As geopolitical conditions worsen and the human toll of Russia’s invasion of Ukraine mounts, the economic impact is rising as well, especially on global energy markets.
Though the impact on Canada’s gross domestic product will be minimal thanks to Canada’s strong energy industry, consumers and businesses will bear the full cost of rising inflation.
Oil prices were already doubling because of pent-up demand as well as low supplies. After the invasion began on Feb. 24, the Brent crude benchmark surpassed $110 US a barrel for the first time since 2011.
Although high oil and gas prices had been good news for the Canadian economy over the past few decades, this time is different.
Canada will remain relatively insulated compared to Europe because of its energy independence. The increase in oil prices could cause Canada’s GDP to change by just under 1% as the effects of reduced consumption are offset by increased energy revenues.
What is more concerning is that it will push inflation to levels not seen since the early 1980s, as every $10 US increase in the price of oil per barrel can drive up inflation by 0.4 percentage points, according to the Bank of Canada.
Since natural gas prices are less globalized, they will see less dramatic increases in Canada and will have little overall impact on GDP and inflation.
While the net effect of this shock seems minor, a closer look reveals clear winners and losers: The energy industry will have its best year since 2014, while consumers and businesses in other sectors will feel the pain of high energy prices.
The energy industry
Canada remains in an advantaged position as a top global energy producer and exporter, and will not have to worry about energy shortages.
To get a sense of the economic gains to the energy industry, look no further than Alberta, which accounts for 80% of Canada’s total oil production. Alberta’s budget is expected to be in a surplus this year for the first time since 2014.
Since energy makes up nearly 10% of Canada’s total GDP and more than a fifth of Canada’s total exports, these economic gains will help offset the negative effect of high oil prices on other parts of the economy.
Still, energy production in Canada is landlocked and concentrated in Western Canada. Although large quantities of crude oil are exported, Canada does not have a ready way to export natural gas to Europe and increase revenue should the war drag on.
Consumers and businesses
The war is the latest in the series of events including the pandemic, supply chain disruptions, natural disasters and protests that have pushed up consumer prices.
Businesses will experience higher costs of operation, especially those in energy-intensive industries like manufacturing and agriculture. These costs will be passed on to consumers.
Consumers will feel the pinch when filling up their tanks. In addition, high oil prices increase transportation costs, which, in addition to high business operation costs, will push inflation near 6%.
The prolonged inflationary environment will hurt consumers, especially those on the lower income spectrum, and undermine consumer demand and confidence as well as economic growth.
Policy response
Canada might not benefit from high oil prices this time, but in the long run, it might not be a bad thing.
The Canadian dollar, which in the past was closely tied to crude oil prices, has remained steady in recent weeks. This signals a marked departure of the Canadian economy from oil and gas, which is in line with the country’s goals to become carbon neutral by mid-century.
The Canadian government is unlikely to implement policies to help consumers cope with high oil prices.
First, Canada does not have tools like the strategic petroleum reserve in the United States, because the oil sands could function as reserves, and they are already expected to produce at record levels to keep up with demand.
More important, Canada is committed to reduce its carbon emissions through annual increases in its federal carbon tax. After all, the intent of the carbon tax is to make fossil fuels more expensive, discouraging consumption.
One way to think of the current energy shock is like an unexpected and expensive carbon tax. Attempts to reduce prices, through further rebates or otherwise, would offset the purpose of the carbon tax.
In the end, this shock might act as a catalyst for the energy transition. If high oil prices persist, businesses will eventually innovate and switch to renewables. Consumers will adapt by reducing consumption and driving less. The government will fund projects to accelerate the widespread use of renewable energy.
Our model assumes that the energy shock will be temporary. Current sanctions are leaving energy relatively intact because much of Europe relies heavily on Russian oil and gas.
Should the war drag on, we would have to revisit the model and reexamine the economic impact on consumers as well as businesses.
The takeaway
While an acute energy shock will result in a small overall net effect on the economy, a prolonged shock could hold down consumer demand and delay an economic recovery.
Businesses and consumers will bear the brunt of higher prices. And after a series of economic shocks over the past two years, patience is required. As economists like to say, the cure for high prices is high prices.
Persistent high inflation will encourage households and businesses to find ways to adapt. This shock might also act as another wakeup call for Canada to reduce its dependence on fossil fuels and build a more resilient economy.
