11-010-XIB
Canadian Economic Observer
October 2007

The new underground economy of subsoil resources: no longer hewers of wood and drawers of water

by Philip Cross*

The 5-year surge of the Canadian dollar to parity with the US greenback has been driven by high commodity prices, among other factors. The revival of Canada’s resource sector immediately conjures the hoary image of Canadians as ‘hewers of wood and drawers of water’, with all its negative connotations going back to biblical times¹. This paper shows that this characterization of our resource sector is outdated, if it was ever true.

A number of structural and cyclical factors have reduced the importance of forestry products in Canada’s exports. Instead, since 2002 there has been a large shift in the resource sector away from trees and towards commodities found mostly underground, notably oil and metals. Rather than being ‘hewers of wood and drawers of water’, it is more accurate (if less catchy) to say Canadians are ‘conveyers of crude and moilers of metals’.

This change in the resource sector reflects commodity prices that are currently in the midst of their longest and largest upswing on record. The increase started in 2003 in the energy sector, where prices doubled before leveling off in 2005. Then the boom became more pronounced for metals, where prices have tripled. By last year the upturn had spread to agricultural products, where a doubling for grain boosted farm prices by 50%. While the details for each commodity are different, one common theme is a global economy in its fastest 5-year period of growth on record back to 1970.² China’s manufacturing growth, with a concomitant demand for natural resources used as inputs, has been particularly important.

This paper looks in more detail at how energy, mining and agriculture have each profited in turn from this so-called ‘Super Cycle’ for commodities, and contrasts this with the lethargic state of our wood- and water-based industries. The analysis focuses primarily on export earnings³ and prices, which capture the magnitude of the surge in commodity demand more than the volume of output or employment. It concludes by looking at whether the primary sector (agriculture, forestry, fishing and mining) and utilities have been more prone to a ‘boom or bust’ cycle than the rest of the economy.

Figure 1

Energy

The commodity price boom began in the energy sector. At the start of 2003, energy exports were only Canada’s fourth largest export group. Quarterly revenue from crude oil and natural gas exports were nearly equal in 2002, at just over $4 billion. Over the next three years, natural gas grew faster than crude oil, largely due to stronger prices. By late 2005, energy products were Canada’s most lucrative export.

However, since 2005 these two energy industries have gone in markedly different directions. Crude oil exports have jumped a further 50%, as record-breaking prices were reinforced by new projects coming on-line. Higher gasoline prices have also boosted exports of refined petroleum products since 2002, although at just over half the rate of crude oil exports (63% versus 107%). This reflects the growth of heavy oil from the oilsands and the shortage of upgraders and refineries to process it in Canada.

Figure 2

Meanwhile, natural gas prices and production have plummeted since a mild North American winter in 2006 created a surplus of inventories that persists to this day. The setback for this industry was even more abrupt, coming on the heels of record high prices in the aftermath of Hurricanes Katrina and Hugo in the fall of 2005.

Compounding the problems of the Canadian gas industry has been the sudden emergence of liquefied natural gas (LNG) as an alternative source in US markets. LNG imports into the US have risen 58% in the first seven months of 2007 compared with the same period in 2006. This US$1.6 billion increase was matched exactly by a drop of Canada’s gas exports to the US in the past 12 months.⁴ The growth in LNG reflects improvements in its transportation and in the building of terminals in the US and in supplying countries to convert it from gas to liquid and back to gas. LNG terminals under construction in the Maritimes will further increase supplies to the US.

Overall, exports of other energy products have changed little since 2002. Electricity exports (which are the closest to ‘drawers of water’ in exports) reached their zenith in 2001 during California’s electricity crisis. Since then they have fallen from $4.2 billion to $2.5 billion (partly because utilities in the US increasingly use gas-fuelled turbines). The drop for electricity exports has been offset by a recovery for coal exports, fuelled by Asian demand.

Metals and minerals

Metals prices quickly followed energy in taking off after 2002, although the increase for metals has been ‘stronger for longer’ than even energy. Prices for a wide range of metals have set new records, including nickel, copper, zinc, and iron ore. Non-metallic minerals also have soared, notably potash, uranium and diamonds. Altogether, metals and minerals account for the bulk (66%) of exports of industrial goods.

Figure 3

Largely as a result of higher prices, industrial goods have become Canada’s leading export. The turnaround was most pronounced for metal ores and alloys, where exports have doubled in four years, after almost a decade of no growth.⁵ The profitability of metals also attracted large inflows of foreign investment in the past year.

Figure 4

It is frequently asserted that Canada exports too many of its metal ores without further processing them. However, this is not a good description of how the mining industry operates in Canada. Canada exports $40 billion of metal alloys (which are ores refined to a finished or semi–finished state), versus only $11 billion of ores which require smelting and refining. Alloys also received a boost from the rapid growth of precious metals, reflecting the growth of diamond exports from 2002 to 2004 and rising gold prices thereafter.

What is less well known is how much metal Canada imports for further processing. Overall, Canada imports nearly $10 billion of metal ore. About one-third is gold. Starting in 2004 gold from Latin America that used to be shipped to the UK for refining was sent to Canada, which refines and then re-exports it to the UK. Last year, Canada’s gold imports reached $3.4 billion, up from $0.8 billion in 2003, while exports doubled to $5.4 billion over the same period. A further 15% ($1.5 billion) is alumina, used as an input in the production of aluminum, most of which is exported (at $9.5 billion, aluminum is Canada’s leading metal export). Another $1.5 billion is copper ore, much of it from Latin America to be refined and then re-exported.

Certainly, some ores are exported abroad for further processing. Examples include copper ore to Asia, iron ore to Europe and Asia, and nickel ore to Norway. The lesson to be drawn is that metal ore is processed in Canada when the economics justify firms doing so, irrespective of where it is mined.

Exports of other mining products also have grown even faster than metals in 2007. This mostly reflects soaring uranium prices and strong potash demand.

Farming and fishing

Agriculture and fishing have long been major components of Canada’s resource sector, and remain by far the largest employers in this sector.⁶ Still, low prices and supply disruptions (notably the moratorium on cod fishing and the ‘mad cow’ outbreak) depressed incomes for much of the last two decades, leaving agricultural exports the smallest in the resource sector for much of this period.

However, recently agricultural markets have improved sharply. Grain export earnings have jumped by nearly 50% since mid-2006. Compared with their drought-affected low in 2005, grain exports have nearly doubled in value in just two years.  The largest increase was for wheat, where prices hit a record US$9 a bushel. Still, at about $4 billion wheat exports remain well shy of their historic highs of $5 billion set in the 1990s.

Canola is the fastest-growing grain export. Just since 2002, it nearly doubled to a record $1.8 billion last year and is set to break that mark in 2007. Demand has been fuelled by the trend away from trans fats, which has seen a switch from hydrogenated oils to canola. And like metals, Canada has been moving up the value-added chain, exporting $900 million of canola oil last year. Total exports of all canola products now rival wheat as Canada’s largest agricultural-based export.

Figure 5

Not all of the new-found prosperity in farming comes from exports. Farm cash receipts from corn have increased 51% in the first half of 2007 from 2006, reflecting domestic demand for it as a bio-fuel (almost no corn is exported).

Fish exports have nearly doubled since 1990, despite the collapse of the cod industry in the early 1990s. The moratorium on cod fishing was reflected in a 22% drop in exports of fresh and frozen fish between 1990 and 1994. But the industry adapted in several ways. Most notably, it accelerated the switch from groundfish to crustaceans (such as crabs, lobster and shrimp) and molluscs, which remained in plentiful supply. Snow crabs have been particularly strong, briefly surpassing lobster in 2004 before falling back.

Figure 6

By the 2000s exports of shellfish had grown to over $2 billion, accounting for well over half of all fish exports and four times greater than their level in 1991. Other adjustments made by the fish industry include more aqua-farming of other species, notably salmon.⁷ This helped exports of fish other than crustaceans and molluscs to recover to $1.6 billion last year, almost equal to their pre-moratorium peak in 1990.

Forestry and hydro

Exports of forestry products peaked at $42.8 billion in 2000, and then fell steadily to an annual rate of $30.9 billion in the first half of 2007. This weakness reflects both lower prices (compounded by the rising loonie) and declining volumes for its three largest components—lumber, pulp, and paper. Exports for each of these three commodities are nearly one-third below their recent peaks, although each took a different path to its current low.

Figure 7

Paper products have shown the most persistent weakness among forestry exports. While the declines for lumber and pulp are con­centrated in short periods (leaving the hope for a rebound), paper demand has fallen steadily since 2001. Mostly, this reflects the unrelenting decline in newsprint demand from the US, down 47% since early 2001 as printed newspaper readership dwindled and formats shrank.  The ongoing shift of media platforms to the web shows no sign of slowing.

Wood exports exhibit the most variability, as cycles in US housing demand were compounded by the imposition of various duties and quotas in the softwood lumber dispute with the US. Despite these various disruptions, overall wood exports held up well, hovering at about $20 billion into 2005. Since then, the sharp retrenchment of US housing demand has steadily eroded exports. Compounding weak US housing were the rising loonie and supply problems (ranging from lower quotas in Quebec to the pine beetle infestation in BC).

The decline of forestry exports in absolute terms, while all other exports kept growing, has significantly lowered the importance of forestry products. Forestry had stood as high as 18% of exports in 1978. As recently as 1998, they were Canada’s largest resource export, ahead of metals, energy and agriculture. But by the first half of 2007, they trailed the other three: energy was the first to leapfrog forestry in 2001, mining followed in 2006, while agriculture surpassed forestry exports for the first time ever in 2007. As a result, the share of forestry products in total merchandise exports has slid from 10.8% in 1998 to just 6.5% so far in 2007.

Utilities have lagged behind the growth of other resource industries since 2000. This largely reflects slow growth in demand for hydroelectric power, especially from 2000 to 2004 when it posted no change. As noted earlier, the peak of electricity exports occurred in 2001, after which they receded quickly. Domestic distribution of natural gas by utilities has also fallen since 2000.

Output and jobs

Most of the recent growth in resource incomes has been driven by higher prices. Still, the resource boom has also been reflected in increased real output and employment in this sector. This section looks at production of resources in more detail, including why output in some sectors has been more responsive to higher prices than others. It concludes by looking at whether resources are more susceptible to the ‘boom-bust’ cycle than the rest of the economy.

In volume terms, output in the primary sector has not kept pace with the overall economy since 2002 (11.8% growth versus 13.7%). It has fared slightly better in terms of employment, with the primary sector growing marginally faster than the total (11% versus 9.8%). Implicit in these comparisons is that output-per-employee has been sluggish in the resource sector, a phenomenon we analyzed in considerable detail earlier this year.⁸

The largest expansion in output since 2002 has been in mining (outside of oil and gas). Non-metallic minerals drove the advance, up 27%. Initially, the increase reflected the continued development of diamond mines in northern Canada. More recently, output of potash has risen in response to high prices.

The turnaround for metals followed a decade of decline, unlike the repeated boom-bust movement of energy prices. Perhaps because of the memories of this protracted decline, investment and output in metals and minerals have been slower to respond to the boom than in energy.

Production of metal mines has fallen even as prices soared. The sluggishness of metals output reflects the exhaustion of existing ore bodies and the long lags in finding and developing new ones. Gold is the best example of the depletion of existing mines, with the physical volume of output down 50% so far this decade ever as prices hit a 28-year high this summer.⁹ Zinc output has also fallen steadily, while copper was down slightly. A spate of new investment plans (notably in Quebec and BC) may yet give a boost to output of these metals.

Output of some metals has risen after prices rebounded. Nickel is the best example, with output hitting a 30-year high after the Voisey’s Bay project came on-line. Despite several strikes, iron ore output has risen about 15% over the last two years, when strong demand from China’s steel industry sent prices to record highs. This follows three decades of decline, which left this industry only half the size of its 1979 peak.

The recent boom in metals prices has triggered higher investment. Since hitting a low of $1.5 billion in 2002 and 2003, investment in metal mines has topped $2 billion. However, despite the increase in investment, output has declined steadily. This is at odds with the experience in the 1990s, when increased investment resulted in higher output after about two years. This may reflect diminishing returns, as firms have to dig deeper or mine in more remote and less productive areas.

Figure 8

Production of oil and gas was also initially slow to respond to record high prices, with output essentially unchanged in 2003 and 2004 and into the first half of 2005. But since then, output has jumped nearly 8%. All of the increase originates in oil, which has expanded 13% since 2002 while natural gas has stalled.

These changes in oil and gas output reflect a number of factors. First, natural gas production has fallen from its record high in 2002. The drop reflects the declining productivity of the basins in western Canada and off Sable Island. The collapse of gas prices in 2006 accelerated this downward trend, with drilling down 40% between the spring of 2006 and 2007.

Second, the increase in oil output since 2002 has been entirely the result of the development of the oilsands, as output from conventional wells has receded. As a result, the oilsands share of all oil output has risen from 34% in 2002 to 46% so far this year. The bulk of this increase was driven by output of raw bitumen, which has a lower price than synthetic or light crude since it must be processed more. However, this price gap has shrunk since 2002, as more upgraders and refineries can handle lower grade bitumen. As a result, both the number of barrels of oil output and the constant dollar value have risen in tandem since 2002.

Figure 9

Are resources more cyclical?

It is often asserted that one of the downfalls of a growing reliance on resource-based industries is their ‘boom-bust’ nature. However, examination of output and export earnings yields an overall impression of stability comparable with the rest of the economy.

A comparison of the standard deviation (a measure of variability) of average annual industry growth rates in real GDP since 1991 shows that resources have a slightly higher variability of growth (2.1 versus 1.6 for total business sector GDP).  This is due largely to agriculture and utilities, where the weather helps push up their standard deviations to 5.4 and 2.7 respectively.  Mining is little different from non-government services (1.6 versus 1.5).  Interestingly, both construction and manufacturing exhibit more variability than non-farm resources.

Of course, real output may not reflect the variability of prices. However, the record shows that export earnings of most resources rarely decline on an annual basis. In the 35 years from 1971 to 2006, exports fell in only five for energy products and in six for agricultural and industrial goods (and some of these declines were marginal). This put them on a par for avoiding annual losses with machinery and equipment and other consumer goods, which each posted four years of decline. The auto sector and forestry products stand out as the most susceptible to yearly declines, with 9 and 11 respectively. Even then, nearly half of these declines for both autos and forestry originated after 2000, suggesting they reflect more structural than cyclical factors.

More formally, comparing the standard deviations of annual export growth reveals that resources are actually more stable than manufactured goods (machinery and equipment, autos and consumer goods). The standard deviation for resources since 1991 was 7.0, versus 9.2 for manufactured goods. The standard deviation was actually lowest for agricultural products (6.2) and industrial goods (7.1). At 11.6, forestry was only slightly above manufactured goods, which ranged from 10.8 for autos to 10.3 for machinery and equipment and to 9.2 for consumer goods. Energy products were the most variable, with a standard deviation of 20 points mostly due to their rapid growth since 2000.¹⁰

The ability of most large resource sectors to avoid declines reflects in part how the different components move to offset weakness in some sectors. The recent slump in natural gas exports, for example, has been masked within energy exports by the strength for crude oil. Similarly, the moratorium on cod fishing in 1992 was accompanied by a diversification into other types of seafood.

Conclusion

Driven by the historic surge of commodity prices, the Canadian economy has been re-discovering its resource base over the last five years. However, the growth of this sector has been anything but traditional. Oil output has shifted from conventional oil and gas to the oilsands. Precious metals are more dependent on diamonds, as gold mines are depleted. The fishing industry has switched from groundfish to shellfish in response to the near-exhaustion of some traditional species. Grain producers are moving from wheat to canola in response to changing consumer tastes.

This article has challenged several myths about Canada’s resource sector. Metals and energy products found underground now drive the growth of resources, not wood or water. And industries such as metals and canola are leaders in adding value here in Canada, rather than exporting raw resources abroad for more processing. Finally, the resource sector’s export earnings appear to be no more subject to the ‘boom-bust’ cycle than the rest of our exports.

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Notes