Despite the gloomy headlines and dire warnings, there is still a segment of the population who think the oil shock might not be so bad for the Canadian economy. They're intelligent, reasonable people who have good, rational reasons for thinking that we're getting all wound up about something that might offer ample silver lining around the conspicuous dark cloud.
I like these people. I applaud their optimism. I wish I could agree with them.
Their argument doesn't seem unreasonable. They don't deny that lower oil prices hurt oil producers, and by extension hurt incomes not only of those producers but also the people who work for them, with them and around them, and the governments that collect taxes from them.
But, these oil-shock optimists say, there's a big consumer and non-energy business upside that mitigates, if not entirely offsets, the obvious energy-sector downside. Cheaper fuel prices put more money in the pockets of Canadians who pay regularly for fuel. The same goes for all the businesses that use energy to produce and distribute their products. It is essentially a transfer of money from the oil companies to, well, everyone else.
It's not an even tradeoff for Canada, though, because we produce more oil than we consume. So the downside for the overall domestic economy should outweigh the upside. However, the optimists point out, Canada's main trading partner – the United States – is a net consumer of oil; the benefits of the oil drop to its consumers implies a boost in demand for Canada's non-energy exporters.
And on a global basis, there's a widespread assumption that shifting oil money to consumers from producers isn't just a wash. Consumers, many economists believe, are more likely to actually spend it, while oil producers are more likely to toss the money on their already enormous cash pile. (The world's oil-based sovereign wealth funds hold more than $4-trillion U.S. in assets, according to recent estimates.) For this reason, the common assumption is that, all things being equal, the upside to an oil plunge does more overall economic good than harm.
It's an assumption based on history – sort of. But more to the point, it is based on faulty logic.
John Llewellyn of Llewellyn Consulting, an independent economic research firm in London, wrote recently that this belief has been extrapolated from the experience during prior oil shocks – but those tended to be sudden upward price spikes, rather than high-speed declines. In those cases, indeed, consumers responded quickly to the shocks, reducing their spending on other things as their fuel costs took a substantially bigger bite out of their disposable income. Producers, on the other hand, didn't spend their gains sufficiently to offset the decline in consumer spending; they saved rather than spent.
This led to a belief that consumers' spending behaviour is more sensitive to big swings in the oil price than producers. By extension, transferring the money in the other direction – to consumers – would be expected to take what would have been producer savings and converted them into consumer spending.
That, Mr. Llewellyn argues, is a misunderstanding of what was truly going on in these previous oil shocks. It's not a case of consumers responding more quickly and fully to price changes than producers; it's a case of the group losing money in this oil-wealth transfer being under more pressure than the one receiving the windfall.
"The losers, through the transfer, have to bring their expenditure down into line with now-reduced income. The gainers, however, are under no such pressure: They can take their time."
This suggests that when the oil shock is to the downside, the producers are the ones forced to quickly respond to tumbling incomes – which, indeed, we have already seen, with the significant spending and job cuts in the Canadian oil patch. Consumers, in this scenario, are the ones under no particular pressure to spend their gains. And, given the record-high household debt levels in Canada, there's good reason to think they might lean toward saving.
It's noteworthy that despite greatly improving the mood of U.S. consumers – the U.S. Conference Board's consumer confidence index clocked in this week at its highest reading since 2007 – the oil-price plunge has yet to translate into a boost in their spending. U.S. retail sales, excluding gasoline, was down 0.4 per cent in December from November. Durable goods orders slumped 3.4 per cent in December, on top of a 2.1-per-cent fall in November.
In short, the hoped-for consumer boost certainly hasn't surfaced yet. And while oil's decline likely will eventually fuel some gains in consumer demand, don't count on them living up to all the wishful thinking.