Greetings, forex friends! Bank of Canada (BOC) Governor Stephen Poloz gave a speech over at oil-rich Alberta on Monday wherein he talked about “riding the commodity cycle.”
His speech was essentially a sort of pep talk to the people of Alberta, who have been hit the hardest by falling oil prices, and didn’t really have anything of great value for well-informed veteran forex traders, which is probably why the Loonie’s forex price action wasn’t affected as much. But his speech did give a good summary on how the Canadian economy got to where it is now (i.e. in a state of recession) that forex newbies (and veterans who want a quick refresher) may appreciate.
1. What the heck is a commodity cycle?
Well, in Poloz’s own words: “A large and persistent increase in demand leads to sustained upward pressure on resource prices over a number of years. The higher prices act as an incentive to boost supply, and companies act by, for example, investing in new capacity and finding methods to increase efficiency … the higher output generated by those investments combines with stabilizing demand to bring about a period of downward pressure on prices. Faced with lower prices, companies may scale back investment and production. Ultimately, the lower prices will encourage demand, and the reduced investment will crimp future supply, leading to higher prices. And producers will ride the price cycle all over again.”
If you prefer a list format:
- Demand increases
- Price increases due to higher demand
Okay, I’m just pulling your leg. Here’s the actual list:
- Demand for resources increases
- Price increases due to higher demand
- Companies exploit higher prices by increasing productivity
- Higher supply due to higher production levels leads to lower prices
- Lower prices are no longer attractive, so companies scale back on their operations
- Demand for resources increases due to lower prices; cycle start overs again
In a nutshell, it’s the law of supply and demand at work on a much grander scale.
2. Why are oil prices slumping?
Poloz attributed the falling oil prices to a sharp rise in supply, “thanks primarily to technological advances in oil extraction everywhere.” Poloz also singled out the United States and its entry into the oil market, saying that oil output from the U.S. “essentially didn’t exist before 2008,” but it reached around 4.2 million barrels per day in 2014, which is “roughly equivalent to all the oil that Canada produces in a year.”
Regarding the demand side of the equation, Poloz noted that the recent slowdown in China and the earlier slowdown in India both contributed to lower commodity prices, but both emerging economies are “still an important source of demand” now that both economies are growing at a more moderate yet sustainable pace.
3. What has the BOC done about it?
Unfortunately, the BOC cannot really do anything about it directly since that is mostly up to the private sector. The private sector is still struggling to adjust to the supply shock, and “these complex adjustments will take considerable time,” but the BOC is doing what it can to help make the transition less painful, which includes the two rate cuts for this year and the BOC’s accommodative stance on monetary policy.
Poloz also pointed out that not interfering with the floating exchange rate (unlike other countries that I won’t mention *cough* Switzerland *cough*) has allowed the Loonie to depreciate in response to falling oil prices, reducing the deflationary pressure on the economy as a whole. The same policy of non-interference also apparently helped to avoid an overheating of the Canadian economy when the Loonie went above parity to the Greenback due to oil surging from $25 to over $100 from 2002 to 2012.
4. What’s next for Canada and oil?
Poloz didn’t have any forward guidance for Canada or the future direction of oil prices, saying that technological advances have historically made predictions very difficult, which I think is a cop out, but I digress. As an example, he cited the situation back in the 1970’s when practically every pundit was saying that the world will run out of copper by the year 2000 due to insatiable demand for copper wires, but fiber-optic cables came along later, which made copper wires obsolete.
Since Poloz didn’t have anything to say about the future of oil prices, I’m gonna give my take instead. I don’t know how the deep the oil rabbit hole is gonna be, but I don’t think we have seen the bottom quite yet since there are currently a lot of events that could potentially increase the downside risks.
For one, we have the Iran deal and its implications to the global oil supply to worry about. Also, we mentioned in our School of Pipsology that Canada has been the main dealer of “black crack” or oil to the U.S., but the increased domestic oil production in the U.S. will soon mean that Uncle Sam will be getting high on his own supply since U.S. oil imports have been contracting at an alarming rate. Well, it’s alarming only from Canada’s perspective.
Furthermore, the U.S. House of Representatives just recently passed a bill to repeal a ban on U.S. oil exports. It would still have to go through the Senate, but if the ban is repealed then the U.S. could become a major player in the oil market as well, so Canada’s primary customer could potentially end up being its competitor, which is gonna be very bad for Canada and the Loonie.