Tuesday, October 21, 2014

Energy costs, CAD level and inflation expectations

Oil prices are crashing, from a peak of $105 per bbl its down to $83, a massive 20% drop in the price of energy in the last 4/5 months.  First, the world is awash with oil (granted not cheap oil) but oil nevertheless is plentiful.  From the Montana Bakken fields to Libya production has outpaced faltering demand for oil.  For the American producers, the headache is that production costs are high. According to some analysts, fracking production costs are in the upper 80s  which means that light and sweet crude at $83 is a massive problem for the producers of this "synthetic" oil.

Even up here in Canada, oil at $83/bbl is a problem, because some of the more recent oil sand projects have exploitation costs that are near that level (older projects are apparently producing at around $40/50 per bbl).  I've said it here, and I said it often, Canada is a bit of an oil play.  Canada accounts for nearly 20% of America's oil consumption.  An addiction that many Americans would like to break -- although I am not so sure that Canada's oil sands are much worse than America's fracking business...

At any rate for Canada lower oil prices is a double edged sword!  The currency drops -- importing foreign inflation -- as trade is a massive component of Canada's economy -- also stimulating exports; Canadian exporters in the past 2 years (since the CAD has dropped from parity to $0.89), and lower energy prices have translated into a more competitive environment.

Canada's economy while not on fire is doing well... just look at all the illegal immigration from  -- France!  The headline numbers:

  1. Inflation at 2%
  2. GDP growth:  2%
  3. GDP growth (July) 0.0% 
  4. Unemployment:  6.8% -- its like 1% to 1.5% lower if we use America's scale
The economy is not exactly on fire, but North America is doing a lot better than Europe or Japan -- that's something.  

The big question in Europe is:  Deflation is it a problem here?  Deflation like inflation can be a good thing -- but of course its a question of scale.  The problem with deflation is that its like inflation; it can easily get away from you if the conditions are right.  Currently, inflation risks are low:  why because the economy is working somewhat below potential.  This is changing with a shift in Canada's labour pool -- like the US, Canada's aging demographic will reduce potential GDP growth.  As we get closer to potential GDP growth level, inflation trends could re-emerge.

There are no signs of deflation in Canada -- none!  Although everyone is expecting the 11 year old housing boom to come to an end...soonish.  The reality is that Canada has more of a tendency to import trends -- it is a much more open economy, and while we import from the entire world, the reality is that Canada's southern neighbour accounts for nearly 3/4 of all trade activities.  The reality is that America is not, has not, and is unlikely to face deflation pressures.  

The current dislocation of America's wage market is not creating those pressures -- nothing will. Although most people focus on Average wages, the more telling figure is Median wages.  America's Median wage is around $53,000, while for Canada its around $80,000.  The average wage is greatly influenced by wage disparity -- a more important feature of the US economy (in fact, Canada is ranked 8th while the US is ranked 17th).  

Canada's economy is a second degree play for investors -- if you like energy, primary ressources (mining, metals and agriculture) its a very interesting investment play.  Energy costs are important but not as much as commodity prices.  The CAD at 0.89/USD is fairly well priced -- and a good representation of the two countries "Big Mac index"


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