The loonie, oil's crash, and why this isn't anything like 2008 -

The loonie, oil’s crash, and why this isn’t anything like 2008

As you watch the oil price, keep the Canadian dollar in mind before you hit the panic button


Loonie 20141031Bank of Canada governor Stephen Poloz, a master of the econo-metaphor, has described the relationship between the Canadian dollar and oil in many colourful ways—as oil drops, the impact on the terms of trade might not immediately impact the dollar, but, “like walking a dog on one of those leashes that stretch out and snap back,” the value of oil and the value of the dollar will be linked. Over the past couple of weeks, the dollar has been pulling a lot of leash off the reel, depreciating rapidly against the U.S. dollar as oil dropped. The impact has been stark, especially in the longer-term outlook for oil in Canadian dollar terms.  The question producers must be asking is whether a sub-90-cent dollar is a long-term reality, or whether the leash will snap back and leave Canadian producers and governments feeling a much greater hit from the drop in world oil prices. Still, no matter what happens with the Canadian dollar as the oil shock propagates through the global economy, this is a long way from 2008.

Let’s start with a look at oil in U.S. dollar terms—over the past month, we’ve seen oil prices for the West Texas Intermediate crude benchmark at their lowest point since mid-2010, with prices holding well-below $80 per barrel. As you can see in the graph below, this is not simply viewed as a short-term fluctuation—the futures market has oil barely above $80 60 months from now — a forward view of oil about as bearish as it has been over the past five years.


WTI Forward Curve. Source: Bloomberg.

Over the same period of time as oil’s recent decline, the Canadian sollar has seen an equally rapid fall, as shown below. If we look just over the past year, the slide has been dramatic, with much of the drop happening since oil’s global slide started to accelerate in the late summer. In the first six months of the year, as oil was appreciating, the Canadian dollar had begun to climb slowly again.

Canadian dollar forward curve. Source; Bloomberg.

Canadian dollar forward curve. Source: Bloomberg

If you combine these two curves and ask what the $CAD-hedged future price of oil (the Canadian dollar price at which you could lock in future oil purchases or sales) has done over the past six months, you get a very different story than that which you’d see if you looked only at the WTI forward price alone.

Canadian-dollar-hedged oil forward prices.  Source: Bloomberg.

Canadian-dollar-hedged oil forward prices. Source: Bloomberg.

With the impact of the Canadian dollar taken into account, the long view on oil in Canadian dollar terms is not anywhere near as bearish as you might think. In fact, looking three to five years out, which would be the relevant time horizon for the start-up of a new oil sands projects, the market is now reflecting expected future cash flows higher than we’ve seen in at the same period each of the last three years — the question, as I mentioned above, is whether the Canadian dollar has run too far, and that leash will snap back.  However, it would have to snap back a fair bit, especially in the long term, to make this year’s oil prices look worse than 2012’s or even last year’s long view.

To put this recent drop in oil prices into perspective, the Canadian dollar doesn’t always buffer producers against a fall to the degree that it has this time around. In the figure below, you can see five forward curves, a comparison between this year’s June and November curves, hedged in Canadian dollar terms, compared to the same time periods in 2008 over which time the financial crisis was just beginning to take hold. For reference, I’ve also included the Feb. 12, 2009 curve, the week in which WTI hit its lowest value during the crisis.

Comparison of 2008 and 2014 oil price forward curves. Source: Bloomberg.

Comparison of 2008 and 2014 oil price forward curves. Source: Bloomberg

In June, 2008, a Canadian producer could lock in future production at or around $130 Canadian dollars per barrel. Within five months, this had dropped to a little over $100 in the long term. Within another three months, crude bottomed out, with spot prices more than 50 per cent lower than those we see today, but with significant optimism looking ahead. Over the past five months, we’ve seen a drop a little less than half as large in the front end of the oil price curve as what was seen over the same period in 2008, and we’ve seen virtually no drop at all in the long-run view in Canadian dollar terms. That should give producers, and Alberta’s new premier, some relief.

So, what’s the bottom line? Over the past four months, the Canadian dollar has done what you’d expect it to do—it has acted as a shock absorber, buffering the Canadian economy from a significant commodity shock. Of course, this shock absorption isn’t free—it comes at the expense of our global purchasing power and, thus, Canadians’ real wages and real wealth, but it’s important to recognize nonetheless. The as-yet-unanswered question is whether, channeling governor Poloz, the shock absorber has bottomed out and we should expect a hard rebound, or whether there’s still travel left in the system. Over the coming weeks, as you watch the oil price, make sure to take a quick peek at the Canadian dollar as well before you hit the panic button.



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The loonie, oil’s crash, and why this isn’t anything like 2008

  1. Part of this is propaganda as CAD value was in decline well before the il price drop. So why practice blame deflection? Fact that BoC/Ottawa creates so much thin air money for debt has a impact too and was leading the CAD value drop long before the oil drop. Do not get me wrong, oil is part of it, but I don’t believe for one minute its the major part of it.

    When CAD started its fall, early 2013, oil was over $100 USD/barrel. It clearly was well ahead of the oil prices drop, so much so other factors MUST have played a big roll.

    No legitimate investor is buying government debt be it provincial or federal, its a ruse, BoC creates it out of thin air, banks then buy the debt without any legitimate borrower. They do this to present the illusion of solvency as the reality is investors to not lend money for rates below inflation to lose value.

    This is what caused the US mortgage crisis, why lend money to lose value? So people wanted their money back and debtors could not pay fair rates of interest or pay back the principle. But politicians love the blame game, reality is our govmints are bankrupt. And its bing reflected in CAD currency devaluation.

  2. I personally think you place far too much emphasis on the five year futures markets (and the $CAN exchange rate as it affects this year’s AB budget) as some crystal ball to predict the long term viability of the oil sands industry. Afterall, what’s the planning horizon for an oilsands project that may be in production for decades? And do most producers hedge?

    You’d think a multi-national like Imperial Oil (Exxon Mobil sub) would have a much longer term view and strategy for the profitability of the oil and gas industry. But, I can recall a major slashing of projects (and hence consultants) in the mid to late 90s when the price of oil tanked for a period of time.

    Hopefully, lessons have been learned since then – though there may be some longer term global structural changes underway right now. Perhaps too early to tell.

    • Btw, as an aside, I see some of the economics writers and commenters taking some delight in discounting Jeff Rubin’s wrong prediction of $200 oil not so long ago (certainly before the shale directional drilling, 3D seismic and multi-fracking explosion).

      Some of us older types who weren’t in grade school at the time, do recall that the boom in the early 80s was fuelled by predictions of $100 oil in 80s dollars. This included the O&G companies, the banks who financed the investments – the Feds who based the NEP on similar forecasts, and even the Lougheed gov’t who agreed with a renegotiated NEP (celebrated by the infamous clinking of the champagne glasses).

      I seem to recall one economist just a few years ago mentioning an oft-quoted study that claimed $100 billion of lost (deferred in reality) investment due to the NEP. When he provided the link to the study, it was revealed that it was done shortly after the NEP was introduced using similar forecasts of rising world oil prices, before the actual price cratered in 1986. So in theory, not in reality.

      Predicting oil prices, as many have pointed out, is a mug’s game.