the Damage
we export our output in exchange for consumer goods
and other imports. It’s nominal GDP, and net national
income, where the benefits of climbing commodity prices
showed up in the last cycle, and which will now take it
on the chin. And nominal GDP forms that revenue base
for governments and thereby ties in to the sizeable hits
noted below.
Two analytical approaches exist for gauging the countrywide fallout from cheaper oil. A top-down vector, auto
regressive (VAR) model looks at historical information in
correlated time series to identify how real GDP might
respond post-shock. Our version of that model suggests
a hit to growth of only a quarter-percent in a little over a
year (Chart 3), near the three-tick dent that the Bank of
Canada has referenced for the annual impact.
We estimate that the GDP deflator will be about 1½%
weaker in 2015 as a result of oil’s slide (running at 0.4%
vs 2% in our previous forecast) even allowing for a
rebound in crude in the back half of the year. As a result,
the hit to nominal GDP will be more than 2%, no
small matter, and the dent to real gross domestic income,
what Canadians can effectively buy on the proceeds
of our output, is already approaching that from some
major past shocks. Given that fact, it’s less surprising that
many Canadians feel the economy is doing “less well”
than the recent decent GDP performance might suggest
(Chart 4).
But given the recent dramatic increase in oil’s weighting
in the national economy, models derived on historical
relationships will end up understating the current
vulnerability. For that reason it is also useful to undertake
a “bottom-up” calculus, taking first the effect on a
number of key players—consumers, corporations, and
governments—and, importantly for GDP growth, the
impact on their spending. That analysis, and a review of
provincial sensitivities, suggests that we are looking at
about twice that impact, or a half-percent off real
GDP, and we’ve therefore trimmed our growth outlook
for 2015, to 2.2% (vs 2.7% previously).
Catch-up Time, for Now
The half-point off national real growth also masks a
much deeper dent into real and nominal growth in the
oil-producing regions of the country. The energy sector
Chart 5) directly accounts for nearly 10% of Canada’s
GDP, but in the oily corners of the country—Alberta,
Newfoundland & Labrador and Saskatchewan—that
sector’s weighting is closer to 25-30%. Energy’s share of
the Ontario economy is a scant 2%, and that province will
actually benefit from a weaker C$, a cheaper oil import
bill, and a firmer US outlook as that country reaps the
benefits of savings on its oil trade deficit.
Will the Real GDP Measure Please Stand Up
Canada isn’t Norway or Russia, which derive a quarter
of GDP from oil. And a half-percent on real GDP growth
hardly seems earth shattering. Forecasts are often out by
that much anyway. But in this case, real GDP isn’t really
the best measure for the economic consequences of
declining oil prices, since it only measures the volume of
production domestically, not what we can then buy when
Chart 3
Chart 4
VAR Model Suggests 0.25% GDP Hit From 35% Oil
Price Drop, Based on Historical Data
Real National Income Shock Already Approaching
Some Historic Ones
0.00
7
-0.05
6
% decline in Gross National Income
($ impact in brackets)
$100 bn
5
-0.10
4
-0.15
$46 bn
3
-0.20
2
-0.25
1
$35 bn
$34 bn
0
-0.30
Q1
Q2
Q3
Q4
Q5
Q6
Great
Recession
Q7
Source: CIBC, Note: 1961:Q3 - 2014:Q3, variables Cdn Real GDP, US$ WTI
price, CAD/USD, 10-year GOC Yield
2001 US
recession
Asian Crisis
2014 Shock
(Q2-Q4, est)
Source: CIBC
2
CIBC WORLD MARKETS INC.
In Focus—December 16, 2014
Chart 5
Chart 6
Regional Winners and Losers
Last Oil Price Collapse Hit Alta, Sask, N&L Hardest
35
Mining, Oil & Gas Extraction: % of GDP (2013)
2009 Growth: %
5
30
0
25
-5
20
-10
15
-15
10
Canada
5
0
N&L Sask Alta Man
BC
NS
NB
Qué
Real GDP
-20
Ont
Nominal GDP
-25
PEI
BC
Alta Sask Man Ont Qué
NB
NS
PEI N&L
Source:Statistics Canada
Source: Statistics Canada
So pick your economic indicator—real or nominal GDP,
business investment, employment, corporate profits,
merchandise trade, housing starts—and oil’s deep dive
will leave a notable mark on prospects in a handful of
provinces in 2015.
global economy mired in recession next year. Still, the
decline in energy prices looks to be sufficiently large to tip
once-robust nominal GDP growth into negative territory
for Canada’s three oil-rich provinces.
On the flip side, the combination of a stronger US
economy, cheaper energy prices, a depreciating currency
and still-low interest rates is a pretty favourable mix
for the country’s more factory-intensive provinces. We
staked out a much more positive view of Ontario’s
relative growth prospects back in the summer as the
US economy accelerated and the C$ eased, and our
conviction around that call has only grown. In fact,
Ontario could be poised to lead the country in real GDP
growth in 2015, with Québec likewise due for a notable
acceleration (Table 1).
Just how much of a hit are we talking about? Consider
the underperformance of the oil-levered provinces back
in 2009, when WTI declined nearly 40% year-on-year.
At that time, the hit to GDP in Alberta, Newfoundland
& Labrador and Saskatchewan was disproportionately
large. Most striking was the underperformance in nominal
output, as lower commodity prices saw the value of
production implode. Things won’t get as ugly as 2009;
after all (Chart 6), the decline in oil prices should fall short
of that earlier collapse, and importantly, we don’t see the
Downside Risks for Loonie
Table 1
Provincial Economic Forecast: Nominal GDP Decelerates in 2015
Y/Y %
Chg
BC
Alta
Sask
Man
Ont
Qué
NB
NS
PEI
N&L
Cda
Real GDP Growth
Nominal GDP Growth
2013A 2014F 2015F 2016F 2013A 2014F 2015F 2016F
1.9
3.8
5.0
2.2
1.3
1.0
-0.5
0.3
2.0
7.2
2.0
2.4
4.1
1.0
2.2
2.1
1.8
1.1
1.5
1.8
0.5
2.4
2.5
1.7
1.9
2.6
2.8
2.4
1.7
2.3
2.0
-1.0
2.2
2.7
2.8
2.8
2.5
2.9
2.5
1.6
2.3
1.8
-1.0
2.6
3.2
7.1
5.5
3.7
2.4
1.5
0.5
2.4
5.0
10.7
3.4
4.2
7.5
1.5
4.0
3.8
3.2
2.5
3.5
3.5
1.0
4.2
3.8
-3.0
-1.8
3.8
4.9
4.3
3.4
3.8
2.8
-5.0
2.6
3
5.2
6.5
6.2
4.9
5.1
4.7
3.8
4.4
3.9
4.1
5.2
There are, however, some positive
offsets for all provinces. For one,
monetary policy isn’t static, and can
respond to these developments. The
run of consensus-topping growth and
core inflation to Q3 2014, and our view
that the output gap was narrower than
the BoC suspected, would have tilted
the Bank of Canada towards an earlier
move to tighten.
CIBC WORLD MARKETS INC.
In Focus—December 16, 2014
But a half-point off real growth will leave only marginal
progress towards closing the remaining gap. The recent
decline in oil and other commodity prices points to lower
near-term trajectory for inflation. Although a smaller
output gap and a lower C$ could help insulate core,
headline inflation in 2015 should average below 1½%,
with oil prices and gasoline both hovering near halfdecade lows, about three-quarters of a percent below
our earlier expectation.
Chart 8
Who Benefits and Who Loses from $70 Oil Prices?
$Bn/year
10
5
0
-5
-10
-15
-20
*Direct vehicle
and heating costs
only
-25
Since lower crude prices are a net benefit to the US, and
a net hit to Canada, we see an even longer gap in the
timing of the first rate hike, with the Fed raising rates as
early as next March, and the Bank of Canada pushed back
one quarter relative to our prior forecast into Q4 2015.
-30
-35
-40
Consumer Savings* Industry Revenues
Fed & Prov
Revenues
Source: CIBC, Statistics Canada
In terms of the Canadian currency’s underlying dynamics,
modeling by researchers at the Bank of Canada suggests
that a 40% drop in oil prices, shaves about 5% from the
loonie’s value against the greenback. A 100-bp tightening
in Canada-US spreads levers a near-4% decline. Combined
with somewhat disappointing trade data recently, lower
prices for energy and other commodities and more
evidence of the Bank’s reluctance to go head to head with
the Fed in the rate hike game, now point to an 81-cent US
bottom for the C$ in the next few quarters. That’s about
5% lower than our prior estimate (Chart 7).
Canada go directly to oil-based fuels—motor vehicles and
heating. Crude acquisition costs represent about half of
the cost of a litre of gasoline in Canada currently. Allowing
for the “wedge” created by transport costs, refiners’
margins, and non-ad valorem taxes, each $2 drop in crude
shaves about a cent per litre from pump prices, so even if
oil rebounds to average $70 next year, the savings could
provide Canadians with the equivalent of a $10 bn boost
to incomes (Chart 8).
As with any transitory bump in income, not all of that
money is likely to be spent. History in fact suggests a
somewhat noisy relationship between gas prices and
consumption, with the data complicated by the fact that
recessions coincided with some past oil price declines.
Even assuming a modest 50% propensity to consume,
gasoline’s decline could nonetheless still add $4-5 bn to
household spending in 2015, or roughly half a percent of
total consumption. That, however, ignores second round
impacts on consumption if governments tighten fiscal
policy through sales or income tax hikes, and the negative
impacts associated with a lower overall trajectory for gross
national income.
Winners and Losers
Ignoring income impacts on some Canadians from weaker
oil, consumers are the biggest first-round winners from
the dive in oil prices. Roughly 5% of consumer outlays in
Chart 7
C$'s Sensitivity to Oil & Canada-US Spreads (L);
Negative Implications for Currency (R)
% chg in C $ vs US$
0
-1
90 US cents
88
-2
86
-3
-4
The Bank of Canada is looking to transition the economy
towards a greater reliance on capital spending and
exports. For the former, note that oil and gas spending
has accounted for nearly a third of non-housing
investment in Canada and oil prices have been the second
most important determinant of business capital spending
(Charts 9, 10).
84
-5
82
-6
35% decline in 100 bps tighter
80
oil prices
C da-US bills
yields
Note: CIBC, based on Issa,
Lafrance, Murray, BOC (2005)
78
Prior
Current
15Q1 15Q3 16Q1 16Q3
Source: CIBC
4
CIBC WORLD MARKETS INC.
In Focus—December 16, 2014
Chart 9
Chart 11
Oil & Gas Nearly a Third of Canadian
Non-Housing Investment
Most New Oil Sands Plants Less Costly (L);
Canadian O&G Balance Sheets Also Stronger (R)
20
15
5
0
91
95
99
03
07
11
14
median, %
100
114
87
80
60
40
20
Cdn Mined, No
Upgrader
10
120
Bakken (Typical)
25
Breakeven Prices, US$/bbl
Cdn SAGD
100
90
80
70
60
50
40
30
20
10
0
Permian (Texas)
% share
Brazil Offshore
30
Source: Statistics Canada, CIBC
7.7
12.1
0
Interest
C overage
Ratio
Debt-toEquity
10 Large US Shale Plays
5 Largest TSX Oil & Gas
Source: Bloomberg, CIBC
Chart 10
Crude Prices Second Most Important Factor
Affecting Canadian Investment
Even so, some delays within the oil sands sector, and
a more substantial downdraft will be seen in Canadian
conventional oil drilling, as well as the country’s own
shale gas plays. We estimate that an average price of
$70/bbl will lead to a real decline of about 8% or $5-6
bn next year, representing a 2-3% hit to overall business
machinery and investment spending.
Relative importance, based on regression on
normalized data, 1990:1 - 2014:Q2
35
30
25
20
15
Poof: There Goes $10-13 bn
10
5
Governments are the third directly affected party, with the
impacts magnified relative to equivalent swings in other
segments of the economy. Oil differs from, say, machinery
manufacturing, in that provinces own the resources
within their borders, and reap the proceeds of auctions
for development rights and royalties on production.
Additionally, a fifth of production, primarily east coast
offshore, occurs on Canada-lands.
10 year
GOC Yield
Return on
Equity
CAD/USD
Corp
Profits
Real Oil
Prices (ch
over 4
qtr)
Capacity
Utilization
0
Source: CIBC
Long lead times for oil sands projects and substantial
sunk costs for projects underway mean Canadian capital
spending isn’t as sensitive in the short-run as US shale
to pricing developments. Most projects on the boards
or under construction currently are in situ facilities.
Those have breakeven levels 30% or more below the
mining projects that drove earlier stages of oil sands
development. The balance sheets of larger Canadianlisted oil producers are also healthier than those of many
of the small-to-medium sized firms at the vanguard of the
US shale revolution (Chart 11), leaving them less at the
mercy of investor and lender sentiment.
All told, even allowing for some wins in revenues of oilimporting provinces as their economic prospects improve,
the government sector stands to lose some $10-13 bn
even if oil hangs on to a $70 average. Of that, Ottawa’s
hit would be on the order of $5 bn. While Ottawa benefits
from having a fixed, rather than ad valorem tax on
gasoline, it will take a hit on corporate GST and personal
taxes on the fallout from lower nominal GDP. While a
portion of that damage was factored in to the last fiscal
update, there’s perhaps a further $2.5 bn/year downside
adjustment still to be realized, which would put a crimp
5
CIBC WORLD MARKETS INC.
In Focus—December 16, 2014
into the room for any initiatives in the upcoming budget,
or even force some yet-to-be-announced restraint on the
spending side to pay for tax relief already unveiled.
sheet health that characterizes both provinces. Moreover,
there’s ample scope to raise revenue from other sources
should oil ultimately fail to reflate. Deep cuts in spending
or tax hikes in the near term would only exacerbate
the economic drag in the coming year. Newfoundland
& Labrador’s situation is more challenging, given its
outstanding debt, and it will therefore face more difficult
choices ahead.
The $5-8 bn we expect in provincial revenue losses are
more stark than they appear, since we are netting out
gains in revenues for oil-importing provinces that see an
economic lift from cheaper oil and a firmer US economy,
against much larger losses for oil-exporting regions.
These revenue hits leave open the possibility of additional
economic downside from fiscal tightening should the
negatively impacted provinces choose to cut spending or
raise taxes to stay closer to earlier deficit targets.
The bottom line is that references to a few decimal places
in real GDP miss the point. The value of what Canada
sells to the world, not just the volumes, is what filters into
wages and profits, government revenues, and economic
well being. The country outpaced the US in income
growth in the last business cycle largely owing to the
rising tide of a super-cycle in commodities.
Three provinces, Alberta, Newfoundland & Labrador and
Saskatchewan, face the brunt of the damage. Even at
an average $70/bbl, our own model of Alberta’s fiscal
sensitivities points to a $7 bn hit to revenue in 2015/16
(relative to the 2014 budget plan), as WTI’s freefall
swamps the beneficial impact of a cheaper Canadian
dollar. Alberta’s premier recently came to a similar
conclusion. Saskatchewan and Newfoundland & Labrador
could each be forced to live with $400-700 mn less in
revenues in 2015/16.
Today’s concerning energy price backdrop won’t last, as
the world will ultimately need oil from Canada, Brazil
offshore, and even costlier sources, suggesting a return
to something north of $80/bbl in the years ahead. And
this isn’t anywhere near a recessionary environment given
that 75% of Canada’s exports lie outside the energy
sector, and include big weights for manufactured goods
destined for an improving US economy. But behind that
national picture, there are regional and sectoral stories
that will play out for at least a year if not longer, raising
the stakes for policy makers and investors who had grown
accustomed to good news from the oil patch.
“Deficit” may be a bad word in Alberta, but if ever
there was a time to run a budget shortfall and dip into
reserve funds, it’s now. There’s more than sufficient fiscal
flexibility in Alberta and Saskatchewan to withstand a
year or two of revenue vulnerability, given the balance
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