Beyond Keystone

7/28/2019 Beyond Keystone

1/12

Economicinsights

CIBC World Markets Inc. PO Box 500, 161 Bay Street, Brook iel d Place, Toronto, Canada M5J 2S8 Bl oomberg @ CI BC ( 416 ) 594-7 00

C I B C W o r l d M a r k e t s C o r p 3 0 0 M a d i s o n A v e n u e , N e w Y o r k , N Y 1 0 0 1 7 ( 2 1 2 ) 8 5 6 - 4 0 0 0 , ( 8 0 0 ) 9 9 9 - 6 7 2

Economics

Avery Sheneld(416) 594-7356

[email protected]

Benjamin Tal(416) 956-3698

[email protected]

Peter Buchanan(416) 594-7354

[email protected]

Warren Lovely(416) 594-8041

[email protected]

Emanuella Enenajor(416) 956-6527

[email protected]

Andrew Grantham(416) 956-3219

[email protected]

text text text

h t t p : / / r e s e a r c h .cibcwm.com/res/Eco/EcoResearch.html

Judging by the ramp-up in Canadasmessaging to Washington, which hasincluded everyone rom energy sectorparticipants, politicians and hockey coaches,were in the inal crunch on a WhiteHouse decision over the Keystone pipelineproject. There will be a sigh o relie iPresident Obama is able to put aside meresymbolism and approve a project that willhave no material bearing on global climate,particularly relative to what America could

do i it took its own coal appetite seriously.

But recent developments in the global oilindustryrom Venezuela to Iraq, romNorth Dakota to Mexico, rom Caliornia toChinasuggest that Keystone is just one oseveral important pieces o the puzzle orCanadas energy sector. Three key trendsrising shale oil prospects stateside, the shit inconsumption growth to Asia, and a growinglist o oil producing countries open to oreign

participationall pose challenges i Canadais to maximize the value o its resource base(see pages 6-8).

Keystone will improve access stateside, andput a cap on adverse price dierentials orWestern Canadian producers. But growthin US shale output, coupled with a muchsoter trajectory or medium term demandgrowth stateside, put Americas net importrequirements on a collision course withCanadian plans to ramp up its output by a

urther two million bbl/day over the balanceo this decade.

Long term projections or the US to be ullysel-sucient have to be taken with a graino 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 aheador Asia, and we doubt supply-demandconditions will permanently sustain pricesbelow Canadian project break-evens. But itsincreasingly important that Canada move onone or more o the alternative pipelines toget our product headed Asias way. Canadasown central and eastern oil markets areoil markets aremarkets areanother option, but longer term demand

growth there is also likely to be lacklustre.

Clarity on the pipeline ront will also becritical to attracting the capitalbothdomestic and oreignneeded to nance thegrowth in Canadian production. Only a hal-decade ago, due to restrictions elsewhere,Canada represented more than hal o thereserves accessible to oreign capital. Today,there are many more competitors or thosesame investor dollars. Not only in the US

shale plays, but much urther aeld. Iraq isrebuilding, Mexico is looking more open toinfows o oreign capital and expertise, andthe winds o political change could at somepoint see the same swing in Venezuela.

The policy implication or Canada is thatwhile Ottawa has imposed some newrestraints on oil sands activity by oreignstate-owned enterprise, other measureson the policy dial may have to move theother way. With more competition or

investor dollars, decit-ghting ederal andprovincial governments may have less roomto manoeuvre in setting taxes and royaltiesthan was earlier the case. Both pipelines andreasonable royalties will be critical to avoidkilling the black-gold goose.

Beyond Keystoneby Avery Sheneld

April 3, 2013

Three key trends...all pose challengesif Canada is tomaximize the valueof i t s resource

base...


2/12

CIBC World Markets InC. Economic Insights - April 3, 2013

2

MARKET CALL

INTEREST & FOREIGN EXCHANGE RATES

Theres no reason to change our call that the Fed is on hold through mid-2015, but that call rests on a viewthat the end o QE will bring less stimulative rates at the long end (see pages 3-5). Frankly, were surprisedat how well long rates held in (or both the US, and by extension, Canada) given that our once top-o-consensus orecast or US Q1 growth is now a much more widely held view. European news is part o that

story, and since we see a lingering impact rom those risks, and US growth will slow towards mid-year, wevepushed o most o our projected bond market sell o until late this year.

The changing o the guard at the Bank o Canada isnt likely to alter its stand-pat stance, particularly withhousehold credit growth in check. Weve slowed the path ahead or 2-year rates as weve chipped ourorecast or growth slightly downward, but are in agreement with the Bank that its next move, well o inH2 2014 or even early 2015, will be a hike not a cut.

Having moved more than hal way there, dollar-Canada pulled back rom our June 1.05 target. But weresticking to our guns on that call, expecting sotness in global growth to take some o the shine o ourcommodities-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 sotness.

2013 2013 2014

END OF PERIOD: 2-Apr Jun Sep Dec Mar Jun Sep Dec

CDA Overnight target rate 1.00 1.00 1.00 1.00 1.00 1.00 1.25 1.50

98-Day Treasury Bills 0.96 0.95 0.95 0.95 0.95 1.10 1.30 1.602-Year Gov't Bond 1.00 1.10 1.20 1.45 1.55 1.70 2.00 2.20

10-Year Gov't Bond 1.87 2.00 2.10 2.40 2.55 2.70 2.80 2.85

30-Year Gov't Bond 2.51 2.60 2.70 2.90 3.00 3.05 3.10 3.15

U.S. Federal Funds Rate 0.16 0.10 0.10 0.10 0.10 0.10 0.10 0.10

91-Day Treasury Bills 0.07 0.10 0.15 0.15 0.15 0.15 0.15 0.15

2-Year Gov't Note 0.24 0.30 0.35 0.45 0.45 0.60 0.80 1.10

10-Year Gov't Note 1.86 2.00 2.15 2.45 2.60 2.70 2.75 2.80

30-Year Gov't Bond 3.10 3.20 3.35 3.60 3.70 3.75 3.80 3.90

Canada - US T-Bill Spread 0.90 0.85 0.80 0.80 0.80 0.95 1.15 1.45

Canada - US 10-Year Bond Spread 0.01 0.00 -0.05 -0.05 -0.05 0.00 0.05 0.05

Canada Yield Curve (30-Year 2-Year) 1.51 1.50 1.50 1.45 1.45 1.35 1.10 0.95

US Yield Curve (30-Year 2-Year) 2.86 2.90 3.00 3.15 3.25 3.15 3.00 2.80

EXCHANGE RATES CADUSD 0.99 0.95 0.96 0.97 0.99 1.02 1.04 1.02

USDCAD 1.01 1.05 1.04 1.03 1.01 0.98 0.96 0.98

USDJPY 93 96 95 94 93 92 91 90

EURUSD 1.28 1.27 1.25 1.28 1.28 1.30 1.31 1.32

GBPUSD 1.51 1.47 1.45 1.49 1.50 1.53 1.55 1.57

AUDUSD 1.05 0.99 0.96 0.99 1.01 1.03 1.04 1.06

USDCHF 0.95 0.96 0.98 0.96 0.97 0.96 0.95 0.97

USDBRL 2.02 1.92 1.93 1.95 1.94 1.97 2.01 2.05

USDMXN 12.28 12.64 12.66 12.75 12.82 12.88 12.95 12.95


3/12


3

Go Ahead, Fight the FedAvery Sheneld and Emanuella Enenajor

Last year, xed income investors rode Ben Bernankescoattails towards surprisingly strong returns. That was

true not only or the US Treasury and mortgage bondsthe Fed was buying, but given their correlation to theAmerican market, Canadian bonds as well. But as wemove closer to the signicant acceleration in growth weexpect in the US or 2014, investors need to think abouttheir own exit strategy beore the Fed starts its.

For a number o reasons, its time to go ahead and ghtthe Fed, and sell what the central bank is buying. It mightnot be possible or American central bankers to live up totheir simultaneous pledges or what they will do about

the unds rate and their bloated balance sheet. What theFed says today about its exit strategy may simply not beoptimal or it to pursue when the time comes to beginunwinding its extraordinary stimulus, and the marketcould begin to recognize that issue beore this year isout.

How Patient on the Funds Rate?

For now, theres little reason to believe that the Fed hasits nger on the rate hike trigger. Infation is tame, labourmarkets still have ample slack, and the optimal unds

rate today might well be negative, i that were possible.With one dissenting vote, the central bank is pledging toleave rates near zero until the jobless rate hits 6.5% orinfation looks to persist about 2.5%, both quite distanttargets.

While that type o orward guidance was unusual, wevebeen down this road beore, on the other side o the 49t

parallel. Mark Carneys team at the Bank o Canada wasalso acing the zero bound in the overnight rate backin 2009, and a market that was stubbornly pricing inrate hikes a ew quarters ahead. To fatten the curve itissued a conditional commitment, pledging that ratehikes would be eschewed until ater the second quarteo 2010, as long at the economy tracked the Banksorecast.

At least one key Fed player, Janet Yellen, has suggestedthat the FOMC is going urther than the Bank o Canada

in a material way. Carneys team was simply describing itsview on the orecast and the rate outlook that would beconsistent with it. Yellen argues that the Fed is actuallycommitting to hold rates lower or longer than it wouldideally. Unable to set the unds rate at the optimal levetoday, which would be negative, the Fed promises tohold it lower than the typical Taylor Rule ormula wouldimply in the uture (Chart 1). As a result, two-year ratestoday trade as i the unds rate was instead starting romnegative.

But promises can be hard or central banks to keep. Even

the Bank o Canada, acing rmer-than-expected growthand infation, ended up raising rates one meeting earlierthan its conditional pledge would have allowed.

Chart 1

Fed Strategy: Pledge to Over-Stimulate In Future

Source: Federal Reserve

Chart 2

6% Joblessness Was Consistentwith Fed Funds Rate at 1%

Source: Haver Analytics, CIBC

0%

2%

4%

6%

8%

10%

12%

Sep-1996 Jun-2000 Mar-2004 Dec-2007 Sep-2011

Unemployment

Rate

Fed Funds

Target Rate

FF Rate @ 1%

with 6%

joblessness

0%

1%

2%

3%

4%

5%

2011 Q1 2013 Q2 2015 Q3 2017 Q4

Modified Taylor Rule

Baseline (primary dealer survey)

Optimal Policy

Fed Funds Rate


4/12


I long rates were at normal levels (and we shall arguethey are not) the Fed might be able to bite the bulletand stick to its word on the timing o the rst rate hike.A zero percent overnight rate alongside a 6.5% joblessrate would not, in itsel, be obviously out o line, at least

judged by the last cycle. In 2003, ollowing 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 o the curve does not look at all like itdid back then. Ben Bernanke himsel believes thatquantitative easing and twist have pushed the 10-yearrate some 100 bps lower than it would be otherwise.Using estimates o the economic sensitivity to rates ateach end o the curve rom Rudebusch, we nd thatmonetary policy (including QE) is delivering a dose ostimulus equivalent to having an undistorted long endand a unds rate at -4% (Chart 3).

Leaving all o that in place as the unemployment ratereached 6.5% would, judging by the past cycle, risk aninfationary overheating. Either the Fed will have to pushthe unds rate up on a steep track and sooner than itpromised, or the long end will have to steepen up quickly,either through market orces or Fed action to unwind QEin 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 useden route to greater stimulus, would be the rst to beundone as policy turns less stimulative. But the centralbankers are saying just the opposite.

While the rst step in tightening will be to cease newasset purchases and reinvestment o principal paymentson securities holdings, active tightening steps are thensupposed to all be concentrated at the short endmodiying orward guidance, raising the ed unds rateand concurrently upping the interest rate on reserves,and using reverse repo operations to drain short term

liquidity. Actually selling long assets is spoken o inhushed tones as a distant prospect, i at all.

The Fed, however, has an incentive today to convinceinvestors that such an unwind o curve fattening assetholdings is not in the cards. I investors thought it was,QE would be ineective, as the Feds buying would bemet with a crush o long bond selling by others. So theFed has had to walk a careul line on its messaging tomarkets, and the question is, should we believe it?

So ar, markets have. Indeed, since July 2012, the rise

in the 10-year interest rate has almost entirely been dueto higher infation expectations, not a re-pricing in othe term premium on anticipation o an eventual Fedbalance sheet reduction (Chart 4). Today, the 10-yeaaverage infation rate is tracking 2% based on TIPSpricing, as per the Feds threshold guidance. PrimaryDealers expect even less o a balance sheet unwind thanmaturities/prepayments ater 2014 would imply (Chart5). Thus, any sales would take markets by surprise andcould spell a spike in rates.

How may the Feds exit actually play out? Past USexperience doesnt tell us anything, because QE hasntbeen done beore. In Japan however, the central bankmoved to reduce the size o its balance sheet in 2006before acting on overnight rates, not ater (Chart 6)That said, the Japanese case was not entirely analogous

Chart

Rates Rise on Infation Outlook, Not Early QE End

Source: Bloomberg, CIBC

Chart 3

Substantial Stimulus o Fed Extraordinary Policy

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

-6%

-4%

-2%

0%

2%

4%

6%

2004 2008 2012

Fed Funds

Rate

Equivalent

stimulus

impact

(including QE)

Drivers of change in 10-yr rate since July '12

Higher short-

term rates

Higher

inflation

premium

Term

premium/other

a/o 1-Apr-13


5/12


to that o the US. For one, BoJ ocials had guided themarket to that ordering in speeches in 2005. Moreover,the bulk o the asset accumulation was in short termbills, so these could roll o the books quickly once theexit began, without any need to sell assets. But still, thecentral bank thought it important not to continue to holdsuch a large balance sheet as the economy recovered.

The Fed will similarly need to act to prevent huge excessreserves rom prompting equally huge money supplygrowth through the lending channel (which in the process

shits them into required reserves). Short o the draconianstep o a massive hike in the reserve requirement, itsargument is that it can prevent an infationary outburstin lending while still holding a huge balance sheet, bypaying banks to leave idle unds on deposit with them.

Chart 6

Bank o Japan QE Exit: Balance Sheet ReducedBeore Rate Hikes

Chart

Dealers Expect Only a Very Slow, Passive Reductionin Fed's Balance Sheet

Source: Bank of Japan, Bloomberg, CIBC

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

While easible on paper, doing all o the work at theront o the curve risks steering monetary policy miles ocourse, a concern Charles Plosser has raised. It could endup hammering sectors sensitive to short rates to containmoney growth, or alling behind in the need to preventexcess money and infation. The Fed will be relying onthe unds rate and what it pays on excess reserves to

do two simultaneous taskscontrolling demand in theeconomy and the pace o money supply growth, andwill be doing so without a roadmap. The central banksmodels will provide no guidance on the pace at whichreserves need to be held back as idle deposits by raisingshort rates, since they are calibrated to eras without anequivalent excess reserves bubble.

The saer alternative would be to ollow Japans routeand combine a wind down o Fed assets with measuresto tighten through short term rates. That could beaccomplished, or example, i the Fed did a reversal o

twist, and sold long mortgage bonds or shorter Treasuriesthat would roll o the books through maturities. Thatwould address another problem or the Fed: as it nowstands, maturities will drain its Treasuries holdings, leavingit with a balance sheet ocussed on other assets, when itsultimate goal is to end up holding only Treasuries.

But to admit any o this now would be counterproductiveto the Feds eorts to depress long rates, as it would seeinvestors dumping long bonds as ast as the Fed is buyingthem, anticipating the policy reversal.

Test Brakes: Steeper Grade Ahead

The Fed wants to convince us that it could end or start toreduce QE purchases by the end o this year, but preservea stasis in the bond market until its ready to raise ratescome mid-2015. But that sort o pregnant pause will behard to engineer. A steeper US yield curve, and higherlong rates in Canada as well, are a likely eature o thisyears second hal. Either markets will start to anticipatethe QE unwind and put upward pressure on long rates ontheir own, or it will begin to doubt the Feds willingness

to do all o its initial tightening at the short end.

Theres no rush to act, since the next couple o quartersare likely to bring slower economic growth. But graduallyparing duration in xed income investments through2013 could still be rewarding. That will entail sellingwhat the Fed is buying, but ghting the Fed this year wilbe much less painul than staying on the central banksteam or too long.

-1200

-1000

-800

-600

-400

-200

0

Passively* shrink (start

2015)

Median Primary Dealers'

Expectations

Estimated change in Fed asset holdings (2014-16)

US$, bns

*passive reduction $25bn/mo

0

20

40

60

80

100

120

140

160

180

Apr-01 Feb-04 Dec-06

Other Assets

Treasury Bills

Bonds

Bills Purchases*

Trillions of

*loans made against pooled collateral

Bank of

Japan raises

the policy

rate


6/12


6

Chart 1

Top Oil Producers

Chart 3

Cost o Bottlenecks to Remain HighEven Ater Recent Spread Improvements

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

The US shale supply revolution and an inexorable tiltin demand towards Asia are just two o several orces

transorming the world oil industry, with importantimplications or industry, governments, and otherstakeholders in Canada, the worlds th-ranked producer(Chart 1).

Even back in 2010 Canadas energy resource sectordirectly accounted or 7% o GDP. Add in capitalspending, and that gure would be well into doubledigits. Hal o Canadian crude production trades looselyo landlocked WTI, the rest o Western Canada Select(WCS), a bitumen-based heavy benchmark. Attesting tothe sectors economic clout and a key recent concern,Canadians ound the public airwaves lled last winterwith the arcane subject o crude price dierentials.Bottlenecks on both the transportation and upgrading/rening side saw quality (ie. heavy-light oil) and locational(WTI vs Brent) dierentials explode during the winter, withthe gap between WCS and WTI hitting a record $43/bblat one point, versus a historical average o $17.

Renery/upgrader restarts, and a heavier reliance onfexible but costlier to operate rail pipelines, haveseen a airly dramatic improvement lately, particularly

in heavy spreads. Notwithstanding such improvements,Canada continues to ace a notable long-term challengeshipping its oil to market, given anticipated supplygrowth on both sides o the border. The ailure to investin needed transport inrastructure could still prove costly

Changing Global Realities Buet Canadas Oil PatchPeter Buchanan

or Canadian producers, governments, and the economyto the extent that investment plans are delayed or scaledback. Assuming currently planned projects proceedCIBCs equity team has predicted that Canadas totaproduction could rise by a urther 2 mn barrel/day bydecades end (Chart 2). As opposed to earlier hopes oa quick x to bottlenecks, pipeline capacity will likely

struggle or years to match aggressive supply growth onboth sides o the Canada-US border. Given lower realizedprices or producers and royalties, a Brent-WTI dierentiao around $10/bbl based on higher railing costs would

Chart 2

Wall o Canadian Oil Will Strain Transport &

Upgrading Capacity

0

2

4

6

8

10

12

Russia Saudi

Arabia

US China Canada

Mn bbl/day

0

1

2

3

4

5

6

7

80 85 90 95 00 05 10 15 20

Cdn crude production,

mn bbl/day

Trajectory

implied by

announced

projects

Source: NEB, CIBC

Source: NEB, Bloomberg, CIB

0

5

10

15

20

2530

35

40

23-Aug

12-Sep

2-Oct

22-Oct

9-Nov

29-Nov

19-Dec

8-Jan

28-Jan

15-Feb

7-Mar

27-Mar

$Bn annualized, 30 day mov. avg

Note: Revenue loss based on

"normal" WTI premium of $2/bbl

vs Brent and $17/bbldiscount of

Western Canada Select to WTI

$15.2 bn

$16.5 bn

2014 2015

Projected


7/12


reasonably until a hal-decade ago, but has worked lesswell since.

Hard-to-gauge political, technological and economicactors make the oil market a orecasters nightmareJust how much urther Americas dependence on importsmight decline is thus a matter o some conjecture. A

lack o inormation on perormance over the ull wellie cycle urther compounds prediction diculties. Thasaid, some seasoned observers like the IEA now believethat good supply prospects or both gas and oil couldhelp the US achieve overall net energy sel-suciency inabout two decades time. That actors in not only currentshale oil projects, but the potential o promising as-yet-undeveloped sources, like Caliornias Monterey shales.

Beyond the shale supply bulge, two other seismic actorsare aecting Canada. First, is a dramatic re-orientation odemand to Asia. Second is a more competitive investment/production landscape, as changes in a number o othercountries create, or oer prospects, o improved access tocountries that were previously o limits to many players

Global Demand Skewed Increasingly Towards Asia

On the demand side, Canadas traditional locationainvestment advantage rom being right next to theworlds largest oil importer is unlikely to last much longerA decade ago China produced more oil than it used. Thisyear the Asian industrial giant is on track to dethrone the

US as the worlds top importer o black gold (Chart 5let).

We expect Chinas economy to grow at a scaled back 7-8% pace over the next decade. While that will likely limitoil demand growth to about 3-4% per year, China usesar more crude than it did ten years ago. Even that scaledback percentage rate will consequently add the equivalento the UK to the global demand pie every couple o yearsNor is China alone. The combination o hearty economicgrowth and greater energy intensity owing to liestyleurbanization and other changes mean that Asia is now

home to three o the worlds ve largest oil-consumingeconomies.

Rising consumption there (Chart 5, right) comes alongsidecontinuing downside pressure on demand in the industriacountries. The US now uses about 2 million barrels o oiless than it did beore the Great Recession. While a sub-par recovery is partly to blame, other actors are also atwork, as illustrated by the act that vehicle miles havecontinued to decline recently even as signals or both

Chart

Shale Oil Revolution Shits the US Supply Curve (L);Import Share o US Market % (R)

Source: US DOE

translate into an eective opportunity cost o some $15billion per year (Chart 3). Thats not quite so crippling aslast winter, but still equal to nearly 5% o the GDP oCanadas two largest oil-producing provinces.

Shale: The Underestimated Revolution

Contributing centrally to the altered pricing backdropare stunning supply changes stateside. Shale oil hasgone rom a negligible share o US production ve yearsago, to one-third currently (Chart 4, let). At $40-60/bblor so, ull-cycle costs are well below a conventional oilsands mining operation, but above most Middle Eastproduction. The shale oil revolution has heightenedcompetition or the same channels used to transportCanadian oil to market. It is an outgrowth o sweepingdevelopments on the natural gas side. Both the shale gasand oil revolutions draw on similar technologies, includinghorizontal drilling and the use o proprietary chemicals tosustain production.

While the shale upheaval has been years in the making,involving painstaking technical renements as well asbreakthrough technologies, the consequences havebeen both swit and dramatic. Breaking a 35-year longdowndrat, total US oil production rose or a ourthstraight year in 2012. Output this year is likely to reach thehighest level in about two decades. No less visible havebeen the trade implications. The percentage o the USmarket supplied by oil imports has allen rom over 60%

less than a decade ago to about 45% today (Chart 4,right). For the time being, the surge o production hasalso upended an historical relationship stressed by supplybears, the Hubbert Curve, that tracked US oil production

0

1

2

3

45

6

7

8

1990

1995

2000

2005

2010

2015

Shale/Other Tight

Other Lower 48 onshore

Lower 48 offshore

Alaska

production, mn bbl/day

30

35

40

45

50

55

60

65

95 99 03 07 11 15 19 23

imports/US oil

consumption (%)


8/12


Source: BP, CIBCSource: NBS, DOE, CIBC

the economy and job growth have improved. Given acontinuation o those trends and weakness related tothe economic situation in Europe, Asias share o globaloil consumption is likely to increase urther, to 33% inthe next two years vs about 20% or the US and 15%or Europe.

A More Competitive Investment Playing Field

A third important change is on the investment policy ront.Canada was once among only a handul o countries

welcoming oreign capital in the oil sector. Just over adecade ago, nearly three-quarters o global oil reserveswere eectively o limits to major global players (Chart6), due to state-run rms, outright prohibitions, securityor other considerations. Change is aoot on that ront aswell. Iraqs recently liberalized oil industry displaced Iranas the second largest OPEC producer last summer. Whilethe country can still be a perilous place to operate, theparticipation o western integrated and oreign state-runrms (used to dealing with tricky political and securityissues) has seen production double rom levels just beorethe 2003 war. The countrys massive 135 bn barrels o

reserves are the cheapest source o additional crude onthe planet. Even i the desert nation is able to attain justhal o a planned urther 5-6 million bbl rise through2020, that would still aect global markets.

Nearer to home, Mexicos new president has announcedplans to revamp its 1917 constitution to encourageoreign irms to make badly need investment in the

rening sector and provide the capital and technologyneeded to tap deepwater and heavy oil resources. Detailsare expected by the summer. Nietos proposals are themost ambitious yet to counter a sharp decline in existingelds, including aging super-giant Cantarell. IncludingOrinoco heavy oil, Venezuelas reserves are the largestin the world, surpassing Canada and Saudi ArabiaPresident Chavezs death may not bring an immediatepolicy about- ace. But as in Mexico, the need to osedeclines in aging existing elds and accelerate growthcreates potential longer term pressure to ease the states

shackles.

The oil and gas sector accounts or the second largestcomponent o Canadas corporate cash pile. Even wherecompanies are not ready to take the plunge just yet, theallure o enticing investment prospects down the roadcould be an inducement or rms to stay liquid, hangingonto their cash a while longer.

Clearly, global energy markets are in a period osweeping, multi-dimensional change. The break-up owhat was then the worlds top crude producer, the Soviet

Union, dramatically impacted markets two decades agoTodays ongoing shits are potentially no less signicantIn Canadian terms, they will likely require steps to ensurebroad access or Canadian crude, not only to traditionamarkets like the US but aster growing ones overseasand an investment climate that remains competitive withothers now opening their arms to oreign capital.

Chart

China's Oil Imports Poised to Surpass US (L); AsiaHas Accounted or Two-thirds o New Demand (R)

0

2

4

6

8

10

12

14

16

Jan-

04

Jan-

06

Jan-

08

Jan-

10

Jan-

12

China

United States

net imports, mn bbl/day

Chart 6

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

0

10

20

30

40

50

60

70

80

Asia Middle

East

Rest of

World

% of Total Growth in

World Oil Demand,

2002-12

2000

Closed

Other Open

CANADA

Partly Open/PotentiallyImproving Access

Today


9/12

CIBC WORLD MARKETS INC. Economic Insights - April 3, 2013

9

Concentrated DiversificationBenjamin Tal and Andrew Grantham

2000 and 2007 indeed worked to slow the pace of

export expansion. But despite this massive appreciationexports still managed to expand at a pace of just ove1.5% a year.

Furthermore, a detailed sectoral analysis of the impactthe rise in the C$ had on Canadian manufacturingsuggests a much more complex picture than youget from a text book. Chart 2 maps the relationshipbetween vulnerability to a rising dollar (based on exportdependance, import competition at home, and savingson imported components) and actual GDP growth. Intheory, this chart should have shown a clear downward

sloping trajectory. But as can be easily seen, that was notthe case.

Yes some high vulnerability sectors such as papemanufacturing and furniture did underperform. Butequally vulnerable sectors such as machinery andelectrical equipment actually outperformed. Ditto fothe other side of the spectrum, where low vulnerabilitysectors such as textiles and chemical manufacturingdisappointed. Similar sectoral analysis by labour marketperformance and export penetration to the US resulted

in equally mixed pictures. Simply put, the evidencesuggests that the dollars appreciation is only one factorout of many that impacted the trajectory of exportsover the past decade. Other factors such as US demand

The volume of Canadian exports today is at the same

level it was a decade ago. And after rising for mostof the previous decade, the share of non-US exportsin total exports has hardly changed in the past fouryears. In fact, recently it has been moving in the wrongdirection. Furthermore, within the non-US space, allrecent activity was concentrated in one countryChina.This uni-diversification is certainly not what the architectsof Canadas nine free trade agreements with non-USpartners have envisioned. But the relative success ofCanadian exporters in China should be seen as anindication that Canada can and should compete in otheremerging 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 decadefor 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 valueof the Canadian dollar. But the reality is much moremultidimensional. A quick glance at Chart 1 suggests thatthe 35% appreciation in the value of the loonie between

Chart 1

The Lost Decade

Source: Statistics Canada, CIBC

Chart 2

No Clear Correlation Between DollarSensitivity and GDP Performance


Canadian Export Vol. Index (2007=100)

60

65

70

75

80

85

90

95

100105

110

97 99 01 03 05 07 09 11

US$/C$

11%

US$/C$

35%

US$/C$

5%

High C$ sensitivity Low C$ sensitivity

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

-20 0 20 40 60 80 100

Index of $ vulnerability

furniture

machinery

wood

products

electrical

equip.

paper mfg

chemical

mfgtextiles

beverages/

tobacco

food

mfgpetroleum/

coal

AvgannualGDP%g

rowth

(07-12)

transp.

equip.


10/12


10

diminishing returns from NAFTA, increased competitionfrom emerging markets and a notable cost cutting by USmanufacturers may be just as important.

Regardless of the source of the weakness, the key questionis to what extent Canadian exporters are adjusting quicklyenough to reverse that trend. The US economy is finallyshowing signs of life, but with restrictive fiscal policyand no leveraged-based surge in household spending,the American economy of tomorrow will fall well shortof generating the demand Canadian exporters enjoyedprior to the great recession.

Its a Small World After All

That reality is not escaping Ottawa which in recent yearshas intensified its efforts to diversify the countrys export

machine. And at first glance there appears to be somesuccess. The share of non-US exports in total Canadianexports rose from 13% in the beginning of the decadeto todays 25%. The bad news is that this ratio has beenstuck at 25% for more than four years (Chart 3). So despiteintensifying efforts, Canadian export diversification islosing momentum. In fact, on a year-over-year basis, ourexports to non-US destinations are now falling.

But the story goes beyond speed. Chart 4 tells the taleAlmost all of the improvement in export diversificationover the past decade came from two sources: the UK

and developing countries. A closer look at the tradeflows to the UK reveals that virtually all of that gain wasdue to the 300% increase in the price of goldhardlyan inspiring diversification story. So we are left withdeveloping countries as the key source of Canadasexport diversification of the past decade. And a quick

Chart 3

Stuck At 25%


Chart 4

Growth in Share of Total Exports (2003-2012)


-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

UK EU Japan Other

OECD

Developing

%-pts

Chart 5

Developing Market Focus All About China

Source: Industry Canada, CIBC

Share of Non-US Exports in Total

Exports

0.00

0.05

0.10

0.15

0.20

0.25

0.30

01 02 03 04 05 06 07 08 09 10 11 12 13

-6%-4%-2%0%2%4%6%8%

10%12%14%16%18%

Argentina

Brazil

Bulgaria

Chile

China

Estonia

Hungary

India

Indonesia

Latvia

Lithuania

Malaysia

Mexico

Pakistan

Peru

Philippines

Poland

Romania

Russia

South

Africa

Thailand

Turkey

Ukraine

Venezuela

Change in Share of Canadian Exports to Developing Markets (2008-2012)


11/12


11

top 15 Canadian exports to China, 10 overlap with thetop US exports (Chart 6, right). That means over halfof Canadian exports to China encounter strong UScompetition. But even with a strengthening C$, that is abattle some sectors have been winning. Improvements inmarket share within areas such as oil seeds, grain & fruitalong with pulp and aircraft, are proof of that fact.

On the reverse, there is only limited evidence thatcompetition from China is forcing Canadian companiesto withdraw from American markets. China has seenits greatest penetration into the US in areas such asclothing, toys and games and more recently electricagoods (Chart 7, left). While not unimportant areas forCanadian exporters, they were never the main focus ofCanadian trade with the US. Those areas made up onlyaround 15% of Canadian exports to the US a decadeago. And even though that percentage has dipped alittle, they still account for around 12% today (Chart 7,

right).

Canadian firms have rightly been looking beyond theUS market, as growth there fails to reach pre-recessionlevels. However, that diversification has been largelylimited to China. And given slower and shifting growthdynamics there as well, that poses its own risks. Butwhat the Chinese experience shows is that, despite astrong currency, Canadian companies have been able tocompete and win in a very competitive emerging marketenvironment. That should encourage them to broaden

their horizons into other growth markets in the decadeahead.

glance at Chart 5 suggests that this diversification storyis also very concentrated, and becoming more so. Since2003, China has accounted for more than half of thegrowth in developing market exports. But in the past fiveyears, it has accounted for all of the growth. Exports toall other developing countries (with the exception of tinyBulgaria) 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 decadesuggests that focus is no bad thing. However, Chinahas slowed and authorities aim to refocus the economymore towards domestic consumption. That will requirea different product mix that Canadian companies maynot, at present, be positioned to fill. Also, competition inChina is fierce and rising fast, with companies around theworld seeing its vast population as potential purchasersof their goods and services.

What the experience in China does show, though, isthat Canadian companies can compete and succeedin developing markets. Although the share of Chineseimports stemming from Canada remains quite low (alittle over 1%), it has at least edged up over the last 10years (Chart 6, left). In contrast, most other developedcountries have seen their share of Chinese imports fallover that same period. And it is not an oil story, withpetroleum only a small proportion of Canadian shipments

destined for China.

Particularly noteworthy is how well Canadian companiesare competing with their Southern neighbours. Of the

Chart 7

China Pentration into US Not a Major Factor forCanada

Source: International Trade Centre, CIBC

Chart 6

Competing and Winning Against US in China

Source: International Trade Centre, CIBC

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

Canada

UK

France

Italy

Germany

US

Change in Share of Chinese

Imports 2003-12 (%-pts)

0%

2%

4%

6%

8%

10%

12%

14%

16%18%

20%

2003 2012

% of Total Cnd Exports to US (8

sectors of highest Chinese

penetration into US)

Industries Competing with US

% Chinese

imports

from Cda

Pulp of wood, waste 13%

Oil seed, grain, fruit 11%

Mineral fuels, oils etc 9%

Elect., electronic equip. 6%

Machinery, reactors 4%

Organic chemicals 3%

Plastics and articles 2%

Commodities nes 2%

Vehicles excl. railway 2%

Aircraft, spacecraft 2%

0

5

10

15

20

25

30

Apparel

(knitted)

Furniture

Apparel

(other)

Leather

Footwear

Toysetc

Machinery

Electrical

equipment

Increase in China's Share of

US Import Market

(%-pts, 2003-12)


12/12


12

CANADA

ECONOMIC UPDATE

UNITED STATES

This report is issued and approved or distribution by (a) in Canada, CIBC World Markets Inc., a member o the Investment Industry Regulatory Organization o Canada, the Toronto Stock Exchange, the TSX VenturExchange and a Member o the Canadian Investor Protection Fund, (b) in the United Kingdom, CIBC World Markets plc, which is regulated by the Financial Services Authority, and (c) in Australia, CIBC AustraliaLimited, a member o the Australian Stock Exchange and regulated by the ASIC (collectively, CIBC) and (d) in the United States either by (i) CIBC World Markets Inc. or distribution only to U.S. Major Institution

Investors (MII) (as such term is dened in SEC Rule 15a-6) or (ii) CIBC World Markets Corp., a member o the Financial Industry Regulatory Authority. U.S. MIIs receiving this report rom CIBC World Markets Inc(the Canadian broker-dealer) are required to eect transactions (other than negotiating their terms) in securities discussed in the report through CIBC World Markets Corp. (the U.S. broker-dealer).This report is provided, or inormational purposes only, to institutional investor and retail clients o CIBC World Markets Inc. in Canada, and does not constitute an oer or solicitation to buy or sell any securitiediscussed herein in any jurisdiction where such oer or solicitation would be prohibited. This document and any o the products and inormation contained herein are not intended or the use o private investors ithe United Kingdom. Such investors will not be able to enter into agreements or purchase products mentioned herein rom CIBC World Markets plc. The comments and views expressed in this document are meanor the general interests o wholesale clients o CIBC Australia Limited.This report does not take into account the investment objectives, nancial situation or specic needs o any particular client o CIBC. Beore making an investment decision on the basis o any inormation containein this report, the recipient should consider whether such inormation is appropriate given the recipients particular investment needs, objectives and nancial circumstances. CIBC suggests that, prior to acting oany inormation contained herein, you contact one o our client advisers in your jurisdiction to discuss your particular circumstances. Since the levels and bases o taxation can change, any reerence in this repoto the impact o taxation should not be construed as oering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors. Past perormance is not guarantee o uture results.The inormation and any statistical data contained herein were obtained rom sources that we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upoas such. All estimates and opinions expressed herein constitute judgments as o the date o this report and are subject to change without notice.This report may provide addresses o, or contain hyperlinks to, Internet web sites. CIBC has not reviewed the linked Internet web site o any third party and takes no responsibility or the contents thereo. Each sucaddress or hyperlink is provided solely or the recipients convenience and inormation, and the content o linked third-party web sites is not in any way incorporated into this document. Recipients who choose taccess such third-party web sites or ollow such hyperlinks do so at their own risk. 2013 CIBC World Markets Inc. All rights reserved. Unauthorized use, distribution, duplication or disclosure without the prior written permission o CIBC World Markets Inc. is prohibited by law and may result iprosecution.

First quarter growth now looks likely to track 1.7%, only a bit below our earlier projection. With a soter startto the year, weve knocked our 2013 orecast back to 1.6%a tick below our prior call. Infation quickenedin February on hotter-than-expected prices at the core level, although sot growth suggests little chance oconsumer prices heating up measurably above 2% in the near-term.

As we had anticipated, the US economy is enjoying a solid start to 2013, with Q1 GDP on track or a more

than 3% annualized gain. However, part o that strength is illusionary, thanks to a rebound in growth rom thehurricane-disrupted Q4. Meanwhile declines in consumer and manuacturing condence are already fashingwarning signs or the second quarter outlook. A couple o sub-2% quarters in Q2/Q3, as scal tighteningnally bites, will slow progress on bringing down unemployment. Only in 2014 will a sustained recovery likelybe seen, with the jobless rate alling but infation heading higher.

CA NA DA 12Q4A 13Q1F 13Q2F 13Q3F 13Q4F 14Q1F 2012A 2013F 2014F

Real GDP Growth (AR) 0.6 1.7 2.3 2.0 2.1 2.4 1.8 1.6 2.4

Real Final Domestic Demand (AR) 2.6 0.3 1.2 1.5 1.7 1.9 1.9 1.3 1.7

All Items CPI Inflation (Y/Y) 0.9 1.0 1.2 1.6 2.0 1.8 1.5 1.4 2.0

Core CPI Ex Indirect Taxes (Y/Y) 1.2 1.3 1.3 1.7 1.9 1.7 1.7 1.5 1.8Unemployment Rate (%) 7.2 7.0 7.2 7.3 7.2 7.1 7.3 7.2 6.8

U.S. 12Q4A 13Q1F 13Q2F 13Q3F 13Q4F 14Q1F 2012A 2013F 2014F

Real GDP Growth (AR) 0.4 3.2 1.7 1.9 2.6 3.7 2.2 2.0 3.2

Real Final Sales (AR) 1.9 2.1 2.0 2.2 2.7 3.8 2.1 2.1 3.3

All Items CPI Inflation (Y/Y) 1.9 1.8 1.9 2.3 2.6 2.6 2.1 2.1 2.5

Core CPI Inflation (Y/Y) 1.9 2.0 1.9 1.9 1.9 2.0 2.1 1.9 2.1

Unemployment Rate (%) 7.8 7.8 7.7 7.7 7.7 7.6 8.1 7.7 7.4

Beyond Keystone

Documents