Can Canada's new budget survive inflation?
Trudeau has created the problem but is unlikely to be able to solve it or survive it
Chrystia Freeland put up a creditable effort in her first budget, trying to walk the line betweent the status quo and keeping Trudeau’s promises to Jagmeet Singh while keeping Canada afloat financially. It is a tricky nut to crack and her first budget comes close. It seems to make sense if you buy into its assumptions. I don’t.
The budget assumes that inflation will abate to below 3% for the next five years and that short term interest rates (3-month treasury bills) will continue to be priced to produce interest rates of 2% or less in the period. I stopped reading the budget details at that point.
The inflation rate in the United States was reported at 8.5% today, the highest since 1981. The U.S. wholesale inflation rate was reportedly even higher at 11.2%, the highest gain on record. In 1981 interest rates were over 20%. Today the American central bank is tentatively raising interest rates with a 3% rate in its sights. Does anyone see anything wrong with this picture?
There is a global energy shortage in its early stages. The shortage is caused by left wing policies that pretend CO2 is harmful and the inane policies are sold to citizens as “necessary” to “fight climate change”. Leave aside that the manmade climate change theory is nonsense, and give some thought to what it means for energy prices, in particular natural gas and oil. Oil prices are now hovering around US$100 a barrel and there is little evidence of a “supply response”. Instead, well managed oil producers have read the writing on the wall and do not want to be left with stranded assets as a result of foolish climate policies. Instead, they are paying down debt, increasing dividends and buying back stock. That is sensible. Why plan for a long term future in a country whose government is committed to putting you out of business?
Energy is one of the most critical elements of Canada’s economy. Everything runs on energy and it has to come from somewhere. Trudeau’s dream that the Canadian economy can run without fossil fuels suggests he needs therapy for his delusion. We live in a cold climate and snow covered solar panels and idle windmills are no solution to home heating when it is well below zero. Our government meddles in the automotive market to promote electric vehicles (EV’s) which will one day be mainstream since they are better technology than internal combustion engined (ICE) vehicles - quieter, faster and easier to maintain. But our electrical grid is ill-equipped to hand millions of EV’s and our homes lack adequate service entrance panels and supporting transformers to support an EV in every garage. The capital to upgrade 8 million households to support home charging of EV batteries is well beyond the financial reach of our municipalities today. A rough estimate of that cost is somewhere between $5,000 and $10,000 per home or $40 to $80 billion. Of course, the federal government could foot the bill and add a bit more to our trillion dollar national debt.
The EV “revolution” in Canada faces competition from auto assemblers in the United States who see the federal piggy bank as a source of funds to expand their production of EV’s and there will be a turf war emerge based on where those assembly plants will be located. In parallel to the need to upgrade the electrical grid, a rapid rise in EV production will create huge demand for battery metals like nickel, cobalt and lithium and for copper for the EV motors and grid expansion, and it take about two minutes to realize those commodities cannot scale up fast enough to make Biden or Trudeau’s dreams come true.
Prices of metals will keep rising. Higher metal prices and higher energy prices compel higher inflation. The energy issue will not go away.
The violence in Ukraine has exposed the energy issue in spades. Europe depends on Russian natural gas but suddenly seeks alternatives under pressure to stop buying from Putin to “fund his war” on Ukraine. But Europe has not invested any capital in having an infrastructure capable of importing much seaborne natural gas and if Putin shuts down the pipeline from Russia the current shortage becomes a crisis of epic proportions. America to the rescue as President Biden promises to provide U.S. liquidifed natural gas to Europe, but stumbles over his own policies targeted at curtailing natural gas drilling on federal lands and a shortage of pipeline and LNG infrastructure to be able to supply Europe’s total needs.
American will see private capital put a lot of money into LNG terminals to capitalize on European natural gas prices 5 to 10 times those available in North America. That rush to export LNG will bring import the natural gas shortage to United States and Canada who already see natural gas prices north of US$6.00 a thousand cubic feet with little friction stopping that rise from continuing. Only two years ago, Canadian natural gas producers saw prices in the $1.00 per thousand cubic feet range and were struggling to survive.
The United States oil situation is even more dire than natural gas. Biden killed Keystone XL on his first day in office and his activist leader of the Bureau of Land Management put a morass of regulatory hurdles in front of oil companies seeking to increase output, until they pretty well gave up. Absent new capital for drilling and pipelines, U.S. oil output will succumb to the natural decline inherent in oil reservoirs and the global shortage is more likely to get worse than ease.
Some basic math is useful. World oil production is about 100 million barrels a day. The natural decline is about 30% for conventional oil, higher for shale oil, and lower for older oil producing fields and oil sands, with an average decline rate of about 20% although one study puts that average at 4.5%. Assume the 4.5% is correct (it is the lowest I have seen in any study). That means enough capital must be allocated to oil drilling to add 4.5 million barrels a day to maintain production at current levels. Capital efficiency rates vary but on average are about $25,000 per barrel per day of added production. Capital outlays needed to sustain production are 4.5 x $25,000 = $113 billion each year. Of course, the evidence is that the actual decline rate is much higher and the amount of capital needed to prevent a deepening global energy shortage is close to $1 trillion than $113 billion.
Consider the decline rate. It is possible to test the decline rate by backing into it based on reported capital outlays and production. The IEA reports global oil industry capital spending in 2019 was $496 billion (down from $778 billion in 2014). Despite the almost $500 billion of capital spending, global oil output in 2020 dropped about 6%. If the $25,000 capital efficiency is in the ball park, the global decline rate must be north of 20% with $500 to $700 billion needed to restore oil output at 100 million barrels a day, and about double that needed to fill the growing hole in supply as the world economy continues to expand.
Capital is leaving the oil industry in the wake of left wing climate policies. Statista puts estimated 2022 industry capital outlays at $US310 billion. While the data on capital efficiency and decline rates is debated, there is little doubt that 2022 will see a decline in world oil output but little chance there will be a reduction in demand. Higher prices are in the cards. Joe Biden blames the lack of U.S. production growth on “greedy oil companies” preferring profit to production. I guess no one told Joe that corporations’ goals are profits, not output. He will find that out soon enough. He may also find out that telling an industry his goal is to put them out of business won’t encourage them to expand.
Back to the Canadian budget, it faces some problems. Persistent high energy prices, rising inflation and necessary increases in interest rates to keep the inflation genie in the bottle mean the budget’s assumptions are nonsense. It is hard to blame Chrystia Freeland for issuing a budget that hasn’t a hope in hell of materializing - she lives under the thumb of our drama teacher Prime Minister who has yet to demonstrate any evidence he can count.
One scenario that will throw this budget and the Liberal government’s future into a cocked hat is the likely result of inane policies. That scenario is inflation in the teens, interest rates in the teens, and energy prices substantially higher than today. With interest rates at 12% for example, the $30 billion interest payments in the budget morphs into $120 billion just as the higher rates trigger a recession and drive unemployment up by millions of people with Employment Insurance costs adding $20 to $30 billion to ongoing deficits. This vicious cycle will peak just in time for the 2025 election and voters will toss Trudeau and his band of zealots into the trash bin of history and pave the way for Pierre Poilievre to take over. The campaign slogan will be “it’s the economy, stupid”.
Imagine, a Prime Minister who will build pipelines, develop our massive energy resources, promote our extractive industries and put millions of Canadians to work in high paying jobs as resource revenues right the ship of state. Historians will record Justin Trudeau as the worst Prime Minister in Canadian history and Canada will once again be a country we can be proud of rather than an international laughing stock.
Sound far fetched? I think it is odds on. A man can dream.