Canadian energy’s last gasp

30 mars 2020

The past five years have been unkind to the Canadian energy sector and its investors.

A hypothetical C$100 investment in the S&P/TSX Composite Index would have grown to just shy of C$120 today even after the sustained market decline of the past several weeks. In contrast, the same investment in the energy sector would be worth just C$55 (see Chart 1). But for all the past woes, today’s weakness in the energy sector has come even more swiftly than during the 2015/16 energy recession. Crude oil prices have declined more than 70% in just the first quarter of this year to the low $20s per barrel in the U.S. (WTI) and to just $6 in Canada (Western Canadian Select), as of March 27. In our view, the damage from the one-two punch of the coronavirus and the Saudi Arabia-Russia price war is unlikely to heal anytime soon. This dynamic has potentially serious consequences for Alberta’s economy, long-term federal tax receipts and lenders into the oil patch.

Energy sector woes are not confined to Canada or even the stock market. The MSCI World Energy sector has fallen even more sharply than Canada’s so far this year, and the U.S. high yield bond market has seen the energy sector decline three times as much as the rest of the index (see Chart 2). But the problems facing Canadian producers are substantial:

  • When many governments are launching programs to build a cash-flow bridge to the other side of the crisis for households, companies and industries impaired by the coronavirus outbreak, the energy sector hasn’t seen lifelines extended and may face widescale bankruptcies in high-cost basins, such as Canada’s.
  • Oil prices below $30/barrel are uneconomic for Canadian producers. The cost of transporting Canadian oil to the US market costs about $12/barrel to arrive at the U.S. Gulf Coast by rail under a long-term contract, whereas pipeline delivery runs north of $10/barrel, according to S&P Global.
  • Another sign that current prices are unprofitable is the wave of capex cuts across the Canadian energy sector of around 25% to one-third.
  • Pipeline access to the rest of the world continues to face environmental opposition, and Canadian energy still generates a high level of carbon emissions even after solid improvement in recent years. Policies aimed at reducing carbon emissions are gaining traction.

Policy roundup: turning on the tap
Canadian policymakers took further steps this week to support the domestic economy and financial markets. A coordinated and aggressive policy response is warranted to help alleviate the impact from both the ongoing containment measures and severe disruptions in the oil patch.

The federal government upped its support for laid-off/furloughed workers and small-and medium-sized businesses through multiple channels by:

  • Doubling down on direct income relief with an additional C$25B in spending, which includes a taxable benefit of C$2,000/month to individuals who lost income due to the pandemic.
  • Covering 75% of wages for eligible business in order to prevent widespread layoffs, a massive increase from the initial 10% that was promised last week.
  • Launching the Canada Emergency Business Account, where banks will provide C$40K government guaranteed loans to businesses – of which up to C$10K could be waived for repayment.

With respect to monetary policy, the Bank of Canada (BoC) took steps to simulative economic activity and boost bond market liquidity by:

  • Cutting the overnight interest rate half a percentage point to 25bp. The Bank now views the current policy rate as the “effective lower bound”, implying that further rate cuts to zero or negative territory is off the table for now.
  • Finally marking its foray into quantitative easing. The bank will conduct open market operations through the Commercial Paper Purchase Program and by purchasing C$5B per week of Canadian government bonds on the secondary market. The pace of bond buying could bring the BoC’s holdings to 10% of GDP in a year – a similar order of magnitude as seen in other developed countries.

The awe-inspiring policy response, domestically and globally, has been a product of unprecedent coordination between government, central banks, and quasi-public entities. Significant and credible stimulus packages are an important factor that can instill confidence in markets, though we believe the spread of the disease needs to slow further before volatility abates for risk assets.

Equities: coming up for air
The S&P/TSX Composite Index rose last week following the most rapid decline into bear market territory in history. With the number of new coronavirus cases still climbing in many parts of the world, it’s still too soon to rule out another setback. Elevated levels of implied volatility suggest we should be prepared for large market moves, both up and down.

The S&P/TSX Composite Index is still down more than 25% this year and the weakness has been concentrated in the most cyclical sectors like energy and consumer discretionary. Equity markets are likely cheering the equally rapid and massive delivery of economic stimulus measures and support to the financial system that will likely cushion the blow, but there is still a lot of news yet to come on the economic and earnings front to confirm the full extent of the downturn.

For the near term, we favor quality and minimum volatility factor exposures within the stock market to potentially limit the swings. We’re underweight value, and the energy sector’s struggles appear likely to persist. At the same time, investors should keep long-term investment objectives front and center. The share of stocks and other riskier assets in investor portfolios has declined even more rapidly than during the financial crisis. For investors with a longer time horizon, we suggest rebuilding back to benchmark weights in stocks to regain an overall neutral stance.