Impacts of Lower Oil Prices on Canada

Using our January forecast as a base, we worked with the Canadian macroeconomic model to assess the impacts on Canada's economy of a US$10 (17%) reduction in oil prices. We've also assumed a proportional decline in natural gas prices. This is consistent with a high historical correlation between oil and gas prices. As well, the assumption of the impact on natural gas prices is of great importance to Canada, as most of the trade surplus in energy is derived from natural gas.

As the rise in oil and natural gas prices has boosted Canada's trade balance over the past few years, so would a decline in prices lower it. The trade surplus in energy, mostly oil and gas, stood at $51 billion in the third quarter of 2006. A 17% reduction in prices would lower the surplus by about $9 billion per year. This implies a direct hit on national wealth of $9 billion—not insignificant, but tiny (0.2%) compared with Canada's net worth of $4.8 trillion at the end of the third quarter.

If consumers, businesses, and governments decided to completely offset the negative hit on wealth by cutting spending, the impact on gross domestic product would be much larger (0.6%), as current production, which GDP measures, is about three times smaller than the net worth. Fortunately, there are good reasons to expect that Canada's total GDP would see very little impact of lower energy prices, although the influence on the industrial and regional components would be considerable.

Let's start with the bad news. The loss of wealth would be concentrated in the oil and gas sector, resulting in lower profitability and thus reduced activity. Employment, profits, exports, and government revenue from the oil patch would suffer. Real energy exports would be expected to fall 1.1% below the baseline this year and 2.6% below next year. Regionally, of course, Alberta's economy would take most of the negative hit.

Good news, however, would counterbalance the ill effects on the oil patch. The first piece of good news would be stronger external demand. In particular, Global Insight would expect a 0.2% and 0.5% boost to U.S. GDP in 2007 and 2008, respectively. In addition, the Canadian dollar would likely decline one U.S. cent from the baseline by 2008, further boosting Canadian exports. On net, Canadian export volumes would be unchanged relative to the baseline in both years.

Another piece of good news would be stronger real personal disposable income due to lower gasoline and natural gas prices. As a result, consumer spending would be 0.1% and 0.2% higher than in the baseline this year and next, respectively.

On net, Canada's economic growth would still come in at 2.1% in 2007 and 3.0% in 2008, as in the January forecast. The regional composition of growth, however, would be less lopsided. The weaker oil and gas sector would take the froth from Alberta's economy, while the stronger U.S. demand and the weaker dollar would provide a welcome boost to Ontario and Quebec manufacturers. Meanwhile, consumers and businesses across Canada would benefit from lower energy prices.

by Wojciech Szadurski