Oil Spells Trouble For Canada

 

• Impact of global trade downturn forcing accommodative policy responses
• Price rout in oil resulting in mounting layoffs in key oil producing regions
• Disinflation creeping into the economy

Most of the larger oil producers have had a tough year on account of the steep decline in oil prices which has impacted everything from employment to national budgets. For major exporters like Russia and Saudi Arabia, this dependence on energy exports has necessitated the drawdown of vast foreign currency reserves in order to prop up the economy and offset the emerging budgetary gaps. As a major commodity producing region, Canada has not been immune from the broad amount of commodity deflation occurring across the globe. When combined with developments in the energy patch, its own domestic industry is coming under pressure due to the downturn in external demand and weakening outlook as other countries quietly devalue and engage in price competition to protect market share. The result has been substantial losses in the Canadian dollar which show no signs of slowing in spite of the uncertainty facing the neighboring United States.

The Fundamental Picture

While Canada has largely skirted the most devastating impacts of the 60% plus decline in oil prices, an extended period of low prices do not benefit the underlying fundamentals for Canada as evidenced by the latest uptick in unemployment and downtick in inflation. Unemployment in general benefited from the gains in raw materials during the commodity super cycle, with certain areas like Alberta benefiting from oil prices that exceeded $100 for much of the past few years. For tight oil plays like the oil sands which require higher extraction costs, these projects operated well above break-even points. However, with the downturn in oil prices, many of the geographical regions that saw a rapid rise in fortunes witnessed an equally swift reversal in prosperity. Although many projects are still operational owing to more efficient production measures, layoffs continue to grow as companies look for any form of cost saving measures.

With unemployment rising from multi-year lows of 6.60% to 7.00% since January and disinflation creeping into the economy with consumer prices trending lower, the outlook for the broader Canadian economy looks especially challenging. The most recent CPI numbers showed that annualized inflation was trending slightly below longer-term targets set by the Bank of Canada with core CPI falling to 2.10% while the headline figure printed at 1.30%. While still well above the levels seen across most advanced economies, the slowdown has forced continued responses from policymakers as the Central Bank attempts to cushion the economy from the impact. The oil industry in particular has created the conditions for this sharp retrenchment, with production falling from almost 4.00 million barrels per day to just shy of 3.20 million per day, highlighting the woes facing companies as they attempt to stay competitive and finance outstanding debt.

The Bank of Canada has been extremely dovish in its approach to handling the wave of commodity deflation that is impacting the local economy.  Rates have dropped from over 1.00% as recently as last December to the current level of 0.50%. Based on existing conditions and the reality that oil prices might be stay low for an extended period of time according to projections from the leading bodies and banks, the Bank of Canada might be forced to take rates even lower in subsequent monetary policy meetings. The policy moves have generally been beneficial for the weakening of the Canadian dollar which has also softened on the back of oil prices. Due to agreements made with other advanced economies, Canada is unable to directly intervene in currency markets. Nevertheless, monetary policy can influence the exchange rate mechanism as evidenced by the Canadian dollar currently trending near multi-year lows.

The USDCAD pair in particular is currently ebbing near multi-year highs last seen in 2004 as the Canadian dollar remains subdued. The potential for another rate cut based on the prevailing and projected economic conditions also contribute to the case for further upside in the currency pair.  Although uncertainty in the United States has contributed to some shakiness in the US dollar, broadly, the trend remains to the upside in the pair with dips considered excellent places to take Call positions leveraging recent momentum higher. The target remains the most recent highs at 1.3352 especially as the US dollar sees sustained inflows from the prospect of normalizing interest rate policy and benefits from widespread risk-aversion.  Further accommodative action from the Bank of Canada could see recent lows in the Canadian dollar quickly eclipsed on that basis alone, adding to the bullish argument for USDCAD.

Conclusion

Bearing in mind the outlook for crude oil and expectations that oil prices will fail to rebound for several years due to existing oversupply conditions and declining global demand, the Canadian dollar has much more ground to give versus peers, notably the US dollar. Although Canada has not experienced the same sort of losses as other global commodity producers, the retreat in oil prices has certainly weighed on economic projections with the weakness likely to spur further accommodation down the road from Central Bank policymakers. The confluence of lower oil prices and shifting monetary policy are enough to keep the economy competitive in an era where devaluation has become an increasingly popular tool to fight for market share in the export economy. With these factors combined with worsening underlying fundamentals, the Canadian dollar has substantially more room to fall before policymakers can take another pause.