Commodity hedging could help provinces manage sudden swings from surplus to deficit: CIBC

Provincial performance gap narrows as volatile resource markets dampen outlook for some regions, while budding U.S. recovery lifts others

TORONTO, Jan. 29, 2013 /CNW/ - Canada's resource-rich provinces whose fortunes have been dampened by commodity price swings should consider hedging against those risks, even if it means giving up part of the revenue windfall when prices are high, notes a new report from CIBC World Markets Inc.

Canada's "resource bounty has in the past decade been a big winner for government coffers.  But resources are called cyclicals for a reason, and provincial finance ministers are now acutely aware that a bountiful surplus can turn into a gaping deficit in a hurry when commodity prices slip," says Chief Economist Avery Shenfeld at CIBC in the latest Economic Insights report. "The result is that fiscal outcomes in any one year are highly uncertain, leaving finance ministers struggling to explain why they held spending lean when revenues were gushing in, or why a deficit suddenly emerged and forced borrowing up in the process."

In the corporate world, strategies for protecting revenues against adverse swings in commodity prices are routinely used and could be similarly applied by governments, says Mr. Shenfeld.   "To smooth out the bumps and allow time to adjust" to new commodity prices, resource producers and buyers "typically use derivative markets to hedge against some of the price risks in the near term, giving up some of the upside in exchange for protection against large adverse swings.

"There's no reason why provinces couldn't do the same, locking in a range for current year fiscal results, and giving time to make adjustments in revenue or expenditure policies in the following year's fiscal plan should the resource price trend persist. That would clearly be preferable to surprising the bond market with in-year borrowing changes, or rushing to make mid-year spending swings that might not be optimal on other public policy grounds."

Provincial sensitivities to commodity price swings can be dramatic, the report notes. For example, a $10 per barrel drop in oil costs Alberta $2.2 billion in its fiscal bottom line, and hits Saskatchewan and Newfoundland by nearly $200 million each. "Provinces also have exposures to other commodities including potash and natural gas. The revenues at risk not only include direct royalties but also land sales and corporate income taxes that are correlated with underlying commodities."

Mr. Shenfeld notes that provinces are already using hedging strategies to manage interest rates and currency risk by swapping foreign-denominated debt into Canadian dollar obligations, as well as to use other "instruments to lock in favourable rates when the market is ripe."

Mr. Shenfeld adds that hedging strategies "aren't cut and dried decisions, nor is there a one-size-fits-all approach given the variation in exposures and the commodities involved. But it's at least worth a serious look by finance ministers, and Canadian taxpayers, finding themselves increasingly at the whim of volatile resource markets."

Elsewhere in the report, Senior Economist Warren Lovely and Economist Emanuella Enenajor note that a "sideways profile" for some key commodity prices could dampen fortunes in the year ahead for Canada's West.

"Critically, North America's limited pipeline capacity means Alberta crude oil is trading at a growing discount to international benchmarks. That has triggered a substantial falloff in provincial royalties and, as some recent announcements highlight, jeopardizes investment and prospects in the oil patch."

Alongside pipeline constraints, Europe's recession and softness in emerging markets "have dimmed the lights in heretofore fast-growing resource rich provinces, creating intense fiscal pressure in uncommon places."

Meanwhile, as commodity related pressures face some regions, a budding U.S. recovery is lifting others, resulting in the performance gap narrowing between provinces.

"American domestic demand is in its ascendance, and as we settle into 2013, it's the provinces more levered to U.S. consumer and housing market demand that are better positioned to ride out less supportive domestic fundamentals and uncertainty overseas," note Mr. Lovely and Ms. Enenajor, adding that Ontario in particular stands to benefit.

"Once-slower growing regions like Ontario are seeing economic and fiscal fortunes hold up better, with a big assist from a reviving U.S. economy.  While not exactly redefining Canada's "haves" and "have nots", the provincial economic and fiscal playing field is now more evenly balanced than at any time in the past decade."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/eijan13.pdf

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SOURCE: CIBC World Markets