It isn’t just Alberta’s problem now.
The plummeting price of Canadian heavy crude oil has been a source of of rising anxiety in Calgary and misery for investors in the energy sector. But it is more than that. As the downturn deepens, it’s becoming a cause of worry for the entire domestic economy, and for government finances that haven’t fully recovered yet from the oil crash of 2014 to 2016.
The numbers are extraordinary. This week, the country’s heavy-oil benchmark, Western Canadian Select (WCS), fell to US$13.46 per barrel, lower than at any point during the oil recession of several years ago.
Jim Gray, a veteran of Canada’s energy sector and chairman of the energy group at Brookfield Asset Management Inc., offers another eye-popping figure to describe the potential damage: By some calculations, total government revenue from royalties and taxable income related to heavy oil could fall by $10-billion. That works out to about $700 per Canadian household. But that’s only one fairly narrow measure of the costs.
Canada’s economy is suffering in other ways, too, from a surplus of energy and a shortage of pipelines in which to ship it. Natural gas prices are weak, and conventional, non-heavy Canadian crude also sells at a price lower than West Texas Intermediate (WTI), the North American benchmark. On the other side of the country, East Coast refineries, unable to get Alberta oil, are relying upon imports of more expensive Brent crude from the North Sea. (Brent trades for about US$67 a barrel.)
Add it all up, and toss in the spinoff effects of slower activity in other sectors of the economy, and the economic damage of oil’s drop runs well into the tens of billions of dollars. At 85, Mr. Gray has lived through decades of ups and downs in Canada’s energy sector, but he believes that the current downturn could prove particularly harmful if it persists.
“This is an urgent issue. I’ve never been more concerned,” said Mr. Gray, who co-founded Canadian Hunter Exploration Ltd. in 1973 (it was acquired in 2001 by Burlington Resources Inc., which is now owned by ConocoPhillips).
He’s not alone. Alex Pourbaix, chief executive officer of Cenovus Energy Inc., warned this week that Alberta faces a “wholesale economic catastrophe.” And DBRS, the credit rating agency, declared that "Canada’s oil sector has become untethered from global oil market dynamics.”
Part of the problem lies with the bearish moves in WTI, a U.S.-based benchmark that many observers cite when describing global oil prices. WTI traded at about US$57 a barrel on Friday, down 25 per cent since early October, amid a brewing trade war between China and the United States and fears of slowing global economic activity at a time when global energy production is robust.
But the real frustration in Canada stems from the sharp decline in the price of WCS oil. Even after the heavy oil benchmark rebounded on Friday, to US$17.43 per barrel, it’s still down 70 per cent since the middle of May, and sells at a bizarre US$40-a-barrel discount to WTI.
Canadian heavy oil has always traded at a discount to WTI to account for the fact that it is both more expensive to transport to Gulf Coast refineries and to refine it into usable petroleum products. But the historical average over the past 10 years is between US$17 and US$18 a barrel. The massive spread that exists now, observers say, reflects Canada’s inability to get new pipelines approved, which is causing a buildup in oil inventories as new projects come on stream. According to RBC Dominion Securities, producers are struggling to ship some 250,000 barrels of oil per day.
Mr. Gray isn’t the only observer trotting out gruesome numbers to describe the potential damage should these conditions linger. The Canadian Association of Petroleum Producers estimated that the wider spread between WCS and WTI cost Canadian heavy oil producers about $50-million per day in lost revenue in October alone. Over a year, that would add up to $18-billion in lost revenue.
Looking toward the year ahead, Peters & Co. Ltd., a Calgary-based investment company, estimated this week that a WCS discount of US$40 a barrel would cost Alberta $5-billion in lost royalties in 2019, or 10 per cent of the province’s budget – and that doesn’t include the financial impact of slower economic activity, such as lower income tax revenues.
Economists are starting to consider the broader potential damage that could affect all Canadians, though oil-producing regions will feel more pain than, say, regions that are net consumers of crude.
“Do the latest energy market developments have Canada’s economy over a barrel?” Avery Shenfeld, chief economist at CIBC World Markets, said in a recent note. “For now, what’s clear is that the oil sector – responsible for Canada’s largest export product as well as up to a third of business capital spending in good times – will be reverting to a drag on growth forecasts in upcoming quarters.”
The last time the price of oil fell this sharply, between 2014 and 2016, Alberta slipped into a recession that knocked 7.2 per cent from the province’s gross domestic product (GDP). The pain didn’t end at the provincial boundary, though.
Large Canadian banks set aside more than $420-million in 2015 to handle bad loans to struggling energy companies; the S&P/TSX Composite Index slumped 24 per cent, affecting anyone with investments tied to the Canadian stock market; the Canadian dollar plummeted 25 cents against the U.S. dollar in the space of two years, bottoming out at 68.6 U.S. cents in early 2016.
Canadian economic growth virtually stalled and sent the unemployment rate from 6.6 per cent in January, 2015, to 7.2 per cent within a year. The Bank of Canada responded by cutting its key interest rate twice to keep the national economy from getting stuck.
Economists believe that a repeat of these dire conditions isn’t necessarily in the works. Canada’s oil patch is more efficient today than it was in 2015.
“Given the operating break-even costs we’ve seen, we estimate that WTI would need to drop below US$50 per barrel on a sustained basis before Canadian output was significantly curtailed,” Stephen Brown, senior Canadian economist at Capital Economics, said in a note.
As well, railways are building their capacity to move the oil that can’t be handled by pipelines, easing some of the export bottlenecks. Last time, Canada’s energy sector was coming off a development boom, making the downturn particularly painful; today’s downturn follows a period of far more muted capital spending.
Nonetheless, observers believe that the deteriorating energy market has emerged as the biggest headwind facing the Canadian economy, eclipsing the importance of recent bickering over trade tariffs and renegotiating the North American free-trade agreement.
Douglas Porter, chief economist at BMO Nesbitt Burns, said that the depressed price of Canadian oil could shave between 0.3 and 0.5 percentage points from Canadian GDP over the next year if current conditions persist – which isn’t great when the forecast for GDP growth in 2019 is just 2 per cent.
“The longer it goes it on, the deeper oil drops, the more intense the damage,” Mr. Porter said.
The current price of Canadian oil is about half the price used by the Bank of Canada to support its economic assumptions in its most recent monetary policy report, released in October. In other words, the central bank’s relatively upbeat assumptions used to support gradual interest rate hikes already appear to be way out of date.
What’s more, the current price of WCS is well below the price at which oil traded in 2015, when the Bank of Canada cut its key interest rate in an attempt to shore up the country’s economic activity. In January, 2015, when the central bank cut its rate by a quarter of a percentage point, for example, WCS traded at about US$37 a barrel.
Economists expect that Bank of Canada governor Stephen Poloz, who has been relatively quiet about oil prices, will have to address the issue as the central bank contemplates hiking its key interest rate over the next couple of months. The bank has raised rates five times since July 2017 as it attempts to normalize monetary policy after nearly a decade of ultra-low rates, but may have to rethink its policy, at least in the short term.
“At the very least, I think the Bank of Canada has to become more cautious. They have to respect the fact that we could be in a different environment for a longer period of time,” Mr. Porter said.
Within the oil patch, observers are certainly bracing themselves for challenging times ahead.
“There is plenty of blame to go around here. But the point is that there is an enormous economic cost to all of this,” Mr. Gray said. “And it isn’t just Alberta that’s suffering, but the federal government and the other provinces, right down to the Maritimes.”