The Federal Reserve has kept its zero interest rate policy (‘ZIRP’) for several years (and much longer than originally anticipated) whilst the European Central Bank seems to be getting serious about doing ‘better’ and has now reduced the deposit rate at the ECB to -0.30%. It’s already remarkable a central bank doesn’t seem to have any problem to reduce interest rates into the negative territory, but now Canada is considering making the same step as well.
Even though Canada’s benchmark interest rate is still relatively ‘high’ at 0.5%, the governor of the Central Bank of Canada has now hinted at a negative interest rate as well. That’s interesting, but not really surprising when you look at the current situation of the mining sector and the oil and gas sector, which have been important backbones of the Canadian economy for quite a while.
The gold and copper price aren’t really giving mining companies a lot of hope and not only have the corporate tax payments from the sector been reduced, several mines have announced layoffs, reducing the employment rate in Canada. That’s tough luck, but the oil and gas sector might be in an even worse shape, and especially the province of Alberta will be in for a lot of pain in 2016 (and we would honestly be extremely surprised if the GDP in Alberta would increase ). Unfortunately this will create a ripple-effect throughout the entire Canadian economy and the Toronto Stock Exchange has lost 17.5% since April of this year which is more than three times as much as the loss of the Dow Jones Index in the same time frame.
Just have a look at the oil and gas price, and it shouldn’t surprise you the majority of the oil and gas producers is ‘underwater’ and won’t generate a profit this year. To make things even worse, some companies won’t even be able to generate a sufficient amount of operating cash flow to fund the sustaining capital expenditures to keep the oil and gas production at a stable level. And the remark made by John Arnold about the US oil and gas sector is also pretty much valid for the Canadian energy sector. Once the ‘good’ hedges will start to unwind, the sector will be in a lot of pain.
And what do you think will happen next? Indeed, several oil and gas exploration and production companies will be unable to avoid bankruptcy and this could result in a domino-effect in the Canadian economy. Not only will the GDP decrease, the unemployment rate will increase and more and more people will be unable to make their mortgage payments. The Bank of Canada expects its economy to grow by 2% in 2016, but we are afraid that’s an overly optimistic stance and only based on the weak Canadian Dollar which obviously enhances the export numbers. Just have a look at how the junior oil index is behaving (the next chart is the Junior Oil Index ETF, issued by the Bank of Montreal).
Long story short, if the Central Bank of Canada doesn’t do anything (literally ‘anything’), Canada could be in for a shocking 2016 if the oil and gas prices don’t recover. 2015 was alright as the majority of the O&G companies had some decent hedges in place and the weakening Canadian Dollar also helped the sector, but the total amount of hedged volumes as well as the hedge prices will go down from next year on and the entire sector will be in a lot of pain.
So the Canadian central bank very likely won’t have any other option but to reduce the interest rate to at least incentivize banks to not withdraw credit facilities from these oil and gas companies. Should the central bank do nothing, Canada will be in an extremely horrible shape from next year on, and the GDP reductions might actually spiral out of control as a vicious circle cannot be excluded at this point.
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First published here: http://www.zerohedge.com/news/2015-12-13/next-domino-canada