Economic Insights

April 3, 2013

Beyond Keystone
by Avery Shenfeld

Economics
Avery Shenfeld (416) 594-7356 avery.shenfeld@cibc.ca Benjamin Tal (416) 956-3698 benjamin.tal@cibc.ca Peter Buchanan (416) 594-7354 peter.buchanan@cibc.ca Warren Lovely (416) 594-8041 warren.lovely@cibc.ca Emanuella Enenajor (416) 956-6527 emanuella.enenajor@cibc.ca Andrew Grantham (416) 956-3219 andrew.grantham@cibc.ca

Judging by the ramp-up in Canadas messaging to Washington, which has included everyone from energy sector participants, politicians and hockey coaches, were in the final crunch on a White House decision over the Keystone pipeline project. There will be a sigh of relief if President Obama is able to put aside mere symbolism and approve a project that will have no material bearing on global climate, particularly relative to what America could do if it took its own coal appetite seriously. But recent developments in the global oil industryfrom Venezuela to Iraq, from North Dakota to Mexico, from California to Chinasuggest that Keystone is just one of several important pieces of the puzzle for Canadas energy sector. Three key trends rising shale oil prospects stateside, the shift in consumption growth to Asia, and a growing list of oil producing countries open to foreign participationall pose challenges if Canada is to maximize the value of its resource base (see pages 6-8). Keystone will improve access stateside, and put a cap on adverse price differentials for Western Canadian producers. But growth in US shale output, coupled with a much softer trajectory for medium term demand growth stateside, put Americas net import requirements on a collision course with Canadian plans to ramp up its output by a further two million bbl/day over the balance of this decade. Long term projections for the US to be fully self-sufficient have to be taken with a grain of salt, but its now less clear that Americans

will need every drop Canada could export. The world will still need Canadas crude, given still ample demand growth ahead for Asia, and we doubt supply-demand conditions will permanently sustain prices below Canadian project break-evens. But its increasingly important that Canada move on one or more of the alternative pipelines to get our product headed Asias way. Canadas own central and eastern oil markets are another option, but longer term demand growth there is also likely to be lacklustre. Clarity on the pipeline front will also be critical to attracting the capitalboth domestic and foreignneeded to finance the growth in Canadian production. Only a halfdecade ago, due to restrictions elsewhere, Canada represented more than half of the reserves accessible to foreign capital. Today, there are many more competitors for those same investor dollars. Not only in the US shale plays, but much further afield. Iraq is rebuilding, Mexico is looking more open to inflows of foreign capital and expertise, and the winds of political change could at some point see the same swing in Venezuela. The policy implication for Canada is that while Ottawa has imposed some new restraints on oil sands activity by foreign state-owned enterprise, other measures on the policy dial may have to move the other way. With more competition for investor dollars, deficit-fighting federal and provincial governments may have less room to manoeuvre in setting taxes and royalties than was earlier the case. Both pipelines and reasonable royalties will be critical to avoid killing the black-gold goose.

text text text

Three key trends... all pose challenges if Canada is to maximize the value of its resource base...

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Economic Insights - April 3, 2013

MARKET CALL
Theres no reason to change our call that the Fed is on hold through mid-2015, but that call rests on a view that the end of QE will bring less stimulative rates at the long end (see pages 3-5). Frankly, were surprised at how well long rates held in (for both the US, and by extension, Canada) given that our once top-ofconsensus forecast for US Q1 growth is now a much more widely held view. European news is part of that story, and since we see a lingering impact from those risks, and US growth will slow towards mid-year, weve pushed off most of our projected bond market sell off until late this year. The changing of the guard at the Bank of Canada isnt likely to alter its stand-pat stance, particularly with household credit growth in check. Weve slowed the path ahead for 2-year rates as weve chipped our forecast for growth slightly downward, but are in agreement with the Bank that its next move, well off in H2 2014 or even early 2015, will be a hike not a cut. Having moved more than half way there, dollar-Canada pulled back from our June 1.05 target. But were sticking to our guns on that call, expecting softness in global growth to take some of the shine off our commodities-linked currency. We remain bulls on the US dollar overall, see the euro vulnerable to political and banking developments, and the Aussie dollar to lower rates and resource price softness.

INTEREST & FOREIGN EXCHANGE RATES

2013 END OF PERIOD: CDA Overnight target rate 98-Day Treasury Bills 2-Year Gov't Bond 10-Year Gov't Bond 30-Year Gov't Bond U.S. Federal Funds Rate 91-Day Treasury Bills 2-Year Gov't Note 10-Year Gov't Note 30-Year Gov't Bond Canada - US T-Bill Spread Canada - US 10-Year Bond Spread Canada Yield Curve (30-Year 2-Year) US Yield Curve (30-Year 2-Year) EXCHANGE RATES CADUSD USDCAD USDJPY EURUSD GBPUSD AUDUSD USDCHF USDBRL USDMXN 2-Apr 1.00 0.96 1.00 1.87 2.51 0.16 0.07 0.24 1.86 3.10 0.90 0.01 1.51 2.86 0.99 1.01 93 1.28 1.51 1.05 0.95 2.02 12.28 2013 Jun 1.00 0.95 1.10 2.00 2.60 0.10 0.10 0.30 2.00 3.20 0.85 0.00 1.50 2.90 0.95 1.05 96 1.27 1.47 0.99 0.96 1.92 12.64 Sep 1.00 0.95 1.20 2.10 2.70 0.10 0.15 0.35 2.15 3.35 0.80 -0.05 1.50 3.00 0.96 1.04 95 1.25 1.45 0.96 0.98 1.93 12.66 Dec 1.00 0.95 1.45 2.40 2.90 0.10 0.15 0.45 2.45 3.60 0.80 -0.05 1.45 3.15 0.97 1.03 94 1.28 1.49 0.99 0.96 1.95 12.75 2014 Mar 1.00 0.95 1.55 2.55 3.00 0.10 0.15 0.45 2.60 3.70 0.80 -0.05 1.45 3.25 0.99 1.01 93 1.28 1.50 1.01 0.97 1.94 12.82 Jun 1.00 1.10 1.70 2.70 3.05 0.10 0.15 0.60 2.70 3.75 0.95 0.00 1.35 3.15 1.02 0.98 92 1.30 1.53 1.03 0.96 1.97 12.88 Sep 1.25 1.30 2.00 2.80 3.10 0.10 0.15 0.80 2.75 3.80 1.15 0.05 1.10 3.00 1.04 0.96 91 1.31 1.55 1.04 0.95 2.01 12.95 Dec 1.50 1.60 2.20 2.85 3.15 0.10 0.15 1.10 2.80 3.90 1.45 0.05 0.95 2.80 1.02 0.98 90 1.32 1.57 1.06 0.97 2.05 12.95

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Economic Insights - April 3, 2013

Avery Shenfeld and Emanuella Enenajor

Last year, fixed income investors rode Ben Bernankes coattails towards surprisingly strong returns. That was true not only for the US Treasury and mortgage bonds the Fed was buying, but given their correlation to the American market, Canadian bonds as well. But as we move closer to the significant acceleration in growth we expect in the US for 2014, investors need to think about their own exit strategy before the Fed starts its. For a number of reasons, its time to go ahead and fight the Fed, and sell what the central bank is buying. It might not be possible for American central bankers to live up to their simultaneous pledges for what they will do about the funds rate and their bloated balance sheet. What the Fed says today about its exit strategy may simply not be optimal for it to pursue when the time comes to begin unwinding its extraordinary stimulus, and the market could begin to recognize that issue before this year is out. How Patient on the Funds Rate? For now, theres little reason to believe that the Fed has its finger on the rate hike trigger. Inflation is tame, labour markets still have ample slack, and the optimal funds rate today might well be negative, if that were possible. With one dissenting vote, the central bank is pledging to leave rates near zero until the jobless rate hits 6.5% or inflation looks to persist about 2.5%, both quite distant targets.
Chart 1

Go Ahead, Fight the Fed

While that type of forward guidance was unusual, weve been down this road before, on the other side of the 49th parallel. Mark Carneys team at the Bank of Canada was also facing the zero bound in the overnight rate back in 2009, and a market that was stubbornly pricing in rate hikes a few quarters ahead. To flatten the curve it issued a conditional commitment, pledging that rate hikes would be eschewed until after the second quarter of 2010, as long at the economy tracked the Banks forecast. At least one key Fed player, Janet Yellen, has suggested that the FOMC is going further than the Bank of Canada in a material way. Carneys team was simply describing its view on the forecast and the rate outlook that would be consistent with it. Yellen argues that the Fed is actually committing to hold rates lower for longer than it would ideally. Unable to set the funds rate at the optimal level today, which would be negative, the Fed promises to hold it lower than the typical Taylor Rule formula would imply in the future (Chart 1). As a result, two-year rates today trade as if the funds rate was instead starting from negative. But promises can be hard for central banks to keep. Even the Bank of Canada, facing firmer-than-expected growth and inflation, ended up raising rates one meeting earlier than its conditional pledge would have allowed.

Chart 2

Fed Strategy: Pledge to Over-Stimulate In Future

5% 4% 3% 2% 1% 0% 2011 Q1 Fed Funds Rate Modified Taylor Rule Baseline (primary dealer survey) Optimal Policy

6% Joblessness Was Consistent with Fed Funds Rate at 1%

12% 10% 8% 6% 4% 2% 0% Sep-1996 Fed Funds Target Rate FF Rate @ 1% with 6% joblessness Unemployment Rate

2013 Q2

2015 Q3

2017 Q4

Jun-2000

Mar-2004

Dec-2007

Sep-2011

Source: Federal Reserve

Source: Haver Analytics, CIBC

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Economic Insights - April 3, 2013

If long rates were at normal levels (and we shall argue they are not) the Fed might be able to bite the bullet and stick to its word on the timing of the first rate hike. A zero percent overnight rate alongside a 6.5% jobless rate would not, in itself, be obviously out of line, at least judged by the last cycle. In 2003, following the recession, the Fed had the overnight rate at only 1% with the unemployment rate dipping a tad below 6% (Chart 2). But the rest of the curve does not look at all like it did back then. Ben Bernanke himself believes that quantitative easing and twist have pushed the 10-year rate some 100 bps lower than it would be otherwise. Using estimates of the economic sensitivity to rates at each end of the curve from Rudebusch, we find that monetary policy (including QE) is delivering a dose of stimulus equivalent to having an undistorted long end and a funds rate at -4% (Chart 3). Leaving all of that in place as the unemployment rate reached 6.5% would, judging by the past cycle, risk an inflationary overheating. Either the Fed will have to push the funds rate up on a steep track and sooner than it promised, or the long end will have to steepen up quickly, either through market forces or Fed action to unwind QE in a way that promotes higher long rates. Which Exit Door? Simple logic would seem to suggest that removing the distortion at the long end, which was the last tool used en route to greater stimulus, would be the first to be undone as policy turns less stimulative. But the central bankers are saying just the opposite.

While the first step in tightening will be to cease new asset purchases and reinvestment of principal payments on securities holdings, active tightening steps are then supposed to all be concentrated at the short end: modifying forward guidance, raising the fed funds rate, and concurrently upping the interest rate on reserves, and using reverse repo operations to drain short term liquidity. Actually selling long assets is spoken of in hushed tones as a distant prospect, if at all. The Fed, however, has an incentive today to convince investors that such an unwind of curve flattening asset holdings is not in the cards. If investors thought it was, QE would be ineffective, as the Feds buying would be met with a crush of long bond selling by others. So the Fed has had to walk a careful line on its messaging to markets, and the question is, should we believe it? So far, markets have. Indeed, since July 2012, the rise in the 10-year interest rate has almost entirely been due to higher inflation expectations, not a re-pricing in of the term premium on anticipation of an eventual Fed balance sheet reduction (Chart 4). Today, the 10-year average inflation rate is tracking 2% based on TIPS pricing, as per the Feds threshold guidance. Primary Dealers expect even less of a balance sheet unwind than maturities/prepayments after 2014 would imply (Chart 5). Thus, any sales would take markets by surprise and could spell a spike in rates. How may the Feds exit actually play out? Past US experience doesnt tell us anything, because QE hasnt been done before. In Japan however, the central bank moved to reduce the size of its balance sheet in 2006 before acting on overnight rates, not after (Chart 6). That said, the Japanese case was not entirely analogous
Chart 4

Chart 3

Substantial Stimulus of Fed Extraordinary Policy

6% 4% 2% 0% -2% -4% -6% 2004 Equivalent stimulus impact (including QE) 2008 2012 Fed Funds Rate

Rates Rise on Inflation Outlook, Not Early QE End

Drivers of change in 10-yr rate since July '12 Term premium/other Higher shortterm rates

Higher inflation premium a/o 1-Apr-13

Source: Rudebusch (FRBSF Economic Letter, 2010), Haver Analytics, Federal Reserve, CIBC

Source: Bloomberg, CIBC

CIBC World Markets Inc. Chart 5

Economic Insights - April 3, 2013

Dealers Expect Only a Very Slow, Passive Reduction in Fed's Balance Sheet
Estimated change in Fed asset holdings (2014-16) US$, bns Passively* shrink (start 2015) 0 -200 -400 -600 -800 -1000 -1200 *passive reduction $25bn/mo Median Primary Dealers' Expectations

While feasible on paper, doing all of the work at the front of the curve risks steering monetary policy miles off course, a concern Charles Plosser has raised. It could end up hammering sectors sensitive to short rates to contain money growth, or falling behind in the need to prevent excess money and inflation. The Fed will be relying on the funds rate and what it pays on excess reserves to do two simultaneous taskscontrolling demand in the economy and the pace of money supply growth, and will be doing so without a roadmap. The central banks models will provide no guidance on the pace at which reserves need to be held back as idle deposits by raising short rates, since they are calibrated to eras without an equivalent excess reserves bubble. The safer alternative would be to follow Japans route, and combine a wind down of Fed assets with measures to tighten through short term rates. That could be accomplished, for example, if the Fed did a reversal of twist, and sold long mortgage bonds for shorter Treasuries that would roll off the books through maturities. That would address another problem for the Fed: as it now stands, maturities will drain its Treasuries holdings, leaving it with a balance sheet focussed on other assets, when its ultimate goal is to end up holding only Treasuries. But to admit any of this now would be counterproductive to the Feds efforts to depress long rates, as it would see investors dumping long bonds as fast as the Fed is buying them, anticipating the policy reversal. Test Brakes: Steeper Grade Ahead The Fed wants to convince us that it could end or start to reduce QE purchases by the end of this year, but preserve a stasis in the bond market until its ready to raise rates come mid-2015. But that sort of pregnant pause will be hard to engineer. A steeper US yield curve, and higher long rates in Canada as well, are a likely feature of this years second half. Either markets will start to anticipate the QE unwind and put upward pressure on long rates on their own, or it will begin to doubt the Feds willingness to do all of its initial tightening at the short end. Theres no rush to act, since the next couple of quarters are likely to bring slower economic growth. But gradually paring duration in fixed income investments through 2013 could still be rewarding. That will entail selling what the Fed is buying, but fighting the Fed this year will be much less painful than staying on the central banks team for too long.


Source: NY Fed, CIBC. Passive reduction: ceasing Treasury reinvestments & reinvestment of principal payments on agency debt & MBS.

to that of the US. For one, BoJ officials had guided the market to that ordering in speeches in 2005. Moreover, the bulk of the asset accumulation was in short term bills, so these could roll off the books quickly once the exit began, without any need to sell assets. But still, the central bank thought it important not to continue to hold such a large balance sheet as the economy recovered. The Fed will similarly need to act to prevent huge excess reserves from prompting equally huge money supply growth through the lending channel (which in the process shifts them into required reserves). Short of the draconian step of a massive hike in the reserve requirement, its argument is that it can prevent an inflationary outburst in lending while still holding a huge balance sheet, by paying banks to leave idle funds on deposit with them.
Chart 6

Bank of Japan QE Exit: Balance Sheet Reduced Before Rate Hikes

180 160 140 120 100 80 60 40 20 Bonds Treasury Bills Other Assets Dec-06 Bills Purchases* Trillions of Bank of Japan raises the policy rate

0 Apr-01 Feb-04 *loans made against pooled collateral

Source: Bank of Japan, Bloomberg, CIBC

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Economic Insights - April 3, 2013

Changing Global Realities Buffet Canadas Oil Patch

Peter Buchanan
Chart 2

The US shale supply revolution and an inexorable tilt in demand towards Asia are just two of several forces transforming the world oil industry, with important implications for industry, governments, and other stakeholders in Canada, the worlds fifth-ranked producer (Chart 1). Even back in 2010 Canadas energy resource sector directly accounted for 7% of GDP. Add in capital spending, and that figure would be well into double digits. Half of Canadian crude production trades loosely off landlocked WTI, the rest off Western Canada Select (WCS), a bitumen-based heavy benchmark. Attesting to the sectors economic clout and a key recent concern, Canadians found the public airwaves filled last winter with the arcane subject of crude price differentials. Bottlenecks on both the transportation and upgrading/ refining side saw quality (ie. heavy-light oil) and locational (WTI vs Brent) differentials explode during the winter, with the gap between WCS and WTI hitting a record $43/bbl at one point, versus a historical average of $17. Refinery/upgrader restarts, and a heavier reliance on flexible but costlier to operate rail pipelines, have seen a fairly dramatic improvement lately, particularly in heavy spreads. Notwithstanding such improvements, Canada continues to face a notable long-term challenge shipping its oil to market, given anticipated supply growth on both sides of the border. The failure to invest in needed transport infrastructure could still prove costly
Chart 1

Wall of Canadian Oil Will Strain Transport & Upgrading Capacity

7 6 5 4 3 2 1 0 80 85 90 95 00 05 10 15 20 Trajectory implied by announced projects C dn crude production, mn bbl/day

Source: NEB, CIBC

for Canadian producers, governments, and the economy, to the extent that investment plans are delayed or scaled back. Assuming currently planned projects proceed, CIBCs equity team has predicted that Canadas total production could rise by a further 2 mn barrel/day by decades end (Chart 2). As opposed to earlier hopes for a quick fix to bottlenecks, pipeline capacity will likely struggle for years to match aggressive supply growth on both sides of the Canada-US border. Given lower realized prices for producers and royalties, a Brent-WTI differential of around $10/bbl based on higher railing costs would
Chart 3

Top Oil Producers

12 10 8 6 4 2 0 Russia Saudi Arabia US China Canada Mn bbl/day

Cost of Bottlenecks to Remain High Even After Recent Spread Improvements

40 35 30 25 20 15 10 5 0 Note: Revenue loss based on "normal" WTI premium of $2/bbl vs Brent and $17/bbl discount of Western C anada Select to WTI $16.5 bn $15.2 bn $Bn annualized, 30 day mov. avg

15-Feb

2-Oct

22-Oct

28-Jan

7-Mar

8-Jan

29-Nov

23-Aug

12-Sep

19-Dec

27-Mar

9-Nov

2014 2015 Projected

Note: Figures are for Dec'12 and include all petroleum liquids. Source: IEA

Source: NEB, Bloomberg, CIBC

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Economic Insights - April 3, 2013

translate into an effective opportunity cost of some $15 billion per year (Chart 3). Thats not quite so crippling as last winter, but still equal to nearly 5% of the GDP of Canadas two largest oil-producing provinces. Shale: The Underestimated Revolution Contributing centrally to the altered pricing backdrop are stunning supply changes stateside. Shale oil has gone from a negligible share of US production five years ago, to one-third currently (Chart 4, left). At $40-60/bbl or so, full-cycle costs are well below a conventional oil sands mining operation, but above most Middle East production. The shale oil revolution has heightened competition for the same channels used to transport Canadian oil to market. It is an outgrowth of sweeping developments on the natural gas side. Both the shale gas and oil revolutions draw on similar technologies, including horizontal drilling and the use of proprietary chemicals to sustain production. While the shale upheaval has been years in the making, involving painstaking technical refinements as well as breakthrough technologies, the consequences have been both swift and dramatic. Breaking a 35-year long downdraft, total US oil production rose for a fourth straight year in 2012. Output this year is likely to reach the highest level in about two decades. No less visible have been the trade implications. The percentage of the US market supplied by oil imports has fallen from over 60% less than a decade ago to about 45% today (Chart 4, right). For the time being, the surge of production has also upended an historical relationship stressed by supply bears, the Hubbert Curve, that tracked US oil production

reasonably until a half-decade ago, but has worked less well since. Hard-to-gauge political, technological and economic factors make the oil market a forecasters nightmare. Just how much further Americas dependence on imports might decline is thus a matter of some conjecture. A lack of information on performance over the full well life cycle further compounds prediction difficulties. That said, some seasoned observers like the IEA now believe that good supply prospects for both gas and oil could help the US achieve overall net energy self-sufficiency in about two decades time. That factors in not only current shale oil projects, but the potential of promising as-yetundeveloped sources, like Californias Monterey shales. Beyond the shale supply bulge, two other seismic factors are affecting Canada. First, is a dramatic re-orientation of demand to Asia. Second is a more competitive investment/ production landscape, as changes in a number of other countries create, or offer prospects, of improved access to countries that were previously off limits to many players. Global Demand Skewed Increasingly Towards Asia On the demand side, Canadas traditional locational investment advantage from being right next to the worlds largest oil importer is unlikely to last much longer. A decade ago China produced more oil than it used. This year the Asian industrial giant is on track to dethrone the US as the worlds top importer of black gold (Chart 5, left).

We expect Chinas economy to grow at a scaled back 78% pace over the next decade. While that will likely limit oil demand growth to about 3-4% per year, China uses Chart 4 Shale Oil Revolution Shifts the US Supply Curve (L); far more crude than it did ten years ago. Even that scaled back percentage rate will consequently add the equivalent Import Share of US Market % (R) of the UK to the global demand pie every couple of years. production, mn bbl/day imports/US oil 65 Nor is China alone. The combination of hearty economic 8 consumption (%) 7 growth and greater energy intensity owing to lifestyle, 60 6 urbanization and other changes mean that Asia is now 5 55 home to three of the worlds five largest oil-consuming 4 economies. 3 50
2 1 0

45
95 00 05 10 15

19

19

90

40 35 30 95 99 03 07 11 15 19 23

Shale/Other Tight Other Lower 48 onshore Lower 48 offshore Alaska

Rising consumption there (Chart 5, right) comes alongside continuing downside pressure on demand in the industrial countries. The US now uses about 2 million barrels of oil less than it did before the Great Recession. While a subpar recovery is partly to blame, other factors are also at work, as illustrated by the fact that vehicle miles have continued to decline recently even as signals for both


20

20

20

Source: US DOE

20

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Economic Insights - April 3, 2013

China's Oil Imports Poised to Surpass US (L); Asia Has Accounted for Two-thirds of New Demand (R)
16 14 12 10 8 6 4 2 C hina net imports, mn bbl/day
80 70 60 50 40 30 20 10 0 Asia Middle East Rest of World % of Total Growth in World Oil Demand, 2002-12

Proportion of Reserves Open/Potentially Open/ Closed to Western Integrateds

2000

Today

C losed Other Open C ANADA Partly Open/Potentially Improving Access

United States 0 Jan- Jan- Jan- Jan- Jan04 06 08 10 12

Source: NBS, DOE, CIBC

Source: BP, CIBC

the economy and job growth have improved. Given a continuation of those trends and weakness related to the economic situation in Europe, Asias share of global oil consumption is likely to increase further, to 33% in the next two years vs about 20% for the US and 15% for Europe. A More Competitive Investment Playing Field A third important change is on the investment policy front. Canada was once among only a handful of countries welcoming foreign capital in the oil sector. Just over a decade ago, nearly three-quarters of global oil reserves were effectively off limits to major global players (Chart 6), due to state-run firms, outright prohibitions, security or other considerations. Change is afoot on that front as well. Iraqs recently liberalized oil industry displaced Iran as the second largest OPEC producer last summer. While the country can still be a perilous place to operate, the participation of western integrated and foreign state-run firms (used to dealing with tricky political and security issues) has seen production double from levels just before the 2003 war. The countrys massive 135 bn barrels of reserves are the cheapest source of additional crude on the planet. Even if the desert nation is able to attain just half of a planned further 5-6 million bbl rise through 2020, that would still affect global markets. Nearer to home, Mexicos new president has announced plans to revamp its 1917 constitution to encourage foreign firms to make badly need investment in the

refining sector and provide the capital and technology needed to tap deepwater and heavy oil resources. Details are expected by the summer. Nietos proposals are the most ambitious yet to counter a sharp decline in existing fields, including aging super-giant Cantarell. Including Orinoco heavy oil, Venezuelas reserves are the largest in the world, surpassing Canada and Saudi Arabia. President Chavezs death may not bring an immediate policy about- face. But as in Mexico, the need to offset declines in aging existing fields and accelerate growth creates potential longer term pressure to ease the states shackles. The oil and gas sector accounts for the second largest component of Canadas corporate cash pile. Even where companies are not ready to take the plunge just yet, the allure of enticing investment prospects down the road could be an inducement for firms to stay liquid, hanging onto their cash a while longer. Clearly, global energy markets are in a period of sweeping, multi-dimensional change. The break-up of what was then the worlds top crude producer, the Soviet Union, dramatically impacted markets two decades ago. Todays ongoing shifts are potentially no less significant. In Canadian terms, they will likely require steps to ensure broad access for Canadian crude, not only to traditional markets like the US but faster growing ones overseas, and an investment climate that remains competitive with others now opening their arms to foreign capital.

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Economic Insights - April 3, 2013

Concentrated Diversication
Benjamin Tal and Andrew Grantham
The volume of Canadian exports today is at the same level it was a decade ago. And after rising for most of the previous decade, the share of non-US exports in total exports has hardly changed in the past four years. In fact, recently it has been moving in the wrong direction. Furthermore, within the non-US space, all recent activity was concentrated in one countryChina. This uni-diversication is certainly not what the architects of Canadas nine free trade agreements with non-US partners have envisioned. But the relative success of Canadian exporters in China should be seen as an indication that Canada can and should compete in other emerging markets. The Lost Decade Global trade in goods has surged by 70% since 2002. In Canada the volume of imports has risen by 45% while the volume of exports was essentially unchanged. Regardless of how you look at it, this was a lost decade for Canadian exports. And for a small, open economy, this is not a positive trajectory. It is easy and perhaps convenient to link the export malaise of the past decade to the surge in the value of the Canadian dollar. But the reality is much more multidimensional. A quick glance at Chart 1 suggests that the 35% appreciation in the value of the loonie between 2000 and 2007 indeed worked to slow the pace of export expansion. But despite this massive appreciation, exports still managed to expand at a pace of just over 1.5% a year. Furthermore, a detailed sectoral analysis of the impact the rise in the C$ had on Canadian manufacturing suggests a much more complex picture than you get from a text book. Chart 2 maps the relationship between vulnerability to a rising dollar (based on export dependance, import competition at home, and savings on imported components) and actual GDP growth. In theory, this chart should have shown a clear downward sloping trajectory. But as can be easily seen, that was not the case. Yes some high vulnerability sectors such as paper manufacturing and furniture did underperform. But equally vulnerable sectors such as machinery and electrical equipment actually outperformed. Ditto for the other side of the spectrum, where low vulnerability sectors such as textiles and chemical manufacturing disappointed. Similar sectoral analysis by labour market performance and export penetration to the US resulted in equally mixed pictures. Simply put, the evidence suggests that the dollars appreciation is only one factor out of many that impacted the trajectory of exports over the past decade. Other factors such as US demand,
Chart 2 Chart 1

The Lost Decade

Canadian Export Vol. Index (2007=100) 110 105 100 95 90 85 80 75 70 65 60 97

No Clear Correlation Between Dollar Sensitivity and GDP Performance

Avg annual GDP % growth (07-12) 3 2 1 0 -1 -2 -3 -4 food mfg electrical equip. machinery

petroleum/ coal

US$/C $ 35% US$/C $ 11% 99 01 03 05 07 US$/C $ 5% 09 11

transp. beverages/ equip. tobacco chemical mfg textiles

wood products furniture paper mfg

-5 -6 -7 -20

20 40 60 Index of $ vulnerability

80

100

Source: Statistics Canada, CIBC

High C$ sensitivity

Low C$ sensitivity Source: Statistics Canada, CIBC

CIBC WORLD MARKETS INC. Chart 3 Chart 4

Economic Insights - April 3, 2013

Stuck At 25%
Share of Non-US Exports in Total Exports 0.30 0.25 0.20 0.15 0.10 0.05 0.00 01 02 03 04 05 06 07 08 09 10 11 12 13

Growth in Share of Total Exports (2003-2012)

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 UK EU Japan Other Developing OECD %-pts

Source: Statistics Canada, CIBC

Source: Statistics Canada, CIBC

diminishing returns from NAFTA, increased competition from emerging markets and a notable cost cutting by US manufacturers may be just as important. Regardless of the source of the weakness, the key question is to what extent Canadian exporters are adjusting quickly enough to reverse that trend. The US economy is nally showing signs of life, but with restrictive scal policy and no leveraged-based surge in household spending, the American economy of tomorrow will fall well short of generating the demand Canadian exporters enjoyed prior to the great recession. Its a Small World After All That reality is not escaping Ottawa which in recent years has intensied its efforts to diversify the countrys export
Chart 5

machine. And at rst glance there appears to be some success. The share of non-US exports in total Canadian exports rose from 13% in the beginning of the decade to todays 25%. The bad news is that this ratio has been stuck at 25% for more than four years (Chart 3). So despite intensifying efforts, Canadian export diversication is losing momentum. In fact, on a year-over-year basis, our exports to non-US destinations are now falling. But the story goes beyond speed. Chart 4 tells the tale. Almost all of the improvement in export diversication over the past decade came from two sources: the UK and developing countries. A closer look at the trade ows to the UK reveals that virtually all of that gain was due to the 300% increase in the price of goldhardly an inspiring diversication story. So we are left with developing countries as the key source of Canadas export diversication of the past decade. And a quick

Developing Market Focus All About China

18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% Argentina Change in Share of Canadian Exports to Developing Markets (2008-2012)

Lithuania

Philippines

Pakistan

Russia South Africa Thailand

Estonia

Hungary

Latvia

India

Mexico

Peru

Poland

Brazil

Malaysia

Bulgaria

Romania

Indonesia

Ukraine

China

Chile

Turkey

Source: Industry Canada, CIBC

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Venezuela

CIBC WORLD MARKETS INC.

Economic Insights - April 3, 2013

glance at Chart 5 suggests that this diversication story is also very concentrated, and becoming more so. Since 2003, China has accounted for more than half of the growth in developing market exports. But in the past ve years, it has accounted for all of the growth. Exports to all other developing countries (with the exception of tiny Bulgaria) have actually seen declining shares of our EM exports. Wins in China Shows Canada Can Compete Of course, rapid growth in China over the last decade suggests that focus is no bad thing. However, China has slowed and authorities aim to refocus the economy more towards domestic consumption. That will require a different product mix that Canadian companies may not, at present, be positioned to ll. Also, competition in China is erce and rising fast, with companies around the world seeing its vast population as potential purchasers of their goods and services. What the experience in China does show, though, is that Canadian companies can compete and succeed in developing markets. Although the share of Chinese imports stemming from Canada remains quite low (a little over 1%), it has at least edged up over the last 10 years (Chart 6, left). In contrast, most other developed countries have seen their share of Chinese imports fall over that same period. And it is not an oil story, with petroleum only a small proportion of Canadian shipments destined for China. Particularly noteworthy is how well Canadian companies are competing with their Southern neighbours. Of the

top 15 Canadian exports to China, 10 overlap with the top US exports (Chart 6, right). That means over half of Canadian exports to China encounter strong US competition. But even with a strengthening C$, that is a battle some sectors have been winning. Improvements in market share within areas such as oil seeds, grain & fruit, along with pulp and aircraft, are proof of that fact. On the reverse, there is only limited evidence that competition from China is forcing Canadian companies to withdraw from American markets. China has seen its greatest penetration into the US in areas such as clothing, toys and games and more recently electrical goods (Chart 7, left). While not unimportant areas for Canadian exporters, they were never the main focus of Canadian trade with the US. Those areas made up only around 15% of Canadian exports to the US a decade ago. And even though that percentage has dipped a little, they still account for around 12% today (Chart 7, right). Canadian rms have rightly been looking beyond the US market, as growth there fails to reach pre-recession levels. However, that diversication has been largely limited to China. And given slower and shifting growth dynamics there as well, that poses its own risks. But what the Chinese experience shows is that, despite a strong currency, Canadian companies have been able to compete and win in a very competitive emerging market environment. That should encourage them to broaden their horizons into other growth markets in the decade ahead.

Chart 7 Chart 6

Competing and Winning Against US in China

Change in Share of Chinese Imports 2003-12 (%-pts) 0.4%
Industries Competing with US % C hinese imports from C da Pulp of wood, waste Oil seed, grain, fruit Mineral fuels, oils etc Elect., electronic equip. Machinery, reactors Organic chemicals Plastics and articles 13% 11% 9% 6% 4% 3% 2% 2% 2% 2%

China Pentration into US Not a Major Factor for Canada

Increase in China's Share of US Import Market 30 (%-pts, 2003-12) 25 20 15 10 5 0 Apparel (knitted) Furniture Apparel (other) Leather Footwear Machinery Electrical equipment Toys etc
% of Total Cnd Exports to US (8 sectors of highest Chinese penetration into US) 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2003 2012

0.2% 0.0% -0.2% -0.4% -0.6% -0.8% -1.0%

Canada

France

Italy

Germany

UK

US

C ommodities nes Vehicles excl. railway Aircraft, spacecraft

Source: International Trade Centre, CIBC

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Source: International Trade Centre, CIBC

CIBC World Markets Inc.

Economic Insights - April 3, 2013

ECONOMIC UPDATE
CANADA Real GDP Growth (AR) Real Final Domestic Demand (AR) All Items CPI Inflation (Y/Y) Core CPI Ex Indirect Taxes (Y/Y) Unemployment Rate (%) 12Q4A 13Q1F 13Q2F 13Q3F 13Q4F 14Q1F 2012A 2013F 2014F 0.6 2.6 0.9 1.2 7.2 1.7 0.3 1.0 1.3 7.0 2.3 1.2 1.2 1.3 7.2 2.0 1.5 1.6 1.7 7.3 2.1 1.7 2.0 1.9 7.2 2.4 1.9 1.8 1.7 7.1 1.8 1.9 1.5 1.7 7.3 1.6 1.3 1.4 1.5 7.2 2.4 1.7 2.0 1.8 6.8

U.S. Real GDP Growth (AR) Real Final Sales (AR) All Items CPI Inflation (Y/Y) Core CPI Inflation (Y/Y) Unemployment Rate (%)

12Q4A 13Q1F 13Q2F 13Q3F 13Q4F 14Q1F 2012A 2013F 2014F 0.4 1.9 1.9 1.9 7.8 3.2 2.1 1.8 2.0 7.8 1.7 2.0 1.9 1.9 7.7 1.9 2.2 2.3 1.9 7.7 2.6 2.7 2.6 1.9 7.7 3.7 3.8 2.6 2.0 7.6 2.2 2.1 2.1 2.1 8.1 2.0 2.1 2.1 1.9 7.7 3.2 3.3 2.5 2.1 7.4

CANADA
First quarter growth now looks likely to track 1.7%, only a bit below our earlier projection. With a softer start to the year, weve knocked our 2013 forecast back to 1.6%a tick below our prior call. Inflation quickened in February on hotter-than-expected prices at the core level, although soft growth suggests little chance of consumer prices heating up measurably above 2% in the near-term.

UNITED STATES
As we had anticipated, the US economy is enjoying a solid start to 2013, with Q1 GDP on track for a more than 3% annualized gain. However, part of that strength is illusionary, thanks to a rebound in growth from the hurricane-disrupted Q4. Meanwhile declines in consumer and manufacturing confidence are already flashing warning signs for the second quarter outlook. A couple of sub-2% quarters in Q2/Q3, as fiscal tightening finally bites, will slow progress on bringing down unemployment. Only in 2014 will a sustained recovery likely be seen, with the jobless rate falling but inflation heading higher.

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