Think Oil Prices Are Headed To $100? Keep Your Eyes On CADJPY

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 oil prices. From our economics 101
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 rally when
energy prices increase because those currencies are from countries that tend to
be net exporters of commodities such as crude oil. Therefore the oil producers
within the country 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. As indicated in the chart below,
there is a clear relationship between both of these instruments. Since the
beginning of 2004, oil prices and the Canadian Dollar / Japanese Yen (CADJPY)
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’ most significant oil supplier.
Unbeknownst to many, the size of their 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 their Alberta oil sands to
the economically recoverable category. China has begun to take 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. China-Canada 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’ 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 as
time passes, they are 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 under
perform.

As indicated in the earlier chart, 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 towards $100. If oil prices retrace to $40
a barrel on the other hand, then CADJPY could fall back to $80.

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 and 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 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 towards $40 a barrel. However that may very well require a further
rally in oil.

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 2.50 percent positive interest rate differential over Japan,
which seems little 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.