Thinking Through the Fall-Out of Lower Oil Prices

Canada’s economic and fiscal debates in recent months have been dominated by the possible impacts of the sudden fall in oil prices since last autumn on growth, employment, and fiscal balances.  Finance Minister Joe Oliver delayed the budget, the Bank of Canada shocked markets with a rate cut, and Alberta Premier Jim Prentice is now promising a shock-and-awe austerity budget unlike any that province has experienced.  And these are just the first-round policy responses.  More drama surely lies ahead.

I have prepared for Unifor a summary economic bulletin that reviews the many and varied impacts of the oil price decline: the good, the bad, and the ugly.  It is available here.

My main findings include:

• The current oil price is not “low” by historical standards, and the recent volatility is not at all unusual.  No-one should be surprised by what has happened.  For those who believed naively in “super-cycles” and hoped that commodity prices could only go in one direction, this is an inevitable awakening to reality.  It was reckless to build a business plan for a single company (let alone an economic strategy for an entire nation) around the assumption of $100 oil (or anything close to it).
• The impact on nominal GDP of lower oil prices is certainly negative. Inflation will fall to near zero levels.  The nominal tax base will be smaller.
• The impact on real GDP will be muted. Real petroleum production will not be hurt (and in fact will continue to grow). Real activity in new exploration and development projects will be badly hurt — and there will be important spin-off effects from that investment downturn. This will be partly or wholly offset by new spending and activity among sectors that benefit from lower energy costs: including transportation industries and consumers.
• The impact on employment will be even more muted: petroleum is about the least labour-intensive major industry in Canada’s economic portfolio (every million dollars of GDP in petroleum extraction supports just one-half of a job — versus GDP multipliers of 10 or more in other sectors), so the downturn in activity there will have proportionately modest impacts on total employment.  Without doubt however there will be significant disemployment in petroleum investment and related fields, and this will cause tremendous pain and uncertainty in some parts of the economy.
• The biggest “positive” from the oil price downturn will be experienced through a lower dollar, which will stimulate production, export, investment, and eventually job-creation in a wide swath of trade-exposed sectors.  The benefits of the lower dollar, however, are limited by key factors — including the destructive closure of manufacturing capacity in the past decade (which cannot be replaced with the snap of a finger), and the lingering fear among firms that the dollar may be allowed to shoot right back up again when oil prices eventually recover.
• The fiscal impact on Ottawa is modest — not surprising, given Ottawa’s small and indirect ties to oil wealth (no royalties, low corporate tax rates).  Most of Ottawa’s impact is felt through lower nominal GDP (and hence some of that is offset automatically by the lower rate of nominal escalation in some program spending).
• The fiscal impact in oil-producing provinces will be enormous, and the resulting shock of coming austerity (unless citizens in those provinces are able to stop it) will be among the most negative (if self-inflicted) side-effects of lower oil prices.

I also review briefly some of the policy lessons that Canadians should be learning from the oil price downturn, including:

• An urgent need to boost investment spending (public and private) to offset the coming decline in petroleum investment.
• The long-term need to maximize value-added connections to Canada’s petroleum production (both upstream, through more Canadian content in investment projects, and downstream, through more refining and processing of our own resources).  These value-added connections help to smooth the fluctuations that seem inevitable in resource markets.
• The need to support those who will be negatively affected by the oil patch downturn, including by fixing our EI system (currently less than 40% of unemployed Canadians get any benefits at all, and coverage rates are very low in the Western provinces).
• The opportunity provided by the oil shock to finally and belatedly develop a climate change policy, providing clarity to the industry in advance of the next upswing.

The fingerprints of the oil price slowdown were all over the fourth quarter GDP numbers that came out this week, including:

• The GDP deflator fell during the fourth quarter at an annualized rate of 2.3% — the first significant deflation since the worst months of the global financial crisis.
• Hence nominal GDP growth for the quarter was negligible, with falling prices offsetting the modest uptick in real activity (which grew at an annualized 2.4% during the quarter).
• Real GDP growth was boosted by a big inventory build.  In fact, two-thirds of real GDP growth during the quarter was allocated to inventories … not a good sign.
• Real GDP was hurt by big declines in non-residential business investment (falling at 2.3% annualized rate) and exports (down at a 1.6% annualized rate).  Nominal exports were falling much faster in the quarter (at an annualized rate of 8%).
• Real GDP for 2014 as a whole grew 2.5%, led once again by debt-fueled consumer spending (2.8%) and a more promising uptick in real exports (5.4% for the year, despite the fourth quarter downturn).

The oil price downturn will hopefully spark a much-needed rethink by Canadians (and their governments) about how to manage our resource wealth in a manner consistent with stable, sustainable, value-added economic progress.  In the meantime, however, there is no doubt that a national economy far too dependent on this single volatile sector is going to experience some major adjustments (some positive, some negative) in the immediate future.