[Editor’s note: The following article originally appeared on the websitehttps://oilandgas-investments.com on March 1]
Currencymovements affect the prices of oil and gas stocks as much as commodityprices. And I think there is an increasing likelihood a mix of slightlyrising oil prices and a steady to lower Canadian dollar could result ina big jump in Canadian oil stocks in March and April.
Regularreaders know we have not been bullish on energy stocks, especiallynatural gas. But we believe oil stocks could have a tradable jump upfor a couple reasons:
- The big oil ETF in the U.S. is symbol USO and it’s cleaning up its act. We wrote an article in early February that outlined how the large size of this very popular investment vehicle has forced oil prices lower every month. This has been by far this website’s most read story. Essentially, they have to roll over their oil contracts each month so they don’t end up taking physical delivery of the commodity itself. For several days this skews the market; the oil market isn’t real for awhile, and investors hate that. Bowing to public pressure, USO will now roll over their contracts over a longer number of days, hoping to not influence the market. If they are successful, we believe investors will cheer this more orderly market and use it as an excuse to move the oil price higher.
- There is evidence that the market is looking for any excuse to move the global oil price higher. People can talk about fundamentals all they want, and over the long term they rule, but over the short term emotions rule and there is a rising bullish sentiment on oil in the markets right now. The markets took oil to $147/barrel, and then it took oil down to $35/barrel. The market can move oil wherever it wants it to go as traders and the public accentuate the trend. When we see Canadian oil stocks moving 6-12% on an up day, much more than they should on any new fundamentals, it tells us they are a coiled spring waiting to be let go.
- Continued uncertainty in equity markets will keep the U.S. dollar higher for longer than most people believe. This means a relatively lower Canadian dollar, which means a higher oil price in Canadian dollars. If oil is US$40 per barrel and the Canadian dollar (nickname: the loonie) is at par with the greenback, then oil in Canada is the same price. But if the US$ rises to $1.25 to the loonie, then Canadian oil prices really are rising to 1.25 x 40=CAD$50/barrel. That means increased cash flow and stock prices for Canadian producers.
Wesee this as a likely scenario for the spring of 2009. We don’t believethe fundamentals of the global economy are going to allow for anysustained rise in the oil price over the next few months. But the stock market does look 6-9 months ahead. And I think we’re about to have another round of hope before another round of gloom in oil.
Old trading patterns are now history
Over the last couple weeks, we hear the market saying loudly that in times of crisis it is moving to gold and the US$. Those two now appear to be trading in tandem, not inversely as before.
Andthe oil price no longer moves against the U.S. dollar, or in tandemwith the Canadian dollar. So for producers and investors alreadysuffering from collapsing commodity prices, many of the old trading andmarket relationships now seem to have broken down.
This makes guessing even short term movements in commodities and stocks and currencies very difficult.
Backin 2004 hordes of retail and institutional investors jumped on theenergy bandwagon. They soon became used to a very simple relationship,what became a principle of resource and commodity investing - if theU.S. dollar went down, energy prices (all commodities, really) wentup. The two had a very strong inverse relationship because the U.S.dollar is the world’s reserve currency, and commodities are priced interms of U.S. dollars internationally. All things (demand, supplymainly) being equal, commodity prices compensate for currency movements.
Aboutthree months ago, in December 2008, the price of oil de-coupled fromits longer-term relationship with the dollar. See this chart fromReuters:
Butit’s not just the U.S. dollar that de-coupled. The Canadian dollar hada relatively positive relationship with the oil price. As oil went, sowent the loonie, reflecting its petro-currency status given Canada’simmense oil sands reserves - which became increasingly profitable from2004-2008. Investors understood and accepted this, and used therelationship to position themselves for gains. For the last 4-5 yearsit was part of the game.
Those relationships brokedown in December 2008, and strict market fundamentals, or at least themarket’s greatest fears of them, have overtaken as the driving factorin the oil price - i.e. a global recession, or something worse, andpotentially much less demand.
When the pastrelationships still held, Canadian producers had a cushion againstfalling energy prices. That is no longer the case. As the price of oilfell from US$147 to US$40 per barrel, the CDN$ fell 20% against theUS$. So US$40 oil is really CAD$48 oil for Canadian producers, i.e.the currency movements gave them a cushion.
But as we say, over the last two months, there has been little correlation between the oil price and currencies.
Our first draft of this article was about how a higher Canadian dollar will lower cash flow and stock prices for Canadian energy producers. And investors do need to understand how that works. (More on that below)
Butas the Dow Jones Industrial Average broke through support in the 7500range, the US$ rallied again on safe haven buying and we think it willstay high as long as the market continues to grind lower- creating abetter cash flow scenario for Canadian producers - and better profitscenario for their shareholders.
What happens if the Canadian dollar rises?
Let’ssay the loonie goes from US$0.80 to US$0.88, and oil just stays atUS$40, that CAD$48 per barrel turns into CAD$44 - and that 10% pricedecline comes right off the top lines of Canadian energy producers -opposite of the scenario a few paragraphs up. And with much lowerprofit margins at these prices, that 10% top line revenue reduction caneasily translate to a 20%-plus reduction to the bottom line profit, orheavens forbid, increased losses.
With these recentcurrency and oil price correlations now gone, this would be especiallydevastating for the Canadian oil producers should the CAD$ rise.Natural gas prices are already close between Canada and the U.S. - with a 15 cent difference between the AECO Canadian price (found at www.ngx.com ), and the NYMEX US$ price (found at https://money.cnn.com/data/commodities/). Since most Canadian gas is consumed within Canada the effect therewould be minimal, but it would still lower export pricing.
Butwith oil priced globally in US$, and the price of oil dropping or evenstaying steady while the loonie rises against the greenback, the endresult would be like a hidden tax on Canadian producers’ cash flow, and investors’ valuations.
Theabove chart plots the U.S. dollar in terms of Canadian dollars(candlesticks, in black), and separately plots the United States OilFund (USO-green line) as a proxy for the price of oil. USO is a popularETF tracking the spot price of WTI light sweet crude. What isimmediately apparent is the strong historical inverse relationship ofthe Index to the US$, and the recent pronounced disconnect as oilstarted its collapse back in July 2008. While crude has continuedfalling the last few months, the currency pair has been trading in aconsolidation pattern - very close to a point of resolve where either abreakdown or breakout would be expected.
So inconclusion, many of the ingredients that made past tradingrelationships attractive have broken down. The US$-oil inverserelationship has ended for now. In fact, we may see oil and the dollarrise together in the near term (as the US$ has done with gold lately.)
Thiswould mean that Canadian producers immediately stand to benefit,selling oil for appreciating U.S. dollars and a higher price - a doubleboost that should give Canadian energy stocks a lift. However, arising Canadian dollar would mean any rise in the oil price ismitigated, and if oil stays constant would mean lower cash flows for Canadian producers. The charts tell us this is increasingly unlikely in the short term.
This article was written by a member of the Stockhouse community.
To read more work by Keith Schaefer, visit https://oilandgas-investments.com.