Last week my holidays were spent reflecting on what’s going on in the world and what it means for us in Edmonton. I started the year with the phone ringing off the hook by very anxious people wanting to talk about the fall in the price of oil, the provincial budget and the impact on their businesses … and I returned to the office this week to quickly realize that the phone is still ringing.
So, I thought I’d take this opportunity to share some of my recent speaking notes, and to encourage a collective call to action.
2014: The Year of Living Anxiously
Last January, following our annual IMPACT Luncheon, I began characterizing our economy as utopia, with 5.5% GDP growth, 3.9% population growth, 4.9% unemployment, $95 price of oil. The Edmonton economy was on fire and the Conference Board of Canada was predicting 4.9% GDP growth for Edmonton in 2014, and the top performing city in the country for 2015, 2016, 2017 and 2018.
We were not as optimistic at EEDC. We worried that the market was overpriced. We became concerned about governments thinking 3.9% population growth would last forever. We were closely watching the surge in supply of tight oil out of the US at the expense of Saudi Arabia losing market share. We felt the Alberta economy was becoming overheated with labour costs reaching all-time highs. And we were most troubled about social unrest because of the unemployed youth in the east, throughout the US and around the world.
We launched a scenario planning initiative with the help of Incite Marketing to come up with a document that hopefully encouraged the business community to start thinking that the current economic environment, utopia, may in fact change and change quite quickly. Although published in May, I have attached this EEDC document here for your use and benefit.
Geopolitics of Oil
In 2008, the price of oil plummeted from $140 to $40 in a matter of six months – a $100 drop. It was driven by a financial crisis. Bear Stearns collapsed in March 2008 and Lehman Brothers then collapsed in September. Banks refused to honor each other’s credit, shipping and trade halted, and tankers full of oil were stranded in oceans without the ability to dock. It was a totally different situation than today.
Today, oil has plummeted from $105.93 to $50.46 in the past eight months – a $55 drop. It has been driven by a geopolitical agenda of OPEC states (specifically Saudi Arabia) in direct defense of its market share in the United States, and with the goal of putting highly-leveraged and high marginal-cost producers around the world out of business.
Who are those? The US has drilled >20,000 new wells in the last 4 years. They now product 9Mb/d vs 10Mb/d in Saudi Arabia. Most of those shale oil companies are highly leveraged and in need of cash flow. As prices have declined, it now costs more to develop new wells than they are making on existing ones, which is unsustainable, and the low prices will start to squeeze many highly-leveraged producers out.
And who are the high marginal-cost producers? Venezuela is the highest and dangerously close to defaulting on its debt. Nigeria has had to raise interest rates and devalue its currency, as has Russia. Iran is a high cost producer flirting with economic and political unrest. And Brazil offshore and Canada’s oil sands operators are next in line of the highest marginal cost producers.
With Venezuela, Nigeria, Iran, United Emirates, Algeria and Kuwait all high cost OPEC states, the Saudi’s who are in charge need to walk a careful line such that their quest for market share doesn’t create war in the Middle East or an overthrow of power in Russia. If either of those events happen, the price of oil could soar, and we’re seeing anticipation of that this week and in the markets over the past 45 days.
Response by Alberta
When we look at our scenarios, a $50 price of oil regardless of global expansion/contraction is a tough scenario for the Government of Alberta. Our provincial government will move into cost containment mode (program cuts and salary rollbacks) and hopefully make incremental vs. drastic changes to their fiscal framework – something that is desperately overdue. Capital expenditures will be reduced but funded through deficits, as they have learned their lesson of the Klein years and understand that they the need to invest in infrastructure otherwise burden future generations. These are unpopular but essential moves, as Alberta needs to create stability in its financial model in order to provide long-term, sustainable funding to essential programs in the years ahead.
We live in a province that has been consistently out of balance. We have an energy strategy and an energy funding strategy. That is it. Our post-secondary strategy, our healthcare strategy, our diversification strategy, out budgeting strategy has proven that it cannot withstand a -20% change in the price of oil … and that is detrimental to the long-term health of our economy, our people and our communities.
I sympathize with our Premier who has inherited this problem of revenue volatility, as these are the same problem as we experienced in the 1980s, the 1990, the 2000s and now in 2015. And it will be the same volatility problem that we will experience in the 2020s, 2030s and 2040s unless we take action and show the political leadership necessary to make incremental changes to our tax structure, our savings policies, our discipline around expenditure growth, and our transparency around financial reporting such that the public can understand our financial situation and support him in making the tough decisions.
Impact on Business
There is a range of perspectives on what this will mean for business, from the Conference Board’s prediction of a recession to local predictions that we will weather through similar to 2009-2010. Given no one can accurately predict the price of oil or geopolitical stability, I would encourage business to focus on the reality that has emerged:
- We are in a provincial budget crunch and a global competitiveness crunch.
- Operating costs in the oil service sector are up 50% over the past 5 years with wage inflation running around 6% per year. This has created an overheated sector that is in need of correction.
- Capital expenditures are looking to be down 30%-35% in conventional energy business.
- Capital expenditures are looking to be down 15%-20% in the oil sands business.
- Layoffs have started, and we are anticipating the corporate sector will eliminate 25,000 – 30,000 jobs in 2015. This will impact out-of-province workers in northern Alberta and approximately 20,000 families and high paying jobs (mostly in the Calgary area) in the coming year.
- Our provincial unemployment rate will rise to 6.5%-7.0% which will have a socio-economic impact on our major cities, but will be felt to a much greater extent in southern Alberta.
- Household incomes will remain flat, but still at quite a relatively high level of disposable income.
- Household and personal debt will get concerning as rates flirt with rising in late 2015.
- Canadian dollar will continue to follow the price of oil, resulting in a boom in tourism and our export industries (forestry, agriculture, manufacturing, etc.) will expand with US/Global growth.
- $4 Billion of new construction in Edmonton’s downtown will go ahead as planned, as most projects are well underway and will continue through 2015-2016.
I know I am supposed to be the booster of our city and economy, but I am also a realist and I care deeply about the long-term success of our local businesses and the financial health of our families. My suggestion is that we should get used to this level of oil pricing at $50, but prepare budgets for $40 oil. This may sound lower than what you are hearing by most economists, but I was trained to always budget for reality and adapt to an optimistic environment, as opposed to having to do it the other way around.
So What Can You Do?
Given “hope” is not sound strategy, there are a few things we can all do to prepare ourselves and our businesses accordingly. You can take or dismiss these as you wish:
- Focus on your balance sheet, be it corporate or personal, and develop a plan that you can share with your bankers, accountants and other professionals in a proactive manner.
- Communicate openly with your employees and family about the situation. Reset their expectations and involve them in the level of preparedness that needs to be taken by everyone.
- Re-forecast with an understanding that population growth and income levels will remain flat.
- Those with strong balance sheets should be looking for opportunities and acquisitions.
- Those with high cost structures should address systemic and productivity issues with their business models.
- Advocate openly for the need to make incremental changes to our tax structure, which are needed, as our elected officials need the courage to do the right thing.
A Bright Future
National messaging about our province has been much bleaker than required. Yes, we need to: (1) Establish discipline around our expenditure growth; (2) Make incremental changes to our tax structure; (3) Institute a de-politicized savings/investment policy; and (4) Establish transparency around financial reporting such that the public can understand our financial situation and support the Premier in making the tough decisions. But the message must go further.
We need to communicate “why” we are doing this and not just running massive deficits like other jurisdictions. Our message needs to also say that “Alberta is committed to implementing these four steps over the next 2.5 years, and once we do this, our province will be: (1) Still the most tax advantaged jurisdiction in North America; (2) Blessed with an abundance of energy, food, fibre and materials that the world demands; (3) Armed with the strongest and smartest labour force of 18-36 year olds that now understand what it takes to be competitive; and (4) Filled with Canada’s best managed companies with solid business models and diversified markets that outperform whether the price of oil is $140 or $40.
Our message to the world, and to Albertans, needs always to be aspirational – we know the changes that we need to make, and then look out because before you know it, Alberta will be back out front leading the nation, bigger and stronger and more competitive, like we have been consistently over the past fifteen years.
We have work to do. Let’s make the changes. And then let’s get the plan underway.