Oversupply of oil could be trouble for Canada

The Canadian dollar responded, by rising, and investors dutifully updated expectations for a rate hike, giving about 50-50 odds for a boost at the Bank of Canada’s next meeting, on July 12.

And then, well, er, um ... about that oil shock ...

And about those rate expectations. Turns out it might be time for a rethink

On Tuesday, benchmark West Texas intermediate crude wandered into technical bear territory, dropping to near US$43 a barrel — a 22-per-cent decline from the 52-week high hit in January. It fell further Wednesday, by another two per cent, despite news from the U.S. Energy Information Administration that showed crude inventories had declined more than expected.

That inventory number should have buoyed oil markets, but pessimism seems to have set in. And not without reason.

It comes down to supply and demand.

On the demand side, the Organization of Petroleum Exporting Countries (OPEC) and some others express official optimism that a resurgent global economy will offset the supply glut. But the evidence for that demand renaissance has a few holes in it.

In Japan, the world’s fourth-largest oil consumer, imports fell by 13.5 per cent last month, but that’s consistent with the long-term trend: according to the EIA, demand has fallen by nearly one-quarter over the past decade.

In the United States, the expected warm-season surge in gasoline demand has failed to materialize, and the EIA predicts total petrol consumption growth this year will be basically flat.

China — the world’s biggest net importer — has a big supply problem of its own. Gasoline and diesel reserves are so high that some of the country’s biggest refineries are poised to shut down for the entire third quarter, amounting to about 10 per cent of China’s total refining capacity, according to Reuters. On the supply side, the North American shale industry has continued to grow at the expense of OPEC. Simply put, OPEC’s production cuts have led to prices that, while low, are still high enough to keep U.S. and Canadian tight-oil producers solvent. According to oilfield services company Baker Hughes, the number of rigs in the U.S. increased to 1,092 during the week ended June 16, marking the 22nd week in a row that the rig count has risen. In Canada, meanwhile, Baker Hughes reported an increase to 159 rigs — 2.3 times the number at the same time last year.

Meanwhile, Libya and Nigeria — two OPEC countries exempt from the production cuts because they’re grappling with de facto civil wars — have got their act together enough to ramp up production. So has Iraq. As a result, overall OPEC output in May — the same month the cartel agreed to renew its caps — rose by more than 330,000 barrels a day.

And then, finally, there’s the question of what OPEC does next spring when its latest production agreement — which isn’t working to establish a price floor in the low $50s — ends next year.

So let’s put it this way: the Canadian economy might have put one oil shock behind it, but that doesn’t mean another one isn’t on the way.

If that happens, the central bank would have 50 basis points less room to cut than it did in early 2015. If it cut anyway, then it would only be throwing gasoline (we have lots of it, anyway) on already overheated regional housing markets in Vancouver and Toronto.

You also might want to wonder how much another 25 bps off the overnight rate would do to spur business investment, especially in the oil patch, if crude sinks again below US$30 a barrel.

Right now, the Bank of Canada’s biggest friend might be the weak loonie, which has been sinking this week right along with oil prices. That, at least, should encourage the “broadening” of our economy away from energy, as the Bank has been hoping for several years now. If it hikes in July, as some expect, that dividend evaporates.

In short, neither oil prices nor the Canadian economy is out of the woods yet. So we probably shouldn’t count too much on the Bank of Canada moving anytime soon from its preferred position: on the sidelines.