Rubellite Energy Corp T.RBY

A note from BMO

[buylow]

9 Implications of $90 Oil

Douglas Porter, Robert Kavcic and Benjamin Reitzes

Oil remains the single most important commodity, and its peaks and valleys have played a starring role in almost every major economic cycle of the past 50 years. With WTI now hovering over US$90/barrel, oil prices remain more than $30 above levels prevailing just a year ago and the pre-pandemic trend. That 50% leap has been a major factor behind the outsized global inflation readings of recent months, and has already contributed to higher consumer inflation expectations. While some of the upswing in 2022 may reflect tensions on Ukraine’s border, the discipline of OPEC+ and the lack of a significant U.S. supply response are more fundamental supports. We have thus boosted our oil price assumption for this year to $85 (from $75) and to $80 in 2023 (from $77.50), compared with an average of $68 in 2021. Here are nine key implications of the persistent strength in crude oil prices: 1) It aggravates an already fraught inflation backdrop. Every $10 rise in oil prices bumps up headline inflation by roughly 0.4 ppts in both the U.S. and Canada. Inflation in Canada excluding energy products was just under 3.8% y/y in December, and has averaged 2.4% over the past two years. While sturdy, that pace of inflation would barely raise an eyebrow without the powerful tailwind from surging energy prices.

Consensus expects headline inflation to average 5.2% in the U.S. this year, then recede to 2.6% in 2023, from January’s 7.5%. In Canada, inflation is expected to ease from an average of 3.7% this year to 2.3% in 2023, from just under 5% now. All of these projections risk being caught badly offside—yet again—if oil’s north-bound march continues. For example, the Bank of Canada’s latest CPI projections assumed an average oil price of just $70 this year—$90 oil could keep that headline figure closer to 5% for the full year. The longer-term outlook for inflation remains surprisingly stable, even with the big bump of the past year (Chart 1). In fact, the Treasury market’s implied U.S. five-year inflation rate, five years from now, has actually eased in recent weeks to just above 2%, a bit below the norm of the past decade. The clear risk is that sustained strength in oil prices upsets this cozy consensus, especially since expectations have drifted apart from crude prices in recent weeks.

2) It will restrain consumer spending and will tend to dampen the global recovery. Higher energy prices famously act like a tax on consumers. The above estimate of the inflation impact, in turn, clips real disposable incomes by a similar tally. This hit tends to partially come out of savings and some from spending on other items. Traditionally, a $10 rise in crude has shaved U.S. GDP growth by roughly 0.1 ppts. This traditional relationship had weakened in prior years, as U.S. energy production soared. However, with shale output now responding only weakly to the most recent comeback in energy prices, higher oil prices are likely again to re-emerge as a growth drag. The final twist in the current environment is that U.S. households still have a massive cache of excess savings, although now heavily skewed to upper income cohorts, so higher prices will weigh. It’s a bit more nuanced in Canada, where high oil prices have had largely a small positive impact on growth since the country became a significant net oil exporter. However, a sluggish capex outlook in the sector dulls the supportive aspect, at a time when consumers are facing record high gasoline prices. On balance, we would judge the latest run-up in prices as being an overall neutral for the domestic growth outlook. 3) It puts yet further upward pressure on interest rates. Short-term policy rates face additional pressure from higher oil prices due to the direct inflation implications, even if the growth outlook is dinged at the same time. Suffice it to say, this can make for some extraordinarily tough monetary policy decisions. For example, policy was slow to ease in the 2008 financial crisis because oil prices were reaching record highs that summer (the ECB even hiked that year!). That can be doubly true for oil producers, such as Canada. The Bank of Canada made it crystal clear that policy rates are moving higher in short order. There are universal expectations for a 25 bp rate hike on March 2, while the market is nearly pricing a quarter-point hike in each of the next six meetings. Higher oil prices will only reinforce the BoC’s current bias to raise policy rates. Notably, the lack of appreciation in the Canadian dollar despite the rise in oil prices only adds to the pressure on the BoC. 4) It likely won’t move the needle on capital spending.

Canada’s growth outlook is commonly perceived as highly dependent on the energy sector. Post-GFC, the oil & gas sector was indeed a huge driver of growth, helping Canada outperform from 2010 to 2014, until oil prices crashed mid-decade. Much of that growth came through the investment channel, as money poured into the oil sands. However, those flows dried up when oil collapsed in late 2014, and never recovered. The ESG movement has created an additional hurdle for the oil patch to attract capital. The oil & gas sector has gone from a 30% share of total investment in 2013, down to just under 11% in 2021Q3 (Chart 2). There’s probably some upside from current trends, but we’re unlikely to be in the same area code as the decade-ago levels. Higher oil doesn’t provide the growth torque it once did.

5) It will boost Canada’s balance of payments.

Merchandise trade swung into a surplus in 2021 for the first time in seven years, fuelled by a record $104 billion surplus in energy products, more than doubling from the prior year. In Q4 alone, the surplus jumped to $33 billion ($131 billion annualized), which translates into more than 5% of GDP (Chart 3). Both are record highs, even eclipsing the surplus when oil was above $140/bbl in 2008, as crude oil production has risen by roughly 30% since then. This turnaround, alongside a firmer investment income balance, has lifted Canada’s overall current account into a small surplus for the first time since 2008, and after years of deficits of around 3% of GDP—a fundamental positive for the loonie.

6) It will provide some (limited) support for the Canadian dollar.

Traditionally, there has been almost an air-tight relationship between oil prices and the loonie. However, that link has weakened in recent years, and has seemingly all but been broken in the past year (Chart 4). As noted, this is despite a larger energy weight in trade than ever before. The lack of significant new investment in the industry (both new capital spending, and foreign investment in the sector) has weakened the oil/loonie link. However, at least part of the lacklustre loonie response reflects a broad-based rise in the U.S. dollar in the past year. In fact, against a basket of non-US$ currencies, the Canadian dollar has appreciated by 4% from a year ago, and was one of the stronger currencies in the world in 2021. For example, the loonie is up about 8% y/y against the Australian dollar.

7) It will support Canadian equities. Energy directly accounts for 15% of the TSX index, versus 3.5% for the S&P 500. This has helped drive relative TSX outperformance so far this year, a rarity in recent years. The TSX has also proven to perform relatively well against inflationary forces, helped by its larger exposure to commodities. Against a backdrop of monetary policy tightening, the TSX has found a strong niche thanks to more exposure to value-oriented dividend-paying equities (including the energy sector where cash flow now looks strong), and less exposure to high-flying technology where valuations are a concern. 8) It will balance the Canadian regional growth picture.

We expect Alberta to outperform the national average with 4.4% growth this year, and lead the country at 3.8% in 2023. While a capex boom in new project development is not likely, as seen earlier in the 2000s, industry cash flow and local incomes will be well supported. Alberta’s jobless rate should converge back down toward the national average over the forecast horizon, after struggling with a soft labour market in the years leading up to the pandemic. At this point, we don’t see an extreme disparity in growth versus regions such as Ontario and Quebec, which will also remain drivers (Chart 5).

9) It will provide more upside for government revenues.

Alberta, Saskatchewan and Newfoundland & Labrador are positioned for good-news budgets this spring. In Alberta, for example, the latest FY22/23 $3.3 bln deficit estimate was based on $64 WTI. Every $1 increase adds roughly $230 mln in revenue, and that relationship strengthens as prices rise and more projects reach payout status. Suffice it to say that we could soon see surpluses. Credit spreads in oil-producing provinces have already compressed. Alberta 30-year spreads have narrowed to the tightest level in almost three years versus Ontario, about 5 bps back. Note that the last time Alberta ran a balanced budget (FY14/15), Alberta 30-years traded about 20 bps through Ontario (Chart 6). Federal government revenues will also benefit from higher incomes and nominal GDP. Our current forecast assumes nominal GDP growth at least a full percentage point stronger than Ottawa assumed in the fall fiscal update, for 2022 and 2023.

Disclosures