For CAD To Fly, Crude Must Recover

The two dance partners in the above diagram (the “Red” line is an ETF for the CAD versus the USD, and the “Blue” line is a popular oil futures ETF) were tripping the light fantastic for most of 2014, entwined in their commodity-based correlation two-step. When the bottom fell out of oil prices, the race was on to find new support levels. The market is trying to form a new bottom, but Goldman is not convinced. As for the last twelve months, while oil prices fell 57%, the Loonie declined 17%, not exactly a one-to-one relationship, but a clear enough one to use for future reference purposes.

Crude oil is currently around $45 a barrel. The “USD/CAD” pair is presently in a tight range about a 1.325 mean. If we take the $60 and $20 predictions for oil prices and do the math on a direct relationship basis, then we can at least establish high and low boundary limits for the following discussion. First, the topside – For $60 oil, that is a 33% increase, which would translate into a currency adjustment of 9.8%, or a value of 1.195. On the low side for oil – For $20 oil, a 44.4% decline would equate to a 13.1% decline, for a value of 1.499.

Get The News You Want

Read market moving news with a personalized feed of stocks you care about.

Get The App

To put each of these values in perspective, we need only check on the year-end forecasts from a few of the largest banks in Canada. As quarter end approaches, the foreign exchange departments for these banks are actually revising their estimates for the remainder of 2015, as well as for valuations out into 2016 and beyond. As of their last publication date, a selection of these values ranged between 1.26 and 1.30, as of December 31, 2015. It is also interesting to note that forecasts for 2016 converge upon 1.24 to 1.25, a gradual strengthening move as the global economy picks up steam, and commodity prices, including those for oil, recover to higher levels.

Oil market pundits have had a field day writing both positive and negative articles about the travails of Black Gold. We are now into “Silly Season”, so to speak, in that it is more difficult to attract the attention of the public. Most of us have tired of the many “The-sky-is-falling” scenarios. Yes, it was nice to have low-priced gasoline during the summer travel season, but our dependence on oil and its many petroleum derivatives is not about to disappear anytime soon. Even Goldman admits in its doomsday prognostication, a worst-case scenario, by the way, that the current fundamentals for oil are improving.

The press, however, thrives on sensationalism. When you dig a little deeper into the Goldman (NYSE:GS) announcement, their estimates are meeker than the press would have you believe. According to Bloomberg, “Goldman trimmed its 2016 estimate for West Texas Intermediate to $45 a barrel from a May projection of $57 on the expectation that OPEC production growth, resilient supply from outside the group and slowing demand expansion will prolong the glut. The bank also reduced its 2016 Brent crude prediction to $49.50 a barrel from $62." Goldman foresees a glut and a longer re-balancing period.

What are the current fundamentals? Here are a few facts to consider:

• The International Energy Agency’s (IEA) previous report for August noted that, “Global oil demand revised up from previous report; fastest pace in five years.” Yes, demand is increasing, but it is still being overwhelmed by supply. As a result, the IEA contemplates the “process is likely to be prolonged as a supply overhang is expected to persist through 2016 - suggesting global inventories will pile up further.”
• In its most recent report for September, the IEA announced that, “The latest tumble in the price of oil, which hit a six-year low in August, is expected to cut non-OPEC supply in 2016 by nearly 0.5 million barrels per day (mb/d) – the biggest decline in more than two decades.” Lower output in the United States, Russia and North Sea is contributing to this decline, a quickening of the re-balancing cycle that the oil industry is enduring at present. As one analyst put it, “The Saudi-led cartel's master plan to pump record amounts of oil in order to squeeze other producers out of the market appears to be working.”
• As margins fall and OPEC exporting countries continue to feed the supply glut, U.S. oilrig counts have dropped more than 50%. This precipitous decline can only speak to reduced supply in the future, a good thing when it comes to oil prices going forward.
• On the political front, a heat up in Middle East tensions always has a severe impact on oil supply-chain dynamics. Whether or not hostilities in the region will throw the proverbial monkey wrench into current estimates is anyone’s guess at this time, but analysts warn that near-term supply forecasts are based on a best-case scenario. Any disruption at all could bring back higher oil prices.

As both the IEA and other analysts have pointed out in article after article, “Crude Oil Is Seeing Improving Fundamentals.” The present situation is on the mend, but it will be a rocky road to absolute re-balancing, the reason being that net short positions are running as high as they were last March. Short-covering rallies back then fueled a 40% bump up in prices on a whim. A similar situation now exists. Volatility will persist, $60 oil can easily be achieved if the shorts begin to waver. Timing is the real issue.

The Canadian economy is heavily dependent on oil and mining exports, but it is also closely tied to the economic goings on down in the lower forty-eight states, as well. Canada is “Number Two” in oil exporting nations, right behind Saudi Arabia, and roughly half of its exports, including oil, are destined for the United States. Based on the first two quarters for 2015, Canada could technically be termed to be in recession, but, with GDP growth figures of a negative 0.2% and 0.1%, respectively, the dreaded “R” word could be reserved for later, based rounding errors alone.

The Bank of Canada, like many other central banks, has been lowering interest rates to weaken its currency and thereby encourage more export traffic. The jobs picture has been favorable, but unemployment rates appear to be bottoming out. At its meeting last week, the BoC decided to pass on another reduction. It noted that, "Economic activity continues to be underpinned by solid household spending and a firm recovery in the United States, with particular strength in the sectors of the U.S. economy that are important for Canadian exports…While the overall export picture is still uncertain, the latest data confirm that exchange rate-sensitive exports are regaining momentum."

The Loonie did not react to these and other assertions that it would take time for a recovery to stabilize. The following chart notes previous movements: