By Richard J. Wylie, CFA, Vice-President, Investment Strategy, Assante Wealth Management
Among many surprises during 2016, including the U.K.’s vote to leave the European Union and the election of Donald Trump as U.S. president, was OPEC’s November agreement to limit oil production – the first such agreement in eight years. Perhaps more surprisingly, it extended beyond the cartel, as Russia agreed to unprecedented cuts to its own output. Weakness in the Canadian dollar has supported foreign interest in our trade goods and the revival in world energy prices that followed the OPEC accord has augmented this foreign interest. While investors would typically focus on the positive aspects of a stronger energy market, there is also an ancillary risk as inflationary pressures, while largely absent for a number of years, may be fuelled by higher energy prices. Investors should be aware of both sides of the story.
The secular advance in world oil prices began in the early 2000s and provided a material lift to the Canadian economy. The run-up in oil prices eventually produced an all-time high of US$147.27 for the West Texas Intermediate (WTI) spot price on July 11, 2008. At these elevated levels, unconventional reserves, including Canada’s oilsands, were pushed well into economically viable territory. The Canadian dollar was soon tagged with a “petro-currency” label. On September 20, 2007, the loonie broke above par with its U.S. counterpart for the first time since January 1977. The move up culminated in a modern-era high of US$1.1030 on November 7, 2007. The subsequent financial crisis and Canada’s economic resilience during that period allowed for continued strength in the currency. As can be seen in the accompanying graph, when the Canadian and U.S. dollar were near par in early 2013, the WTI price for oil was virtually identical in both currencies. However, in mid-February 2013, the loonie began to slide.
Over the past few years, weak economic activity globally has curtailed the demand for crude oil. At the same time, unrestrained output significantly boosted supply. World oil prices fell below the lows of the financial crisis, hitting US$26.19 on February 11, 2016, the lowest level seen since May 6, 2003. By September 2016, U.S. crude oil inventories had reached their highest levels in more than 80 years.
Over this span, the free-floating dollar acted as intended and was a buffer for the Canadian economy. The decline in the value of the currency meant that the price of oil (priced in U.S. dollars) did not weaken to the same extent in domestic terms. The value of Canada’s energy exports hit an all-time high in March 2014 ($12.4 billion), representing 28.0% of all exports. However, even the sharply weakening currency was insufficient to fully buoy the terms of trade and Canada’s merchandise trade balance hit a record monthly deficit of $4.2 billion in September 2016. Since then, and coincidental with the rise in world energy prices, Canada’s trade balance has improved. Statistics Canada’s November 2016 data revealed the first surplus ($0.4 billion) since September 2014.
Meanwhile, the weakness in the currency has meant that import prices have increased. In addition, Ontario’s cap-and-trade program and Alberta’s carbon tax, which both came into effect on January 1, 2017, raised gasoline prices dramatically. Stateside, there has been considerable rhetoric over trade, tariffs and self-reliance in energy. Unfortunately, at this juncture the direction of trade in energy and the broader implications for inflation are unclear. As always, investors who take advantage of professional advice can benefit from a longer-term and more circumspect view of the markets and the direction in which they are heading.
1. The “spot” price is the current market price at which an asset is bought or sold for immediate payment and delivery.
2. Energy Information Administration, Weekly Report, September 9, 2016.