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Weekly Talking Points

November 9, 2018

When the Oil Comes Tumblin' Down

Misdirection is one of the first lessons any budding magician learns—draw audience

attention to one thing, to distract them from the much bigger event taking place

elsewhere. One has the nagging sensation that we have just been witness to some

very big acts of misdirection. In a week dominated by the U.S. “magic” of the

midterms, and an initially robust equity market response, here were some other

significant developments hiding in plain sight:

1. The bear market in oil. Friday marked the 10th consecutive daily decline for

WTI, slicing it below $60, and driving it down almost 22% from the peaks hit

barely a month ago. This will be the fifth consecutive weekly drop, and—

unbelievably—this isn’t even (yet) the longest weekly skid this year (there was

a seven-week setback in early summer). Factors behind the sudden slide

include: rising inventories amid ongoing powerful gains in U.S. production,

OPEC over-production, and a watering down of the constraints on Iran’s

exports. On the first point, U.S. output has vaulted 2 million bpd in the past year

alone to 11.6 million, the swiftest annual rise on record and making the U.S. the

largest producer in the world. Meantime, there was also talk this week of Saudi

Arabia abandoning OPEC altogether, hardly a positive for prices.

Now before we rush to radically adjust all economic forecasts, there are a few

points to make on oil’s slide. Some of this move simply reverses the steep runup

in anticipation of the Iran sanctions (a classic buy the rumour, sell the fact).

The severe drop brings WTI prices back to where they ended 2017, which was

actually the highest level of the year. So, current prices are still well above last

year’s average of $51. We were never big bulls on oil for 2019 in any event, and

are keeping our call for next year’s average of $65 (from what looks to be an

average of about $66 this year). Still, the swift reversal will clearly clip headline

CPI across much of the industrialized world at least temporarily, just after most

inflation readings had finally pushed above 2% recently. Look for a quick trip

back below 2% in many economies in the next few months.

Among the major economies, Canada stands out as the most obvious

potential growth casualty from the pullback. Compounding the pain is the

glaring fact that WCS was extraordinarily weak even before the broader setback

in global oil prices unfolded, posting ugly record spreads to WTI. In contrast to

the bulls looking for a quick turn, WCS prices have cratered further to below

$17, maintaining the grotesque spread and deeply darkening Alberta’s outlook.

Markets, forecasters, and policymakers have all been remarkably calm about the

prolonged softness in WCS—Governor Poloz noted it in Monday’s speech, but

blandly suggested that “a shortage of pipeline capacity has been weighing on

prices” and that the recent “especially large” discount was due to maintenance

and “will be temporary”. Heading into a wave of fall fiscal updates, most

notably from Ottawa on November 21, the deep dive in oil is the one new factor

that could throw the proverbial cat among the revenue pigeons.

Suffice it to say that the decision by a U.S. federal judge in Montana to grant an

injunction blocking the Keystone XL pipeline—on which construction was set

to begin next year—adds insult to injury for producers. The news sent an

already skidding Canadian dollar for another loop, driving it down 0.7% on the

week to below 76 cents (or $1.32/US$). President Trump was quick to call the

decision a “disgrace”, and there is the possibility the ruling could be over-turned

by a higher court. Even so, the ruling simply shows the many, many roadblocks

Canadian producers will continue to deal with in order to get product out of the

country, and keeps the dark cloud hovering over future investment in the


2. The Fed’s steely determination. This week’s FOMC meeting was always

going to be a yawner—so much so that some were going to the extreme lengths

of quoting Queen to try to liven it up. Typically, the Fed bends over backward to

not be an election issue, and tends to make as little noise as possible in the

November meeting around any vote. And, given that this was the last meeting

without an accompanying press conference, expectations for any major new

communications were near zero, let alone a rate change from the 2.0%-to-2.25%

range. The Fed delivered on those low expectations… in spades. Making about

as few word changes as possible, and keeping the communique as terse as

possible, the Fed noted that business investment had cooled from its hot pace,

but pretty much everything else was “strong”.

Yet the lead story of a non-event FOMC buried the bigger story of what it didn’t

say—Sherlock Holmes would be all over the dog that didn’t bark in this case:

There was no mention of the market volatility and/or clear signs of cooler

global growth. After all, since we last heard from the FOMC, when they hiked

in late September, U.S. stocks had been through a wrenching correction (the

second of the year), and global PMIs sagged nervily close to the 50 line. For

example, China’s composite private sector version dipped to 50.5 last month.

The comeback from the Fed would likely be: “true, but the U.S. measures

remain at very robust levels averaging almost 60 even with a mild October

retreat”. As for stocks, the Fed would no doubt note that, even with a Friday

spill, the S&P 500 has already recouped half its correction losses (headed for a

2% rise this week), is back above its 200-day moving average and is up 8%

from a year ago. Nothing to see here folks. The main point is that the Fed looks

quite determined to get rates back to neutral, and it’s going to take a lot more

than a garden-variety correction in stocks to dissuade it from that path.

Ditto for the Bank of Canada. The one key takeaway from the Governor’s

speech in London this week was that the Bank will not be thwarted from getting

back to neutral (2.50%-to-3.50%, versus 1.75% now) by a moderate tightening

in financial conditions. On the contrary, Poloz almost seemed to welcome the

back-up in bond yields, if not the reset in stocks, as a natural progression of a

tighter policy world. Notably, while the Fed said nothing about stocks, Poloz

was only too happy to chip in with his views on the market: “Qualitatively,

then, it is logical to expect stock prices to retrace some of their earlier increases

and to exhibit a more normal level of volatility.” Guess we won’t be talking

about the Poloz Put anytime soon!

Sidebar on the Bank’s recent hikes: While we wouldn’t be quite so sanguine

about either the pronounced weakness in WCS, or the ongoing struggles by the

TSX, we still don’t have a serious issue with the BoC snugging policy. It’s

awfully tough to argue against the Bank slowly lifting rates amid the lowest

jobless rate in 40 years and core inflation hovering right around target. Even

with the five rate hikes since last summer, the overnight rate of 1.75% is still

negative in real terms—that is still an abnormally low real rate for an economy

that’s far from abnormally weak. Having said all that, and even recognizing that

the Bank won’t be swayed by market volatility, an extended period of weakness

in oil prices is one new development that could indeed stay its tightening hand.

Let’s just say that the odds on a hike over the next two meetings (i.e., by

January 9) are lower than the market’s guess of 90%.

3. The USMCA may yet provide some further drama. Most of us assumed that,

after more than a year of clouding the Canadian economy with unwanted

uncertainty, the late-September USMCA put the issue to rest. Well, in a belated

tribute to Halloween, the issue has been resurrected by the midterm election

results. The loonie had a fright this week on a news item that Canada and the

U.S. are debating some of the finer points of the initial deal, but that seems like

a minor issue compared with the bigger challenge of getting the deal through

Congress. It’s not the USMCA per se—officially, the Democrats have expressed

only mild reservations about the deal—it’s more that the deep political divide

may mean that the House could be tempted to block any potential “wins”

for the President. The flip side is that, if the Democrats instead want to set a

different and more constructive tone, at least initially, agreeing to approve the

USMCA could be a low-pain path.

Meantime, in another area of potential political drama, it looks like the volume

could be turned down. Here’s one view from an opinion piece in the

Washington Post this week: “The midterm elections, followed promptly by

Attorney General Jeff Sessions’ forced resignation, have rendered special

counsel Robert S. Mueller III’s investigation into Russian interference in the

2016 presidential election politically irrelevant.” The misdirection here of

course is that, while pundits were still waist-deep in analyzing the election

results, Sessions was being shown the door, which would have been massive

news in any other week.

Amid the ongoing drama in Washington, the key point is that many other critical

developments can sometimes be overlooked. Like two-year Treasury yields rising

close to the 3% threshold, their highest level in a decade, and up by more than 2

percentage points from just two short years ago. Or, like natural gas prices quietly

hitting some of their highest levels of the past four years this week (at above $3.75).

Or, like the Mexican stock market getting clobbered this week by 5% (and almost 7%

in US$ terms) on a proposal by the incoming government to curb banks from

charging certain commissions. Or, like the same government looking to follow

Canada’s lead on cannabis legalization, potentially creating a big new competitor and

market. Or, like John Mellencamp (nee Cougar) and Meg Ryan getting engaged.

Douglas J. Porter, CFA | Chief Economist | Managing Director, Economic Research