Canada to feel the burn from collapse of oil industry

A sharp and unprecedented decline in U.S. oil prices last month, triggered by the coronavirus pandemic that sapped global demand for oil, will have a domino effect on Canada, where economic recovery is inextricably linked to the energy sector.

The new economic landscape may weaken future returns in Canadian equities and result in downgrades of energy company bonds, sources said.

While the U.S. and Canada often feel oil price shocks in succession, Canada bears the brunt as its economy is more reliant on the health of its oil and gas industry, which in 2018 accounted for 7.7%, or C$160 billion ($117.3 billion), of the country's nominal GDP, according to data from Natural Resources Canada.

On April 20, U.S. oil futures turned negative for the first time in history, with the price of a barrel of West Texas Intermediate crude oil closing at -$37.63. As of closing April 30, the price of WTI crude oil, the U.S. benchmark, was $18.84.

While the U.S. produces more oil than Canada, "the weight that oil has on U.S. GDP is not as significant as it would be in Canada," said Benoit Labrosse, a Montreal- based partner and vice president at Morneau Shepell Ltd.'s asset and risk management consulting practice. In 2018, the mining industry, which includes oil and gas extraction, accounted for just 1.7%, or $346.6 billion, of U.S. GDP, said data from the Commerce Department's U.S. Bureau of Economic Analysis.

There is a "strong correlation between the performance of oil price in Canadian dollars and the Canadian economy," Mr. Labrosse said.

Blake Haxton, a research analyst focused on the energy and transportation sectors at Diamond Hill Capital Management Inc. in Columbus, Ohio, said: "The U.S. and Canadian energy markets are joined at the hip, literally and figuratively. When there's a problem in the U.S. from a pricing or storage perspective, eventually that impacts Canada."

"Oil is one of Canada's major exports and most of those barrels flow south through the U.S.," he added. "When prices drop in the U.S., prices also fall in Canada. In fact, some Canadian oil is sold based on West Texas Intermediate benchmark pricing. Storage has a similar effect in that when storage capacity in the U.S. begins to fill up, Canadian oil has fewer places to go, driving the price down even further," Mr. Haxton said.

Provinces in western Canada, like Alberta, will face particular challenges due to the oil glut and price swings triggered by COVID-19, since they rely more heavily on revenues from the energy sector, he added.

Alberta's energy sector contributed C$75.2 billion to Canada's nominal GDP in 2018, making the province the highest contributor to the industry, data from Natural Resources Canada shows.

Large Canadian pension plans have their own ties to the energy sector through their investment portfolios. In the fourth quarter, the C$420.4 billion Canada Pension Plan Investment Board, Toronto, committed up to $310 million to support Crestone Peak Resources LLC's definitive agreement to acquire oil and gas assets in Colorado's DJ Basin, the pension fund announced in a Feb. 14 release. CPPIB owns 95% of Crestone, a Denver-based energy company.

CPPIB had C$9.1 billion in "energy and resources" investments within its real assets portfolio as of Dec. 31, a financial statement published by the pension fund shows. It's energy and resources holdings are "focused on direct private investments in the oil and gas, energy midstream, merchant power and (liquefied natural gas), refining and petrochemicals, mining and services, technology, and innovation industries," CPPIB's website states.

Additionally, as of Dec. 31, the C$207.4 billion Ontario Teachers' Pension Plan, Toronto, had C$4.3 billion in oil and gas investments in its inflation-sensitive portfolio alone, according to the pension fund's 2019 annual report. OTPP also has 20% of its C$17 billion infrastructure portfolio invested in energy, although the report does not distinguish between renewable and fossil-fuel energy. The pension fund also has several partnerships with oil and gas companies, the annual report shows.

As part of a COVID-19 economic response plan, Canadian Prime Minister Justin Trudeau announced on April 17 that the government would provide funding to create and protect jobs in the energy sector, including up to C$1 billion to the government of Alberta to support efforts to clean up orphaned or inactive oil and gas wells across the province.

Mr. Labrosse said the U.S. will likely "be back on its feet faster than Canada" in a recovery after the health crisis because the country has a more "diversified economy."

For Canadian pension funds, this outlook may affect their view on Canadian equities, he added.

"If I were to invest my money (as a pension fund) in an equity market, I might choose to be outside of Canada or have a larger allocation outside of Canada than I would normally," Mr. Labrosse said. "I think most (pension) plans across Canada have taken a hit, as equities were down about 20% in the first quarter."

Canadian defined benefit plans in the RBC Investor & Treasury Services universe posted a median return of -7.1% in the first quarter, the steepest decline since 2008, attributed primarily to the health crisis' impact on financial markets, including plunging commodities prices, an April 29 news release said.

The S&P/TSX Composite index was down 20.9% for the quarter, "wiping out the annual gains from 2019 and significantly underperforming the global market. The impact of the international health crisis was the primary cause, but the dispute over the natural gas pipeline and the Russia-Saudi Arabia oil price war were additional factors," the release said.

To the benefit of Canadian pension plans, however, most have already shifted their portfolios over the past five to 10 years to a lower exposure to Canadian equities, Mr. Labrosse said.

"They dialed down their exposure and decided to go into global equity or U.S. equity. (Pension funds) wanted more diversification than what Canada was providing. Because of that, they will be in a better position than if they had stayed heavily in Canadian equity," he said.

As of Dec. 31, CPPIB had 2%, or C$8.2 billion, of its total portfolio in Canadian equities, down from 2.7%, or C$9.1 billion, two years earlier, financial reports published by the pension fund show.

The weakened economic outlook in Canada will affect more than just equities, where a bleaker view on company valuations and profitability has emerged. There will also be a ripple effect that impacts some bonds.

Duncan Mathieson, Toronto-based executive vice president and head of Canadian equities at Addenda Capital Inc., which has around C$30 billion in AUM, said energy company bonds are going to be at higher risk of downgrades than other companies.

"Anything to do with energy right now is a challenge until we get some clarity (on a recovery)," he said. "There are a lot of domino effects that happen with things like this."

Amid the volatility, institutional investors are still more likely to hold tight regarding their asset allocation or investment decisions, Mr. Mathieson said. "If you're taking a longer-term view, you'd want to make sure you don't push the panic button too hard." However, in Canada's energy sector, he does expect "a really challenging investment environment for the next 12 to 18 months."

Tyler Cloherty, senior manager and head of the knowledge center for Casey Quirk, a practice of Deloitte Consulting LLP, New York, expects that there won't be much "panic selling" across asset classes by Canadian institutions in light of the changing economic environment.

"I think from some of the feedback we've heard from the institutional investors, there's been much less panic selling, and the outflows across all asset classes are a lot less stark than, say, the Lehman crisis of 2008," he said.