Chapter

Chapter 8. North American Integration and the Energy Market

Author(s):
Roberto Cardarelli, and Lusine Lusinyan
Published Date:
November 2015
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Author(s)
Lusine Lusinyan, Tim Mahedy, Dirk Muir, Rania Papageorgiou, Andrea Pescatori and Fabiàn Valencia 

The economies of Canada, Mexico, and the United States have become increasingly integrated since the signing of the North American Free Trade Agreement (NAFTA) in 1994. Since then, North America has developed the most intensive set of trade relationships among the world’s main regional blocks, especially in the automotive, aerospace, and natural resource sectors (Baldwin and Lopez-Gonzalez 2013). The increase in vertical intra-industry trade integration has been particularly noticeable: one-quarter of U.S. imports from Canada consist of value added produced in the United States, while the figure is 40 percent for U.S. imports from Mexico (Koopman and others 2010).

Despite an already high level of integration, there is still scope for further deepening including through greater mobility of goods and labor, and further regulatory harmonization (for example, Scotiabank 2014 and Chapter 9). At the same time, all three countries have pursued aggressive policies of trade diversification outside the region, including through the Trans-Pacific Partnership Agreement, trade treaties with Europe, and energy-related arrangements with Asia.

The development of unconventional sources of energy in the region raises questions over the future of North American integration. Will the boom in unconventional oil and gas production lead to more integration of the three countries’ national energy sectors over time, or will it accentuate the recent trend toward trade diversification outside the region? Would the individual countries in the region be better off if the increasing energy production led to more integration between their national energy sectors? How would the benefits from greater energy integration be distributed in the region? And what would be the impact of greater energy integration on the international competiveness of national manufacturing sectors?

The answer to these questions depends on a number of factors that are still uncertain, including how the energy boom will evolve (given the uncertainty over oil prices, depletion rates, and extraction technology); how it would change energy production and consumption patterns within North America; and the broader implications the boom might have on growth and competitiveness across the region.

A closer integration of North America’s energy markets could secure energy independence for the whole continent, providing a cheaper and reliable source of energy to its consumers and producers. But the extent to which the gains will be allocated across the three economies will depend on several factors, such as the energy intensity of national economies and the degree of competition between the national sectors that mostly benefit from lower energy prices. On the other hand, a scenario where the increased supply of energy is exported outside the region could generate a smaller reduction in domestic oil prices, but also lead to a greater appreciation of national currencies, with more benefits for consumers relative to a closer integration of North American energy markets. This chapter discusses the implications of the boom of unconventional energy for North America’s economies and trade linkages analyzing the scenarios with and without further energy integration in the region.

The State of Energy Integration in North America

The energy sectors of Canada, Mexico, and the United States have become more integrated over time, with an intense exchange of oil, natural gas, and electricity between the three countries (Figure 8.1 and Annex Figure 8.1.1):

  • Oil—Canada exports about three-quarters of its crude oil production to the United States, and these comprise about one-third of U.S. oil imports (Natural Resources Canada 2014). While Canada’s share of the U.S. oil market has increased over the past decade, U.S. exports of crude oil to Canada have also risen since the shale boom in the United States. Canada imports half of U.S. exports of motor gasoline but also provides about one-quarter of U.S. imports of motor gasoline blending components. Over 70 percent of Mexico’s crude oil exports are destined for the United States (EIA 2014), although volumes have generally declined since the mid-2000s, reflecting the steady drop in Mexico’s crude oil production and rising fuel demand, as well as increasing U.S. supply. Despite being a large crude oil exporter, Mexico is a net importer of refined petroleum products and was the destination for nearly half of U.S. exports of motor gasoline in 2012–13. Overall, North America as a whole remains a net importer of crude oil and refinery stock, reflecting the large U.S. demand. High demand from Mexico (and, to a lesser degree, the United States) makes the region also a net importer of motor gasoline.

  • Natural gas—Mexico and the United States are net importers of natural gas. Over half of Canada’s natural gas production is exported to the United States, amounting to nearly 100 percent of U.S. natural gas imports and over 10 percent of U.S. total consumption. At the same time, the United States exported 6 to 7 percent of its natural gas production to Canada and Mexico, accounting for about one-third of domestic consumption in both countries.

  • Electricity—Electricity trade in the region is relatively small but increasing (EIA 2015), although the electric transmission systems in Canada and the United States are highly integrated (EIA 2012). Overall, the United States is a net importer of electricity from Canada, although the Pacific Northwest states of Washington and Oregon export part of their sizable hydroelectric capacity to Canada (via the Western Interconnection). Mexico has been a modest net exporter of electricity to the United States, but electrical interconnections between the two countries remain relatively limited in capacity.

Figure 8.1Energy Flows between Canada, Mexico, and the United States

Sources: IMF staff calculations based on data from the U.S. Energy Information Administration, International Energy Agency, and National Energy Board (Canada).

Integration of the energy industries, especially between the United States and Canada, goes well beyond the energy trade. In addition to an extensive network of interconnected pipelines and energy infrastructure, foreign direct investment and supply chains play a key role in national energy industries. In particular, there is the important presence of U.S.-based energy firms in Canada’s oil sands sector, along with a large network of U.S. suppliers who provide goods or services to the sector. The stock of foreign direct investment from the United States in Canada’s oil and gas extraction industry, including support services, more than tripled between 1999 and 2013 (Natural Resources Canada 2014). While some Canadian energy companies (such as TransCanada) are present in Mexico, and Mexico’s state-owned oil company, Pemex, is estimated to have about 100 Canadian suppliers (Dawson 2014), foreign investment in Mexico’s energy sector has until recently been constrained by constitutional restrictions on private investment into the sector. A successful implementation of Mexico’s energy reform could provide an important opportunity for a greater foreign presence in upstream and downstream services in the country (Chapter 4).

Increasingly integrated production chains across North America have resulted in stronger linkages between national energy sectors, and between these and other sectors, including manufacturing. In particular, the data from the World Input-Output Database, a detailed data set on intermediate consumption and production by sector among 40 countries covering 1995–2011, shows that:

  • Energy sectors—The NAFTA countries’ energy sectors used more foreign energy inputs in 2011 compared to 1995 (Figure 8.2). Over this period, the U.S. energy sector’s consumption of energy inputs from Canada and Mexico rose by almost 4 and 3 percentage points, respectively. The energy sectors of Canada and Mexico have also increasingly relied on energy inputs from the United States.

  • Manufacturing sectors—Linkages between manufacturing sectors in Canada and Mexico have strengthened since the mid-1990s, but remain small. While U.S. manufacturers have increasingly imported goods produced by Mexican and, to a lesser extent, Canadian manufacturers (Figure 8.2), the converse is not true, as Canadian and Mexican manufacturers have used fewer U.S. manufacturing goods in their production processes, especially transportation equipment (Annex Figure 8.1.2). The shift toward domestic suppliers in the transportation equipment sector is particularly striking in Canada, where it mirrors the decline in motor vehicle production (IMF 2015 and Chapter 6).

  • Energy-manufacturing sectors—Canadian and Mexican manufacturers have increasingly relied on U.S. energy inputs, which amounted to about 1 percent of their total intermediate consumption in 2011. This linkage was mostly absent in 1995. Furthermore, the share of Canadian manufacturing inputs used in the U.S. and Mexico energy sectors has increased. And while U.S. manufacturing gained further share in Mexico’s energy sector, it has become significantly less important in Canada.

Figure 8.2Mining-Energy and Manufacturing Sector Consumption of Intermediates by Country, 1995–2011

Sources: World Input-Output Database; and IMF staff calculations.

Still, despite progress in energy integration, persistent differences in energy prices across the three countries suggest that this process in the region is far from complete (Figure 8.3). For example, the pretax price for regular gasoline paid by households was the highest in Canada among the three countries since the mid-2000s, while Mexico’s low retail fuel prices reflected fuel subsidies until late 2014. Despite limited data availability, even larger price gaps seem to exist on energy product prices for industrial users, with a similar ranking across countries as for retail gasoline prices. And while the price paid for the natural gas in electricity generation has converged in recent years, the total (post tax and distribution costs) price in Mexico remains higher than in the United States and Canada.

Figure 8.3Pretax Price for Regular Gasoline

(U.S. dollars per tonne of oil equivalent net caloric value)

Sources: Organisation for Economic Co-operation and Development; and IMF staff calculations.

Some of the constraints to energy integration in North America were discussed in more detail in the individual country chapters of this book. Limited infrastructure capacity is a key constraint, but there are also many other factors relating to institutional and regulatory frameworks, which affect the degree of integration (see Chapter 9).

In Mexico, rising demand for natural gas brought the current pipelines to operate close to maximum capacity, while limited participation of private investment in the sector constrained expansion of the existing transportation infrastructure. By allowing private investment in the whole value chain in the energy sector, energy reform promises to alleviate this constraint. Major investment in pipelines will, in the near future, allow higher imports of natural gas from the United States and reduce the need to import liquefied natural gas from as far as Qatar and Nigeria.

In Canada, the challenge has been to transport oil to the U.S. refineries at the Gulf Coast that have been converted to process heavy Canadian crude oil. Indeed, greater competition with growing U.S. oil production for limited pipeline and refinery capacity in North America led to large and volatile discounts on the price of Canadian oil, adversely affecting Canada’s energy exports and investment. Recent enhancements of pipeline capacity to and from the U.S. refining center in Cushing, Oklahoma, have helped alleviate congestion at the refinery, narrowing also the price margin between Western Canadian Select and West Texas Intermediate.

At the same time, the energy and manufacturing sectors of NAFTA countries have become more globally integrated. Mining and energy inputs from the rest of the world have increased in all three countries since the mid-1990s, with the largest increase experienced by the U.S. mining-energy industry, for which the share of non-NAFTA inputs nearly doubled over this period. The United States and especially Mexico have also become more dependent on manufacturing inputs from non-NAFTA countries.

Greater energy production in North America may reinforce the trend toward stronger global integration. The example of Canada’s natural gas sector illustrates this point: Canada’s production of natural gas has significantly declined since the mid-2000s, the same time that production in the United States (Canada’s only significant export market) surged. Diversifying toward non-U.S. markets would likely be the main avenue for reviving the sector’s prospects and reversing the downward trend, which in turn would require building large-scale facilities close to the Canadian coast that could liquefy natural gas and ship it overseas.

Assessing the Impact of Energy Integration in North America

Increasing energy production in North America is posing new challenges for the future of energy integration in the region. With infrastructure capacity and heterogonous regulatory frameworks currently constraining deeper regional integration, the question is whether and how the rise of unconventional energy would change the process of regional integration. Market forces will ultimately determine whether national energy sectors become more integrated or whether diversification outside the region prevails, but policies matter, too.

A key policy decision that may affect the pattern of integration of North America’s energy market is whether the oil export ban in the United States should be lifted. Currently, the United States issues licenses for exporting crude oil solely for exports to Canada and Mexico and for re-exports of foreign-origin oil, although a few types of light crude oil are exempted from export restrictions. The sharp acceleration of energy production following the discovery of unconventional energy resources has fueled the internal debate on whether the restrictions should be lifted, and a bill that removes the restrictions was under discussion in Congress as of August 2015.

Those supporting the ban argue that exporting more oil abroad would raise gasoline prices in the United States and hurt both firms and households. Also, the fact that the United States still imports large quantities of oil means there is room for U.S. refineries to absorb higher domestic oil production, further reducing the country’s dependence on crude oil imports.

Those arguing for lifting the restrictions note that U.S. refineries are not in the position to efficiently process the “light” oil produced in the United States (as they are mostly geared toward refining the heavier crude oil produced, for example, in Canada and Mexico). They note that U.S. consumers would not really benefit from lower oil prices, as domestic gasoline prices track global market prices. On the contrary, international and domestic prices would fall if crude oil exports were allowed. Furthermore, opening sales to global markets by removing the ban on exports would be a major incentive to increase domestic crude oil production, generating considerable benefits for the overall U.S. economy as well as the manufacturing sector.

While in principle achieving tighter integration across North America’s energy sectors is not necessarily an alternative to strengthening their integration with the rest of the world, it is helpful to compare costs and benefits from two highly stylized models of integration:

  • Global integration scenario—Here, energy markets are perfectly integrated, such that any excess energy production in North America is freely exported to the rest of the world. The global energy market has full access to North American energy production, and energy prices are equalized across the world.

  • North American integration scenario—Here, perfect integration is reached only at the regional level, and energy prices are equalized across Canada, Mexico, and the United States. Relative to the globally integrated scenario, to absorb the increase in North American energy production, energy prices in North America have to be substantially lower. Because increased North American production will crowd out energy imports, the rest of the world will also have more energy available, and global energy prices would also fall, although to a smaller extent than in the globally integrated scenario.1

The two alternative integration scenarios are analyzed with the help of the IMF’s Global Economy Model (GEM) (Appendix 1). The use of a general equilibrium framework allows us to capture the impact of the energy boom on consumption, investment, energy prices, exchange rates, and external balances. A dynamic stochastic general equilibrium model—a six-region version of the GEM—is calibrated to represent Canada, Mexico, the United States, the euro area, emerging Asia, and the rest of the world. Energy plays a key role in the model, both as a production and a final good. For simplicity, the model contains only one tradable energy good, including both oil and natural gas.

The energy shock is captured as the difference between the high and low production scenarios discussed in Chapters 2, 3, and 4 (Annex Figure 8.1.3). These highlight in particular the following: (1) the increase in energy production is permanent in the United States and Mexico, but temporary in Canada, where it returns to its baseline value by 2034; and (2) Mexican production peaks permanently at 50 percent higher by 2027, much larger than the permanent peak in the United States (22 percent higher by 2025) and the temporary peak in Canada (12 percent higher in 2019).

As energy supply expands, the global price of energy falls in both integration scenarios. In the global integration scenario, energy prices decline for all countries by about 13 percent in the long term. But in the North American integration scenario, energy prices fall more—about 15 percent—in North America than in the rest of the world, where the decline is about 7 percent (Annex Figure 8.1.4).

In both scenarios and for all countries, lower energy prices are a negative cost shock for firms, equivalent to an increase in total factor productivity. Constraining energy flows within North America, as in the second scenario, would reduce regional manufacturers’ marginal costs of production relative to the rest of the world, serving as a larger positive total factor productivity shock than the first scenario. In this scenario, North American manufacturers would gain market share, both at home and abroad. However, the benefits from lower energy prices are not distributed uniformly across Canada, Mexico, and the United States, as differences in energy intensity matter for the extent to which each country would benefit. In particular, given that Mexico’s manufacturing sector is twice as energy intensive as Canada’s and three times more than in the United States (Figure 8.4), it benefits the most from lower energy prices achieved under the North American integration scenario.

Figure 8.4Energy Consumption by the Manufacturing Sector

(Percent of total intermediate consumption of the manufacturing sector)

Sources: World Input-Output Database; and IMF staff calculations.

Also, in both scenarios, greater energy production leads to an appreciation of the real effective exchange rate, as the unconventional energy boom increases a country’s real wealth, boosts aggregate demand, and puts upward pressure on the relative price of its nontradable goods.

In theory, global energy integration should increase North America’s welfare, as the region would be appropriating a higher share of world income by selling its greater endowment of energy resources to the rest of the world. How this windfall is allocated across the three regional economies would depend on their economic structure. For example, the country with a net energy export position would benefit relatively more from the transfer of income from the rest of the world. And the country with a relatively larger manufacturing sector would likely experience a bigger increase in GDP, as it would benefit relatively more from the lower cost of energy. A system of taxes and transfers available at a regional level would be able to redistribute wealth across countries (and the different sectors and economic agents within them), so that all of them benefit from global integration. In the absence of such system, it is not necessarily the case that global energy integration is a first-best solution for each of the North American economies.

The results of the model show that (see Annex Figure 8.1.4):

  • For the United States, the increase in real GDP does not differ significantly under the two scenarios. Under the North American integration scenario, U.S. manufacturers benefit from the competitive advantage from a stronger decline in energy prices, while consumers benefit from lower energy costs. However, the positive impact on real GDP from these two factors is offset by the relatively larger spillovers from lower real GDP in the rest of world (where energy costs, and consequently production costs, fall less than in the globally integrated scenario). The negative spillovers are greater in the United States than in Canada and Mexico, reflecting the stronger trade links of the U.S. economy with the rest of the world (about 70 percent of both exports and imports).2

  • Mexico’s real GDP (as well as consumption and investment) unambiguously gains under the North American integration scenario. The main reason is that Mexico’s more energy-intensive industries benefit relatively more from the lower energy prices in this scenario. Moreover, the greater decline in energy prices under the North American integration scenario translates into a relatively smaller wealth effect and therefore real effective exchange rate appreciation, which drags less on exports than under the globally integrated scenario.

  • Canada’s real GDP also gains in the short term under the North American integration scenario, but to a lesser extent than in Mexico, as the increase in energy production is smaller. In the long term, however, Canada’s real GDP is marginally higher in the case of global integration, as Canada’s energy production returns to its baseline level. Therefore, in the long run, lower energy prices under the North American integration scenario imply a greater negative wealth effect on Canada. Furthermore, Canada is negatively affected by the relatively smaller increase in consumption in the United States.

The real GDP gains under the two integration scenarios may not necessarily coincide with the gains in terms of income. Presenting the results in terms of “consumption equivalent” may be a better proxy for the welfare effects of the two models of integration than just real GDP, since welfare is increasing in consumption but decreasing in hours worked.3Table 8.1 shows that, relative to the low production scenario, the welfare gains for the United States are marginally greater under the global integration scenario, as the wealth gains from exporting energy outside of North America at higher prices more than offset the positive impact from increased manufacturing production. For Canada, lower energy prices from greater energy production in North America imply a welfare loss in both scenarios (largely as the baseline already builds in a strong increase in domestic energy production), but the loss is smaller in the global integration scenario. On the contrary, the welfare gains for Mexico are greater in the North America integration scenario, as was the case for the real GDP. Intuitively, the welfare gains from exporting energy at higher oil prices in the global integration scenario do not fully compensate the welfare losses stemming from a less competitive Mexican manufacturing sector under this scenario.

Table 8.1Energy Integration Scenarios(Percent deviation from the low production scenario in the long term)
Real GDPConsumption Equivalent
Global integration scenario
Canada0.4−0.3
Mexico4.56.7
United States1.22.2
North American integration scenario
Canada0.3−0.4
Mexico4.87.5
United States1.22.1
Source: IMF staff estimates.
Source: IMF staff estimates.

Conclusions

The process of trade and economic integration that started with NAFTA about two decades ago has made North America the largest trading block in the world. The boom in unconventional energy production is promising to provide a new impetus to regional integration, but it may also reinforce recent trends toward greater trade integration with the rest of the world, especially if regional infrastructure limitations persist.

The potential economic implications of the two distinct models of integration discussed in this chapter suggest the United States is not better off in a world where regional energy integration is pursued at the cost of maintaining barriers to more integration with the rest of the world. As a result, our simulations do not corroborate the economic case for maintaining the crude oil export ban in the United States. Interestingly, while the same conclusion holds for Canada, Mexico seems to be the only country of the three that could benefit from an extreme scenario where perfect integration is reached only at the regional level, reflecting the greater competitive advantage that its industry would derive from lower energy prices in this case.

Annex 8.1. Supplementary Figures

Annex Figure 8.1.1Composition of Energy Exports and Imports, 2012

(Share of total energy/heating value-based exports and imports)

Source: International Energy Agency database.

Annex Figure 8.1.2Intraindustry Linkages in the Transportation Equipment Sector

Sources: World Input-Output Database; and IMF staff calculations.

Annex Figure 8.1.3Energy Production Scenarios to 2025

Source: IMF staff estimates.

Note: Low-production case corresponds to the baseline scenarios for the United States and Canada and the non-reform scenario for Mexico.

Annex Figure 8.1.4Increase in North American Oil Supply

(Percent deviation from the lower production scenario unless otherwise indicated)
(Percent deviation from the lower production scenario unless otherwise indicated)

Source: IMF staff estimates.

In the model, segmentation is introduced as a price wedge being cut on oil prices in Canada, Mexico, and the United States. This implies their domestic demand will rise, driving down imports. Relative to the globally integrated case, energy exports will be lower, as energy is not as cheap outside North America, dampening foreign demand for oil from North American countries.

Note that the results here for the United States differ from that of Chapter 2, in that the segmented market here does not provide an obvious additional benefit. The primary difference is the addition of the oil production shocks in Canada and, in particular, Mexico. Since the lower oil price now extends to two of its largest trading partners, Canada and Mexico, some of the gains from trade with Canada and Mexico are also lost, relative to Chapter 2.

“Consumption equivalent” is the amount of household consumption which, holding labor supply constant, matches the level of utility households would achieve by their standard choice between labor supply and consumption.

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