Slide in oil prices could boost Ottawa's deficit by $3B

Falling oil prices are threatening the federal government’s budget plans ahead of the next election, a new report suggests. However, Ottawa says it’s on track to balance the books.

A report from BMO Capital Markets says Ottawa could see a $3-billion hit to its bottom line due to the roughly 25-per-cent drop in oil prices in recent months to around $83 (U.S.) per barrel for West Texas Intermediate crude and $86 for Brent.

Lower oil prices will mean a drop in corporate taxes and personal incomes, says the report from economists Doug Porter and Robert Kavcic.

“We estimate that the recent move in oil prices will cut the GDP deflator by roughly 1 percentage point, which Ottawa estimates will cost it $2.1 billion,” the report states. “Combined with the small net impact on real GDP, we estimate that the slide in oil would boost Ottawa’s deficit by just over $3 billion — right in line with the contingency cushion currently built in to budget forecasts.”

Its budget brought down in February, the federal government projected a deficit of $2.9 billion in 2014–15, after taking into account a $3 billion rainy day fund. Then the plan is to hit a surplus of $6.4 billion in 2015–16. That includes a $3-billion “adjustment for risk” and comes just as Canada goes into a federal election scheduled for October 2015.

The price of WTI crude has fallen about 22 per cent since June, while Brent has dropped more than 25 per cent. BMO doesn’t expect oil prices to stay this low for long but says, “There is clearly a risk that low prices could persist for at least a few quarters given the supply glut and softer global outlook.”

Oil fears an overreaction?

Capital Economics economist David Madani doesn’t see the slide in oil prices as a major threat to the Canadian economy.

"Even if oil prices remain at current levels, that would still leave them above the marginal cost of domestic production (in the range of US$60 to US$80 per barrel)," he said in a note. "Consequently, we think prices would have to fall further and remain low before posing a dangerous threat to economic prospects."

Madani said a drop in oil prices could put a dent in the government’s projected surplus for fiscal year 2015-16 of more than $1 billion, “but it is unlikely to prevent the Conservatives from going ahead with promised tax cuts.

"What would bother us greatly is if oil prices were to fall close to, or below, $70 per barrel," he wrote. "From what we can gather, anything close to that level probably would throw a spanner in the works."

Finance Minister Joe Oliver told reporters last week in Toronto that government’s forecasts include potential pitfalls in the economy.

“We always, in our projections, take into account downside risks,” Oliver said, according to a report in the Globe and Mail. “Taking that into account, we’re very comfortable in achieving a budgetary surplus next year.”

He said the government feels “very comfortable” with its plan to post a budget surplus next year, according to a report in the Wall Street Journal.

Positive effects of lower oil prices

Economists note that consumers do benefit from lower prices at the pump “which act as an instantaneous tax cut.” Exporters outside of the oil business might also benefit from lower oil prices, alongside a lower Canadian dollar.

“While these indirect positive effects are outweighed by the direct negative hit to the energy sector (and its many suppliers), we suspect the latest move, if sustained, would trim 2015 Canadian GDP by less than 0.2 percentage points,” the report states. BMO has cut its 2015 GDP growth forecast to 2.4 per cent.

The BMO report says small business will also benefit from lower oil prices through lower fuel costs to run their operations.

TD Bank also weighed in on the impact of the drop in oil prices late last week, citing the “downward pressure on Canadian output, prices, and the Canadian dollar,” and potentially employment levels.

“While consumers may feel richer as the price at the pumps comes down, over the longer-term, weaker oil prices are expected to weigh on income, wage, and, ultimately, consumption growth,” says the report from economist Randall Bartlett. “On the whole, government revenues can also be expected to soften modestly.”

Who loses the most?

Lower oil prices will also hurt resource-rich provinces such as Alberta, Saskatchewan and Newfoundland and Labrador, especially given that their provincial budgets are betting on prices in the range of $97 for WTI and $105 for Brent, BMO says.

The Canadian dollar is “the most clear-cut loser” from the drop in oil prices, the economists say, arguing that, for every $10 move in oil prices, the loonie swings three-to-five cents. They note that the Canadian dollar has dropped about six cents since June, in step with sagging oil prices.

“We believe that the Canadian dollar is now close to fair value based on today’s commodity prices, but further weakness in crude would drag the loonie along for the ride,” the economists wrote.

That has its pros and cons: A lower loonie drives exports and can boost government revenues, which log energy prices in Canadian dollar terms.