Outlook 2005

How high oil prices hurt Canada's economy.

The real story about oil prices is not that they are elevated now, but that they will remain elevated six to 12 months from now.

Geopolitical events have no doubt contributed to the recent upswing in energy prices, but what really makes them market movers is the fundamental gap between growing demand for energy and limited supply. Global crude demand rose at an annual rate of over 3% in 2004, the fastest pace in 24 years and more than three times its long-term average. China, India and the rest of East Asia account for half that growth. The timing of this demand surge couldn't be worse: it occurs just as OPEC spare capacity has fallen to a record low of about 600,000 barrels a day. Far from a temporary spike, relatively high oil prices are here to stay, at least as long as the world economy in general, and China in particular, continues to grow at today's robust pace. Look for prices to average between US$45 and US$50 in the next 12 months.

What is the impact on the Canadian economy? Canada is a large exporter of energy. More than half the country's production of oil and natural gas is exported, almost all to the United States. But Canada is also an oil importer–mostly from North Sea sources–to satisfy its own refinery feedstock requirements. Add all that up and you end up with an energy trade surplus of roughly 3% of GDP–nice to have, but not sizable enough to radically alter the economy's destiny.

Increased investment in the energy sector is another potential positive resulting from high oil prices. Overall energy capital spending in 2003 amounted to just under $30 billion, with investment in conventional oil accounting for three-quarters of that amount, and oilsands-related investment for the rest. However, despite the significant increase in energy prices, overall investment in the Canadian energy sector in the first three quarters of 2004 is estimated to have risen by an annual rate of only 6% to 7%. Oil executives have to be fully convinced that higher oil prices are here to stay before they commit mega dollars to extra drilling. Furthermore, long planning lead times and a severe shortage of both skilled labour and natural gas needed for the construction of new projects almost guarantee that any increase in activity in the oilsands in 2005 would be constrained.

Against the backdrop of the limited economic lift from higher oil prices, the downside potential is much more sizable. Canada, after all, is a major consumer of energy. It's cold here, distances between major urban centres are relatively large, and the country's resource sectors use a lot of energy. Indeed, per capita energy consumption in Canada is double that of the G7 average and roughly 20% higher than in the United States. During the first nine months of 2004, Canadians spent an estimated $5.5 billion of extra cash just to fill their gas tanks–an amount that taxed away half their wage growth. If energy prices remain near current levels, drivers would be forced to increase their spending on gasoline by an additional $6 billion to $7 billion in 2005, with reduced buying elsewhere trimming GDP growth by more than half a percentage point.

So Canada's position as a net exporter of energy provides only a thin shield from the damaging blow of elevated energy prices. The high-energy intensity of the country's manufacturing sectors, the direct cost to households and the sensitivity of the Canadian economy to oil-induced weakness south of the border will far outweigh the positives narrowly enjoyed by Western Canada.

Benjamin Tal is a senior economist with CIBC World Markets in Toronto.