Canada in 2020 – Energy: Going dutch

A wealth fund could help stave off long-term malaise, but Canada has more short-term needs.

Jerry Byrne once tried taking advantage of Newfoundland and Labrador’s budding offshore oil sector by flogging industrial computer systems to it. That was in the 1980s, and the sector didn’t take off as planned, so Byrne moved south of the border to look for greener pastures. But now that the province’s oil economy is finally poised to boom, Byrne is back, this time providing custom manufacturing and construction services for the energy industry. And this time, he was right. Revenue at Byrne’s company, D. F. Barnes Ltd., has soared over the past five years from $1 million to $80 million. If Newfoundland’s sector evolves as Byrne believes it will, the future of the former have-not province looks pretty bright, just as Alberta’s did 20 years ago.

Kel Johnston, CEO of Alberta Clipper Energy Inc. (TSX: ACN), an oil and natural gas company based in Calgary, knows exactly what an energy-based economy can do for a province and its businesses. But right now, he isn’t so sure about Alberta’s long-term prospects. Changes to the province’s royalty regime, which take effect in January, have Alberta Clipper increasing its investment in British Columbia, where royalty payouts will be lower. It’s one thing to be rich in resources, quite another to have the government support that “creates an environment where investors can make a reasonable profit,” says Johnston.

Managing a non-renewable energy resource so that people such as Byrne and Johnston stick around to create jobs and bolster regional economies in the long-term is a task easier said than done for the provinces who own them. Johnston’s concern about Alberta’s future was echoed earlier this summer by the Organisation for Economic Co-operation and Development. It warned in its Economic Survey of Canada, 2008 that Canada would not benefit from high energy prices forever, and noted that the struggling U.S. economy could soon mark a change in this country’s fortunes. The global researcher recommended Canada should create something similar to Norway’s sovereign wealth fund, essentially a savings account for commodity boom revenue that would be invested abroad. It also called for Alberta to refine the rules of its Heritage Savings Trust Fund and save all provincial oil and gas revenue in a foreign asset fund. Those savings would allow future generations to benefit from today’s oil and gas revenues and create potential relief when they disappear and the local economy falters.

Already, some believe Canada is showing symptoms of Dutch disease, a term coined in the late 1970s after the Netherlands’ economy went from riches to rags. The country eventually suffered negative consequences after gas reserves were discovered in the North Sea, because the new-found wealth caused the Dutch guilder to appreciate in value, and the manufacturing sector to stall. Sound familiar? By the 1980s, the Dutch economy was suffering slow growth and high unemployment. The trouble with Dutch disease is that its symptoms are not immediately apparent, because the economic impact of currency appreciation is often delayed two years. Problems only became apparent in the Netherlands when revenues from gas resources started to drop, according to a 2006 report, Energy Resources: Boon or Curse For the Canadian Economy?, by Philippe Bergevin, an analyst in Canada’s Library of Parliament’s economic division. After several years of high oil prices, the neglected sectors of the Netherlands economy were unable to fill the gap when gas revenues declined. Bergevin says Canada shows some symptoms of Dutch disease, but that its manufacturing sector’s decline is also tied into the industrialized world’s shift from manufacturing to the services sector. Cheap labour in emerging economies, such as China and India, is largely behind that shift.

Whether the Canadian economy is experiencing Dutch disease or just facing the reality of competing on a global stage, saving some or all of its energy riches could ease economic hardship in the future. Robert Roach, director of research at the Canada West Foundation, an independent think-tank based in Calgary, is one believer in the OECD’s recommendation. If resource funds are managed properly, future governments will have a stable and dependable source of revenue, Roach says. Doug Porter, deputy chief economist at BMO Capital Markets, says if Alberta had been more aggressive in recent years at “stockpiling” foreign assets, such as American and European stocks or bonds, the supply of Canadian dollars would have increased and relieved some of the upward pressure on the loonie. Norway has certainly been able to alleviate some of the pressure on its currency by using its sovereign wealth fund in a similar way. Whether it’s the role of a province to control fluctuations in the dollar is up for debate, but if it were, the size of Alberta’s sovereign wealth fund would have to be large enough to move the dollar. It isn’t, at this point.

Alberta’s Heritage Fund has a balance of $17.1 billion, and its Sustainability Fund has another $7.7 billion, which represents just a fraction of the oil-and-gas revenue generated in the province over the years. Those funds are the envy of every Canadian province, but Norway’s fund had a balance of about US$350 billion as of June 30. Alberta Finance and Enterprise spokesman Bart Johnson says comparing the province to Norway is like comparing apples to oranges, because Alberta is a relatively young province that needs infrastructure development, while Norway was already built out. The Heritage Fund receives money to inflation-proof its balance, as well as occasional deposits, and has received about $1.8 billion over the past two years. The Sustainability Fund benefits only if annual resource revenue is greater than $5.3 billion and the extra cash isn’t being used for infrastructure — such as roads, hospitals and schools — which received scant attention while the province eliminated its deficit and wiped out its debt. In short, the province has long used resource royalties for a variety of spending on more immediate needs.

But increasing Alberta’s royalties to further fund its resource savings accounts is a touchy subject. The energy industry — which is the one that has to pay the royalties — argues that higher rates make the province a less competitive place to do business. (That same argument could be used against carbon taxes if Canadian-based producers are the only ones who have to pay it. Doug Porter points out that most carbon tax schemes under current proposals are income neutral: any revenue raised would immediately reduce income taxes rather than be put aside for future use.) Nevertheless, an Alberta-commissioned review released last October called for increased royalties, a stand supported by Peter Lougheed, the former premier who created the Heritage Fund in 1976. In recent years, he argued, Albertans haven’t been getting their fair share of the province’s depleting resources. Royalty revenues are expected to grow by 20% a year, to an estimated $9.1 billion in 2009–10, although actual revenues will vary by energy prices and production levels.

In the meantime, the call for higher royalties raised the ire of people working directly in the sector, such as Johnston, but also those in secondary industries. David Yager, CEO of HSE Integrated Ltd., a Calgary-based company that provides industrial safety services, marked the first anniversary of Alberta’s royalty review panel report by denouncing the document as a wholesale change of the rules that developed the province’s energy industry. “The rules under which every Alberta petroleum dollar was ever invested were torn up,” wrote Yager in a column on the Calgary Herald’s editorial page.

Yager, whose company derives 70% of its revenue from Canada’s energy sector, urges other provinces developing energy riches — Saskatchewan, B.C. and Newfoundland — to create policies with less government involvement, not more. Of course, his viewpoint used to be largely in sync with the philosophy of the Alberta government: namely, that the free market will sort out most problems. He’s not worried about a time when the taps runs dry: “Alberta won’t run out of oil, not any time soon.” Alberta Clipper’s Johnston believes an investment fund such as the one described by the OECD makes sense, but says good government policy — i.e., staying out of the way of business — must be a priority. If the new royalty regime sticks, Johnston expects Alberta will lose money, because business activity will drop.

What becomes apparent is that Alberta’s oil economy is too mature to make drastic systemic changes, such as creating a wealth fund. But it’s also clear that such an idea isn’t exactly at the top of the agenda of the new energy powers. For instance, Richard Neufeld, B.C.’s Minister of Energy, Mines and Petroleum Resources, announced in September that sales of oil and gas land rights had eclipsed $2 billion, but he’s not keen on a wealth fund. He prefers to pay down the province’s debt and invest in infrastructure, particularly building roads near the new natural gas plays.

In Newfoundland, Kathy Dunderdale, Minister of Natural Resources, says the province’s priority is to invest royalties from all of its offshore oilfields — including Hibernia, Canada’s largest offshore oilfield — into infrastructure and pay down its debt. To ensure the province benefits from its energy resources for years to come, Dunderdale points to a 102-page energy blueprint released last fall, called Focusing Our Energy, that sets out a strategy to 2041. There is no mention of a sovereign wealth fund, but the document and Dunderdale both say that to ensure continued economic health, investing in other industries, such as renewable energy, is essential.

Byrne at D. F. Barnes adds that creating a long-term prosperous future for Newfoundland requires research-and-development investment to determine the best way of extracting oil from the sea floor in harsh conditions and boosting productivity. It also means examining how oil-rich jurisdictions such as Alberta, the United Kingdom, Saudi Arabia, Australia and Norway have developed their resources. Norway’s energy management is a particularly good model for Newfoundland, says Byrne. Both have frigid climates, and a sparse population scattered over a large land mass. Byrne has been to the Nordic country for a first-hand look at how the population of 4.6 million has managed to retain its status as one of the richest in the OECD — a far cry from its pre-oil existence as the poorest country in Scandinavia. He says everything Norway has done should be examined, including its wealth fund. Norway also limited wage increases to the amount of productivity growth in the manufacturing sector, so salaries didn’t spiral out of control, and the country avoided excessive government spending, thereby lowering pressure on its economy and currency.

The idea of a wealth fund isn’t attracting a lot of attention in nouveau-riche Saskatchewan either, where non-renewable resource revenue was forecasted to reach a whopping $2.6 billion last quarter, the highest in the province’s history. The Fraser Institute, an independent think-tank based in Vancouver, crowned Saskatchewan the new oil king of Canada, knocking Alberta off its pedestal as the friendliest environment for oil investment. Johnston calls Saskatchewan’s Bakken deposit the oil-play envy of North America and says government policies, long viewed as unwelcome to business, have completely turned around. John Hopkins, chief executive of Regina and District’s Chamber of Commerce, says Saskatchewan has met with Alberta to ask what the oil-rich province would do if it could redo its energy boom. Lessons learned? Invest early in infrastructure to be able to cope with the population surge and create a strategy for a looming labour shortage that will only worsen as baby boomers retire.

Hopkins believes Saskatchewan’s boom will result in lower taxes, much like those enjoyed by its western neighbour. He also expects that any policy changes will include more consultation with business. Christopher Hopkins (no relation), CEO of Oilsands Quest Inc. (AMEX: BQI), for one, sees a prosperous future. Hopkins has lived through Saskatchewan’s depressed economic times and says investment in oilsands technology is critical to the prairie province’s future success. That’s because the majority of Saskatchewan’s barrels of oil can’t be extracted using current technology, but also because it will create another industry with export opportunities. Hopkins adds that Saskatchewan’s uranium deposits could fuel a nuclear energy boom, thereby diversifying the economy and mitigating any bad times from hitting the prairies in the future.

In Canada’s fractured political makeup, it’s easy for provinces to think short term when they own the resources in their soil. And a long-term plan for businesses is three to five years. Somebody should be strategically planning in terms of decades, not years, but Canada has plenty of pressing problems that need attention. One argument against a national sovereign fund is that the current debt should be paid off first. “The feds continue to run moderate budget surpluses, but still have an outstanding debt of more than $400 billion,” says BMO’s Porter. “Perhaps Ottawa should focus on paying the debt down first, before worrying about creating a wealth fund.” Federal Finance Minister Jim Flaherty told The Globe and Mail in June after the OECD report came out, “We have no plans to have a sovereign wealth fund federally. The approach we’ve taken to intergenerational equity is to reduce the public debt dramatically, to eliminate net public debts of government by 2021.” Other skeptics, such as Derek Holt, a senior economist at Scotia Capital, argue that while such a fund would be good in theory, in practice, it would be subject to political directions that could yield less than optimal results.

If Canada is suffering from Dutch disease, there’s no easy solution, says Herbert Grubel, economics professor emeritus at Simon Fraser University in Vancouver and senior fellow at the Fraser Institute. Historically, high resources prices in Canada have coincided with a high Canadian dollar, and that means the exchange rate needs to be manipulated if other sectors are to be protected. Whether the dollar surges because of greater foreign direct investment in Canadian companies, or an increased appetite from emerging markets for our natural resources, exporters who rely on a low dollar get hurt. A national wealth fund big enough to manipulate the foreign exchange rate could help, but Grubel is an advocate of an equally or perhaps even more ambitious tactic to inoculate the country against Dutch disease: tying the dollar to the U.S. greenback. That way, the currency exchange, as it relates to Canada’s largest trading partner, anyway, would be stable irrespective of high oil.

Other less drastic measures of preventing the erosion of the nation’s economy include the OECD’s recommendations to claw back some of the incentives for the oil and gas industry, such as federal deductions for exploration and development, because these sectors are strong enough on their own. Along similar lines, a closer look at micro-policies, including redesigning the tax system to support new economic sectors, could be a solution, says Scotia Capital’s Holt. Others say the possible onset of Dutch disease is a wake-up call for the manufacturing sector to move up the value chain and make goods that can compete in the global economy. Walid Hejazi, an associate professor of international business at the University of Toronto’s Rotman School of Management, is among those calling for government incentives to spur investment in capital equipment such as accelerated capital cost allowance; offer education credits, decrease corporate taxes, and make other industries, like banking and telecommunications, more globally competitive by reducing trade barriers.

Grubal and Farrokh Zandi, a professor of economics at York University’s Schulich School of Business in Toronto, agree that the booms and busts of an economy are normal, and labour and capital investments naturally move to the hot sectors in a healthy economy. “The economy needs to build in a cushion for these fluctuations,” says Zandi. “But it also needs a strategy for when the economy falters and the problems aren’t transitory, but become more imbedded in the economy.”