Canada should hedge against commodity risk: CIBC

Canada’s resource-rich provinces should consider hedging against commodity risks, even if it means giving up part of the revenue windfall when prices are high, reports CIBC World Markets Inc.

“Resources are called cyclicals for a reason, and provincial finance ministers are now acutely aware that a bountiful surplus can turn into a gaping deficit in a hurry when commodity prices slip,” says chief economist Avery Shenfeld at CIBC.

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He adds, “The result is that fiscal outcomes in any one year are highly uncertain, leaving finance ministers struggling to explain why they held spending lean when revenues were gushing in, or why a deficit suddenly emerged and forced borrowing up in the process.”

To smooth out the bumps and allow time to adjust to new commodity prices, he says, resource producers and buyers typically use derivative markets to hedge against some of the price risks in the near term. This yields some of the upside in exchange for protection against large adverse swings. Governments should do the same.

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“[This] would clearly be preferable to surprising the bond market with in-year borrowing changes, or rushing to make mid-year spending swings that might not be optimal on other public policy grounds.”

Provincial sensitivities to commodity price swings can be dramatic, finds CIBC. For example, a $10 per barrel drop in oil costs Alberta $2.2 billion in its fiscal bottom line, and hits Saskatchewan and Newfoundland by nearly $200 million each.

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“Provinces also have exposures to other commodities including potash and natural gas,” he says. “The revenues at risk not only include direct royalties but also land sales and corporate income taxes that are correlated with underlying commodities.”

Shenfeld notes provinces are already using hedging strategies to manage interest rates and currency risk by swapping foreign-denominated debt into Canadian dollar obligations.

Read: Patient capital He adds hedging strategies “aren’t cut and dried decisions, nor is there a one-size-fits-all approach given the variation in exposures and the commodities involved. But it’s worth a serious look by finance ministers, and Canadian taxpayers, finding themselves increasingly at the whim of volatile resource markets.”

And a “sideways profile” for some key commodity prices could dampen fortunes in the year ahead for Canada’s West, note senior economist Warren Lovely and economist Emanuella Enenajor of CIBC.

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“Critically, North America’s limited pipeline capacity means Alberta crude oil is trading at a growing discount to international benchmarks. That has triggered a substantial falloff in provincial royalties and, as some recent announcements highlight, jeopardizes investment and prospects in the oil patch.”

Alongside pipeline constraints, Europe’s recession and softness in emerging markets “have dimmed the lights in heretofore fast-growing resource rich provinces, creating intense fiscal pressure in uncommon places.”

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Meanwhile, as commodity related pressures face some regions, a budding U.S. recovery is lifting others, resulting in the performance gap narrowing between provinces.

“American domestic demand is in its ascendance, and as we settle into 2013, it’s the provinces more levered to U.S. consumer and housing market demand that are better positioned to ride out less supportive domestic fundamentals and uncertainty overseas,” note Lovely and Enenajor, adding that Ontario in particular stands to benefit.

“Once-slower growing regions like Ontario are seeing economic and fiscal fortunes hold up better, with a big assist from a reviving U.S. economy. While not exactly redefining Canada’s haves and have nots, the provincial economic and fiscal playing field is now more evenly balanced than at any time in the past decade.”