Finance Committee on March 11th, 2015

[The Chair, Conservative, James Rajotte]

I call this meeting to order.

This is meeting number 71 of the Standing Committee on Finance. Orders of the day are pursuant to Standing Order 108(2), a study of the impact of low oil prices on the Canadian economy.

I want to thank our witnesses for being with us here this afternoon in Ottawa. I want to apologize for the delay caused by the vote, and I understand that we may have another vote, but we very much appreciate your being here with us.

We have, first of all, from the University of Ottawa, Monsieur Jean-Thomas Bernard. We have Mr. Philip Cross, from the C.D. Howe Institute. From Memorial University of Newfoundland, we have Professor Wade Locke. From the C.D. Howe Institute as well, we have Mr. Steven Ambler. From RBC Financial Group, we have the senior vice-president and chief economist, Mr. Craig Wright. Welcome.

I understand Mr. Randall Bartlett, from TD Bank Financial Group, had to leave for a personal emergency, so we hope everything is okay there.

You each have five minutes. If you could shorten that at all, it would be very much appreciated.

Professor Bernard, you have the floor.

[Professor Jean-Thomas Bernard, Visiting Professor, Economics, University of Ottawa, As an Individual]

Thank you.

I will just make a few brief comments.

I would like to remind you what we mean by “Dutch disease”. It means that the increase in the development of one or more natural resources causes the exchange rate to go up, which leads to a relative decline in the manufacturing sector. That is the standard definition.

One of my colleagues has studied the phenomenon very closely. He tried to measure the impact on the Canadian economy for the growth period in the 2000s. His study shows that about 42% of the impact on the manufacturing sector of the increase in the exchange rate is the result of an increase in the prices of raw materials.

There are debates on the mechanism causing this negative impact on the manufacturing sector, but in general, the emphasis is on the increase in the domestic prices of services in Canada compared to what is happening elsewhere, an increase that has a negative impact on the entire manufacturing sector.

I would like to mention two other points that are not often mentioned in this debate.

Professor James Hamilton noticed a negative relationship between rising oil prices and economic activity around the world. That is one more effect on Canadian manufacturers. If the increase in oil prices has a negative impact on economic activity worldwide, there is clearly a negative impact on the Canadian manufacturing sector, regardless of all the other effects that may occur.

We must also remember that Canada is a large country and that transportation costs are relatively more significant for the Canadian economy than for the other economies of industrialized countries. Therefore, an increase in oil prices affects the transportation sector, which causes additional challenges for Canadian manufacturers.

The last point has to do with an ongoing debate among economists regarding the effect of this relative decline in the manufacturing sector or the effect on the overall productivity of the Canadian economy as a whole. I would simply like to say that this issue has not been resolved, although we often hear comments about this relationship.

[The Chair, Conservative, James Rajotte]

Thank you for your presentation.

[Philip Cross, Research Fellow, C.D. Howe Institute, As an Individual]

Thanks for inviting me, and in particular for sitting me next to my thesis supervisor at Queen's. I'll be expecting a grade at the end of my presentation.

[Voices]

Oh, oh!

[Philip Cross]

If I get a hook in the middle, you'll know what's up.

I submitted a written version of my presentation in French and English, so I won't go through it in the interest of brevity. A couple of the main points I wanted to bring to your attention were, first of all, that this industry is cyclical. We've had sharp drops before in 1986, 1998, and 2009. The one I wanted to bring to your attention was in 1998. It stands out because that was when conventional oil production peaked in this country and we began the long-term shift to reliance on the oil sands for our oil.

The importance of that is that it shows that even at a time of weak prices other variables can be very important in determining the course of this industry, such as technological change or a change in tax policy. Alberta changed its oil royalties in 1998, which helped kick that industry off. Public attention tends to be fixated on price, and that's not the only thing that's going on here in the longer term.

The other thing I'll bring to your attention is that recessions in the resource sector generally, and especially in the oil industry, are quite different than recessions that we're used to. I was head of business cycle analysis. I studied recessions for Statistics Canada. I declared, you know, when the recessions began, when they ended. I spent a lot of time studying these things. Typically a recession in the auto industry and the housing industry is a very sharp cutback in output and employment. That's not what you get in the resource sector.

What happens in the resource sector? I circulated a graph of what happened in the manufacturing industry versus what happened in the oil industry over the last couple of decades. You can see that when oil output falls it's by very small amounts, 1% to 2%. The recessions in this industry are felt more in prices and profits than output and employment.

The whole dynamics of these recessions are quite different. You'll get a responsive output in the longer term as investment dries up, but you won't get the sharp drops in output that you would in auto assembly or housing. I'll remind people that recessions in the resource sector are different than in a lot of other industries.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Cross.

I have Mr. Locke next, so we'll jump to Mr. Locke.

[Professor Wade Locke, Professor, Memorial University of Newfoundland, As an Individual]

Thank you.

In the interests of brevity as well, I'll just deal with a couple of slides. There's a full slide presentation there for you.

I would point out that the oil and gas industry has been extremely important to Newfoundland and Labrador. We have produced about 1.5 billion barrels of oil since the industry started in 1997. This had a value of $110 billion. We have collected in the range of $18 to $19 billion in royalties, and we have had investment of $34 billion to $35 billion in development and ongoing operations.

We have about 4% or so of our workforce working directly in Newfoundland, and another 4% to 5% of our workforce working in Alberta in the oil sands. The immediate impact of the fall in the price of oil will be through people being laid off and projects being delayed in Alberta. That will have a dramatic and notable impact on our particular economy. The next impact will be through the treasury. We have now gone into a significant deficit, which will have to be dealt with, as a result of relatively lower oil prices. We had oil prices in the range of $105 for the last four years, and suddenly $105 is not a good number to be using. We're going through a substantial change in expenditures and taxes.

Hibernia is the second-biggest producing field in Canada's history. It is behind the Pembina, but a substantial amount of oil comes out of eastern Canada. I would point out that the impacts on Canada will come through a number of ways. One is through equalization, which won't be felt yet, as a result of the falling revenues from lower oil prices to Alberta, Newfoundland, Saskatchewan, and British Columbia. You will see this in two years' time, in terms of lower equalization for places like Ontario.

It is interesting when you look at the forecast. We're expecting by the end of this year to start to return to balance. All of this disruption in the oil and gas sector you should bear in mind is because of a 1% to 2% oversupply, and this caused prices to fall by 60%. It is hard to understand.

There is a lot of uncertainty in terms of the forecast for supply as well. A lot of this is being driven by shale oil production. We're looking at 100 million barrels a day of increased production, from the current levels of 93 million to 94 million barrels, by 2020. It's not at all clear where that oil is going to come from. A large chunk was expected to come from Iraq and Libya, and not all of it is coming from shale.

The other thing I would point out is that a lot of the efficiencies that people talk about for shale have already been achieved. They have been drilling in the sweet spots, or spots that are 10 times more productive than the margins. It is not at all clear that they can continue to produce to this level. In fact, the most recent numbers coming out of the drilling report from the EIA a couple of days ago indicate that in April we're expecting falls in production in shale in three of the four major shale projects. This assumes no growth in demand, as well, in Europe or Japan or any of those places. It wouldn't take much of a change in any of those places to translate into a huge increase in prices.

Right now, we have a short-term issue; the question is how long it will last. The long-term issue is that there's not enough supply in shale or in the alternative sources at current prices for this to happen. If prices were to stay at $60, we'd have problems in Newfoundland in terms of the offshore as well.

I'll leave it there. Thank you.

[The Chair, Conservative, James Rajotte]

Okay. Thank you very much for your presentation.

We'll go to Mr. Ambler, please.

[Professor Steven Ambler, David Dodge Chair in Monetary Policy, C.D. Howe Institute]

Thank you for inviting me.

My comments will be based on the written submission that I sent in, which was basically the Verbatim published by the C.D. Howe Institute on March 2. Copies may have been circulated in advance. If not, the document is available on the C.D. Howe website.

Once again, in the interests of brevity, I'll skip over a lot of stuff.

This is based on our meeting before the January rate announcement by the Bank of Canada and also on the basis of a compilation of written submissions by the members of the monetary policy council at the C.D. Howe. Our consensus was that the overall impact of the recent drop in oil prices is negative.

There were differing degrees of pessimism among the members of the monetary policy council. There was a consensus, however, that most of the negative impacts are going to have an immediate effect on the Canadian economy, whereas the positive impacts are more uncertain and are in general subject to longer lags.

I note in passing, and with interest, that the Bank of Canada's own assessment of the impact of lower oil prices is quite negative, whereas in the last Federal Open Market Committee minutes, their assessment for the impact on the U.S. economy is actually, on balance, positive. Now, I know there are many structural differences between the two economies, but if you look at the importance of the petroleum sector in the two economies, in Canada it's 3%, which gives you a negative overall impact, whereas in the U.S., it's about 1% of GDP. So where it comes out as a wash, maybe, is sort of halfway in between at 2%.

The reason it's complicated is due to the complicated input-output linkages between the petroleum sector, on the one hand, and the other sectors of the economy, such as manufacturing and transportation and other sectors, and we go a through a list of possible negative and positive impacts.

I'll skip to the possible positive ones, which come mostly through the real exchange rate depreciation that accompanied the decrease in oil prices recently and was actually boosted to the tune of about an extra two to two and a half cents on the dollar by the rate decrease by the Bank of Canada in January. One could expect an increase in demand for exports, some incentives by manufacturing and other industries to increase productive capacity, and a shift in final demand by consumers from imports to domestic production.

In terms of the policy implications that follow from this, one strong message that I'd like to convey—it's more of a personal opinion than the consensus view of the council—is that one should never reason from a price change. That's a sort of basic introductory economics message.

To analyze the medium- or longer-term impacts of the price change on things like Canadian exports, it's crucial to know to what extent the decrease in oil prices is a supply-side effect, with increasing supply coming on stream from preceding investments—the so-called shale gas and fracking revolution—or whether the decrease in price reflects projected weaker growth of the world economy. Of course, depending on where you come down on that issue, and it's uncertain—the literature is actually divided on the subject—that leads to either a much more optimistic or pessimistic point of view for the future of things like Canadian exports.

One thing that I think we recommended in terms of policy as the bottom line is that the Bank of Canada should be quite explicit in its own assessment of the reasons for the recent drop in oil prices. Some members of the council I think feared that the rate cut was the result of a pessimistic assessment of prospects for world economic growth, and this could actually have a spillover effect in terms of negatively affecting inflation expectations for the Canadian economy.

My own view as well is to exercise caution, and in terms of monetary policy, to think long and hard because my own view is that the biggest monetary policy mistakes in the last 45 years, not only in Canada but in the world as a whole, have been essentially inappropriate responses to oil price shocks.

This includes the great inflation of the seventies—and it's a bit of a minority opinion—and even the fact that the Fed in 2008, as nominal income in the U.S. was dropping rapidly, kept interest rates fairly high because of a fear of inflation at a time that commodity prices and petroleum prices were increasing.

[The Chair, Conservative, James Rajotte]

Thank you very much for your presentation.

We'll now hear from Mr. Wright, please.

[Craig Wright, Senior Vice-President and Chief Economist, RBC Financial Group]

Thank you, Mr. Chair, and committee members. I appreciate the opportunity to be here and I look forward to the Q and A session.

To pick up after Steve's comments, there is a wide range of estimates in terms of the impact. I think it's somewhere between a small negative to a bigger negative, the more bearish view seems to come from the Bank of Canada. Our view is that it's a small negative, which I think is closer in line with the Department of Finance estimates federally.

When we look at the feed-through effects, there are three things we look at. What's the cause? As Steve suggested, it's different if it's from the supply side than from the demand side. We think much of what we're seeing is the excess supply, and price is corrected. On the demand side, if it were a demand shock then you'd get the follow-through with weakness in demand for all our exports, and not just energy, and it spreads across and it's more negative. Then there is also the depth and the duration.

Often what you find is that the best cure for low oil prices is low oil prices because the markets respond. What you see is that the demand picks up. Many countries produce oil, but all countries use the output of oil. We also see the supply cutbacks, and we've seen some data on the rig counts that suggest it's already taking place. That sets the stage for recovery in oil prices. We think that will take place as we move through the second half of this year and into next year. That's the economics of oil prices. Of course the politics of oil prices is dramatically different and that's what is keeping uncertainty high.

When we look at the impact on the economy we look at the real impact and the nominal impact. On the real side, it will be a negative for energy investment. That will be the negatives that we hear from Newfoundland and Labrador, from Alberta, and to a lesser degree from Saskatchewan.

There are offsets. What we think is that it acts as a significant tax cut for consumers, particularly in the U.S. The U.S. consumers will spend that money and that's going to lift exports for Canada. It's also positive for Canadians. We also see more money available that doesn't go in the gas tank. It goes to spending on other goods.

It's also consistent with the weakness in the Canadian dollar. There is a great deal we don't know about what drives the Canadian dollar, but over a long period of time you do see a fairly tight relationship to oil prices and to commodity prices more generally in the Canadian dollar, so a more competitive currency. That view of those offsets suggests we'll see better news on the export side, a little firmer consumer spending, and non-energy investment should pick up as we move forward.

The nominal side is where the big impact comes from, and that's the price of what Canada produces. The price of what we produce is getting weaker, so we do see nominal GDP get softer. That translates into weaker corporate profits and weaker government revenues. The potential spillover to the economy from that depends in part on what corporations do in terms of job cutbacks or what governments do when the revenue line looks a bit weaker. Are there significant tax hikes or significant spending cutbacks? I think that's the risk, going forward.

If you look at least at the provincial level, most of the provinces that have been hit are fiscally more sound than what we see in other provinces. I think the federal numbers are safe in terms of surpluses as we move forward.

The risk, as suggested earlier, is that the negatives are known in near term, and that the offsets are less certain and appear in the medium term. That's keeping uncertainty relatively high.

[The Chair, Conservative, James Rajotte]

Thank you very much for your presentation.

We'll go to Mr. Cullen, for a five-minute round.

[Nathan Cullen, NDP, Skeena—Bulkley Valley, BC]

Thank you, Chair. Thank you to our witnesses. I find this incredibly engaging, trying to understand what the indicators are showing us.

I want to clear something up first, and it was a bit of a C.D. Howe fight that I think we had going on here, or “debate” is what I meant to say.

In your report, Mr. Ambler, I think you talked about this and I want to compare it to what Mr. Cross said about the time it takes for the impact to be felt on natural resource industries.

Mr. Cross, broadly speaking you said that the natural resource sector doesn't react to a price change like this in the most immediate and quick turnaround.

But in your report, Mr. Ambler, there was a consensus that:

In other words, the negative impact may be faster than traditional models would predict because companies are quickly adjusting their capital plans.

I don't know if there is a contradiction, but just in your testimony today, Mr. Cross, you talked about there being a slower tendency within the natural resource sector to come off of certain investments.

Mr. Ambler, the consensus out of the economists you spoke to talked about this particular uniqueness of the sector, being able to ratchet back much quicker, and feeling those negative impacts faster.

Am I reading what you said right, Mr. Cross, or am I getting it wrong?

[Philip Cross]

First of all, let's clarify the situation here. Steve is here in the position of speaking officially for the C.D. Howe Institute; I am speaking as an individual. I happen to be a research fellow at C.D. Howe, but I did not coordinate my response, as you may have noticed. I don't think it's actually in contradiction.

What I am saying is that you don't see the cutbacks. When there was a recession in the housing and auto industries in 2008-09, housing starts fell 35%, and auto assemblies fell 35%. Oil output is not going to fall 35% this time around.

[Nathan Cullen, NDP, Skeena—Bulkley Valley, BC]

There is too much momentum in the system.

[Philip Cross]

It's not so much that there is too much momentum, as that oil is so capital-intensive. Once you turn on an oil sands plant, you never turn it off, except under the most extreme circumstance.

[Nathan Cullen, NDP, Skeena—Bulkley Valley, BC]

You do cancel future—

[Philip Cross]

What you will see is, immediately, a cutback in investment. In 2008-09 we saw both auto output and investment by the auto industry fall precipitously. This time around in the oil industry, you will see little or no change in output, but you will see a big drop in investment. The investment will lead to lower output in the future, but you won't get that output response right now.

[The Chair, Conservative, James Rajotte]

Colleagues, the bells are ringing. Can I assume consent to continue for the time being?

[Some hon. members]

Agreed.

[Nathan Cullen, NDP, Skeena—Bulkley Valley, BC]

Thank you, Chair. Thank you for that, Mr. Cross.

This debate going on about whether this is a supply-side or demand-side reaction seems.... We are dealing with economics so we are not seeking consensus, but the best appreciation and understanding of this one issue would be fundamental in then determining what actions the federal government may take in a budget.

Is there any correlation between understanding what the cause of this price drop is, and being confirmed in that position, and the type of budget you would suggest being drawn up, or are those two things unrelated?

If it's the supply side, does that change the scope and nature of any budget initiatives or economic initiatives the government may have? If it's the opposite, does it change it as well?

[Craig Wright]

I had mentioned the supply imbalance rather than demand.

I think if we look back through 2014, we see supply running ahead of demand. It wasn't a huge gap, as was suggested earlier, but we saw prices sort of drift lower, and that made sense. As I suggest, that would sow the seeds for an eventual recovery in oil prices. If you look at some of the surveys and inputs into the budget forecasting process, whether provincially or federally, the baseline forecast was a recovery.

Then what we saw—or didn't see, more correctly—was that, on November 27, things were softening up. The OPEC meeting was November 27. OPEC does what OPEC usually does, and I think that was the working assumption everybody had. However, they didn't, because of the concerns or the conspiracy theories, or whatever was driving it. That's why I think the outlook for oil is even more uncertain than typical, because it is not necessarily just about the economics; it's about the politics.

[Nathan Cullen, NDP, Skeena—Bulkley Valley, BC]

Someone in our last panel said this is the biggest reaction to a non-event, which was the Saudis talking about an extra 300,000 or 400,000 barrels a day. The markets responded, and we've seen this. The political nature of this is important, because it affects the economics and the economic output.

If economics was left to its own devices, if the market was left to do what it would do, the commonly used expression “the solution to low oil prices is oil” would be true. Does adding in the geopolitics to this—the Saudis, the Russians, etc.—not create the potential at least for a longer-term experience of these $50-a-barrel prices? Is that a reasonable assumption to make, mixing those two things together?

[Craig Wright]

Yes.