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93619 CURRENT ANALYSIS February 2015 Will lower oil prices provide a boost to Canadian manufacturers? The ongoing oil price shock has seen prices on a WTI basis drop from a recent quarterly high in the second quarter of 2014 of $103/bbl to below $45/bbl at the end of January. Prices have rebounded somewhat in recent weeks to levels slightly above $50/bbl, and we expect there will be some further recovery over the second half of the year; however, even in 2016 our assumption is that WTI oil prices will average $77/bbl, which is well-below the $93/bbl and $98/bbl averages in 2014 and 2013, respectively. The drop in prices and attendant cutbacks in production and investment in the sizeable oil and gas sector has raised concerns about a potential negative impact on the overall Canadian economy. Chart 1: Manufacturing Export Intensity to the United States 2014, % of Canadian manufacturing shipments exported to the United States Transportation Equipment Computer and Electronic Product Chemical Textile Mills Machinery Primary Metal Paper Plastics and Rubber Products Electrical Equipment Wood Product Total Furniture and Related Product Leather and Allied Product Clothing Miscellaneous Petroleum and Coal Products Textile Product Mills Food Fabricated Metal Product Non-Metallic Mineral Product Printing and Related Support Beverage and Tobacco Product 0% 10% 20% 30% 40% 50% 60% 70% Source: Industry Canada, RBC Economics Research Chart 2: Manufacturing GDP Share and C$ Percent of GDP (2012 and 2013 projected) C$/US$ 20 1.8 18 1.6 16 1.4 14 1.2 12 Manufacturing share of GDP (LHS) 1.0 10 C$/US$ (RHS) 0.8 8 0.6 While the impact of lower oil prices on activity in the oil & gas sector is clearly negative, RBC Economics has made the point in previous commentaries that not all regions or sectors will be negatively impacted. Canadian consumers benefit from lower gasoline prices that free up household incomes to purchase other goods and services and help offset a potential negative impact on consumers’ income arising from diminished terms-of-trade and the resulting drop to economy-wide purchasing power. The resulting boost to consumer demand helps businesses outside of the oil & gas sector which also benefit directly from lower energy costs. Moreover, our view is that the decline in oil prices also represents a clear net positive shock to our largest trading partner, the U.S. This is also the view of the Bank of Canada, which noted in the January 2015 Monetary Policy Report that a 45% drop in oil prices is expected to raise U.S. GDP by a full percentage point. Strengthening growth in Canada’s largest trade partner, along with a weaker currency (much of which is also a result of lower oil prices), represents a potentially substantial support to Canadian exporters. Manufacturing industry well positioned to benefit 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Statistics Canada, RBC Economics Research Paul Ferley Assistant Chief Economist (416) 974-7231 [email protected] Nathan Janzen Economist (416) 974-0579 [email protected] Gerard Walsh Economist (416) 974-6525 [email protected] Canadian manufacturers stand out as among the best-suited to benefit from the oil price shock. Data from Industry Canada suggest that close to 50% of Canadian manufacturing sales are exported, and about 80% of those exports are destined for the U.S. Chart 1 shows Canadian manufacturing export intensity (ratio of exports to sales) by manufacturing sub-industry. The largest U.S. export intensity is in the transportation equipment component, but a diverse set of other subsectors including textile mills, computer and electronic products, and primary metal manufacturing also count on the U.S. market for a large share of total sales. Although the benefit to exporters will be tempered to the extent their inputs need to be sourced from the U.S., a strengthening in the U.S. economy and a weaker Canadian dollar, could present a welcome reprieve for a sector that has struggled over the last decade and a half. Despite Canadian manufacturers' exposure to the U.S. market, there has been little transmission of U.S. growth into gains for Canada's manufacturing sector since the turn of the century. This is likely the result of the sector’s sensitivity to the Canadian dollar, which steadily appreciated relative to the U.S. dollar through the 2000s and eroded the competitiveness of Canadian manufacturers. Chart 2 illustrates the correlation of a strengthening dollar and a steadily declining manufacturing sector as a share of GDP through the 2000s. Canadian CURRENT ANALYSIS | FEBRUARY 2015 exports have similarly lagged improving U.S. GDP growth during the recovery from the 2008/09 recession, a fact that, as we have noted in the past, has at least in part been due to a stronger Canadian dollar relative to past recovery periods. Recent declines in oil prices coupled with policy action from the Bank of Canada have caused substantial currency depreciation and are turning the dollar from a headwind to a tailwind for Canadian exporters and manufacturers. Chart 3: Share of GDP: Manufacturing and Oil & Gas % of GDP (based on 2011 input-output tables) 12 10 8 6 Despite a reduced share, manufacturing sector still important for Canada 4 2 O&G & related industries* Chart 2 shows how headwinds over the last decade and a half have reduced the manufacturing sector’s footprint on the Canadian economy, which has raised doubts about how meaningful an offset the sector can provide to the almost certain weakness in the oil & gas extraction sector this year. We would note that, even with deterioration in recent decades, manufacturing output remains an important and sizeable contributor to the Canadian economy. Although manufacturing’s share of GDP has declined to about 11% from closer to 20% in 2000, this is still larger than the 7.8% accounted for directly by oil & gas extraction and closely related industries (Chart 3). Manufacturing *includes oil & gas extraction, support activities for o&g extraction, oil & gas engineering construction, petroleum refineries, and crude oil pipeline transportation Source: Statistics Canada, RBC Economics Research But can manufacturing respond? Chart 4: Manufacturing firm counts It has been argued that the ‘hollowing out’ of the manufacturing sector caused by years of underinvestment means that the sector may lack the capacity to respond to the normal drivers of activity in the form of increased U.S. demand and a weaker currency. This concern has in part resulted from earlier indications of firms exiting the manufacturing sector with the implied loss of production capacity inhibiting the normal boost to production that would ordinarily accompany rising demand. Longitudinal Employment Analysis Program, number of firms 60,000 58,000 56,000 54,000 52,000 50,000 48,000 46,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Statistics Canada, RBC Economics Research Chart 5: Manufacturing ex. Transportation Equipment Capacity Utilization Quarterly. Capacity utilization seasonally adjusted and approximated using GDP weights. 88 86 84 82 80 78 76 74 72 70 1994 1996 1998 2000 2002 2004 Source: Statistics Canada, RBC Economics Research ECONOMICS | RESEARCH 2006 2008 2010 2012 2014 Since 2000 there has been a steady decline in manufacturing firm numbers commensurate with declining output in the sector generally (Chart 4). However, this decline ended in 2012 with the number of manufacturing firms ticking up for the first time in 6 years. Preliminary data on business counts for 2013 and 2014 from Statistics Canada's Business Register are more mixed; however, that data source is also less reliable for making comparisons across time because of difficulties classifying businesses by industry and changes in methodology across survey periods. Data on firm entry and exit rates paint a similar picture to the business count data. Entry rates for manufacturing firms have been consistently below exit rates since 2000, but the latest data available point to a sharp pickup in entry rates to 7.2% in 2012 from 4.8% in 2011. Although this data is admittedly dated, the combination of strengthening U.S. demand and a weaker Canadian dollar which, on an annual average basis, has weakened for 4 consecutive years relative to the U.S. dollar provides reason to believe that the improvements observed in 2012 may have been the beginning of a more positive near-term trend. The argument has also been made that capacity utilization in manufacturing is already getting back close to pre-recession levels despite a tepid recovery in output. This has led to concerns that manufacturers are permanently closing idle capacity and thereby stunting the sector’s ability to meet rising demand. Our view is that these concerns are overstated because the lion’s share of the recent upward pressure on the capacity utilization rate is concentrated in one sector: transportation equipment. Strengthening U.S. car sales, and to some extent reduced business investment in the Canadian motor vehicle sector in prior years, have resulted in record capacity utilization for this sub-sector. Controlling for the impact of the transportation sector, rates of capacity utilization in manufacturing as a whole remain below those typical of the pre-recession period (Chart 5). CURRENT ANALYSIS | FEBRUARY 2015 Chart 6: Manufacturing Capacity Utilization and Investment Annual 24 90 88 22 86 20 84 18 82 80 16 78 76 14 74 12 72 10 70 1990 1992 1994 Already some signs of life 2000 2002 2004 Investment ($ bns) 2006 2008 2010 2012 2014 Capacity Utilization (RHS) Chart 7: Manufacturing Output and Canada GDP Growth Annual percent change 15 Manufacturing GDP growth stronger than Canada GDP growth 10 Real mfg GDP Real GDP Post-recession bounce 5 -5 ytd on pace for just third -10 Manufacturing underperformance outperformance of mfg sector in as CAD Strengthened 2014 since 2000 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2000 -15 1999 Alongside rising exports, manufacturing production has shown signs of improvement. The manufacturing component of monthly GDP declined 1.9% in November; however, a rebound in manufacturing sale volumes is pointing to at least a partial rebound in December while earlier gains leave the measure still on pace to outpace growth in the broader economy in 2014 for just the third year since 2000, with the other two instances in 2010 and 2011 as activity in the sector bounced following an outsized drop in 2009 that was much larger than the decline in overall GDP recorded in that year (Chart 7). In the late 1990s, manufacturing growth was consistently stronger than GDP growth but consistently underperformed through the 2000s as the U.S. economy entered recession in 2001 and the Canadian dollar strengthened steadily through the rest of the decade. 1998 Source: Statistics Canada, RBC Economics Research 1998 The above discussion suggests that there remains capacity for many manufacturing sub-sectors to respond to rising demand from the U.S. The question remains as to whether export-oriented manufacturing firms will take advantage of the recent supportive developments. Our view is that they ultimately will and, on that score, more recent trends have suggested some reason for optimism. Exports, which have lagged growth in U.S. demand during the economic recovery, have been growing more quickly with solid gains in the second and third quarter offset by only a modest pullback in the fourth to leave Canadian exports at the end of 2014 more than 8% above their level a year ago. 1996 2001 While we don’t yet believe capacity constraints are binding on manufacturers, they may become so as production rises to meet demand. If history is any guide, firms will respond to mounting capacity constraints by boosting investment spending. Chart 6 shows the historical correspondence of investment and capacity utilization in manufacturing. Particularly noteworthy is the 1990s during which manufacturing capacity utilization rapidly rose as the economy recovered from recession and prompted stronger investment growth in subsequent years. Recently, both capacity utilization and investment spending have slowly increased and are approaching pre-recession levels. If strengthening demand causes firms to take up their slack capacity, it may stimulate investment spending. Source: Statistics Canada, RBC Economics Research Chart 8: Manufacturing GDP by Industry: 2014 Year-to-date Percent change Transportation Equipment Textile\Clothing & Leather Prod Food Non-Metallic Mineral Product Wood Product Primary Metal Furniture and Related Product Beverage and Tobacco Product All mfg industries Machinery Plastics and Rubber Products Computer & Electronic Product Fabricated Metal Product Although increased production in the transportation sector, largely related to the rebound in the auto market following the recession, has led the way, gains have been relatively broadly-based by industry with most sub-sectors performing notably better in 2014 than their previous 10-year averages (Chart 8). Anecdotal reports are in line with the data. The Bank of Canada’s Q4 Business Outlook Survey pointed to notable weakness in the oil & gas sector; however, comments on manufacturing were unambiguously positive, particularly for those firms that reportedly export significantly to the U.S. (see below) Paper 2014 year-to-date average Chemical Printing and Related Support Activities 10-year average Petroleum and Coal Product Electrical Equipment, Appliance & Component Mfg Miscellaneous -10 -8 -6 -4 -2 2 4 6 8 Source: Statistics Canada, RBC Economics Research Chart 9: Canada Manufacturing vs Oil & Gas Employment Establishment survey, Thousands, Seasonally Adjusted 2200 2000 1800 Quotes from the BoC Q4 Business Outlook Survey: 1600 1400 “The winter Business Outlook Survey continues to provide signs of strengthening demand, especially among export-oriented firms and manufacturers.” “hiring intentions and investment plans are more robust for manufacturers than for firms in other sectors” “Compared with recent surveys, reports of higher investment in machinery and equipment are more widespread in the manufacturing sector, and more projects are aimed at expanding production capacity and reducing costs.” 1200 1000 800 600 Manufacturing Oil & gas extraction 400 200 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Statistics Canada, RBC Economics Research “Capacity pressures are more prevalent among exporters and firms that reported improved sales activity over the past 12 months. Many of these businesses are planning to increase their investment and employment to address capacity constraints.” ECONOMICS | RESEARCH CURRENT ANALYSIS | FEBRUARY 2015 Chart 10: Mfg Employment by Industry: 2014 Year-to-date Percent change Transportation Equipment Nonmetallic M ineral Product Textile M ills Leather and Allied Product Primary M etal Wood Produc t Fabricated M etal Product Food Total mfg Plastics and Rubber Products M iscellaneous M achinery Chemical Paper Furniture and Related Product Beverage and Tobac co Product Electric al Eqpt/Appliance/Comp Printing/Related Support Activities Petroleum and Coal Products Computer and Electronic Produc t Clothing Textile Product M ills -12 2014 year-to-date average 10-year average -10 -8 -6 -4 -2 2 Source: Statistics Canada, RBC Economics Research Chart 11: Canada Manufacturing Output and Employment Year-over-year percent change 15 10 5 -5 -10 Mfg employment -15 Manufacturing GDP -20 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Statistics Canada, RBC Economics Research ECONOMICS | RESEARCH 4 To-date, growth in the sector has still been modest and largely accounted for by productivity increases. As a result, job growth remains a sore spot with employment headcount little changed from recession lows (Chart 9). With that said, the number of workers directly employed in the manufacturing sector still is significantly larger than those employed directly in oil & gas extraction. As well, looking at the industry breakdown, there have been some pockets of improvement in manufacturing employment recently (Chart 10). In general, the largest manufacturing subsectors have seen the best employment dynamics in 2014. For example, data through November suggest that jobs in transportation equipment manufacturing have grown 3.2% in 2014, consistent with mounting capacity constraints in that subcomponent. Chart 11 shows the historical correlation between manufacturing output and employment. Although Canadian employment data is notoriously volatile, stronger output eventually should result in stronger hiring in the manufacturing sector. 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