(….and how Greece could crash the world.)
By JC Collins
After the collapse of oil prices and home valuations in 1986 the oil sands mining town of Fort McMurray became a semi-desolate place of reduced expectations. One of the two mining operations went on strike and I remember the workers picketing on the highway near the site access.
As a teenager my friends and I would drive around an area we called The Dead Roads. The Dead Roads were a planned subdivision which had been under development when the collapse of 1986 happened. The roads had been built, the sidewalks and curbs set, and the utility services to the lots had been roughed in. But no houses had been built.
The price of oil had crashed from $32 a barrel to $10 a barrel in only a 4 month period. Many people lost their jobs with many of those leaving Fort McMurray and moving back to whatever place in Canada they had come from.
The Dead Roads were a place to take girls or gather for quick “tailgate” parties with loud music and strong Canadian beer kept cold in the snow bank. Nowhere in my mind at that age did I understand, or even consider, the macroeconomic effects on our microeconomic environment.
As the years went by the oil sands mining operations refined their methods of digging the ore from the earth and extracting the oil from the sand. Mine operations transitioned from a bucket wheel and conveyor method to a truck and shovel method which reduced the production costs dramatically. At the same time the macroeconomic environment was changing again and oil prices began to increase. By the mid-1990’s the oil sands mines were once more profitable and domestic and foreign investment was again attracted to the region.
The oil sands are unique in that they have a long deposit life, with many of the operations having a mining schedule of 40 years or more. Each mine lifespan will see multiple oil price cycles, and as such the industry can burden the downturns better than shale oil fracking, which has short life spans at each well.
Canada has benefited greatly from a real estate bubble and an oil bubble, both of which began to form in the latter part of the 1990’s and continued to increase leading up to the financial crisis of 2008. Both bubbles are characteristic of a credit bubble, or large expansion of the money supply, and only suffered a minor setback during the Great Recession, before continuing to increase again.
As investment poured into the region, housing prices in Fort McMurray soared alongside metro areas such as Vancouver and Toronto. The demand for workers in the oil sands skewed the labor market from the rest of the country and $200,000.00CAD annual incomes became commonplace.
With so many workers flooding the region, camps ready to accommodate tens of thousands of workers began to spring up around the edges of the mines. This shadow population, alongside the growing population within Fort McMurray, put a huge strain on the housing market and local infrastructure. As new mines were being developed and coming online, the Dead Roads were filled in, and new subdivisions began to be built. Homes could not be built fast enough and the demand put upward pressure on prices.
All the signs of a bubble were clearly visible, but for those in the middle of the racket, working and paying ever increasing bills, the forest could not be seen for the trees. Like the rest of Canada, personal household debt began to grow and those who were lucky enough to purchase homes when the bubble was small saw huge upward valuations. There were many who saw this equity for the illusion that it was, but many more did not. Home equity loans, or second and third mortgages, were taken out on homes which many had barely gotten into in the first place.
Super Duty pickups and Cadillac Escalades were a common site around town. Everyone had “arrived” in boomtown Fort McMurray and the music was never going to stop. “It’s too big to close” became the common expression heard around town. “It can never collapse because everyone, including the banks and CMHC, will lose” was also heard. But everyone failed to understand that Fort McMurray, and the oil sands, do not exist in a vacuum, and like 1986, there are macroeconomic factors which create severe leverage in the region and industry.
The expansion of the money supply, or explosion of credit, was an international event and most countries now have severe, and growing, personal debt and sovereign public debt challenges. Canada is second only to Greece in household debt growth. Between the years 2007 and 2014, both countries experienced the largest expansion of debt growth in the developed world. Canadian household debt currently sits at 162.6%, measured by debt to income.
Norway, and a few other of the European countries have a larger consumer debt ratio, but the growth of those numbers began to slow after 2007 and 2008. Canada and Greece continued to expand the level of consumer debt at ever increasing ratios, with Australia following close behind.
Greece, for its part, has found itself at the tip of the spear for the Eurozone sovereign debt crisis. The sovereign debt level in Greece is threatening to take the whole banking system of Europe down with it, as most Eurozone banks are carrying billions of euros of Greek debt. Back in 2012 Canada refused to agree with International Monetary Fund bailouts for the 17-nation European Union. But that was when oil was over $100 a barrel and there seemed to be no end in sight for the expansion of credit in the national and local economies.
Today, after the historic oil collapse to $40 – $50 a barrel, and set to go lower in the coming months, Canada is under direct threat from the sovereign debt crisis in Europe. The strength of the Canadian economy can no longer depend on a strong currency and high oil prices, and the exposure which Canadian banks and financial institutions have to the growing European contagion will weaken economic growth and prompt an avoidance of risk, which, until now, has been acceptable.
The level of consumer debt in Canada is the largest domestic threat, but the sovereign debt crisis in Europe and the crashing oil and commodity markets are the largest foreign threat. The relationship between Canadian financial institutions and the European banking system is both direct and indirect. Any collapse or systemic shock to the banking system in the Eurozone will cause further sovereign debt strains and affect the credit quality of bank loan portfolios.
This growing aversion to risk will create pressure on bank balance sheets which will lead to further tightening of lending conditions to both household and businesses. The reduced lending will decrease global and domestic growth even further.
The risk of a systemic shock creates a deeper avoidance to that risk, which begins to feed on itself as the broader international deflation increases and global demand decreases. This dual threat of sovereign debt and oil prices has created a situation where Canadian household income and wealth are under direct attack, both domestically and internationally.
It continues to spiral out of control as the systemic contagion spreads, increasing the expectation on banks to continue low interest rate policies, or lower them further, as the Bank of Canada recently did when it dropped the rate to 0.75%. The financial positions of life insurance companies and benefit pension plans are further eroded, which will contribute to the demand for additional household borrowing, ensuring the downward momentum is maintained.
As the EU crisis continues to intensify and spread across Europe (the current agreement between Greece and the EU will not change this course, only slow it down), and oil valuations decrease further, the spillover effect on Canadian banks and financial institutions will grow and reach disaster levels, leading to:
- Higher funding and higher markdowns on direct and indirect exposures.
- Major adverse impact on the Canadian economic growth.
- Increasing losses on domestic loans.
There are 3 systemic risk channels which the European debt contagion can spread to the Canadian banking system. They are:
- A decline in confidence and an increase in risk aversion will drive up the costs of funding for the banks, which will in turn decrease the availability of that funding.
- As assets begin to be marked down on large scale levels the incurred losses for the banks will further increase.
- A dramatic increase in non-performing loans will create more stress on the sovereign debt markets and further erode economic growth, both within the Eurozone and Canada, as well as globally.
It has been determined by the Bank of Canada, the International Monetary Fund, Deutsche Bank, and a consortium of other domestic and international institutions, that the Canadian real estate market is overvalued by anywhere from 10%, upwards to 63%, with the reality being somewhere in the 50% range, which would see levels returned to the year 2000 valuations, right around when the bubble was beginning to form.
The five big Canadian banks are exposed to the same form of high risk mortgages which almost took the whole American banking system down back in 2008. The Royal Bank of Canada is the most heavily exposed and it’s hard to imagine how the banks can address this threat when the extreme levels of consumer debt, and the eroding ability to service that debt, are beginning to crash into the immovable wall of collapsing oil prices and resource industry layoffs which are reaching into the tens of thousands, and beyond.
Add all of that to the European sovereign debt contagion which will spread into the Canadian banking system and the path to an economic ground zero can be clearly seen in the real estate market which has only just begun to tremble and shake.
Already 50% of metropolitan areas in Canada are experiencing real estate price reductions, with Fort McMurray leading the way, with reductions upwards of 17%. Based on information provided by the Fort McMurray Real Estate Board, the average sale price in 2013 was $625,000.00. In 2014 the average sale price was $600,000.00. And in the first month of 2015 the average sale price has dropped to $500,000.00.
That is an average sale price collapse of $100,000.00, in just January. As the number of new home listings continue to increase, and the number of sales decrease, we can expect to see even more dramatic price reductions leading into the spring months of April and May.
Often I think back on the 1980’s and growing up in Fort McMurray. Today the city has much more to offer. It is more family friendly and has developed infrastructure which is befitting of the growth which has taken place. There are world-class athletic facilities and the mine owners have begun encouraging employees to live and invest in the community.
But with the recent collapse in oil prices the industry has taken a hard hit. The cost overruns which have been built into the system over the last 15 years have now become the potential downfall of oil sands mining. Both mine owners and companies providing services to the industry have to come together and find ways to reduce the cost of production so that its oil can compete on the world market.
Whether both can rise to the occasion and make oil sands once more profitable is yet to be determined, but as someone who has both worked in the industry and lived in Fort McMurray, I feel extremely hopeful and encouraged by what I have seen in the last few months.
And yet, thoughts of the Dead Roads are never far from my mind.
The world has changed and the macroeconomic and microeconomic adjustments which are coming are unavoidable. The economic ground zero for Canadian growth is abstractly found in the collapse of oil prices, the bursting real estate bubble, and the systemic risk inherent in the direct and indirect relationship between its banking system and the European sovereign debt crisis. The level of Canadian consumer debt waits in the shadows for the next shoe to drop. – JC