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11-010-XIB
Canadian Economic Observer
August 2008

Feature article

Over a barrel? Canada and the rising cost of energy

by P. Cross* and Z. Ghanem

 

Since 2002, Canadians have faced a steady hike in the price of energy. This escalation has been driven by the soaring cost of crude oil, the price of which has risen for the seventh straight year, a record since commercial production began in 1851.

More importantly, the sustained surge in oil prices appears, by some accounts, to have reached a ‘tipping point’ in fundamentally changing the behaviour of some consumers around the world. For example, automakers in North America have reported a structural shift away from large vehicle purchases since May (notably low fuel-efficiency SUVs). And some governments in Asia have lowered their subsidies to consumers of energy products after budgets were stretched by the soaring cost of oil.

This paper examines some aspects of the impact of increasing energy prices since 2002 on the household and external sectors of the Canadian economy (it ignores the effect on business investment or government revenues, never mind other issues such as regional differences or productivity growth). It starts by reviewing the impact of the recent surge in gasoline prices on the overall share of energy and transportation costs in household budgets. The paper then looks for statistical evidence of whether consumers (notably drivers) are changing their behaviour in terms of the vehicles they buy and how far they are driven. The analysis concludes by examining how Canada’s trade has profited from higher prices as energy expands, driven by the continuing rapid development of the oilsands. Energy has become Canada’s largest export so far in 2008, although imports continue to supply important parts of the country.

Oil leads rising energy prices

Energy prices have driven the boom in commodity prices that began in late 2002. While metals in 2005 and 2006 and grains in 2007 and 2008 have also seen rapid increases, the surge in energy prices has been the strongest and most consistent source of higher commodity prices.

Crude oil has led the increase in energy prices. It rose from an average of US$26 a barrel in 2002 to its recent record of $147. Gasoline prices have followed suit, recently breaching $1.30 a litre in central Canada, just surpassing the previous peak in early 2007 (when a disruption of refinery production in Ontario caused a spike in prices).

Just within the past year, the price of crude oil doubled. Simulations with the standard Input/Output (IO) price model show that a doubling of the price of crude oil could raise the price index of Canada’s total output by 5.4%.1 However, this simulation is based on the behaviour of producers and consumers remaining unchanged despite the shift in relative prices, notably that purchasers of oil do not become more efficient in its use nor substitute cheaper energy sources, and that all cost increases are fully passed on. The largest impact is on the mining industry itself, where prices could increase 40% (most of which is exported). Other above-average price increases in the model occur in manufacturing (7.9%), transportation (7.1%) and fishing (7.0%), all largely due to higher energy use. Most other industries show increases of less than 5%, with most services up around 1% (with the notable exception of a 4.7% hike for travel).

For consumers, a doubling of oil prices could lead to a 2.9% increase in the consumer price index, according to the same IO price model (as for GDP, the model allows for no changes in buying patterns or technology). Most of the impact is on the cost of gasoline within the transportation component. Interestingly, the indirect impact of higher oil prices is greater for food (mostly due to gasoline used by farmers and truckers) than housing, which includes the direct effect on home heating (partly this reflects that most homes are heated with electricity or natural gas, where consumer prices have risen less than for heating oil). For all other components, doubling oil prices raises costs by just over 1%.

Table 1
Impact of a doubling of crude oil prices on consumer prices

  percentage
   
Total 2.9
Transportation 12.5
Food 2.4
Clothing 1.6
Alcohol and tobacco 1.5
Recreation 1.4
Health and personal care 1.4
Household operations 1.3
Shelter 1.2
Source: Input/Output price model for 2007

While gasoline prices have risen significantly, the increase would have been almost twice as much without the rise in the Canadian dollar. Because of the integrated North American market for gasoline, the rising exchange rate has dampened the price increase for consumers in Canada. Gas prices in Canada have risen 84% from 2002 through May 2008, versus a 176% hike in the US. This gap is mostly explained by the 57% rise in the value of the loonie against the US dollar. The slower rate of increase in gasoline prices in Canada relative to the US represents a saving to consumers of nearly $30 billion, the equivalent of 3.2% of personal disposable income.

Natural gas prices also recently hit a high of almost $14 per million BTU, a record except for the hurricane-induced spike in the fall of 2006. However, natural gas prices have been more volatile than oil prices (and they quickly retreated below $10 in July) because natural gas is used primarily for heating and cooling homes, and so is influenced by the weather. Gasoline for vehicles is the determining factor for oil consumption, and its demand fluctuates less.

Figure 1

Gasoline demand has risen steadily

Despite the steady escalation of gasoline prices since 2002, Canadian drivers have so far not cut back their consumption.2 Overall, the retail sales volume of gasoline rose 7.2% from 2002 through 2007, even as the CPI for gasoline jumped 46% over the same period.3 Gasoline consumption rose in every year, with the exception of a 0.4% dip in 2006 (when hurricane damage disrupted supplies and briefly sent prices to record levels).

Interestingly, the largest annual increase in gasoline consumption was in 2007, despite the cumulative impact of years of rising prices. Retail sales of gasoline rose 3.9% last year, largely reflecting a 1.9% increase in kilometres driven as well as lower fuel efficiency. A dip in monthly gasoline sales early in 2008 appears partly to reflect poor driving conditions, due to several snow storms, and demand in the first five months of the year remained 0.5% ahead of the same period last year. The increase in gas consumption in Canada compares with declines in the US.

Figure 2

In the past, drivers in Canada have shown they can sharply curtail consumption in the face of higher prices. The volume of gasoline purchased by consumers fell 12.1% between 1980 and 1984, when prices rose 65%. Consumption also dipped 5.1% from 1989 to 1991 when prices increased 12%. Of course, a major difference in both periods was that real incomes were being squeezed by recessions. Since 2002, real incomes have risen steadily, including a 1.8% gain in the first quarter of 2008 as labour markets remain tight.

Figure 3

The steady gain in gasoline consumption since 2002 reflects both the longer distances vehicles are being driven and the increasing number of less fuel-efficient vehicles on the road.

Canadians drove their vehicles 332 billion kilometres last year, up 5.2% from 2002, and the number of vehicles on the road rose 9.4%.4 New motor vehicle sales in the first five months of 2008 continued on a record pace. Moreover, the share of trucks (which includes CUVs, SUVs5 and mini-vans) in new vehicle sales rose from 46% in 2002 to 50% in the last quarter of 2007. Their share retreated to 46.2% so far this year, which may reflect the first move by drivers to boost fuel efficiency in response to higher prices. Conversely, after five years of decline, the share of passenger cars has risen to 53.8% in the first half of 2008, its highest since the first quarter of 2003 (when gasoline prices were relatively low). But given the 20.3 million vehicles already on the road, at the current rate of 1.7 million new motor vehicle sales a year it will take time to significantly change overall fuel efficiency of the fleet of vehicles being driven.

Figure 4

This year’s sudden shift in North America to smaller, more fuel-efficient vehicles should not cause disproportionate harm to auto output in Canada. Based on a classification developed by Desrosiers Automotive Consultants6, Canada’s auto output closely resembles the recent pattern of North American auto sales (with a slightly greater weight in family vehicles and a correspondingly lower share of entry-level vehicles assembled in Canada). Auto assemblies in Canada were more under-weighted in entry-level vehicles (including compacts) a decade ago, but new factories opened by Asian-owned producers have closed the gap.

Energy’s share of consumer spending

Not surprisingly, the combination of higher prices and increased gasoline consumption has raised the portion of expenditures consumers allocate to gasoline. Last year, Canadians spent 3.6% of their disposable income on gasoline, up from 2.9% in 2002. In the first quarter of 2008, this rose again to 3.8%, compared with its previous record high of 3.3% in 1982 and 1983. Still, the increase was more gradual than the abrupt hike in 1980, allowing households time to adjust.

Figure 5

The increase in spending on gasoline since 2002 was less than the drop in income devoted to purchasing autos, from 6.2% to 5.3%. The drop for autos entirely reflects lower prices, as Canadians increased vehicle purchases over the last six years. As well, nominal disposable incomes have grown by 35% from 2002 through the first quarter of 2008, mostly as rising employment has tightened the labour market.

Meanwhile, the overall share of energy in consumer budgets has been steady (at 6.7%) over the past three years, reflecting lower electricity rates (electricity prices in March were 0.7% below a year earlier, mostly due to a decline in Ontario). As well, natural gas prices have risen only 32% to date in 2008 compared with 2002, versus a 123% hike in the cost of oil for home heating. Led by higher gasoline and electricity prices, energy consumption as a share of disposable income had risen from 5.8% in 2002 to 6.7% in 2005 before levelling off. A mild winter and cool summer so far in 2008 has provided some relief to overall household energy outlays.

Figure 6

Urban transit use grows slowly

Canadians have only marginally altered their driving habits since 2002, and this is reflected in their use of mass transit. Demand for urban transit has barely kept pace with population growth since 2002. From 2002 to the first quarter of 2008, GDP in urban transit systems has risen 10.1%, versus an 8.1% gain in the population over 15 years old.7

Figure 7

Some of the slow increase in demand for urban transit (despite soaring gas prices) reflects faster population growth in rural areas. Since the commodity boom began in 2002, the rural population has grown 11.3%, versus 8.5% in urban areas. In the absence of mass transit systems in rural areas, this shift also helped fuel the increase in both the number of vehicles on the road and the distance they are driven. Of course, higher incomes earned from the commodity boom has also given many rural residents the means to shoulder the burden of paying higher gas bills.

The regional pattern of new motor vehicle sales supports the notion that the commodity boom is helping to fuel the increase in demand for vehicles (and ultimately gasoline consumption). Since 2002, vehicle sales have been driven by gains in western Canada, notably Alberta and Saskatchewan, and in Newfoundland. Moreover, growth in vehicle demand in these resource-rich provinces has been led by trucks rather than cars, which account for just over one-third (35.6%) of new vehicles in these three provinces. Conversely, vehicle sales in central Canada, which are tilted more to cars than trucks (56% versus 44%), have fallen since 2002.

Imports supply nearly half the crude oil consumed in Canada

Given our vast reserves of energy, Canadians think of themselves as self-sufficient in energy. However, Canadian imports of energy products totalled $40 billion last year and are tracking close to $50 billion so far in 2008. According to the IO tables, Canada imports 19.8% of the energy it uses.8 It is more efficient for Canada’s energy trade to flow North/South than East/West. As a result, eastern supplies often come from imports, notably for coal and crude oil. Imports supply two-thirds of coal, mostly for hydro plants in Ontario. Imports supply almost half (46.5%) of the crude oil used in Canada. Most of these imports reflect the regional nature of the domestic gasoline market. It is cheaper for firms in eastern Canada to import crude oil from Algeria and the North Sea than from Alberta.9

Canada has 19 refineries capable of making gasoline, which can process over 2 million barrels a day (one new plant is in the planning stages). Refineries in Quebec and the Atlantic provinces import most of their crude, with some domestic supply coming from offshore Newfoundland.10 The Atlantic provinces export refined petroleum primarily to the US, while Quebec ships to central Canada. Refining capacity has grown rapidly in Quebec since 2002, after several large investments were made.11 Ontario increasingly imports its gasoline from Quebec, as its refinery capacity has not kept pace with demand (in fact, one refinery was closed in 2005). Western Canada refineries process local crude.

Imports of most other energy products are relatively small. Only 15% of natural gas is imported, and just 3% of electricity (imports of gas may rise after a new liquefied natural gas terminal in New Brunswick opens later this year). While imported crude makes up a large share of the oil that is refined into gasoline, only 6% of gasoline is imported in an already-refined state. Gasoline imports nearly double in the summer months, when a seasonal increase in driving exceeds domestic refining capacity and imports from Europe are needed. As well, BC has no large refineries and gets its gasoline from Oregon as well as Alberta. One final quirk is that Newfoundland’s oil refinery exports most of its production abroad, since it contractually cannot sell in the rest of Canada, while gasoline has to be brought in from outside the province (mostly from New Brunswick).12 Imports account for a larger share of some niche markets such as aviation fuel.

Despite these imports, Canada has a massive surplus overall in external trade in energy products. In the first five months of 2008, this surplus was $76 billion at annual rates, as exports were nearly one-third ahead of their level a year earlier. By comparison, the surpluses for industrial goods and forestry products each stood at just over $20 billion.

Energy became our leading export early in 2008

Higher energy prices have fundamentally altered the portrait of Canada’s exports. As recently as 2004, energy was Canada’s fourth largest export, behind machinery and equipment, autos and industrial goods. After rising to third place in the last two years (leapfrogging ahead of autos), so far in 2008 energy is Canada’s largest export earner. Energy exports nearly doubled from $49 billion in 2002 to $92 billion in 2007, and in the first five months of 2008 are running at an annual rate of $125 billion. To put this in historical perspective, Canada’s energy exports totalled only $1 billion in 1971, and just under $14 billion as recently as 1990.

Figure 8

Canada exported 38.3% of all the energy it produced in 2007 (according to the IO tables).13 Around 60% of all the crude oil, natural gas and coal produced in this country is exported.  Most coal exports are metallurgical coal from BC for steelmakers in Asia (Ontario imports thermal coal from Pennsylvania and West Virginia to generate electricity).14 Electricity is the only major energy source that does not have a large dependence on exports, accounting for only 6% of output.

Figure 9

As a result of higher prices and output, energy as a share of total exports has jumped from 7% in 1971 to 12% in 2002 and 26.2% so far in 2008. Crude oil dominates Canada’s exports of energy products, contributing almost half (49%) so far this year. Refined petroleum adds another 17%.

Canada exports refined petroleum because the US does not have sufficient refinery capacity to meet its demand. Moreover, the aging capital stock of American refineries has led to a steady drop in their operating rate as more time is spent on repairs and maintenance.

Natural gas was Canada’s leading energy export from 2003 to 2005, but fell behind as prices slipped. An upturn in natural gas prices is leading a rebound in 2008. Other energy products have posted rapid growth since 2002, notably coal and uranium, which have more than doubled. Still, their share of overall energy exports remains small at less than 6%.

Energy exports will receive another large lift when two large oilsands projects start production late this summer, adding nearly 200,000 barrels a day to Canada’s oil output (worth nearly $6 billion a year at annual rates at current prices). In just the past decade, the oilsands share of domestic crude oil production has risen from one-quarter to almost one-half. These new projects will boost their contribution over 50%. The gains in energy exports have more than compensated for declines in traditional areas such as autos and forestry products.

Conclusion

The recent surge in energy prices, especially for oil, has had a wide range of impacts on different sectors of the economy. Drivers have seen the cost of filling up at the pump rise dramatically. However, sharply lower vehicle prices have helped dampen the overall cost of transportation. This is reflected in record high vehicle sales so far this year.

This study raises questions about how fast people are responding to the shift in energy prices. While vehicle purchases finally moved away from trucks early in 2008, actual gasoline consumption or urban transit use has been slower to respond, reflecting the time it will take to alter behaviour and the fuel efficiency of the vehicle fleet. As well it also partly reflects how exports and incomes benefit from rising oil and gas prices. Energy exports have quadrupled in the past decade to become Canada’s leading export so far this year. In turn, increased export earnings have been a factor in the appreciation of the loonie in recent years, which has dampened the impact of the rising cost of crude oil in world markets.

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Notes

1

The model appears to reflect well what is happening in the economy. From 2004 to 2007, the model predicted that the rising cost of crude oil would boost consumer prices for gasoline by a yearly average of 22%, while the CPI for gasoline actually rose by 19% a year over that period.

2

The source of retail gasoline consumption is the supply and disposition of refined petroleum products (Cansim matrix 134-0004). It is inaccurate to measure gasoline consumption by retail sales of gasoline stations: these include sales by these stores of other items (such as food and tobacco), and exclude gasoline sold by other retailers such as general merchandise stores.

3

The increase jumps to 76% by the second quarter of 2008.  

4

The data on total vehicles on the road and miles driven are from the quarterly Canadian Vehicle Survey.

5

CUVs (cross-over utility vehicles) are mounted on a car chassis, while sports utility vehicles are mounted on a truck chassis.

6

The actual classifications are entry level; large vehicles, including luxury models and SUVs; family vehicles; and pick-ups and panel vans.

7

The population data is from the labour force survey, which includes only people over 15 years old, approximating the driving age in most provinces.

8

The import data is for 2007. Total domestic use is the sum of personal expenditure on energy (which is available for 2007) and business purchases, which is projected from 2004 IO tables based on output growth by industry and the assumption of no change in energy intensity.

9

See Claude Picher, « Commerce : vers la catastrophe » La Presse, June 28, 2008. As well, most refineries in eastern Canada are designed to process higher grades of crude, while the west increasingly produces heavier crude. An overview is provided by The Conference Board of Canada “The Final Fifteen Feet of Hose: The Gasoline Industry in Canada in the Year 2000.”

10

This partly reflects the high cost of shipping oil to Canada, since regulations require this be done only by Canadian-flagged vessels.

11

See “Flambée d’investissements pétroliers”, by M. Gagnon, p. 18 in Constructo Magazine, Mars 2007.

12

From “Fuelling the economy”, p. 4 Perspectives on Labour and Income, summer 2007.

13

Export and energy output data for 2007 are combined with the 2004 IO tables, extrapolated with industry output growth on the assumption of no technological change.

14

From “High-flying coal stocks take major tumble”, Globe and Mail, July 3, 2008.



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