Wednesday, June 24, 2009

The Canadian Dollar Response to an Oil Shock

In a 2006 Bank of Canada working paper, (highly recommended) Issa, Lafrance and Murray showed that, sometime in the 1990s, a structural break occurred in the relationship between the Canadian dollar and energy prices. Whereas prior econometric estimation (see Amano and van Norden 1995) showed that higher energy prices lead to a depreciation in the Canadian dollar, the authors showed that this relationship no longer held and that in fact rising energy prices tend to drive the loonie higher.

This finding shouldn’t be a surprise to even casual observers of commodity and currency markets. The loonie has followed oil in virtual lockstep for many years, hitting 1.10 to the US dollar as oil rocketed past $100/barrel.

To me, it is not immediatley clear why rising oil prices should impact the loonie. Oil is traded in US dollars and so higher Canadian oil exports shouldn't impact the Canadian dollar since the sale of oil does not create additional demand for Canadian currency. However, higher oil prices do create demand for Canadian dollars for the purpose of FDI – international oil companies developing projects in the oil sands do need to pay for assets, labour, etc in local currency. The oil-price break-even rate on these projects is high and so investment is driven by price. Therefore, oil impacts the loonie through the capital account, rather than the current account. (at least that is my take, if I’m wrong, please feel free to tell me so).

I use a version of the Issa, Lafrance, Murray model that, as shown in the dynamic simulation below, tends to track the Canadian dollar fairly closely.


Dynamic Simulation of CAD/US Exchange Rate, 2004-2008


If we are conviced that oil price are a significant driver of the Canadian dollar, then it may be interesting to ask how a future oil price shock will impact the loonie vs. the greenback.
The graph below sets out the baseline scenario for oil prices, based on EIA forecasts, and a somewhat arbitrary path for a hypothetical oil shock that would have the USD price of oil rise to $130 by the third quarter of 2010.

If the future path of oil prices looks more like the green line than the EIA forecast above, then, from the model, we should expect to see Canadian dollar back to parity early next year.


Rising oil prices may get the loonie near parity, even without a steep run-up in prices, particularly if accompanied by weakness in the US dollar. But if oil really starts to run, I think it is very likely that the loonie will approach, or possibly surpass, its previous highs.

2 comments:

Stephen Gordon said...

Oil is traded in US dollars and so higher Canadian oil exports shouldn't impact the Canadian dollar since the sale of oil does not create additional demand for Canadian currency.

My way of thinking about it is that Canadian producers have to pay costs denominated in CAD, so they demand payment in CAD. So for a given CAD-USD exchange rate, a higher USD-denominated oil prices means an increase in the demand for CAD.

And FWIW, I blogged about this paper - and a possible story for why the structural break took place - way back here.

Shock Minus Control said...

Thanks for the link Stephen - I didn't realize that you've been blogging since 2006!

I'm curious if Canadian producers do demand payment in CAD or do they just hedge the currency risk? Although perhaps the two are equivalent.