Speaker 1:
On March 17th, BMO hosted a timely discussion about the outlook on oil prices, financial markets, and the impact on growth in the US and Canada, as well as asset allocation. Featuring a panel of BMO experts, the conversation explored the market and economic impact of the conflict in the current environment and factors that could help stabilize market volatility as the situation evolves.
Speaker 2:
Welcome to Markets Plus, where leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes.
Camilla Sutton:
Welcome everyone to our BMO digital event on the Middle East conflict and how it is likely to impact US, Canadian economies, energy markets, and the broader markets. I'm Camilla Sutton, Head of Equity Research for Canada and the UK here at BMO Capital Markets, and I have two of our best experts joining me today to provide some clarity on the events, how they're unfolding, and how they see them unfolding from here. But first of all, we have Doug Porter, MD and Chief Economist at BMO. And we also have Randy Ollenberger, MD, Oil and Gas Analyst at BMO Capital Markets. Thank you both, Randy and Doug, for joining us today.
Randy, why don't we kick it off with you? Maybe you can help us set the stage a little bit here. Markets have been volatile but functional, and maybe less volatile than some would have expected, while headlines have been relatively confusing. Where are we from an energy perspective with the Middle East conflict, the Strait of Hormuz, the release of barrels from the SPR and energy markets generally?
Randy Ollenberger:
Lots to unpack there, Camilla, and as you said, the market's evolving not only day by day, but minute to minute here. I think you need to step back and recognize, what we're seeing here is really the biggest shock to the oil market since the 1973 oil embargo. This is a big event, and despite that, we're not really seeing, I think as much upward momentum in oil prices as you might expect given the size of this event. So just to put this in context again, the Middle East region produces about 26%, or 26 million barrels a day, of oil production. The Strait of Hormuz accounts for 20% of global oil and product movements and 20% of global LNG movements. So this is a big deal. And the strait has effectively been shut down since the invasion started. There's been a trickle of tankers move through. Normally there's 60 tankers that move through every day. We're likely seeing more like one to five.
And so this is having a big impact on the oil market, and it's going to continue to have a big impact on the oil market, as well as product markets in LNG. I think one of the things we've yet to see is the impact in the physical market. So if a tanker is loaded in the Persian Gulf, it takes about 21 days, or three weeks, to move over to Asia and to some of these other markets. And so if you think about it, the conflict is less than three weeks old. So a lot of the tankers at sea on their way to end use markets right now are full of oil, full of products from before the conflict started. As this conflict drags on, we're really looking at a bit of a gap in that physical market.
So next week, the week after, we're going to start to see some real material physical shortfalls in the oil market, and we think that that could start to drive oil prices higher. Now, of course, headlines are going to continue to buffer the oil market. If President Trump releases a statement on social media saying it's over, you might see oil prices trade lower, but I think it's important to recognize here that this has had a big impact on the oil market and will take time to untangle.
Camilla Sutton:
Thank you for that, Randy. Doug, why don't we move to you in terms of setting the stage and the big picture in economics? Does the current shock materially increase the odds of a growth slowdown in the US and/or Canada? Does our starting point and from where we were in the economy and our energy independence actually buffer some of that? And maybe as you do that, if you can just layer in your base case for where you see growth, inflation and interest rates moving.
Doug Porter:
The short answer is it definitely increases the risk of the slowdown. Just starting off with some really rough rules of thumb that I think still very much hold water, is that every 10% rise in oil prices, more or less pushes up North American inflation by about two-tenths of a percent, and it tends to shave US growth, and ultimately Canadian growth as well, I think, by about a 10th of a percent. So very roughly speaking, we've been basing or changing our economic forecast on an average oil price this year of about $75. Certainly given that today's is $95, you could definitely make a case that we might end up with a full year average somewhat higher than that. But you can back out the percentage changes.
And at this point, we have started to adjust our forecast. We're doing it on a step-by-step basis, depending on what unfolds in each and every week. We try not to change the forecast every week. But up to this point, what we've had to do is bump up headline inflation in both Canada and the US by about a half a percentage point. So heading into this, we thought inflation would average around 2.5% in both Canada and the US. And now we're close to 3% on the US and just a wee bit below that in Canada for this year. And to be clear, through this spring, when we believe that oil prices will be peaking and gasoline prices will be peaking, you're easily going to get headline inflation that's going to move above 3%. It could even test 4%, in the US at least. At the same time, we've also begun to chip away at our growth call.
Now, to answer your question is, was there enough buffer? Starting with the US, I definitely think there was enough buffer. Even though the economy slowed late last year when we got a bit of a disappointing read on US GDP at the end of 2025, the economy still grew by just a little bit more than 2% last year. We thought we were headed for about 2.5% growth in the US this year, partly because of some of the budgetary moves and also because of just the AI spending boom. We have slightly reduced that. We now think the first quarter is going to be a little bit weaker. We're also chipping away at the second quarter as well, but we're still looking at growth of a bit better than 2% in the US, at least up to this point. Just to put that in perspective, a typical year for the US economy over the last 20 years has been real growth of just a little bit above 2%.
We were coming into this year thinking we were going to have a bit of an above average growth year for the US, and we've scaled it back now to being about average. In Canada, somewhat different story because we're not really benefiting from much of the AI spending boom, and also the outlook is being weighed on by the uncertainty surrounding USMCA. So we came into this thinking the Canadian economy was going to have a below average growth year, closer to 1.5% or even a little bit below that. We've since shaved that to close to 1%, partly because the economy came into this year with no momentum. We actually saw a decline in fourth quarter GDP in the first couple months of the year, or even before the conflict broke out, we're looking very soft in the Canadian economy. So now at best, we think we'll grow by about 1%. To put that number into perspective, a typical year for the Canadian economy in the last 20 years has been growth of just a little bit less than 2%. It was starting off below average and we've since reduced it from that point.
Just in terms of what it means for interest rates very briefly, I know we'll get more into this in a moment, one of the big market moves we've seen ... Randy suggested that the markets hadn't really responded that much, and that's true. The one area where we had actually seen quite a response is in the bond market. Right across the curve, we've actually seen quite a step-up right from twos out to 10s in both Canada and the US. It's backed off a little bit this week, but looking at, say, the very important five-year yield in Canada, it's up about a quarter of a percentage point since before this all began since the end of February. And so the general move has been to push yields higher on the view that the central banks have less room to cut interest rates in this environment.
Camilla Sutton:
Doug, you're right, we've got a lot more to dig into there. But before we get into that, Randy, let's switch to you for a quick second here. Do you think, are markets treating this as a temporary supply shock still, or are we really starting to see it get priced in more as a structural geopolitical risk for the future in energy?
Randy Ollenberger:
I think the initial market reaction, if you think about the first week here, was that this is temporary. This isn't going to last very long. The US is going to back away. They're not going to want to see rising oil prices heading into US midterm elections. So I think the consensus view was this is going to be short-lived. As we moved into the second week, I think there was a growing recognition that maybe this isn't going to be the case. And then even in week three here, I don't think the markets fully understand how long it will take to disentangle this. As I said, we had about 20% of oil moving through that straight. Right now, there's a trickle. Some is being redirected through a pipeline to the Red Sea, and so tankers are repositioning over to the Red Sea, but that again, it takes time.
And so we're going to look forward here and see a big drop in inventories globally. That's going to have lasting impacts over the balance of the year. And already in product markets, we're seeing product prices in different markets around the world at $150, $160 a barrel. Normally, the spread between these product prices and oil prices is less than $10. And so there's a really big gap here, and I don't think the market has really caught up to the fundamentals. I think the product markets are really more reflective of the fundamentals. I think announcements like we saw last week by the IEA, they're going to release an unprecedented 400 million barrels, the initial reaction to that is, "Well, that's going to solve this problem." Well, it's not. We have a physical shortage of probably 10 to 12 million barrels a day in the market. That inventory release is probably 2 million to 3 million barrels today.
So this is going to have some lasting impacts that I don't think are fully reflected in the market today. I think we're going to start to see those reflected in the coming weeks as we start to see those physical shortages emerge.
Camilla Sutton:
Doug, let's turn to you and dig a bit deeper on the economy. So when you see an oil shock like this, particularly in terms of the magnitude of it, does it change how the Fed and the Bank of Canada really think about interest rates? Does it change their reaction function or do they just look through it? And I guess as a follow-up to that, are there other financial conditions right now that are at play that are either tightening or loosening financial conditions, so in a sense, working against the central banks?
Doug Porter:
Yeah. And first of all, a supply shock like this is a challenge for central banks. It basically can put upward pressure on inflation and downward pressure on growth, and it is not at all obvious how a central bank should respond to this. Now, the one thing I will say is, we are in a bit of a different situation than we were four years ago when we had another, some would say maybe not as serious, but in some ways it was every bit as serious, oil shock when Russia invaded Ukraine. That one lasted pretty much a year. We did see oil prices go above $120 at one point. The difference between now and then is we're coming into this with milder core inflation than we did four years ago.
I think many folks think back to that episode and think that's what really caused the inflation. That's not really the case. We had a very serious inflation issue even before Russia invaded Ukraine and made a bad situation worse. And just to put in perspective, heading into that, underlying or core inflation in Canada was about 4% and rising. In the US, it was 6% and rising. This time, it's close to 2% in Canada, about 3% in the US, and if anything, fading. So central banks are in a somewhat better position to look through this. If you think back to four years ago, we were starting off with really low interest rates following COVID. We'd had some real inflation in the prior year and we were having supply shortages in all kinds of different goods around the world. And central banks basically had to respond to it almost immediately.
As it happened, the Bank of Canada and the Fed both actually raised interest rates within weeks of Russia invading Ukraine. I don't think that's going to happen this time, because we're not starting off with rates at exceptionally low levels and core inflation is not high and rising in this case. I do think the central banks can, so-called, look through this. In a normal situation, that's what they like to do, is basically just sit on their hands and do nothing. Because if you cut rates, what you're going to do is inflame inflation. And if you boost rates, you're going to hurt an already weakening economy. So really, the best prescription is to do nothing, to do no harm. And I think that's the most likely course of action by both central banks, is basically to stand aside through the first half of this year. Now, the second half of the year may be different, but I do think that what we're likely to see is, because core inflation is not raging in either economy, they do have room to basically stand aside and look through this.
To answer the second part of the question, are we seeing other areas of the market that are doing some of the tightening for them? The short answer is yes. For instance, we have seen that backup in bond yields. And as I mentioned, the five-year yield in Canada has risen by a quarter percentage point. That's an important yield. It does tend to drive mortgage rates. That alone would lead to some tightening. We've also seen the US dollar strengthen almost across the board. It's roughly flat against the Canadian dollar, by the way, since this has begun. But the US dollar has strengthened. That does tend to dampen import prices. It also tends to act as a bit of a tightening. And of course, we have seen a bit of weakness in equity markets.
I think maybe the surprise to many has been how calm the equity markets have been up to this point. But at the margin, we've seen a small decline globally, which again, tends to act as a dampener. So all those major market moves have done a little bit of the work for the Fed, the Bank of Canada for them, in terms of dampening financial conditions.
Camilla Sutton:
So when we think about Canada and the US specifically then, does a shock like this increase the odds that we're going to see policy divergence, so the Fed moving one way and the Bank of Canada moving another way?
Doug Porter:
Slightly nuanced answer to that question. I think we already had a divergence on our doorstep even before this began. Technically, yes, the market has a divergence built in over this year. Actually, if you look at the pricing as we speak, it's still clinging to one Fed rate cut this year. Whereas on the other side of the coin, they've actually got the Bank of Canada hiking rates by a quarter by the end of the year, which by the way, I think is completely off the mark. We can get into that if you like. I simply do not believe the Bank of Canada will be raising interest rates this year for a variety of reasons. But yes, technically the market does have a divergence in policy built into it.
Now, has this shock caused that? Not really. Even heading into this year, we had a really big difference between what the Fed was going to do and what the Bank of Canada was going to do. The conventional view at the start of the year was the bank was going to do nothing and the Fed was going to cut two to three times. So we already had quite a divergence between the Fed and the Bank of Canada. I don't think the shock really changes the difference in terms of how much central banks will cut, because the inflation impact ends up being pretty similar to the two economies. And if anything, at the margin, it's probably slightly less negative for growth in Canada, just because Canada's such a large producer and exporter, that it's not quite as negative for the Canadian economy as it might be for the US economy. So overall, I don't really see it widening the gap in terms of what the Bank of Canada and the Fed would do this year.
Camilla Sutton:
Well, you opened the door to it, so why don't we dig a bit deeper into it then? Why do you think there's almost no chance that the Bank of Canada actually increases rates later this year?
Doug Porter:
Okay, first of all, when you think about it, we're still dealing with the cloud of the USMCA uncertainty. Now, yes, if we miraculously reach a deal by midyear or a little bit thereafter, then I think we can start talking about the possibility of the bank considering a rate hike. But that's a really tall hurdle to get over to get an acceptable deal on the USMCA. My working assumption is we are going to be dealing with this uncertainty on the USMCA right through this year. Keep in mind, one option is to review the USMCA each and every year. Second of all, just the underlying backdrop. We just had an inflation report yesterday from Canada. The three-month trend on core inflation is about 1%. Most of the major measures at core are at the Bank of Canada's target, no worse. There's nothing there suggesting that Bank of Canada should hike rates.
On top of that, we've had next to no GDP growth in the past year, and we've had no employment growth. We just had one of the weakest job numbers that we've ever seen outside of a recession for February when the economy lost more than 80,000 jobs. That is not an economy the Bank of Canada wants to be hiking interest rates into.
Camilla Sutton:
Thank you for that, Doug. Randy, let's switch back to you, something you started on. Well, let's dig a bit deeper into it. We've seen some stress emerge faster in some of the refined product areas faster than what we've seen in crude itself. What does that tell us about where the real bottlenecks are, and how should investors think differently about product markets versus headline oil prices?
Randy Ollenberger:
Yeah, we always believe that product markets actually lead oil prices. Now, if you look at the oil price movements we saw in 2008 as an example, when oil hit $145 in July of 2008, it actually followed diesel, which hit $180 in June of 2008. So product markets tend to have a bit of a leading relationship with oil prices, because at the end of the day, that's what the world consumes, is products, gasoline, jet fuel, etc. It doesn't consume crude oil. And so what we're seeing is these bottlenecks emerge, these shortages emerge in product markets, not only because there's less oil flowing into the market, but because there's less products. The Persian Gulf exported 4 million barrels a day of products principally to Europe. And so what we're seeing are these product markets emerge very rapidly, and we think that that's going to lead to higher oil prices, as I mentioned.
It also obviously means for consumers, higher prices at the pump as both of those shocks flow through the system. So consumers might look at this and see oil prices moving up 10% and see gasoline prices moving up twice that, and really what it reflects is there are shortages in both markets.
Camilla Sutton:
From your lens then, maybe you could highlight two or three of the key tells that volatility is genuinely easy.
Randy Ollenberger:
What we would like to see, I suppose, is some stability in inventories, some stability in product markets. When we think about leading indicators, we get weekly data points on inventories courtesy of the US government. We get daily and minute-to-minute indicators in product markets when we look at the refined petroleum product prices. And so what we'd be looking for is some easing in product prices, some easing in the stresses on inventory, so inventory is not dropping precipitously, starting to stabilize. And I think that that could set the stage for a more stable oil price environment coming out of that, and less volatility. But as we sit here today, volatility is still the watchword. We don't know what direction we're going to see in terms of the conflict, whether it's going to escalate, deescalate. And as I said, we've yet to see really those big impacts on product markets in terms of inventories rapidly coming down, which we think we're going to see in the coming weeks.
Camilla Sutton:
And so let's just pretend like even if the conflict were to end tomorrow, you've talked a bit about how physical markets for the rest of the year have probably changed and that there's probably some scar effects. Can you just walk that through from an investor lens?
Randy Ollenberger:
Yeah. So if the conflict ended tomorrow, we'd see a resumption of tanker loadings in the Persian Gulf. That's going to take some time. There's been a little bit of damage to infrastructure, so we have to take that into consideration. There has been some damage to refineries in the UAE and Saudi Arabia, but not extensive, but it will have a bit of an impact. And for example, if the conflict were to end tomorrow, we'd basically have a three-week gap where there were no tankers moving. And so we're going to have a period of time, say three weeks from now, where there isn't enough products on the market.
Now, the inventory releases from the IEA member countries could help soothe some of that at the same time because those inventories are already in end use markets, but there's going to be a bit of a gap. So oil prices would remain elevated for the next month and a bit, for sure. But depending on how the conflict ends, we could see an ongoing geopolitical risk premium in oil that keeps oil prices elevated. So coming into the conflict, the main narrative was that there was far too much supply in the market and we were going to be building inventories at about 3 million barrels at 82 the first quarter. That is completely off the table. There will be no inventory builds at all this year. There will be inventory draws. And so we're not going back to that $60 or $65 oil price environment. We're going to be looking at a higher oil price environment coming out of this for the balance of this year. And then heading into the subsequent year, it really will depend on all these factors. Is there relative peace in the Middle East and so forth?
So still a lot of moving parts here, but we think oil prices will remain elevated for at least the next couple of months before easing back, but nowhere near to the level they were prior to the conflict.
Camilla Sutton:
And same thing with LNG?
Randy Ollenberger:
Yeah, so LNG here is going to be interesting. Europe typically has to refill storage up to 90% of capacity by the start of the winter. They didn't do that last year. The EU granted a waiver with the idea that they could refill our storage levels from LNG more cheaply this summer. Now, of course, with those disruption in LNG facilities ... Qatar has actually set down their LNG facilities, and that will take weeks, if not months, to recover in terms of start those facilities back up again and start loading tankers again. And so what we're going to see is elevated natural gas prices in Europe, really right through the summer, and that's going to have some negative repercussions for, obviously, Europe. And it could pull up North American gas prices a little bit, but North America is still oversupplied, generally speaking, and so we do have a bit of a disconnect with global markets.
Camilla Sutton:
We've already covered a fair bit of ground, so maybe what makes the most sense here is just to turn it over to both of you and close out with some of the thoughts and some of the most important key takeaways you think it is. If you were an investor thinking about markets and thinking about energy markets in particular, what would be your leaving thoughts? Why don't we start with you, Doug?
Doug Porter:
Sure thing. And of course, the reason why we keep doing these every week is because oil, of course, is the most important commodity in the world. It goes way beyond just the product prices. It will have an impact on food inflation as well, unfortunately. But what really matters ultimately for the economy, for the markets, and I think we've talked about this a number of times, is first of all, how high do prices ultimately get and how long do they stay there? How long does this last? That's still to be determined. The market, of course, has its view. It generally sees those prices coming down pretty abruptly through the second half of the year and then getting back close to pre-war levels throughout 2027.
I think we have to accept the reality that it's quite possible that we're not looking at something quite that friendly. And this is basically how we're handling it is looking at a variety of different scenarios, weighting them, and then try to adjust our forecast accordingly. I think at the very least, I think the steps we've taken are appropriate. We do see a little bit of upward pressure on inflation. It's manageable, but we are probably going to be looking at something closer to 3% inflation this year in both Canada and the US. And on the flip side, it probably does tend to shave growth, at least in the first instance. And of course, if prices stay at these kind of levels for much longer, it's going to keep chipping away at growth as we go through this year.
The good news is we came into this conflict with inflation, I wouldn't say completely well-contained, but it was close to the target in both Canada and the US, especially in Canada. And growth was relatively healthy, especially in the US. So we had a bit of margin for error. But it is an unfortunate, as I said, double-headed shock for the economy. And then it pushes up inflation and it does tend to reduce growth. Not a great combination for central banks, or frankly, for financial markets.
Camilla Sutton:
Not a great combination indeed. Thank you for that, Doug. Randy?
Randy Ollenberger:
Yeah, I think the key takeaway here is to really recognize that we probably haven't seen the peak in oil prices yet. We are going to see some stronger pricing here, and there are some lasting repercussions here that will keep oil prices elevated for longer. Now, investors are, logically, reluctant to capitalize these higher oil prices into equities. But I think it's important to recognize also that these high cash flows coming in the door for a month, two months, do have a significant impact on balance sheets transferring from debt to equity. So, lowering debt levels and really increasing equity values. And so there is some lasting impacts here that need to be reflected in the equity valuations here. And if we were to simply take the current strip, we're looking at free cash flow yields for oil and gas sector that are double digits. So we still think there's some very good value here as the market is underestimating really the impact of high oil prices on balance sheets, but also really probably the duration of elevated prices.
Camilla Sutton:
Thank you, Randy. Very helpful. Well, Randy, Doug, thank you very much for joining us today. You're both very measured experts in a time where we see a lot of different headlines and the markets are volatile. So very much appreciate you being able to join us today. And to our clients, thank you for taking time out to join us. I hope you found our discussion insightful and useful and informative. If you have questions, you can reach out to your salesperson or BMO contact. They'd be more than happy to help you. Thank you everyone for joining us today.
Speaker 2:
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Speaker 1:
The views expressed here are those of the participants and may not necessarily represent those of BMO Capital Markets, its affiliates or subsidiaries. For BMO disclosures, please visit bmocm.com/podcast/disclaimer.
