The viscous circle

We’ve seen the short-term effects of low oil prices on the economy. What happens if prices dip again — or if they return to their previous highs?

For years, we have been wondering how we might live after the oil runs out. But we never thought we might have the opposite: a glut. Nor did we imagine price drops so precipitous that they could affect the revenue forecasts of entire nations. If cheap prices — like those we witnessed between June 2014 and January 2015 — make it unprofitable to exploit smaller projects, what could happen to the economy? Conversely, what will happen if prices return to where they were two years ago? Or if they rise even farther? CPA Magazine decided to probe these questions with the help of economists and industry experts.

First, a little macroeconomic context. High or low oil prices can be either good or bad, depending on who you are. For producers, high oil prices lead to a strong currency, high employment, rising housing prices and increased foreign investment. For consumers, those same prices are a drag on saving and spending, overall wealth and currency values. The converse is true when prices tank.

Here is what the experts had to say.

SCENARIO 1: oil prices stay low or drop farther

Short term: investment budgets across the board will be slashed, while production and extraction in the oilsands will continue at least in the near term, as it’s cheaper to continue production than to suspend and restart. If oil prices stay low, producers with wells that deplete quickly, such as shale oil producers in North Dakota and Texas, will slow production and cut hiring plans. This will negatively affect a complex supply chain of engineering firms, heavy equipment manufacturers and finance and legal services providers. In Canada, the hardest hit will be Alberta, Saskatchewan, Newfoundland and Labrador, where lower provincial royalties and tax revenues will lead to government deficits, tax hikes and cuts in spending. Housing and construction will slow down, leading to more job losses in those provinces. Meanwhile, nonproducing provinces will benefit from the low prices, at least in the short term. For countries such as Russia and Venezuela, where oil and gas make up the majority of exports and revenue, low oil prices will quickly erode currencies, which could lead to debt default and recession. Overall, the global economy will win because there are more net importing countries than exporting countries.

Midterm: less investment today — especially in oilsands and offshore projects — will spell bad news for the Canadian economy beyond 2017-’18 because the benefits of past investment will run out. Any future production requires current investment, which is shrinking. That will affect overall investment in Canada — which, in turn, will put a brake on the entire Canadian economy and GDP growth. If low prices remain for two years or more, smaller producers will go bankrupt and stronger players will buy weaker players with good assets. “There has been a sustained labour shortage of both skilled and unskilled workers in Alberta over the past 10 years and a lot of immigration and migration into the province to fill the gap. That will start to slow down or reverse as the economic centre of Canada shifts out of Alberta to consuming provinces,” says Scott Sharabura, associate partner in global management consulting firm McKinsey & Co.’s Calgary office. “Globally, it will play out similarly. Net exporters suffer; net importers benefit.”

Long term: a prolonged period (five years or more) of low prices, where, say, US$40-a-barrel oil is the new normal, will result in a second downshift in investment because a new range of projects will become untenable. New investment in oilsands production, which accounts for two-thirds of Canada’s oil exports, will come to a halt, says Schulich School of Business economics professor Farrokh Zandi. On net, sustained low prices translate into slow economic growth and losses of hard-to-replace highly skilled jobs in producing provinces. Governments will have to rethink their fiscal policies to deal with growing deficits and unemployment, while trying to encourage diversification. “On the other hand, nonenergy industries such as transportation and manufacturing will be able to cut fuel costs, boost profits and grow, which is good news for Ontario and Quebec,” says Michael Burt, the Conference Board of Canada’s director responsible for industrial economic trends. “A weak dollar will make exports more competitive, although it will lead to more inflation and higher prices for imported goods. The US — a net importer — will benefit and that will spill over to Canada, which sells more than 70% of its exports to the US.”

SCENARIO 2: prices hit a midrange level

Short term: uncertainty about the possibility of a return to US$100-a-barrel oil will lead many high-cost producers to limit production, investment and hiring. “Still, the economics make it worthwhile for producers to adjust,” says Burt. In Canada, that means keeping a tighter focus on costs and looking to expand into global markets beyond the US — something that hasn’t happened to date because prices were so high for so long and because the cost of shipping to other countries (China, for example) negated the price advantage. There will be innovation not only in technologies but also in business models, processes and financial structures in order to be profitable. Meanwhile, consumer countries such as India, the world’s fourth-largest consumer of oil, will gain as the savings will help pay down deficits.

Midterm: “If prices recover to the US$75- to US$80-a-barrel range, the differences between companies and fields will be a lot more prominent,” says Sharabura. “Projects that have good geology and are efficient will do well because there’s still a lot of growth and investment opportunity in the oilsands. There will be a moderate level of capital investment and improved growth. The pressure will be on the supply chain to keep projects economic.” He adds: “If the number of projects going forward is lower, the supply chain will contract, there will be no more labour and equipment shortages, the strong will survive and thrive. Greater efficiency in the industry will be a good thing for the overall economy.” A similar scenario will play out in countries such as Qatar, Kuwait and the United Arab Emirates, where this price range will secure balanced budgets.

Long term: in Canada, US$80-a-barrel oil will force oil-producing provinces to rethink their fiscal strategies, cut spending, raise taxes and review their royalty systems, says Burt. “If, as a province, your current expenditures are being paid by oil and gas extraction profits, that’s not a long-term solution. Even if you have 50 years’ worth of oil in the ground, you are spending a nonrenewable resource on current expenditures. The question becomes, how do you rebalance the tax system so you are saving more of the money associated with oil and living more within your means?” Zandi points to Norway, the largest energy producer per capita in Europe, as a way forward. It created the Norwegian Oil Fund, which passes the bulk of the wealth created by the oil industry to Norwegians on a gradual basis. Since only a small portion of oil revenue moves through to the general economy in any specific period, the country is immune to booms and busts in oil prices. Meanwhile, for nonoil-producing countries, midrange prices will give them room to try other policies to move away from a carbon-based economy. This can include carbon taxes or cap and trade, for example.

SCENARIO 3: prices hit new highs

Short term: producers will be cautiously optimistic, taking a wait-and-see attitude before making any significant changes. The longer the new prices hold, the more uptick there will be in rekindling existing projects and bringing new ones online. Skilled jobs will increase, driving demand for housing and new construction in producing regions. Growth will get a boost, as will the currency. For consuming regions such as the European Union, where economies such as Greece and Spain are struggling, renewed increases in oil prices could choke any economic growth and drive inflation even higher.

Midterm: as confidence grows, so will investment and production. There will be a greater push for increased pipeline capacity, bringing North America’s market access issues of 2014-’15 back to the forefront. Producer countries will have money to invest, which will drive up equity markets globally. “This is especially true in the Middle East, where countries neutralize the inflows of US dollars by investing in US-dollar assets,” says Sam La Bell, vice-president, energy, with Toronto-based Veritas Investment Research. In effect, producing countries flush with energy revenues will start investing globally, pushing up equity values and driving stock markets up, thereby reducing the cost of funding for these countries. This, in turn, will keep interest rates low.

Long term: increasing revenue from net importing nations will shift even more investment in the energy industry. Oil producers/net exporters will return to the years of high growth, tight labour and housing markets, cost inflation and wealth preceding the 2014 collapse, creating a tremendous amount of wealth. More investment in these economies will lead to more demand for their currencies, causing them to appreciate. Countries where energy is the biggest export, such as Iran, Iraq, Nigeria, Russia and Venezuela, will win. However, too much oilbased wealth isn’t such a good thing. The discovery of natural gas deposits in the Netherlands in the 1960s led to newfound wealth, a rise in the Dutch gilder and the economic condition called Dutch disease, whereby all nonenergy exports were less competitive. Meanwhile, consuming states will take a hit. The push and desire to develop alternative energies will pick up again in response to high prices.

A crystal ball sure would be nice.


There are essentially two types of production.

CONVENTIONAL. Pump jacks are used to drill vertical wells.

UNCONVENTIONAL. This includes:

• hydraulic fracturing (fracking), used largely to extract shale oil. Water is pumped into formations to crack the rock in order to allow oil to flow;

• horizontal drilling, used primarily for oilsands and some shale projects. Two wells are drilled: one to inject steam to heat up the crude oil and make it flow; the other to extract the oil.

Conventional and frack well projects are most responsive to oil prices because they require immediate payback. The oil comes up quickly and declines fast.

With oilsands, the type of drilling used (horizontal) means it can take years to develop a project. But it also means you can maintain capacity much longer than you can with conventional and frack wells. For that reason, these types of projects are less vulnerable to short-term price swings.