SPEAKING
FREELY Oil, the yen and the Canadian
dollar By Kathy Lien
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
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Oil
prices have been skyrocketing
over the past few weeks, increasing close
to 45% in the past three months and now crossing
US$70 a barrel. Gasoline prices in certain
US states have already breached $3 a gallon.
It seems as if it was only yesterday (or less
than one year ago) that traders were claiming $40
would be the highest that oil prices could rally.
Now in retrospect, in the minds of many of those
same traders, $40 seems to be the lowest that we
could see oil prices fall to once again.
The sharp surge in energy prices has
nearly everyone scratching their heads about where
oil prices may be headed next and what currency
pair they could trade to profit from that view.
Some oil traders are calling for $80 a barrel
while more aggressive ones are setting their
sights on $100. Yet, in every scenario there are
skeptics who also have valid
arguments and in this case, oil skeptics are
calling the rally a speculative bubble that will
burst sooner or later. However for the actual
majority that are banking on higher oil prices,
trading currencies instead of oil may be more
profitable endeavor due to the unique ability to
earn not only capital appreciation, but also
interest income, something futures contracts
cannot offer.
The rise in oil has made
headlines across the globe for months now. Strong
demand from China and India, the lack of ability
by Saudi Arabia (and other OPEC countries) to
increase oil production as well as weather-related
supply shocks have fueled the continual rise in
crude prices. From our economics textbooks, we
remember that high oil prices act as a tax for
consumers by slowing down consumer spending, which
eventually takes a bite out of growth. Yet the
actual impact of oil prices on different
currencies can be very mixed. Some currencies
stand to benefit significantly from rising oil
prices while others suffer greatly. Traditionally
we know that commodity currencies (the currencies
of countries which are dependent on the export of
particular commodities, eg the Australian dollar
or the South African rand) rally when energy
prices increase because many of these countries
are also net exporters of crude oil; that is,
there is considerable overlap between the
commodity-exporting countries and the
oil-exporting countries. Therefore the oil
producers within these countries are simply
reaping higher profits for the same barrel of oil.
Currencies of countries that are net oil
importers, on the other hand face, increasingly
higher costs whenever energy prices rise. So
taking a look at this from a net oil
exporter/importer perspective, the currency pair
that should be impacted the most by changes in
energy prices is the Canadian dollar and the
Japanese yen (CADJPY).
Why
CADJPY? There are many reasons why CADJPY
should be on the top of list of currencies to
trade for those who have a view on oil prices.
There is a clear relationship between both of
these instruments. Since the beginning of 2004,
oil prices and the Canadian dollar/Japanese yen
currency pair have had an 87% positive
correlation. In fact, for the most part, oil even
acts as a leading indicator for CADJPY. This
relationship stems from the basic characteristics
of each of these countries.
Canada is the
world's ninth largest crude oil producer and they
continue to climb up the list with production in
oil sands increasing regularly. In 2000, Canada
surpassed Saudi Arabia as the US's most
significant oil supplier. Unbeknownst to many, the
size of Canadian oil reserves is second only to
Saudi Arabia. The geographical proximity between
the US and Canada as well as the growing political
uncertainty in the Middle East and South America
makes Canada one of the more desirable places for
the US to import oil from.
Yet Canada does
not just service US demand. The country's vast oil
resources are beginning to get a lot of attention
from China, especially since Canada has recently
stumbled upon a new stash of oil after a
reclassification of its Alberta oil sands to the
economically recoverable category, assisted by
high prices. China has begun to buy stakes in
Canadian oil companies, including picking up a
one-sixth interest in MEG Energy Corp. PetroChina
International also signed a cooperation agreement
with one of Canada's largest pipeline companies.
Chinese-Canadian energy cooperation is only
expected to increase further, barring any huge
protests by the US. China currently imports 32% of
its oil, and according to a report by the
International Energy Agency, China's import needs
are expected to double by 2010 and match that of
the US by 2030. This makes Canada and the Canadian
dollar one of the best currencies positioned to
benefit from a continual surge in oil prices.
On the other side of the spectrum, Japan
imports 99% of its oil (compared to the US's 50%).
Their lack of domestic sources of energy and their
need to import vast amounts of crude oil, natural
gas, and other energy resources makes them
particularly sensitive to changes in oil prices.
There is an inherent fear that continual increases
in oil prices could derail the Japanese economic
recovery. Although Japan has been able to better
weather the fluctuations with time, it is still
not immune to the drag that oil prices will have
on the global economy. If oil prices continue to
rise, it will sap global demand, weakening
purchases of Japanese exports. In recent weeks,
the Japanese yen itself has had a close negative
correlation with the price fluctuations in oil
prices. As oil prices firm, the Japanese yen is
expected to continue to underperform.
If
the correlation that we have seen over the past
year and a half holds, then should oil prices hit
$80 a barrel, we would also expect to see CADJPY
head toward $100. If oil prices retrace to $40 a
barrel on the other hand, then CADJPY could fall
back to $80. So the next logical question to ask
is would be: "Will oil prices hit $80 or retrace
back to $40?"
Taking a look at this from
a markets perspective, the futures market is right
now only pricing in a modest rise in oil prices.
At the time of this writing, December oil futures
contracts were trading at $61.10, not far from
current levels. There has been a lively debate
even within the world of economists about where
oil prices may be headed over the next few months.
The fire fueling the rise in oil is demand
exceeding supply. With supplies having only
limited room to grow and demand expected to
skyrocket over the next few years, oil prices
could continue to head higher. Back in March,
Goldman Sachs predicted oil prices to spike above
$100. With the hurricane season just beginning, it
would not be a surprise to see further concerns
about supply in the months or even weeks to come
as the rigs in the Gulf face further risks. If
prices stay elevated throughout the summer and
fall, then $100-oil becomes even more of a
possibility as we enter the winter season, when
energy usage is generally at its highest.
On the flip side, at some point in the oil
price rally, consumers and businesses will have to
throw in the towel and start taking measures to
cut their consumption or expenditures. This may
happen in baby steps with consumers first delaying
automobile purchases or simply driving their cars
less because ultimately the numbers do add up.
Since the beginning of the year, the average price
of a gallon of gasoline increased by 45 cents.
This means that for a SUV that has a fuel tank of
25 gallons, the 45-cent increase in gasoline
prices amounts to an $11.25 increase in the cost
of filling up the tank. If we hit $100 a barrel,
gasoline prices could shoot up to $3 a gallon, at
which point the SUV owner would go from paying $45
at the beginning of the year to fill up the tank
to $75. The capitulation point could be when we
finally see oil prices reverse and head back
toward $40 a barrel.
The reason why CADJPY
is a better product to express your oil $100 view
than the futures contracts themselves is because
of the ability to earn interest. If you buy direct
oil futures contracts and oil goes up, you will
get to earn capital gains. However if you buy
CADJPY spot, and oil rallies, you will not only
earn capital gains, but also be able to sit back
and earn interest on a daily basis. Canada offers
a 2.5% positive interest rate differential over
Japan, which seems minor at first glance. However,
factoring in leverage, the interest income is
substantially higher. No other product can offer
both interest and capital gains. Yet it is also
important to note that the opposite is true as
well. For those who think oil prices will top out
and move lower, selling CADJPY will require paying
interest on daily basis.
