Response to the US Tariffs Levied on Canada and Mexico

 

Since President Trump’s sweeping electoral victory in November, his advisors made it clear that he would break from past precedents on the use of tariffs. Rather than seeking to rectify trade imbalances, the second Trump administration would use tariffs to achieve pressing foreign policy goals and essentially operate as de facto sanctions. In the Trump World view, a clear benefit of using tariffs versus sanctions is that it does not accelerate the global de-dollarization trend in pursuit of important policy priorities such as curbing cross-border fentanyl flows and migration. Additionally, in our view, the unwinding process for tariffs can be more straightforward than with sanctions, which are often backstopped by or originated in Congress, giving the White House a freer negotiating hand.

 

However, for the tariff targets, the exit strategy can be far more challenging, as the White House has yet to establish clear, quantifiable metrics for success on these policy fronts – which makes calling the duration of these tariffs difficult. A very public deliverable appears to be the best way for a nation to ameliorate the Trump tariff threat. In the case of Colombia, a quick policy reversal allowing deportation flights staved off 25% across-the-board tariffs. Venezuela looks like it may also forestall new punitive measures by agreeing to release American detainees over the weekend and signaling a willingness to repatriate thousands of its nationals who have illegally entered the US. Given the strong anti-Maduro sentiments in Congress, particularly amongst the South Florida delegation, it is not certain that Venezuela will escape unscathed, but the recent actions around American detainees and migration seem designed to address core Trump concerns.

 

While we are not ruling out a relatively swift resolution to the US trade dispute with Canada and Mexico, it is unclear if either have an immediate policy prescription on hand that would result in the unwinding of the 25% tariffs on their US-bound exports, which were imposed under the little-used International Emergency Economic Powers Act (IEEPA). In addition, since this is a nontraditional trade dispute, it is not clear which US officials will have the most sway on the matter. Will Deputy Chief of Staff Stephen Miller and Commerce Secretary pick Howard Lutnick be equally weighted voices, or will the former prove to be the more important principal in this Oval Office conversation, as he already oversees large parts of President Trump’s agenda?

 

Negotiations are ongoing on border security, as are efforts to combat the fentanyl trade, including Canada’s proposed $1.3bln CAD in border patrolling efforts. Nonetheless, the White House has not clearly defined what constitutes success on these fronts and will result in a tariff policy reversal. The fact that the outgoing Canadian Prime Minister Trudeau has difficult personal dynamics with his American counterpart, as well as President Trump’s comments around Canada being the 51st state, further complicates the dealmaking effort.

 

Some key Canadian energy corporates also likely have good lines of communication into the White House through staff members who served in the previous Trump administration. We envision that these individuals will continue to press the case for Canadian energy in Washington. Nonetheless, the broader US-Canada trade standoff looks set to deepen for now even if energy has been granted something of a special situation status, with Ottawa already announcing retaliatory measures on $30bln worth of US goods.

 

Unlike the case with Canada, Mexican energy was not granted a reduced tariff level and will be subject to the same 25% rate as all other exports. Based on our conversations in Washington, President Sheinbaum got off to a rocky start with President Trump, but was able to repair some of the damage during follow-on conversationsthat occurred in English without the use of a translator. President Sheinbaum has already taken some steps to reduce the flow of migrants and fentanyl at the border, including stepped up security actions against cartels and policies designed to curb the flow of non-Mexicans towards the US border. However, President Trump’s apparent request that Mexico repatriate nonnationals could prove an obstacle in upcoming negotiations.

 

Finally, China may actually have an easier road ahead than Mexico and Canada. There may have been a determination that the economic cost of a full-blown trade war with Beijing may be too calamitous. In addition, in our meetings in Washington, it was suggested that China may be able to placate President Trump by offering to make a sizable purchase of US goods, including aircraft, soybeans, and natural gas – LNG in particular may feature, given the President’s early actions on LNG approvals and declaring an energy emergency. In return, China might seek to extract a pledge that the US will not intervene in a China-Taiwan confrontation. While such a pledge might rattle some members of Congress, it would potentially align with the increasingly ascendant JD Vance view that the US needs to pare back its overseas military and financial commitments.

 

Commodities in the Crosshairs

 

Oil Impact

Out of all the places that the Trump administration could have shown restraint, Canadian energy was likely the optimal choice. Looking at the potential profitability impact scenarios on this page, a 25% tariff on energy imports would have likely been enough pressure on profitability that physical disruption would have been highly likely. At 10%, pricing offsets are more manageable, and likely will not require a significant overhaul to physical flows. If margins were to have been squeezed harder, there is some room to rearrange flows north of Cushing to a degree. That being said, the level of potential run cuts and suboptimal economics would have caught up with regional refined product pricing, which would have also likely come with political pressure at the gas pump. If we are using 4Q’24 as a benchmark for net margins, the same level of profitability could be achieved for a Midwestern coking refinery with a 4-6% increase in refined product pricing, and WCS-WTI spreads between -$14 and -$16/bbl, assuming a 10% tariff. While we should start to see seasonal upside pressure for gasoline prices, incremental upside from energy tariffs alone is likely ~$0.15/gal. PADD 3 is much less reliant on Canada and Mexico in terms of total refinery throughput, and PADD 1 refined product flow impacts might result in some localized strain for select customers. Displacing Mexican crude oil: In terms of replacing heavy sour oil from Mexico, aggregate crude exports are already down to 600 kb/d in January (-300 kb/d y/y). As Mexican exports have declined, the US has been increasingly sourcing more crude from Latin America. The displaced heavy sour crudes will likely find homes in Asian markets (Maya crude exports to the US have already dropped below 200 kb/d in 4Q’24), while Isthmus could potentially get additional bids into Europe at an accommodating discount. This is all incrementally positive for continental heavy sour crudes, which should remain tight, and we would expect most of the aggregate price impact to be on quality differentials as opposed to outright spot prices. That being said, incremental broader tariff risk is growing, which is likely the more important narrative, especially given the softer backdrop for refined product markets.

 

Natural Gas Impact

The 10% tariff on energy is still disruptive (versus 25%) to the highly integrated natural gas market in the North America, where the US is both a vital supplier and consumer of natural gas via a highly integrated pipeline system between the US, Canada, and Mexico. The US is a net importer of gas from Canada, which is where this tariff will bite. Outside of those imports, there are also substantial exports to Canada and Mexico, which bear watching in the case of any escalation to this trade conflict. On balance, we think imported gas may absorb most of the price impact. Tariffs are highly unlikely to lower US gas prices, and we believe that these tariffs could lead to mildly higher US gas prices than would otherwise be the case over the near and medium term as long as they are in effect. The duration of these tariffs and any retaliation matters as far as how they would influence broader pipeline flows and longer-term structural changes to the integrated North American natural gas market, as well as any further directional price impacts.

 

Gold Impact

Gold overall has maintained strength since the start of the year and already hit a new all-time high around $2800/oz as of last week’s close. Ahead of the implementation of tariffs, we saw tariff news leading to the arbitrage trade, driving price dislocations in New York versus international prices and moving market participants to shift metal to the US ahead of them. Gold from Canada and Mexico is subject to the full tariff, and, without the energy and critical mineral related carveout, prices of imported metal will reflect the tariff implications and lead to supply chain adaptations and/or a reshuffling of flows over the longer term. According to the USGS, Mexico and Canada are the second- and third-largest suppliers of gold (including ores and concentrates, doré, and bullion; with Canada being the main supplier of ore/concentrate and Mexico of doré, Mexico represented 18% and Canada 16% of total imports between 2019 and 2022). If tariffs broaden further, it simply means that gold will cost more in the US than it otherwise would. At this point, given the outsized role investment demand plays in the gold market here, all things equal, gold investors would absorb any added cost not absorbed by Mexican and Canadian supplies. But if the outlook is positive, investment demand may not change materially regardless. Beyond the direct impact on gold flows from tariffs, we think the more interesting and enduring story here is around what it means for gold appetite as both a risk overlay and as a perceived safe haven. The tariffs news and wave of executive orders and actions in the first days of the Trump administration represent the type of uncertainty that we think could support gold going forward. While the first-round concern is about the metal itself getting caught up in tariffs, we think the more important and impactful concern is this theme of uncertainty. We think it will keep gold supported this year in the face of macro headwinds, and that gold’s role as a risk overlay and perceived haven is as relevant as ever.

 

Power Impact

Canadian electricity exports totaled 33 GWh in 2023 at $3.2bln, and a 10% tariff on cross border electrons could impact market prices in the near term and capacity additions in the long term if they persist. While power imports from Canada make up less than 1% of annual US consumption, it is a significant and growing source of cheap, low-carbon power for some regions, especially the Northeast. Imports also help to offset fluctuations in energy during severe events, critical to American states as the grid becomes more constrained and power demand is set to rise. In response to Trump's tariffs, Ontario Premier Doug Ford has threatened to cut off electricity exports to American states like New York and Michigan. While technically, the Ontario government has the power to instruct the Independent Electricity System Operator to limit electricity exports, Canada’s current federal response has not indicated withholding power is included in the first wave of retaliatory actions. States that have firm contracts to buy power from Canada like New York and Vermont would see the cost of the tariffs passed directly onto customers, while the rest of Canadian power that is purchased on the wholesale market could simply be priced out, the bulk of which would be replaced with domestic natural gas fired power. This trade relationship is set to deepen with the completion of the Champlain Hudson Power Express, a powerline that will deliver 1.2GW of Canadian hydropower into New York City, potentially supplying 20% of its electricity demand by 2026.

 

Elizabeth Arseneau, CIM, FMA Portfolio Manager | RBC Wealth Management | RBC Dominion Securities Inc. | T. 416-960-4592 | F. 416-974-0332 | 2 St. Clair Avenue West, Suite 1900, Toronto, Ontario M4V 1L5