Forecasting the next move in the currency markets is hard at the best of times, as a currency trader, and even more so with the usd to cad, where the two economies of America and Canada are so closely linked. Now this task is becoming harder, as a new and significant variable has to be factored in to our decision making process. Put simply, it is the change from yellow to black, from the gold nuggets of the last eighty years which are now virtually mined out, to the new black gold – oil. The vast reserves recently discovered in Alberta could have a significant impact on the country, its economy, and importantly for us, the currency. So how is this natural resource likely to affect the future strength or weakness of the Canadian dollar? – let’s consider the issue in more detail, and in particular the correlation between commodity prices and currency. For those of you interested in trading oil, I have recently started a new oil trading blog, which is updated daily with a summary of the technical’s and outlook for the trading day. Please just follow the link here to Prices Oil.

Strange as it may seem, the world’s largest reserves of oil, are not lying beneath the deserts of Saudi Arabia, deep beneath the sea in the Gulf of Mexico, or beneath the frozen Siberian permafrost. In fact, they are clinging to grains of sand in the Canadian boreal forest of Northern Alberta. But there is a problem – forget the images of gushing oil wells, the now defunct nodding donkeys of Texas, or the offshore platforms in the Arabian gulf. The oilmen of Alberta are digging up the sand and soil, and extracting the oil which coats each tiny grain of sand. They are called the oil sands for good reason, because these reserves are so vast, that they will help to solve America’s energy needs well into the next century, and within the next few years, will become more significant than all the oil that is currently imported from Saudi Arabia. Current estimates put the reserves at a conservative 2 trillion barrels ( eight times the size of the Saudi’s reserves ), and as the technology and extraction techniques improve, these estimates are likely to increase.

Whilst production costs have fallen in the last five years, these still range between $10 to $15 dollars a barrel for the sand oil, which is considerably more expensive than extracting conventional light crude which is approximately $2 a barrel. The current extraction process involves forcing steam under pressure into parallel bore holes which heats the oil, allowing it to be collected and pumped to the surface. Analysts have estimated that the break even price for oil sands production is around $30 to $40 US dollars a barrel. With oil currently floating around $40 a barrel, production is now slowing  dramatically due to the economies of extraction no longer being viable. If the current price collapse continues then the oil sands of Alberta may remain there for ever.

For the last few years there has been a very close ( but inverse ) correlation between oil prices and the usd to cad currency pair. As oil prices rise, so the usd to cad falls making the long USD/CAD trade the perfect hedge to the rising price of oil. Since the start of 2004, the correlation has been averaging around -84%. So if oil prices fall, will we expect the USD/CAD to reverse with weakness returning to the Canadian dollar? – let’s look at this in more detail.

If oil starts to fall in price, which is quite possible after its bull run in the last few years to over $100 per barrel, this would certainly have a ripple effect out into many economies. In Canada part of the economic growth in the last few years has been as a direct result of the increase in oil prices, coupled with the development of the oil fields of Alberta. Now, every cloud has a silver lining, and as the world’s second largest holder of oil reserves, if the oil falls in price it will also be the Canadian dollar that suffers the most, so the currency will begin to weaken as the dollar strengthens – the usd to cad trend of the last few years will finally reverse. As the Canadian dollar weakens, so the US dollar will strengthen and with falling oil prices the more the US economy benefits creating an opportunity for buying US dollars. Now one obvious question you may have is simply this – if the price of oil is falling and since oil is priced in US dollars, wouldn’t the dollar suffer as a result? The simple answer is no, since most central banks already have large reserves of US dollars anyway, which is the same reason the US dollar does not benefit directly from a rising oil price either.

Should oil fall in price, this would undoubtedly affect the Canadian economy, and if this continued for any length of time, may force the Bank of Canada to reduce interest rates which would weaken the Canadian dollar significantly. My own view is that there will be a pullback  in 2008 for two reasons. Firstly I believe that oil prices will indeed fall back from their current highs, and with the slowdown that ripples into the Canadian economy, the central bank will be forced to reduce interest rates accordingly which in turn will weaken the Canadian dollar – the usd to cad exchange rate will move back towards the 1.10 to 1.15  level.