By Richard Reinhard and Keith Schaefer
Currency movements affect the prices of oil and gas stocks as much as commodity prices. And I think there is an increasing likelihood a mix of slightly rising oil prices and a steady to lower Canadian dollar could result in a big jump in Canadian oil stocks in March and April.
Regular readers know we have not been bullish on energy stocks, especially natural gas. But we believe oil stocks could have a tradable jump up for a couple reasons:
- The big oil ETF in the US 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 US 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$50/barrel. That means increased cash flow and stock prices for Canadian producers.
We see this as a likely scenario for the spring of 2009. We don’t believe the fundamentals of the global economy are going to allow for any sustained rise in the oil price over the next few months. But the stock market does look 6-9 months ahead. And I think we’re about to have another round of hope before another round of gloom in oil.
OLD TRADING PATTERNS ARE NOW HISTORY
Over the last couple weeks, we hear the market saying loudly that in times of crisis it is moving to gold and the US$. Those two now appear to be trading in tandem, not inversely as before.
And the oil price no longer moves against the US dollar, or in tandem with the Canadian dollar. So for producers and investors already suffering from collapsing commodity prices, many of the old trading and market relationships now seem to have broken down
This makes guessing even short term movements in commodities and stocks and currencies very difficult.
Back in 2004 hordes of retail and institutional investors jumped on the energy bandwagon. They soon became used to a very simple relationship, what became a principle of resource and commodity investing – if the US dollar went down, energy prices (all commodities, really) went up. The two had a very strong inverse relationship because the US dollar is the world’s reserve currency, and commodities are priced in terms of US dollars internationally. All things (demand, supply mainly) being equal, commodity prices compensate for currency movements.
About three months ago, in December 2008, the price of oil de-coupled from its longer-term relationship with the dollar. See this chart from Reuters:
But it’s not just the US dollar that de-coupled. The Canadian dollar had a relatively positive relationship with the oil price. As oil went, so went the loonie, reflecting its petro-currency status given Canada’s immense oil sands reserves – which became increasingly profitable from 2004-2008. Investors understood and accepted this, and used the relationship to position themselves for gains. For the last 4-5 years it was part of the game.
Those relationships broke down in December 2008, and strict market fundamentals, or at least the market’s greatest fears of them, have overtaken as the driving factor in the oil price – i.e. a global recession, or something worse, and potentially much less demand.
When the past relationships still held, Canadian producers had a cushion against falling energy prices. That is no longer the case. As the price of oil fell from US$147 to US$40 per barrel, the CDN$ fell 20% against the US$. So US$40 oil is really CAD$48 oil for Canadian producers, i.e. the currency movements gave them a cushion.
But as we say, over the last two months, there has been little correlation between the oil price and currencies.
Our first draft of this article was about how a higher Canadian dollar will lower cash flow and stock prices for Canadian energy producers. And investors do need to understand how that works. (More on that below)
But as the Dow Jones Industrial Average broke through support in the 7500 range, the US$ rallied again on safe haven buying and we think it will stay high as long as the market continues to grind lower- creating a better cash flow scenario for Canadian producers – and better profit scenario for their shareholders.
WHAT HAPPENS IF THE CANADIAN DOLLAR RISES?
Let’s say the loonie goes from US$0.80 to US$0.88, and oil just stays at US$40, that CAD$48 per barrel turns into CAD$44 – and that 10% price decline comes right off the top lines of Canadian energy producers – opposite of the scenario a few paragraphs up. And with much lower profit margins at these prices, that 10% top line revenue reduction can easily translate to a 20%-plus reduction to the bottom line profit, or heavens forbid, increased losses.
With these recent currency and oil price correlations now gone, this would be especially devastating for the Canadian oil producers should the CAD$ rise. Natural gas prices are already close between Canada and the US – with a 15 cent difference between the AECO Canadian price (found at www.ngx.com ), and the NYMEX US$ price (found at http://money.cnn.com/data/commodities/ ). Since most Canadian gas is consumed within Canada the effect there would be minimal, but it would still lower export pricing.
But with oil priced globally in US$, and the price of oil dropping or even staying steady while the loonie rises against the greenback, the end result would be like a hidden tax on Canadian producers’ cash flow, and investors’ valuations.
The above chart plots the US dollar in terms of Canadian dollars (candlesticks, in black), and separately plots the United States Oil Fund (USO-green line) as a proxy for the price of oil. USO is a popular ETF tracking the spot price of WTI light sweet crude. What is immediately apparent is the strong historical inverse relationship of the Index to the US$, and the recent pronounced disconnect as oil started its collapse back in July 2008. While crude has continued falling the last few months, the currency pair has been trading in a consolidation pattern – very close to a point of resolve where either a breakdown or breakout would be expected.
So in conclusion, many of the ingredients that made past trading relationships attractive have broken down. The US$-oil inverse relationship has ended for now. In fact, we may see oil and the dollar rise together in the near term (as the US$ has done with gold lately.)
This would mean that Canadian producers immediately stand to benefit, selling oil for appreciating US dollars and a higher price – a double boost that should give Canadian energy stocks a lift. However, a rising Canadian dollar would mean any rise in the oil price is mitigated, 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.