Just as soaring oil prices, and soaring oil sands production, lifted the loonie to parity and for a while even a premium against the greenback, plunging oil prices and the risk of bankruptcies in the sector have already pushed the currency to a 13-year low with a growing number of foreign exchange traders believing it’s on course to retest the all-time low of 61.7 cents against the U.S. dollar set back in 2002.
Today, like back then, Canadian bond yields are in the netherworld of negative carry; a world where it costs investors yield to hold Canadian bonds instead of comparable U.S. instruments. The yield on a Government of Canada two-year bond is little more than a third of what the U.S. Treasury is paying for that term, while the yield on a 10-year Government of Canada bond is little over half its Treasury counterpart.
In 2002, it was the economic drag from extraordinarily tight fiscal policy in Ottawa that compelled the Bank of Canada to set a far more accommodative monetary policy stance than the Federal Reserve Board. Today the Canadian economy faces a far more formidable challenge from the collapse in oil prices just as it has allocated a record amount of resources to the massive development of one of the highest cost sources of oil supply anywhere in the world – Alberta’s oil sands.
Billions of dollars in cancelled oil sands projects have already led to the deepest decline in business investment since the Great Recession and brought economic growth in Canada to a screeching halt during the first half of 2015. But unfortunately that was only the beginning of the economy’s adjustment to plunging oil prices. The country’s oil-driven model of economic growth wasn’t built overnight and neither will the transition to a more sustainable economy.
As Bank of Canada Governor Stephen Poloz has recently warned, the unwinding of what was once the largest planned investment in any oil region in the world, will be a burden on the Canadian economy for the remainder of the decade. Worse yet, there is still another shoe to drop.
Huge investment cutbacks in future expansion aren’t the only danger the economy faces from its once exalted engine of growth. With Western Canadian Select, the benchmark price for oil sands producers, now trading as low as $15 (U.S.) a barrel, there is no longer an economic context for even today’s current production of over two million barrels a day. Each barrel is being produced at anywhere from a $25-to-$45 loss. Even much lower cost shale producers in the U.S. are being forced to shut in their wells. The U.S. Energy Information Administration is expecting more than a million barrel a day cut in shale production this year in the face of global oil glut estimated north of three billion barrels and still growing.
Running through dwindling cash reserves and with now limited access to capital markets, oil sands operators will soon have no choice but to follow suit, applying yet another brake to an already sputtering Canadian economy. Given the huge start up costs associated with most oil sands operations, once shut, they may never reopen– stranding billions of dollars of fixed assets in the economy and carving out billions more from TSX valuations and in all likelihood from bank loan portfolios as well.
So if a rate cut is not in this week’s Bank of Canada announcement, it’s a safe bet that it will be in the ones to follow. While one can question the efficacy of further reductions to already record low interest rates, particularly in view of how strong interest sensitive demand for housing and autos already are, the real impact of another rate cut will be in validating a lower exchange rate and unleashing the stimulus that it will bring.
The whole idea behind a flexible exchange rate is to allow the currency to act as a shock absorber for the economy. Given how dependent the economy had become on the development of the oil sands, the recent crash in oil prices may be the biggest resource shock that the Canadian dollar has ever had to absorb.
Jeff Rubin is a Senior Fellow with the Centre for International Governance Innovation in Waterloo, Ontario and the author of The Carbon Bubble.