The Oil Price-Loonie Transmission Mechanism

The most interesting comments from Bank of Canada Governor Mark Carney last week, in releasing the Bank’s semi-annual Monetary Policy Report, dealt with the relationship between the price of oil and the Canadian currency.  The Globe and Mail reported Carney as publicly questioning why currency traders automatically presume such a direct link between the loonie and the world oil price.  After all, he accurately pointed out, Canada produces a lot more than just oil.  Why do traders associate our currency with commodity prices in general, let alone this single particular commodity?

Mr. Carney’s remarks had an obvious underlying motivation:  one important concern restraining any future interest rate tightening by the Bank is its concern over a subsequent upward shock to the loonie (which would further batter our already-weak trade performance).  By encouraging currency traders to interpret the dollar’s value more broadly, Carney is trying to short-circuit that kind of reaction.

Moreover, I would argue, there are deeper questions regarding the nature of the “transmission mechanism” by which changes in the oil price would indeed impact the exchange value of our loonie.  The statistical correlation between the two variables seems undeniable: a simple first-difference regression finds that oil prices explain 86% of the variation in the dollar (as described in the CAW’s recent paper on auto policy, “Rethinking Canada’s Auto Industry“, p. 15).  But what explains this link in behavioural terms?  That’s a question that is rarely asked.

Many analysts explain the link simply as reflecting “strong world demand for the things Canada produces.”  This is not directly true.  Canada’s exports of petroleum and a few other staples have boomed, it’s true (both because of growing real quantities and rising unit prices).  But Canada’s overall trade balance has sagged badly during most of the last decade’s energy boom.  The decline in non-resource exports of all kinds (both goods and services, undermined by the overvalued currency) has far outweighed the expansion in resource exports.  In sum, we presently run a current account deficit worth some $50 billion at annualized rates.  That’s a much bigger deficit than the federal government deficit (and much more dangerous, I would argue), yet it gets a fraction of the public attention.  If the world really wanted more of Canada’s output, we wouldn’t be experiencing this contractionary deficit.  (Arthur Donner and Doug Peters recently shone some badly needed light on the current account deficit in this Globe and Mail op-ed.)

The link between real FDI flows (in and out) and the level or change in the dollar is a more realistic possibility, but still not fully convincing.  To be sure, many petroleum companies and projects have been acquired by foreign companies and investment funds, and more are on the shopping list.  In total, however, Canada has been a significant net exporter of FDI since 2007 (after the completion of the extraordinary wave of foreign takeovers that year), which should imply a lower demand for loonies (and hence a lower exchange rate).

I think the link between oil prices and the dollar is experienced more broadly in the form of enhanced foreign appetite for Canadian assets (and especially resource assets) more generally.  That doesn’t require actual FDI flows, or capital flows of any kind, since forward-looking currency traders will build those expectations of value into their judgments and portfolio decisions.  Petroleum super-profits have made Canadian resource companies attractive assets for investors of all nationalities.  Substantial corporate tax cuts reinforce this unique profitability.  Meanwhile, Canada is unique among major oil-exporting countries in having virtually no limitations on foreign ownership of the non-renewable resource itself.

I recently wrote a “primer” on the determinants and effects of the Canadian dollar for Relay (the journal published by the Socialist Project).  There (and elsewhere) I have argued that the link between the price of oil and the currency could be broken by measures aimed at slowing and more carefully regulating the pace of energy developments (especially in the oil sands), reducing the profitability of those projects (through higher taxes and royalties), and by restricting foreign ownership of petroleum assets.  Structural measures like that would be more effective in the long-run, I suggest, than traditional central bank interventions (selling Canadian-dollar-denominated assets in international markets), and certainly than “jawboning” by the central bank.

6 comments

  • Jim – In regard to petroleum “super profits” it is little noted in the mainstream press that Alberta charges a token 1 % royalty on tar sands revenue until such time as the producer has fully recovered their capital costs. In effect this means that if you develop in AB, the people of AB will fully subsidize all your plant and equipment. I know of no other similar royalty plan anywhere else in the world and would think there may be grounds for legal action under NAFTA or World Trade legislation. If Ontario were to offer a similar deal to auto mfg’s to attract them to Ontario can you imagine the lawsuits and the acrimony?
    And there is another hidden bonus to tar sands investment. The producer is able to charge a carry cost equivalent to the rate on the Govt of Canada long bond and include this rate of interest in their cost recovery calculations. The firms are contributing thier own capital but are allowed to charge the opportunity cost of not investing those billions in a secure investment portfolio.
    Note as well that many of these agreements were signed decades ago when the bond rate was 7%. Where in the world today can you earn a 7% risk free rate of return? Only in AB. And another factor that I have been unable to fully qualify has to do with extending the capital recovery period through adding to existing plant and equipment. I cannot validate this but strongly suspect that if the producer is nearing full capital cost recovery under an initial agreement, and that producer decides to make additional capital investment, then that new investment results in the extension of the original agreement i.e. your additional investment postpones moving to a higher royalty rate of 25 %. As a producer you are granted a risk free rate of 7 % on each dollar invested and at the end of the cost recovery process you have ownership of billions of extractive plant and equipment which was fully paid for by the AB taxpayer. This is what is called “capitalism” in AB. This is what is deemed “risk taking” in the boardrooms on red square in Calgary.
    Again, just think of the howls of complaint, the NAFTA and WTO lawsuits, if Ontario was to extend a similar deal to the auto sector. Would have a very positive effect on Ontario employment however.

  • “In effect this means that if you develop in AB, the people of AB will fully subsidize all your plant and equipment.”

    Unless I misunderstand, it sounds like Alberta pays for only 24% of the capital costs, not the entire value. (Not that it is justified)

  • Darwin – The royalty is applied at 1 % until all capital costs are recovered. Once that point is reached it is proposed that the royalty increase to 25 %. I am not aware of any firms that have reached full capital cost recovery. This means that the AB taxpayer absorbs 100 % of the capital costs for infrastructure which is then owned by a private party.
    I am not sure of the interaction between Federal and Provincial taxes. AB applies a royalty which is a direct charge against revenue and this should be recognized by the Feds and expensed. But then the firm presumably is able to obtain a capital cost allowance which is a charge against earnings and results in a lowered amount of tax. In other words, at the Fed level the firm gets the benefit of a CCA which results in a tax reduction but the full capital cost has actually been absorbed by the AB taxpayer – the producer gets something for nothing (the infrastructure) plus a lowered rate of tax (the CCA against the infrastructure). I may be wrong but I suspect that is what is taking place.
    Regardless of the above, the ability to generate a 7 % risk free rate of return on the opportunity cost of forgone interest represents a significant return which is simply not available anywhere in the world today.
    You offered this type of deal in Ontario to the auto sector and the province would be wall to wall auto plants within a decade and the mfgs would be screaming for more labour. In fact ON would look a lot like present day AB.

  • For those interested in issues regarding the trade deficit, the value of the Canadian dollar, etc, there is a very informative article in the National Bank Weekly Economic Letter of March 19, 2012. The Donner and Peters article provided a short quote from it. Here is another:
    ” But in Canada’s case, the deficits of the last three years have been financed by portfolio flows which can be quite volatile and short-term in nature (Charts 10 and 11).” The portfolio flows are illustrated in the graphs noted in the quote.

    This is not very surprising. According to the Bank for International Settlements, the DAILY foreign exchange trade in Canadian dollars was about $62 billion in April 2010. If that is representative of the year-long numbers that means that 22 trillion Canadian dollars were traded in foreign exchange markets that year. That figure dwarfs merchandise and service trade.

    As the National Bank points out it is mostly portfolio shifts that account for the increase in the value of the Canadian dollar over the last 3 years. Why would this be a surprise? There aren’t many hard currencies left in the world: US, Japan, Euro, Swiss franc, Canada, Australia, any others? Europe is an economically dysfunctional mess with a catastrophically bad monetary system that no-one there wants to fix except, bizarrely, the far right. Japan has been in a recession for 22 years with no end in sight. The US seems increasingly politically dysfunctional and its employment recession is in its 4th year now(or is it its 5th?). It is small wonder that Canada, Australia and Switzerland have seem their currencies rise dramatically over the last few years. If you had a billion dollars in financial assets to put somewhere, wouldn’t you shift more of them into Canada than you used to ?

  • Meant to add that the way to reduce the value in the Canadian dollar is to reign in the oil and gas industry and for that matter our other energy exports. I recommend the paper Dave Thompson and I wrote a couple of years ago for an idea on how to do that: Private gain or Public Interest? Reforming Canada’s Oil and Gas Industry.

    Selling Canadian dollars to reduce the value of our currency is a poor solution. It will only increase the profits in the oil and gas industry and encourage still further over-expansion. The Bank of Canada would also have to accumulate vast quantities of US dollars and sterilize the Canadian dollars sold with an increase in outstanding Canadian dollar bonds. Conservatives would then use that supposed debt as a pretext to further reduce spending on our already weak social programs, on the environment, aboriginal peoples, etc.

  • On a related topic, your readers should know that there isn’t necessarily an “efficient market” price for oil. West Canada Select –piped down to the States– goes for ~$86/barrel while benchmarks such as WTI Cushing/Midland go for ~$100. If one considers the ‘sweet’ crude prices then the premium is in the $15-18 range over ‘sour’ prices that I have quoted. Meanwhile, in Europe, Brent crude trades at ~$118/barrel thanks to perceived geopoitical risk (all prices in USD as of today).
    Does not the Western Canada Select pricing argue for crude to be shipped to the central and eastern Canada? I have never understood the aversion to an energy policy in this country–the argument that we should let the market decide the price doesn’t account for there not being one market price and that these prices are increasingly diverging. Trudeau’s hated NEP is the great straw man of policy debates in the West. The bottom line here is that currency traders will drive up and down the currency based on perception, aversion, sentiment and portfolio flows in addtion to economic ‘fundamentals’. The markets turned in 2003 when the so-called commodities super cycle began and Canadian manufacturing has been gutted since.

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