Albertans have long known that even if it hurts them at the gas pumps, high oil prices are good for the provincial economy. For a province beset with seemingly endless challenges over the last six years, news that benchmark crude oil prices had surpassed US$70/barrel in June comes as a much-needed salve. Declining COVID cases, strong commodity prices (even outside of oil), a string of recent investment announcements, and an imminent end to pandemic lockdowns are fueling optimism that Alberta will not just begin the long road to recovery soon; it will come roaring out of the gates.
That said, even though Alberta is the fourth largest oil producer in the world, we still do not produce enough to affect global prices. That means that significant price movements like we’re seeing now represent an external (“exogenous” to economists) shock to the economy, setting off a complex series of impacts and interactions with other economic variables in Alberta and across the country. This commentary explores these interactions and what the broader impact of higher oil prices means for the province.
Why are prices rising in the first place?
Before digging into the impacts, it’s worth taking a minute to talk about why prices are rising in the first place. In a nutshell, it’s the result of recovering global demand as countries around the world ease COVID restrictions and get back to some semblance of normal economic activity.
In early 2020, oil prices plunged, briefly hitting negative territory in April. This was the result of two interconnected events. As COVID was beginning to slow oil demand, the OPEC countries and Russia failed to reach an agreement to cut production in order to maintain prices. When Russia walked away from the agreement, a price war erupted as major producers turned on the taps just as global demand was cratering.
Since that time, there has been a détente. Demand remained weak, but OPEC producers agreed to cut production by about 25% over two months, while low prices drove output lower in non-OPEC countries. As a result, prices recovered and stabilized through 2020.
However, as vaccination rates climb and COVID cases fall, many countries have begun re-opening their economies and their borders, triggering a strong rebound in global oil demand. Meanwhile, OPEC countries have only been gradually ramping production back up, constraining the ability of supply to meet that demand. This combination is driving prices higher. A barrel of WTI oil surpassed US$70/barrel in early June and looks to continue climbing for the rest of the year (unless production accelerates). Indeed, some analysts suggest that oil could hit $100 a barrel in the near future—a price we haven’t seen since mid-2014. Oil companies around the world were hit hard by low prices in 2020. Production fell, reserves declined, and many slashed their drilling and exploration budgets. Adding to that, many companies have been reluctant to invest in major new capital projects as they focus instead on emissions reduction and see a limited runway for fossil fuels during an energy transition.
How do oil prices interact with other economic variables in Canada?
At a high level, the impact of higher oil prices on the economy is pretty clear. Canada is a major global oil producer and crude oil is our largest export product. So, when prices rise, the value of that product increases and the economy grows.
As with everything in economics, however, there’s more to it than that. Below are some of the other ways in which high oil prices can affect the provincial economy.
WTI vs. WCS
The first point to note is that Alberta oil producers don’t receive global prices when they sell their product. There are, in fact, dozens of different oil prices around the world which vary based on factors like density (light vs. heavy), sulphur content (sweet vs. sour), access to world markets, and several others. To simplify things, movements in global oil prices are communicated using what are called benchmark prices, which serve as reference points through which to communicate general trends. West Texas Intermediate (WTI) is the most common benchmark price used in North America. Another benchmark is Brent, which primarily used in European and other overseas markets.
Even in Alberta, the price of oil varies from one deposit to the next. The proxy used to measure Alberta prices is called Western Canadian Select (WCS). WCS prices are always lower than WTI prices for two reasons: Alberta oil is typically heavier and more sour than US oil, meaning it fetches a lower price generally. Secondly, Alberta has only very limited access to export markets outside the US—99% of our oil exports go south of the border. This gives US-based customers bargaining power and allows them to negotiate preferable prices.
The difference between WTI and WCS prices varies over time based on factors like pipeline capacity, production and refinery demand. Last June, it was as low as US$4.34. In late 2018, it was as high as US$46. Over the course of a year, however, it tends to average about US$12 to US$13 per barrel. So far in 2021, the price differential is tracking at the lower end of that range.
Because Canada is one of the world’s largest producers and exporters of oil, higher oil prices are typically linked to a stronger Canadian economy. That, in turn, tends to drive up the Canadian dollar, leading many to consider the loonie to be a “petro-currency.”
While oil prices are far from the only factor influencing exchange rate movements, they clearly have a significant effect (Figure 2). This time is no different. From January to May 2021, as oil prices went from $52/barrel to $65/barrel, the Canadian dollar rose from 78.6 cents US to 82.5 cents US—its highest level in six-and-a-half years.
For Alberta producers, this relationship has a buffering effect on oil price fluctuations. Crude oil is bought and sold in US dollars, so when prices rise, Canadian producers receive more US dollars per barrel, but because the exchange rate is usually higher as well, they get fewer Canadian dollars when they convert back. On the whole, the impact of higher prices far outweighs these exchange rate effects, so the net result is that currency fluctuations smooth out some of the normal volatility in oil prices for Canadian producers. The impact is different elsewhere in the economy. A higher dollar makes Canadians richer; imports and foreign travel become cheaper because our dollar goes farther. However, non-oil exporters and domestic tourism operators suffer because their goods and services become more expensive in global markets.
Oil prices also affect inflation, both directly through increased prices for gasoline, jet fuel and other petroleum products, but also indirectly through the exchange rate effects described above. As of May, Canada’s official inflation rate stood at about 3.6%, but if energy prices were removed, it would have only been about 2.2%. Because they are notoriously volatile, energy prices—along with food prices—are sometimes discarded as economists focus on “core” measures of inflation. However, because oil is used as an input or a feedstock in a wide range of products, the impact of higher prices does tend to seep into other goods, pushing core inflation higher as well.
At the same time, and as noted above, when the price of oil rises, the exchange rate also tends to go up. A stronger dollar lowers the cost of imported goods, helping keep inflation in check. However, this effect tends to lag the direct impact at the gas pumps. It’s worth noting that the present spike in inflation is not due to either of these effects. Rather, it is the result of two concurrent factors: rising housing costs and the impact of the pandemic last year. A year ago, as the economy was shut down, inflation plunged. One year later, growth appears high but mostly that’s because current growth is taking place from a weak base. Some economists are concerned that high inflation today could be the beginning of more persistent and damaging price increases, but it will take several more months before that becomes clearer.
From an economic growth perspective, the most important impact of high oil prices is on business profitability. Oil companies typically track a break-even price—the level above which they will actually make money. This price varies from one company—and even one oilfield—to the next. It can also rise or fall over time due to efficiency gains, technological advances, required maintenance investments, flow rates, or a host of other factors.
Very broadly speaking, Alberta oil companies need a price ranging from US$30 to US$50 per barrel to break even. This means that when oil prices crashed last year, companies were losing money. A lot of money. This year, prices have risen well above the break-even point, meaning that most, if not all, companies are able to turn a profit. These profits are typically distributed into new investments, stock dividends, higher wages, increased hiring, or additional investment. They also mean higher corporate tax collection for the provincial government. Given how 2020 went, however, profits in 2021 are likely to be funneled into debt reduction and otherwise helping companies dig themselves out of last year’s financial hole.
Alberta government royalties
The final point to highlight is that higher oil prices help the provincial government’s bottom line. Royalty revenues are notoriously volatile and have been trending downward over time. However, in its 2021 budget, the provincial government based its revenue numbers on WTI oil prices at US$46/barrel. With prices well above that level now, the provincial government is poised to receive a financial windfall. This is particularly good news given the massive $18.2 billion deficit expected this year, largely due to COVID-related impacts on both revenue and expenditures. The budget notes that at US$46/barrel, a one dollar increase in oil prices would add about $230 million to provincial revenues. But oil prices also drive exchange rates; the budget notes that a one-cent increase in the exchange rate (over baseline expectations of 77.4 cents US) would result in a loss of $165 million.
As oil prices are about US$25/barrel above budget projections, the Alberta government is poised to reap a windfall in 2021. The extent of the revenue jump is hard to predict because the US$1/barrel = $230 million relationship mentioned above is not a linear one—you can’t just multiply 230 million by 25 and arrive at a new revenue projection. Regardless, the provincial government is certain to receive billions of dollars in unexpected revenues in 2021. That will help put a significant dent in the province’s projected deficit for this year.
As a major global producer, Alberta clearly benefits from rising oil prices. Higher prices raise the value of exports, increase profits, and improve the province’s bottom line, even if it means that Albertans will pay more at the pumps. For a province struggling with five years of economic stagnation followed by the covid pandemic, this could not have come at a better time.
The issue, however, is that we can’t count on these prices to be sustained in the long term. What we’re seeing right now is a push-and-pull between short-term demand increases and supply constraints on the one hand and gradual energy transition on the other. On the whole, this means that high oil prices today are a welcome short-term reprieve after years of economic struggle, but they are unlikely to trigger an investment boom like we might have seen 10 years ago. That said, high prices today will help put companies in a much better position to finance their efforts reduce emissions and position themselves for success as we transition to a lower-carbon future.