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Oil prices have surged in the wake of the Iran conflict, but Canada suffers and benefits at the same time. Since Canada is a net exporter of oil, higher oil prices don’t destroy wealth; they simply move it from one part of the economy to another. The real question is who wins and who loses in this redistribution.
There are a few factors to consider during an oil shock like the one we are experiencing now. Brent crude oil has climbed from US$60 per barrel at the start of the year to more than US$100 per barrel in April. It is difficult to determine whether this is temporary or not. The winners and losers are different in each of these scenarios. If this is a temporary increase, the most immediate pain is felt by consumers at the gas pump, as well as through the rising cost of heating, groceries, and other goods and services.
Companies operating in non-energy sectors are also affected by this, as they face the same budget pressures we all do. While it won’t cause them to cut jobs (yet), it puts a focus on discretionary spending and could delay larger capital investments.
On the other hand, there are winners from a short-term price shock. The most obvious is the energy sector. Since these companies typically have higher fixed costs, an increase in revenue translates directly into higher net income. For shareholders, a short-term increase in oil prices leads to higher income and stock prices. Additionally, investors in broad-based TSX funds or ETFs would also benefit because of the high representation of the energy sector in the TSX index.
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The final beneficiary in this scenario is the government. Since they collect taxes and royalties on oil revenues, the government’s immediate cash flow would increase.
A temporary spike is one thing. But a sustained increase in the price of oil creates different pressures. The biggest impact would be continued inflation. If the price increases are significant, we could be reliving the 2022 scenario when the Bank of Canada raised interest rates to fight post-pandemic inflation. Higher mortgage rates resulting from this would decrease real estate demand and hurt homeowners with variable-rate mortgages or mortgages coming up for renewal. Also, the outlook for non-energy sector companies would only get worse, possibly leading to the beginning of recession.
A long‑term increase in oil prices would still benefit the same two stakeholders: the energy sector and government tax revenue. But the benefits of increased tax revenue for the government are not without risk. This can result in overdependence on tax revenue from oil prices, so a future decline could have a significant impact on the tax revenue base.
Given where we are now, what should you do?
1. Don’t predict
It is tempting to get caught in the cycle of forecasting what will happen next. This often results in an all-or-nothing bet on a specific event, such as the timing of the end of a war. However, this leads down the path of speculation and usually results in the same success rate as a coin flip.
2. Assess your situation
An investor who is retired and withdrawing from their investments will experience this oil price increase differently than someone who is in the accumulation stage. If you are the former, you will need to have enough in safe liquid investments, such as bonds, to fund your withdrawals during an extended period of market volatility.
3. Rebalance now
A market decline can be emotionally difficult but it is the optimal time to rebalance your portfolio. If you started with a portfolio that was 50 per cent equity and 50 per cent fixed income, during a market pullback, your ratio will change. Getting back to your original ratio will mean you sell some fixed income and add to your equity. It makes sense financially since you are purchasing equity at a lower price, if you can get past the noise of market predictions.
4. Oil matters, but interest rates matter more over time
While the early 1980s are a distant memory, 2022 is fresh in everyone’s mind. Interest rate increases during these periods had a significant impact on the economy and financial markets. Oil shocks and geopolitical events make headlines because they hit home emotionally and are easy to understand. Interest rate changes tend to be more theoretical, but ultimately, they will have a significant financial impact on Canadians. The biggest risk of this price shock would be if it created prolonged inflation that required the Bank of Canada to raise interest rates.
It is easy to see the negatives of the oil shock we are experiencing by looking at the gas pump, but there are positives as well. We live in an oil-exporting country, so that helps buffer some of the pain. But the real impact is the redistribution of wealth resulting from an oil price shock. The benefits are mainly experienced in the country’s oil producing provinces, but the costs are spread across the broader economy. Oil shocks may be unpredictable, but your response doesn’t have to be. Investors have tools to protect their portfolios regardless of how long this price increase lasts.
Anwar Husain is an award-winning finance professor at the University of Toronto and a senior investment adviser and wealth adviser with Richardson Wealth. He is also a published author in several peer-reviewed academic journals in the areas of finance and economics. He can be reached at Anwar.Husain@RichardsonWealth.com