Philip CrossA drop in oil prices has helped slow Canada’s economy but, as Philip Cross writes in the Financial Post, an underperforming manufacturing sector hasn’t done much to offset the downturn.

By Philip Cross, August 17, 2015

In the endless discussion about whether or not the economy is in recession, commentators too quickly assume all of the weakness in GDP early in 2015 was driven by the oil industry after prices collapsed. No question oil and gas output has slumped, down 3.2 per cent since December. As typically happens, all of the cuts were to conventional oil and gas output; oilsands producers did not lower production in 2015 (except for repairs), just as their output never fell during the 2008-2009 downturn because of the high fixed costs of these plants. Exploration and drilling for conventional oil was hit the hardest, down by a third.

Unfortunately, the default position that all the recent weakness in the economy was oil-related ignores the importance of one-time factors, which may be reversing over the summer. And it doesn’t take much to move the needle on GDP, which is important given the hysterical attention paid to 0.1 per cent changes these days. A factory that produces $83 million more in one month raises GDP (which is measured at annual rates) by $1 billion or 0.1 per cent. Can even the world’s best statistical agency —which arguably Canada has – capture every $83 million change in output by firms across the country in its preliminary estimates? Not a chance.

While the downturn in the energy sector was widely-anticipated, forecasters expected an offset from two sectors that benefit from lower oil prices — consumers and manufacturers. Consumers gain from lower prices for gasoline and home heating oil, although this is partly offset by the higher cost of imports that result from the lower exchange rate that falling oil prices encourage. Manufacturers should unambiguously benefit from both the direct impact of reduced energy input costs and the indirect boost from the lower loonie (or Canada’s drachma as The Montreal Gazette’s cartoonist recently called it), although the exchange rate stimulus is now smaller after firms restructured their operations over the past decade to minimize their exposure to currency fluctuations.

Consumers have kept their part of the bargain. Despite a slow start to the year due to record cold in Eastern Canada, retail sales volume has risen 1.6 per cent as motorists begin to spend their savings at the pump on other goods. Other consumer services have also been buoyant, notably recreation and more recently travel-related industries as the lower exchange rate encourages travel within Canada.

However, manufacturers have compounded rather than offset the weakness in the oilpatch, cutting production 3.7 per cent so far this year. So what happened to the forecast benefit to factories? To answer that, check the industry breakdown of lower factory output since December. The number one contributor is the auto industry, down $1.7 billion despite record high auto sales in the U.S. (this ignores the spin off on feeder industries such as iron and steel). Canada’s auto output fell early this year when Chrysler closed its minivan plant in Windsor for retooling and has remained low through May. Chrysler is investing over $1 billion to expand and upgrade production of minivans, its first retooling of the plant in 20 years. Retooling is not unusual in auto plants — indeed, it is essential to maintaining our share of North American output in the long run – but clearly it’s done with an eye to the very long-term and not the cyclical ups and downs of the economy. Production started up again in June, giving a boost to manufacturing sales.

The next largest contributor to lower factory output is capital goods, notably machinery (due to cuts for resource-related machinery) and metal fabricating (affected by the weakness in both autos and the oil industry — the latter buys pre-fabricated structures to house workers in remote sites). Economists apparently under-estimated the linkages built up between the energy industry and our manufacturers in recent years.

Besides autos and capital goods, there has been weakness in factory output for everything from wood to chemicals to food, for reasons ranging from structural damage to B.C.’s lumber industry to a cold winter that delayed both farmers’ demand for fertilizer and the harvest of lobsters off the East Coast until June. Oil refining is a notable exception to the slump in manufacturing, ramping up output as motorists (even our sainted brethren in B.C.) increased consumption 4 per cent a year since prices began falling in 2013 – good luck to the carbon tax crew reversing that trend without hefty and therefore politically suicidal increases.

Whatever the reason for the weakness in manufacturing outside of autos and capital goods, the slump in export demand apparently came to a decisive end in June. Exports jumped 6.3 per cent, their best month in over a decade, driven by a surge for a wide range of manufactured goods.

The next couple of months should reveal whether cyclical or one-off factors explain the largest part of the weakness of this year’s GDP through May. The cyclical downturn in oil-related industries undoubtedly will continue into the second half of the year as prices plumb new lows for the year. If they are the predominant force in the economy, the recovery of GDP will be shallow and hesitant over the summer. On the other hand, a quick pick-up in economic growth would suggest much of the slump originated in retooling, cold weather and other factors unrelated to the business cycle.

Philip Cross is the former Chief Economic Analyst at Statistics Canada.

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