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Will the loonie lead crude this time?

Recent strength in the Canadian dollar may portend a rally in crude prices.

Historically, the CAD/USD exchange rate has tracked crude prices reasonably well. Using weekly data going back to 1983, the two series have a 67% correlation. In recent weeks, however, the Canadian has broken out and is powering towards parity with its American counterpart. In contrast, crude oil prices have languished in the $80 range. Will the Canadian dollar take a break from its recent hot streak, or is a rally in crude more likely?

If history serves as any guide, the Canadian dollar has actually led crude prices at major inflection points in the past decade. As highlighted in the chart, in the spring of 2000, the Canadian dollar weakened as the tech bubble burst, but crude oil prices hung tough until November before falling to around $20. In early 2003, the Canadian dollar broke out above 70 cents, but it took crude until 2004 to break out of its $20-$40 four-year long trading range. In November 2007, when the loonie broke down below parity, oil prices continued to rise for another nine months before peaking at $147 per barrel.

Canadian Dollar and Crude Oil Correlation Chart

Canadian Dollar and Crude Oil Price Correlation Chart

Based on these observations, it is not unreasonable to assume that we can expect a rise in oil prices in the coming months. Furthermore, the macro environment appears conducive to higher crude prices as demand is recovering (albeit slowly), and the Fed has maintained its commitment to keep near-zero interest rates for the foreseeable future (which artificially keeps other countries’ rates low). Finally, the slope in the contango of the crude futures curve (December 2018 versus April 2010), at just over $12 (or about 1% compounded per year), is quite gentle, which suggests that a collapse in the price of oil, similar to what occurred in 2008, is not imminent.

On balance, the odds for a rise in the price of crude oil are favorable, and Canadian investors looking to play this theme as a spread trade could go long a crude oil ETF priced in Canadian dollars, which effectively hedges the effects of currency movements from the change in oil prices.

Happy trading!

Jason F. Moschella (Consulting Editor)

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