Rising oil prices seen as mixed blessing for Canada

(September 27, 2005) The obvious economic benefits brought by surging energy exports will be spread unevenly across the country, padding federal coffers and boosting the oil-rich provinces, while wreaking havoc on the manufacturing sector, according to the latest forecast from TD Economics.

The report predicts sustained high energy prices on the global market, calling it the greatest energy shock since the early 1980s. As with that period, global inflation rates are expected to rise, while net-importers are seen curtailing business investment.

“The offset for an oil exporting country like Canada, is that it also stimulates business investment, increases government revenues and, to some extent, lifts personal wealth — factors which should help to keep the Canadian economy growing modestly this year and next,” says Don Drummond, senior vice president and chief economist of TD Bank Financial Group.

The relative strength of the Canadian economy may attract additional, non-energy investment, but the oilpatch will remain the focus of attention. The resulting inflow of cash into the Canadian economy will have a downside, however, as global investors drive up the value of the Canadian dollar.

“There has been a long standing view that rising energy prices have a negligible, if not negative impact on Canada’s currency, largely because of its detrimental short-term effects on the economy,” says Drummond. “But times have changed and Canada’s large and growing trade surplus in energy has fundamentally conferred ‘petro-currency’ status on the loonie.”

The TD forecast see the Canadian dollar spiking to 87 cents US in early 2006, before settling back to about 83 cents US by the end of the year.

The rising dollar and elevated energy costs could deliver a double whammy to Eastern Canada’s manufacturing base. Margins will be squeezed as operating costs rise, while exports become less competitive in Canada’s primary market — the U.S.

“With the profit picture deteriorating in manufacturing, many of these factories will have to continue cutting their workforces and streamlining operations just to remain competitive,” says Drummond.

The resulting slowdown in Ontario and Quebec will weigh on overall economic growth. While national GDP should rise by a modest 2.9 to 3%, the economies of the western provinces are expected to grow at nearly 4%.

The eastern provinces are likely to face another challenge on the interest rate front, as the Bank of Canada takes a nationwide overview of growth and raises rates to 4% by the second quarter of 2006, TD says.

“Such an increase is probably not going to be enough to cool the red-hot Western Canadian economies that are already bumping up against serious capacity constraints, most notably in their labour markets,” says Drummond. “But these higher rates will certainly add to the challenges for Central Canada and will contribute to holding back growth rates in this region to sub-par levels.”

The high price of oil is not expected to last forever, though, according to a report TD released last week, which predicted crude would drop to $45 a barrel by 2007. Unfortunately, the predicted cause of this decline is a massive slowdown in the U.S. economy, which will further hurt Canadian exporters.

This forecast stands in sharp contrast to CIBC’s prediction earlier in September. According to Jeff Rubin, chief economist and chief strategist at CIBC World Markets, the price of oil will continue to rise, despite the economic problems it will cause, and hit $93 a barrel by 2007.

“While the full economic impact of expected oil price increases is difficult to gauge, at a minimum, the economic drag from higher energy prices should quickly cap rising short-term interest rates in both Canada and the United States,” Rubin said. “Apart from possibly one more rate hike on either side of the border, Mr. Rubin noted that we are likely at a cyclical peak in short-term interest rates thanks to soaring oil prices.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com