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December 10, 2014

 

Oil price drop should yield mixed returns

Producing provinces will suffer. But the rest of the country will get the equivalent of a big tax cut.

 

Canadians have been getting a good idea what the rest of the world thinks of us in recent weeks. Oil prices have tanked by more than 35 percent since mid-June and the Canadian dollar has followed suit, off by nearly six cents since the start of the year. The loonie is a petro-currency they are saying.

 

The reality is far more subtle. Canada is more like a two-tired economy. Several provinces, notably Alberta and Newfoundland are major oil producers and thus benefit in a high price environment. That’s particularly true of tar sands players, who are generally high cost producers.

 

Lower gas prices are like a tax cut

However although the “have-not” provinces love the transfer payments their governments get from the producing provinces, most Canadians benefit from lower oil prices. Almost any driver can tell you within a couple of pennies how much he paid per litre of gas the last time he filled up his car. Economists thus regard oil price drops much like a tax cut, because the extra cash goes directly in consumers’ pockets.

 

Canada’s manufacturing sector also benefits big-time in a low energy price environment. That six cent drop in the exchange rate makes Canadian goods significantly cheaper in other markets. That’s particularly in the United States, and countries such as China, whose currencies are tied to the greenback.

 

The drop could be temporary

However according to one expert, the existing environment won’t last. “The long-term marginal cost of producing oil is on the rise,” wrote Luc Vallée, chief strategies at Laurentian Bank Securities, in a recent report. “Therefore regardless of what happens in the short-run, a strong price recovery in the mid-to long-term is the most likely outcome.”

 

Valée could be right. While there are several theories as to why prices have come down so far so fast, one of the most credible relates to a desire by Saudi Arabia to drive America’s oil fracking producers out of business. Innovations in fracking have dramatically increased US oil output, however much of the industry is heavily leveraged, with junk bond debt. If Saudi Arabia can run a few of those producers out of business, or even scare off investors for a while, this would substantially increase the Kingdom’s longer term pricing power.  

 

Ed Clark, a former CEO of TD Bank Group, suggests that one way Canadians can prepare for such developments, is to upgrade their skill sets, to focus on higher value-added exports. “Stop competing with Michigan. Start competing with Massachusetts,” Clark told a Toronto audience last week, at a conference hosted by the Economist magazine. Clark also warned that the Canadian economy be in big trouble if the country does not change the way it does business.

 

Hopefully Canadians will use the extra cash and time that those lower oil prices are providing, to boost their skills, not just to take more Sunday drives.     

 

peter@peterdiekmeyer.com

 

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