Oil Spill, Monthly Perspectives | Portfolio Advice & Investment Research – #FinanceFridays with Kathryn Del Greco, CIM, FSCI, CSWP

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When it comes to investing, there is no shortage of surprises. Most recently, there were two notable ones that grabbed the attention of investors: the precipitous drop in the price of oil and the Bank of Canada’s interest rate cut.

Since July 2014, the price of oil has dropped roughly 50%, a pace and magnitude no one expected. The shock of the steep drop in oil prices has impacted financial markets and economic growth. While the sudden decline is clearly unfavourable for the energy sector, there are segments of the economy that are likely to benefit from the lower oil price, in particular the consumer sectors.

In this issue of Monthly Perspectives, we explore the impact and ripple effects of low oil prices and highlight how investors should view energy exposure in their investment portfolios. Additionally, we discuss the recent surprise move by the Bank of Canada to cut interest rates, a decision made in response to the drop in oil prices to a level that will be negative for economic growth, while both the downside risks of inflation and financial stability have increased. With this decision, it has become clear that interest rates in Canada will remain lower for longer—a familiar refrain which continues to be heard globally.

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Crude oil prices have fallen further and faster than anyone had predicted. The price of West Texas Intermediate crude oil has plunged from close to US$100 per barrel (bbl) in the first half of last year to below US$50/bbl this January, and there is much speculation of further downside in the months ahead. To understand why this has happened, and where crude oil prices might be headed, it is essential to understand the recent factors driving the collapse.

The price drop reflects a combination of weaker growth in global demand for crude oil and continued growth in supply. The by-product has been an excess supply situation of close to 1.5 million barrels per day in early 2015. In very rough terms, one could argue that the retreat from US$100/bbl to around US$70-$75/bbl was largely a demand problem. Specifically, the bulk of growth in world crude oil demand in recent years has come from increasing requirements in developing countries, like China. However, there has been a material slowdown in these economies that is likely to be sustained, with a corresponding negative impact on growth in demand for commodities.

However, the drop in crude oil prices from the US$70-75/ bbl range to below US$50/bbl appears to be largely driven by the lack of a supply response to weaker demand. In November, the Organization of the Petroleum Exporting Countries (OPEC) cartel signaled to financial markets that they would not respond to lower prices by cutting their oil production. Many view Saudi Arabia as the swing producer for global oil, and its officials were clear about the acceptance of lower prices for quite some time. Many have interpreted this as a price war. OPEC has been losing market share due to rising oil supply from non- OPEC nations, particularly U.S. shale oil production. Since the cost per barrel of oil for Saudi Arabia is very low, it can use the fall in oil prices to squeeze their competitors out of the market, and there is already a stream of news about new oil investment projects in North America being delayed and rig counts declining.

Ultimately, supply will adjust and the glut of oil will be reduced, but this could take a couple of quarters to start to happen. Accordingly, TD Economics expects crude oil to average below US$50/bbl a barrel in
the first half of this year, rise to modestly above US$50/bbl in the second half of this year, and average around US$65/bbl in 2016. This is a U-shaped profile of prices, rather than the traditional V-shaped bounce back.

There are many economic and financial implications to this outlook. Financial markets have been fretting about the potential deflationary risks. These fears are likely overblown. While lower energy prices will push headline inflation rates down, prices for other goods and services are not likely to fall. Moreover, markets do not appear to be paying enough attention to the fact that lower oil prices stimulate global economic growth. Indeed, the oil shock is creating a huge income transfer between oil producing and oil consuming nations. For example, American households are likely to save as much as US$900 per household from lower gasoline prices, and much of the savings will be spent by consumers, who represent close to 70% of the U.S. economy. This boost to U.S. personal spending is coming at a time when the economy has gained momentum, which makes it likely that the U.S. Federal Reserve (Fed) will still raise rates this year. The challenge on the global front is that while America will be a source of strength, the boost from lower oil prices isn’t going to change the core story of slow growth in Europe, Japan and emerging markets.

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Were it not for the oil price collapse, the Canadian economy would likely grow at close to 2.7% this year. But, with the oil shock, economic growth will rise at close to 2%. The greater impact on the economy is to the regional outlook, where oil-rich provinces will slow sharply. There is also a large blow to income growth both nationally and provincially, because while oil will be produced, the energy sector will get a lot less money per barrel, translating into far fewer tax dollars for the government. Although the economy will weather the storm, the Bank of Canada took out some insurance in January by cutting interest rates, and they could ease policy further. This has led to further weakening in the Canadian dollar. With the Fed likely to raise interest rates and the Bank of Canada now easing, one can imagine a scenario where the Canadian dollar falls as far as US$0.75. However, a weaker currency will help boost Canadian exports at a time when the U.S. economy is strengthening, and the low interest rate environment will remain stimulative to economic activity. So, the oil collapse should not derail the Canadian expansion, but it will take some steam out of it. That means investors will get lower Canadian yields for longer and will be holding a weaker currency.

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