CAD Faces Oil Price Headwinds, but Analysts See a Rebound in 2023

CAD Faces Oil Price Headwinds, but Analysts See a Rebound in 2023

 Published: December 21st, 2022

The return of declining crude oil prices is pulling the Canadian Dollar down according to one of Canada's biggest banks.

Analysts at Bank of Montreal (BMO) say the recent dip in oil prices looks like a trend, and is contributing to the Loonie’s recent decline. They do say, however, that an oil price recovery is expected next year. That would give CAD some support.

‘The unexpected decline in oil prices over the past seven days has trickled through to forex markets in the ways we would expect,’ wrote BMO in a recent currency briefing. For the Canadian Dollar, that’s manifesting as underperformance linked to oil market dynamics. ‘The surprising shift in crude prices is hammering commodity currencies like CAD.’

In fact, the Loonie has been the biggest loser amongst the major commodity currencies over the past 30 days, though it's not alone. The Norwegian Krone, Europe's top petrocurrency, is also on the back foot.

BMO says all these moves confirm the oil linkage. ‘What we are seeing is a broad rally for oil importing currencies while oil exporter currencies suffer.’

The Pound to Loonie (GBP/CAD) exchange rate has risen for five weeks in a row, extending an appreciating trend that first emerged in September 2022.

‘Canada's dollar is being held hostage by oil market dynamics,’ said Scotiabank’s currency strategy unit in an analyst note. 'Oil exporting currencies were some of the weakest performers this week, reflecting investor worries that a global economic downturn is likely on the horizon.’

At time of writing GBP/CAD’s spot price was 1.6767 at the time of writing, with international payment rates for a standard bank account holding at roughly 1.62.

Crude connections

Back in May, the historic link between oil prices and CAD looked like it had been broken forever.

The Loonie slipped against the greenback as markets opened on 15th May 2022, despite a significant rally in oil prices. Analysts said at the time that the divergence in crude and CAD pricing would probably to be temporary, though it wasn’t the first time the traditional oil-loonie correlation had been broken.

CAD dipped by around half a percentage point against the US dollar for the 2022 year-to-date. That’s despite a 60 per cent increase in global crude prices and a 34 per cent gain for Canada’s benchmark Western Canada Select in the same timeframe.

For investors who follow petrocurrencies like the Canadian Dollar and Norwegian Krone, there's an expectation that their value will rise and fall in tandem with oil prices. May’s price action therefore came as a shock to many. Analysts at Canada’s CIBC bank, however, noted that the relationship between CAD and oil has been evolving for years. Many forex traders simply hadn’t understood that things had changed.

In a market analysis, CIBC’s currency research unit wrote that ‘despite what we’ve witnessed in terms of CAD’s steadiness in the face of volatile crude prices, statistical evidence is building that supports the notion of a weaker link between oil and CAD, which tends to correspond with softening Canada-US interest differentials.

CIBC’s research showed that that capital spending and investment in Canada’s oil sector fell from almost four percent of GDP in late 2014 to just above one percent in 2021. That drop in capex happened regardless of oil price rises that occurred frequently through the period.

The take-away is that rising oil prices no longer came with a propensity to drive increased employment, income growth, or inflation. ‘That de-coupling has meant that oil prices have less influence than they used to on Bank of Canada (BoC) monetary policy,’ CIBC wrote.

‘If we consider the period from late 2018, when capital spending in the Canadian oil sector had finished its retrenchment, the correlation disappears completely, even dipping into negative territory at times. Investors have stopped looking at oil prices as a driver of relative interest rates between Canada and America’.

Losing the oil-Loonie link might have upside

Despite the disruption it may cause forex traders engaging in fundamental analysis, CIBC says that a softening correlation between CAD and oil prices might be a favourable development for Canadian upstream oil companies. It means their own foreign currency earnings are less likely to be at the whim of rising and falling Loonie exchange rates.

‘They’ll be in a better position to reap the benefits of climbing crude price per barrel without having profitability chipped away by appreciation in the Canadian dollar. On the flip side, if oil prices do start to retreat from recent highs, it shouldn't drag down demand for CAD, which is what we would have expected to see in the past.’

A weaker oil-dollar dynamic could also potentially lead to a reduction in the extent to which domestic Canadian oil companies use currency hedging to reduce the risk of exchange rate volatility, which often involves buying more Canadian dollars.

Similarly, a lessened correlation could lend a supportive hand to the Loonie in periods when global oil prices are falling, and particularly if there has been a shift to large scale hedging positions.

The market support could arrive if spurred by already-lower hedge ratios and dipping oil prices, which might potentially lead to a rise in hedging-related demand for Canadian dollars.

CIBC says it continues to foresee a modest weakening in the Loonie over the next two quarters, however that has less to do any likely slippage in the oil price than with changes to Bank of Canada monetary policy.

‘We're of course aware of the Ukraine conflict and the upside surprises in inflation that have already occurred. Nonetheless we’re standing by the 100 basis points we expect from both the Bank of Canada and the US Fed in 2022, with further rises likely in store for 2023 and 2023.

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