What does the Bank of Canada really think drove oil prices?

With its decision on April 13 to leave interest rates unchanged, the Bank of Canada continues to grapple with how to respond to the crash in commodity prices. As it stands, the central bank has estimated that the plunge in oil has wiped $60 billion off the national income. Rates are already near zero, so any further deterioration in the economy raises the spectre that unconventional measures, such as quantitative easing, would be next on the central bank’s agenda.

What Stephen Poloz and his colleagues might do in the future is an interesting issue. But there’s another question that is rarely asked: what does the Bank of Canada really think has been behind the wild swings we’ve seen in resource prices over the past number of years?

Within the last month, two Bank officials reiterated what might be termed the official party line about the resource boom that benefitted Canada right up until 2014. First up, on March 30, was Deputy Governor Lynn Patterson, who spoke about how the economy was adjusting to the fall in commodity prices.

Patterson provided context for her remarks, noting:

A broad-based boom in global commodity markets began in the early 2000s. It was fuelled by growing demand from emerging-market economies. Canada was a big beneficiary of the rising prices.

Next up, on April 5, Senior Deputy Governor Carolyn Wilkins emphasized the relationship between Chinese economic growth and Canadian prosperity, observing that:

China’s growth has also meant better prices for the resources Canada sells. China has become the world’s second-largest consumer of oil, with its demand doubling over the past 15 years. It now buys half of the world’s output of base metals, compared with less than 20 per cent in 2001.

Patterson and Wilkins were on the same page as Poloz, who back in September similarly argued that commodity prices had risen due to emerging market demand. Those high prices, he said, spurred increased investment in resource projects, which in turn eventually unleashed a wave of new supply (think U.S. shale oil).

In putting himself in the “emerging markets were responsible” camp, Poloz himself was simply following in Mark Carney’s footsteps. Back in 2012, Carney was adamant: this was a resource boom fuelled by China and it was sustainable.

The story isn’t so simple, however. While the Bank has generally said commodities soared because of real world supply and demand, along the way there have been hints and some polite dissenting voices, suggesting other factors were at play.

A perfect example of this can be seen in an internal Bank of Canada memo Maclean’s wrote about four years ago. The document, written in 2011 by one of the Bank’s analysts, examines the reasons food, oil and metals prices were going crazy at the time. While saying fundamental factors played some role, the memo stated:

There are increasing signs of instability, illiquidity, volatility and price dislocation, all attributable to the speculative or financial participants, rather than the core commodity participants. Since the size of traded commodity markets remain much smaller than that of other financial markets, any marginal increase in commodities investment by market participants…has a disproportionate impact on prices.

Fast forward to December 2015 and the Bank of Canada’s Financial System Review. Buried in the report, among a discussion of risks, the central bank wrote the following:

If there was an additional large and broad-based drop in commodity prices, the impact on the Canadian financial system would become much more important. In such an environment, financial pressures on commodity producers, particularly those that are more highly leveraged, could become intense. Likewise, the impact on households and supporting businesses would be more severe. A credit event associated with a global resource company could spill over into a widespread tightening in financial conditions, extending well beyond this sector and into the global financial system.

It’s the final sentence (emphasis added) that is most interesting, as it echoes something Deputy Governor Timothy Lane worried about in a 2012 speech:

Could the failure of one of the large trading houses cause serious disruption in the commodities markets in which it played a market-making role? And, could the losses that a trading house incurs through the positions it has taken in commodities have significant knock-on effects on the financial system?

Lane, for the record, stated in 2015 that the commodity price run-up was overwhelmingly due to fundamentals.

Yet his 2012 comment, and the risk identified by the Bank in its December report, serve to undercut the argument that financial players have not had a significant effect on resource prices.

Think about it this way: for a resource company to incur such huge losses that they result in “a widespread tightening of financial conditions,” not simply for commodity producers but indeed the global financial system, the size of the bets at play would have to be very, very significant. Moreover, it stands to reason that those bets (the “positions it has taken in commodities”, in Lane’s words), probably were a key reason that prices rose in the first place.

In its April Monetary Policy Report, the central bank addressed the oil price, which has strongly rallied off its February low of $26 to stand at over $40 per barrel today:

Uncertainty about the nature and speed of supply and demand adjustments is contributing to recent volatility in oil prices. Factors influencing these price movements include reductions in US shale oil production, temporary supply disruptions in Iraq and Nigeria and improved market sentiment with respect to global growth (particularly for China).

Market sentiment has certainly improved. Indeed, as Reuters energy analyst John Kemp points out, hedge funds now hold near-record bets that oil prices will rise. At the end of March, speculators held futures market positions equivalent to over half a billion barrels of oil, more than double the level of December 2015. Importantly, he notes that, “There has been a close correspondence between hedge fund positions and the movement of oil prices since early 2014.” What this suggests, particularly because oil inventories remain very high, is that the recent rebound in commodity prices has less to do with the real world and more to do with financial speculation.

All this means that if speculators flee, resource prices could take yet another dive—delivering yet more pain to the Canadian economy.