China announced a USD586 billion stimulus package Nov. 9, an amount equal to nearly a fifth of the country’s GDP. Global markets reacted with initial glee before turning negative in the face of discomforting economic news.

But the prospect of serious pump priming in the global economy’s growth leader had longer lasting impact on the Toronto Stock Exchange: The commodity-intensive board held onto gains Monday even as the major US indexes wilted under disappointing earnings announcements.

China’s effort is certainly no panacea for Canada or the world economy. There are many hurdles to surmount. But the announcement and the corresponding impact on publicly-traded Canadian companies tied to commodities illustrates several important points. One, Canada is intricately tied, and it’s a positive link, to a global economy the growth, which is now led by emerging Asia. Two, emerging Asia’s growth means demand for Canada’s resources will only increase--once we cycle out of this malaise. And three, Canada has used its resource wealth to establish a solid financial system.

What follows is the Canadian Currents article from the November 2008 issue of Canadian Edge. At a time when questions about the direction of the global economy dominate not only the financial media but regular news as well, I thought it would be useful to speak with our in-house energy and Asia experts, Elliott Gue of The Energy Strategist and Yiannis Mostrous of The Silk Road Investor, respectively. Providing a Canadian context for our conversation is, of course, CE’s Roger Conrad.

Question: What would a deep global recession mean to Canada?

Roger Conrad: The best way to think generally about Canada’s economy is in two parts. The eastern part is more industrial and has traditionally depended heavily on exports to the US. It includes Atlantic Canada, French-speaking Quebec and Ontario and is where most of the population lives.

The western part of the country is heavily dependent on the development and export of natural resources. Most resource exports still go to the US, including the fast-growing oil sands. But over the past few years an increasing amount of them have gone to developing Asia.

It’s this new relationship that’s really helped Canada buck the worst of the troubles in this country. But a deep global recession that really knocked down growth in China would have a very serious impact on growth.

Elliott Gue: A deep global recession would be a big negative for crude oil and, to some extent, natural gas prices. As Roger noted, Canada’s economy has a significant dependence on energy and commodity prices so the economy would clearly be hit by falling prices.

Question: So, Elliott, where are we now in the cycle? And what do the long-term fundamentals say about the direction of energy prices?

Elliott Gue: We’re not really seeing a truly global recession at this time, and I suspect the current weakness in energy commodities will be short-lived. On the demand side, there’s clearly been a retrenchment in developed-world oil demand. The latest Oil Market Report for the International Energy Agency (IEA) projects that oil demand from the developed world will fall by nearly 1.1 million barrels a day in 2008 and a further 600,000 barrels a day next year. The decline has been led by a slowdown in the US; US oil demand is likely to decline close to 1 million barrels a day in 2008.

Meanwhile, demand from the developing world has slowed slightly but is still growing at an impressive pace. In fact, demand is growing so quickly it’s offsetting the declines from the developed world--global oil consumption is expected to be up around 450,000 barrels a day in 2008 and closer to 650,000 barrels a day next year. There does not appear to be a recession in the developing world at least in terms of oil consumption.

And investors are paying far too little attention to the supply side. Recent data out of the IEA suggest that production from mature oilfields is declining at a far faster pace than previously thought--oil production from key mature fields in regions like the North Sea, Mexico and even Russia is falling quickly. Even in the favorable economic environment of the past four years, producers in these regions have had a difficult time maintaining their production

To make matters worse, smaller firms in high cost markets like the North Sea start cutting back their drilling plans when oil falls below USD80. Falling activity levels will quickly show up in supply statistics.

Bottom line: the longer oil prices remain depressed, the more profound the effect on global oil supply. If, as I suspect, the US economy and oil demand stabilize towards the latter half of 2009, there just won’t be sufficient supply to meet that demand. We’re likely to see crude back over USD100 by late 2009 or early 2010.

Question: Roger, how deep is Canada’s relationship with Asia and where do you see it going?

Roger Conrad: The more China and other Asian nations develop their economies--and governments are clearly committed to doing that--the more resources they’re going to need. Canada is the natural seller of those resources, and I see exports continuing to grow for at least the next 10 years. One of the most telling numbers I’ve seen on this relationship is the percentage of Canadian exports that go to the US. Back in the late 1990s, this figure was in the high 90 percent range pretty much every year. Ten years later, it’s in the low 70s and still falling. That’s how commodity prices were able to keep rising through the first half of 2008, even with the US economy going into the tank.

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Again, the great untold story on how badly Canada gets hit in this downturn is what happens to Asia. I defer to Yiannis on this. But my view is if China can bottom at 8 percent growth next year, they’re still going to need a lot of resource exports, and that should keep Canada on the whole from feeling this worst of this crisis.

Yiannis Mostrous: I agree. A lot of investors and commentators forget that the important development in the Chinese economy remains that of its domestic economic strength.

As for the global economy slowdown, I expect that the Chinese government will step up its investment plans in order to boost domestic economic activity.

Chinese authorities have traditionally stepped in to support the economy during difficult times through fixed-asset investment (FAI) increases. Their target has been to keep overall FAI growth at around 25 percent for the past eight years; before 2000, the goal was 15 percent.

Importantly, the rest of the region will also come out relatively fine from the crisis because it has a high savings rate and lower degree of financial leverage on both the personal and corporate level.

And Asian countries have current account surpluses--India and South Korea are the exceptions--as well as strong foreign exchange reserves. They have enough room to cut rates now as needed because they had raised rates earlier in the year due to higher inflation.

Elliott Gue: In addition to direct trade links, clearly Asia has a profound effect on the market for Canada’s key export commodities. Strong growth in demand for oil, natural gas, and agricultural commodities has been a key driver of the rally in these markets over the past five years.

Whether Canada ships its oil to the US or China, Asian demand is clearly having an impact on prices.

Question: At what energy price does Canada’s energy patch become noncompetitive on global markets?

Roger Conrad: The oil sands region is certainly pretty close to being there with oil under USD70 a barrel. Operating costs for this process have actually risen along with output, in large part because turning oil sands to useable fuel is pretty much a mining and chemical processing operation and requires large amount of electricity costs.

I think we can actually expect costs to rise even more going forward, as the industry is forced to tackle environmental effects, so oil sands is probably going to need an oil price of USD90 or higher to be economic in the long haul.

That said, it is a rising percentage of Canada’s oil exports and North America has become dependent on it to some extent. If the price of oil stays at this level for more than a few months, a lot of these projects could be shut down. That would potentially take a lot of energy off the market, which would all else equal push prices back to a higher level of equilibrium. That’s oil sands.

The conventional oil and natural gas that’s the bulk of Canada’s output is actually pretty competitive at a lot lower energy prices. Dividends would have to come down if oil were to drop to USD30 a barrel or gas fell to USD3 or so per million British thermal units (MMBtu). But they’d still be in business.

Elliott Gue:  This varies wildly by producer. Based on comments made during recent quarterly conference calls by the big services companies, some North American oil projects are economic at USD55 oil. But there are also small producers who aren’t profitable unless oil is over USD100.

A good rule of thumb is to watch oil around USD70 to USD80. Under that range, you’ll see capital spending cuts by smaller, higher-cost producers in the US and Canada. Above that range, drilling activity should remain at least stable.

It’s also worth noting that the credit crunch has had a profound impact. Many independent producers rely on debt capital to fund their drilling plans. Reduced access to capital has prompted some to cut back their spending even if they’re profitable with oil at current prices.

In addition to oil, keep an eye on natural gas prices and supplies in North America as a whole. In 2006 and 2007, North American natural gas prices were at depressed levels, and drilling activity in Canada was hit hard, far harder than in the US. While activity appeared to pick up earlier this year as gas prices spiked higher, it never recovered to the levels last seen in 2005 and early 2006.

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With the 12-month natural gas strip--the average of the next 12 months of futures prices--currently at around USD7 to USD7.50, many smaller gas producers in Canada and the US alike aren’t profitable. The break point for the big independent exploration and production companies is around USD7.50 to USD8--below this range, companies scale back their drilling plans. We are already seeing that as several producers have announced cuts to their spending plans. I suspect the US rig count will fall by 300 to 500 rigs by mid-2009 as producers idle rigs and cut back drilling plans. Canada will see continued weak activity levels if gas stays where it is today.

Longer term, North America has the potential to become the dominant gas producer worldwide, overtaking even Russia in terms of production. The reason is the vast so-called unconventional gas fields that are being exploited in the US and Canada alike. Recent advanced in drilling technology have made these fields economic and production is soaring.

Just a few years ago, most energy pundits felt falling Canadian production would force the US to import massive quantities of gas in the form of liquefied natural gas (LNG). Now, thanks to unconventional gas, there’s talk of building LNG export facilities to allow North American gas to be transported to gas-hungry markets in Europe and Asia.

Question: Roger, let’s talk about the Canadian banking system. Can it survive a global recession?

Roger Conrad: Obviously, financial institutions all over the world take a hit when growth slows. But as we’ve pointed out in Canadian Edge, Canada’s banks are a great deal more conservative than US banks have been.

There was never a subprime crisis because they never went hog wild on subprime loans. In fact, the only significant writeoffs have had to do with investments in the US, and in US mortgage-backed securities.

Another advantage Canadian banks have had in this crisis is the Canadian corporations they lend to are also very conservative. Put that with the Canadian government’s pretty steady support of the country’s banks and you have a very nice combination for keeping lending flowing in a difficult environment.

Question: The ability to withstand a significant downturn: Yiannis, how is Asia’s financial system set to survive?

Yiannis Mostrous: Banks, consumers and companies in Asia enjoy low debt levels. As a result there are no serious economic threats from the poor liquidity conditions and financial insolvency issues plaguing the Anglo-Saxon economic system.

Question: “Whither Asia” is a topic many mainstream media types have pounded on during the last six to eight weeks. What kind of growth can we reasonably expect there in 2009?

Yiannis Mostrous: Well, I do think the Chinese economy will perform better than a lot of people think next year. Everyone’s talking about a slowdown in exports, and that this will hit China hard.

It’s true that an export slowdown will be a negative--in the past three years, exports have contributed substantially to GDP growth, and the economy grew at around 10 percent. But if we look a little further back, we’ll see--at times--that net export growth was in the low single-digits (in 2004) or even negative (in 2003). But GDP growth managed to rebound to the 10 percent area.

If you’re willing to account for the abnormality of the current global financial situation, thereby subtracting a few more growth points, China should still be able to deliver very respectable 8 percent growth next year.

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