Oil Prices and Interest Rates Bottom Out

By Angus Gillespie

Plummeting international oil prices have put a smile on the faces of commuters filling their gas tanks while simultaneously eliciting a distinct frown on the faces of governments whose countries depend on the revenues generated through taxes to ensure the continuation of a number of essential programs and services. As one of the world’s largest oil producers – and the 11th largest economy – you can put Canada squarely in amongst those nations.

In June, 2014, a barrel of oil was selling for about $114. By the end of January it had continued its rapid descent all the way down to $48 and the corporate fallout has been immense.  Numerous oil projects in Alberta and B.C. have been shelved while workers sit on the sidelines, uncertain as to when they’ll be called back, if at all.  Suncor recently laid off 1,000 workers in just one example.

A Game of Chicken

The drastic drop in crude oil pricing stems from a multi-billion dollar high-stakes game of chicken being played out by the United States and the Organisation of Petroleum Exporting Countries (OPEC). The U.S. has been very public in its plans to be energy self sufficient by the year 2020, with only a limited amount of import oil continuing to come from Canada beyond that date. However, such a courageous pledge was made when oil prices were well beyond $100 per barrel.

The Americans’ commitment to expanded usage of fracking techniques to access oil in shale rock along with added discoveries in the Gulf of Mexico has only served to enhance those expectations of the U.S. government. Very few anticipated the U.S. would find so much oil using the controversial high-pressurized liquid method – and the asame can be said regarding the amount of oil available in the Canadian oilsands.  OPEC has responded by refusing to lower its oil production quotas, instead opting to further flood the marketplace with an abundance of crude to the point it has driven prices to low levels not seen in years. The OPEC reasoning would seem to be quite simple. The likely assumption on their part is that with oil devalued so much it will lessen the enthusiasm of the United States to continue on with its far more time-consuming and costly methods of fracking, which is infinitely more complicated than just drilling large pools of awaiting crude out of an underground hole.  At $114 per barrel, there is economic justification for putting in the costly investment to be self sufficient because a sizable profit can be recognized; at $48, not so much – at least that’s what the OPEC nations are banking on. Conventional thinking is that anything less than $60 per barrel makes fracking financially unviable. However, the U.S. has yet to blink and remains publicly adamant about continuing on with its program.

When North America started putting an additional million barrels of oil on the market it was immediately assumed OPEC would rebalance the total and cut its output by the same amount in order to keep prices stable. That didn’t happen. Countries such as Russia, Nigeria and Venezuela are desperate for revenue generated by oil, whether it’s at $110 per barrel or $45 per barrel because their economies are in tatters, so they are going full-steam ahead on the belief that any money is better than no money.

Meanwhile, Saudi Arabia added its own unique wrinkle to the story by keeping its output levels the same, driving prices down and making the projects for extracting much of the U.S. and Canadian oil financially unreasonable.  The Saudis and their OPEC Gulf region allies have chosen not to sacrifice their own market share to restore the price. As it is, it’s estimated the Saudi’s have about $900 billion in reserves.  It also costs a mere $6 for them to pump each barrel of crude out of the ground.  They feel they may not get full value for their oil now, but will recoup it in the future when prices go back up.

In the meantime, Canada is a country that sits on the outside looking in on this epic energy battle, waiting to see if such projects as the Keystone XL pipeline and/or the Northern Gateway plan will ever get the final go-ahead.  Those affiliated oilsands projects, like fracking in the U.S., are far more expensive than the conventional drilling for sweet light crude just waiting to be pumped up out of the ground. The only pipeline that Canada controls unilaterally without external decision-making is the reversal of heavy oil Line 9 between Ontario and Quebec, making it the most likely one to happen first.

BofC Rate Reduction

The prolonged downturn in oil prices and an otherwise bland economic output was enough for the Bank of Canada to take notice, with Governor Stephen Poloz lowering the trendsetting overnight interest rate by 25 basis points to a miniscule 0.75%.  Oil’s valuation decline of about 60% over the past eight months equals billions of dollars lost to government coffers. Until the unpredicted monumental slide in oil prices, the federal government was all but certain to come in with a handsome surplus to the tune of about $1.9 billion. All that changed and now only a great deal of manoeuvring will prevent a budget shortfall.

During a recent visit to Niagara, Prime Minister Stephen Harper chimed in on the economic situation, offering his confidence in the Bank of Canada’s decision. He also did his best to downplay the effects of the slide in oil prices, followed by a repeated promise that his government will balance the budget in 2015-16, a political accomplishment viewed as critical prior to an election set for October. Normally, the year’s fiscal budget would have been released by now, but Finance Minister Joe Oliver is gathering more data before determining what will be included in the document, now that it has become apparent oil revenues will not bring in nearly as much revenue as had been forecasted. The budget will not be ready before April and it could easily be delayed beyond that.

Regardless of when it is tabled, it is abundantly clear that Harper fully expects the budget to be balanced.

“In terms of fiscal policy, the appropriate action is to make sure that as long as the economy continues to grow, we balance our budget,” he says. “What the government will continue to do to build jobs and protect jobs is follow our economic action plan. Things we’re doing today, such as cutting red tape, programs to aid the creation of small business, programs to aid innovation, programs to ensure the manufacturing sector is strong and growing and revitalized and negotiations for opening new markets for trade and keeping our taxes low with sound public finance.”

Despite widespread shock amongst many financial analysts and business leaders, the prime minister also showed no outward concerns about the lowering of interest rates in an effort to kick-start a lethargic economy.

“The Bank of Canada conducts monetary policy independently of the government but the government has full confidence in the actions the Bank has taken,” he responded.
In specifically addressing the massive decline in oil prices, Harper again put a positive spin on a very difficult situation.

“Obviously it’s significant for the government’s finances – not as much as Alberta – but it’s significant,” Harper says. “But the oil industry isn’t remotely the entire Canadian economy. There are many benefits to other parts of the economy because of these developments. Although the oil industry in some regions will face some pretty significant adjustments the fact of the matter is this is a resilient industry that knows prices go up and down.”

The most frustrating aspect of what has happened is that virtually all of it is out of the hands of Canadians – be it government or business leaders.  It’s an international event that must play out, and until it becomes clear which way the industry proceeds in the future, it’s a game of wait and see. The energy sector has always been one filled with peaks and valleys, and this is no exception.

“I’ve been through many of these price cycles in my political and economic career and I have every confidence that the industry will weather the storm, with some difficulty, there’s no doubt about it,” Harper declares. “But they will emerge strong for the long-term. We live in a world of volatility. These things are creating some shocks that will impact us but will not throw us off our fundamental growth path or undermine the strong fundamentals of the Canadian economy.”

Net Gain or Loss?

Financial experts often ponder whether it’s a net benefit or a net loss to the economy when oil prices are so low. There is obviously a “sweet spot” where it aids both importing and exporting, but that number is imprecise – much like the argument about whether an 80-cent dollar or a parity dollar is best. Keep in mind on the one hand you have those ecstatic drivers paying about 50 cents less per litre than they were just a few months ago and are likely to spend the gas savings in other areas to help stimulate other sectors of the economy – such as retail or hospitality, for example.  On the other hand you have the energy companies, who, love them or hate them, cumulatively pay billions of dollars in taxes each and every year to the federal government and also the provincial governments where oil is drilled or refined. Replacing that kind of multi-billion dollar tax base is not an easy task to say the least.

Marvin Ryder from the DeGroote School of Business at McMaster University says time will ultimately be the determinant as to the overall impact.
“Economists are trying to determine whether this will be a net benefit or a net loss to the economy, and it’s moved so far so fast, we really don’t know,” he frankly states.

“We can’t tell you with absolute certainty what the impact of this is going to be.”

This tremendous uncertainty is the primary reason for Federal Finance Minister Joe Oliver delaying the budget for 2015-16. Although the fiscal year ends on March 31, the earliest we can expect to have the budget tabled will be April – and it will likely be later than that in order for Oliver and his finance team to properly evaluate everything once the dust has settled.

Numerous energy projects in Alberta, B.C. and other regions have already been delayed or mothballed because with oil below $50 per barrel, the extraction costs are no longer feasible.

“We think Alberta and Saskatchewan are going to fall into recession, but a recession is when you have two consecutive quarters in which the economy shrinks, so we’re not going to know they’re in recession until the latter part of this year. By that time they may be getting themselves out of recession, but you’ve got two economies that are instantly going to have a lot of negative repercussions,” Ryder says.

Oddly enough, there may be one provincial economy that may do well because of the falling oil prices and the decline in the Canadian dollar – and that’s Ontario, where the industrial sector has been struggling. When the dollar was at parity with the U.S. currency it made exporting goods that much more difficult.

“Companies like Ford, GM and Chrysler were thinking about packing up some of their production and moving south of the border, but now at an 80-cent dollar most of those things are just the opposite,” Ryder says. “If I’m making things out of plastics – which is petroleum based and therefore cheaper – suddenly we’ve got this double-plus for the Ontario economy.”

If there is a criticism to make about Stephen Harper’s government is that there was no waiting for a balanced budget before an announcement was made regarding promises for various sectors as well as tax cuts, making it retroactive to 2014. The government jumped the gun, assuming the overall economic recovery would continue on relatively the same pace it had for the previous two or three years. But the international oil pricing war put a quick end to that. However, we’ve already got income splitting and enhancements to the universal child benefit in place – so the money is spent, based largely on oil revenues that are no longer there.  It’s now Finance Minister Oliver’s job to find that money somewhere else with the anticipated $1.9 billion surplus entirely wiped out.

“We think these oil price declines are going to effect the federal government’s revenue stream by somewhere between $2.6 billion and $4.2 billion,” Ryder states. “The $4.2 billion is the Conference Board of Canada estimate; the $2.6 billion is the Bank of Canada estimate.”

Finance Minister Oliver could make a gamble that the outlook for sectors such as energy will improve over the next year and make projections based on that. The government also keeps its own insurance policy tucked away for a rainy day, and it comes in the form of a $3 billion contingency fund.  Both Harper and Oliver admit that some of that money may be required to top off unexpected shortages in other sectors.

“The contingency fund is obviously available for unforeseen circumstances,” Harper states, admitting that this is such a situation where usage would be appropriate, if necessary.

Ryder is of the opinion that the drop in oil prices won’t put Canada into recession but rather it will shave the previously anticipated growth rate of the economy.

“Last year the economy grew at 2.4%, but now 2015 is looking more like 2% with the possibility of 1.8%,” he says. “The lower interest rate at .75% is a bit of insurance to help stimulate the economy. Come April, we may see the rate go back up to 1% and it could stay there for the rest of the year.”

Consumer Spending

Bank of Montreal’s Chief Economist Doug Porter is concerned that an economy already strongly skewed towards the promotion of the housing market and consumer spending will spell bigger problems if more people are convinced they can handle increased debt-loads in order to purchase homes that would normally be beyond their means if interest rates were even marginally higher.

“Far from helping growth, the rate move could actually increase consumer and employer anxiety and uncertainty,” Porter wrote in a note to clients. “More fundamentally, the economy’s shape is arguably already heavily skewed by the persistence of negative real interest rates, and the cut threatens to make the skew grotesque.”

The Bank of Canada had held its benchmark rate at an even 1% for more than four years.  Very few analysts had foreseen a move on the Bank’s part in an effort to stimulate a lagging economic base. The primary concern for Porter and many financial analysts is the added pressure that will be put on household debt levels that hit record levels in 2014.

Financial data indicates the national economy still has a bit of momentum, but it’s becoming more difficult to detect. The expectation is economic expansion of 2.1% this year and 2.4% next year. There are already some financial analysts opining that the Bank of Canada may cut the rate again if stimulus remains weak.
Meanwhile the man who will soon be in the spotlight, Finance Minister Oliver, says he won’t pressure the nation’s banks to follow the Bank of Canada’s latest interest-rate cut, or take steps to influence the housing market.

“I do not intend to interfere with the day-to-day operations of the banks,” Oliver says while in Davos, Switzerland for meetings at the World Economic Forum. He also says all options are currently on the table for balancing the budget, including the possibility of dipping into the $3 billion contingency fund, echoing the words of the prime minister. The budget will not be released any earlier than April.