In this post, oil’s relationship with the Canadian Dollar – US Dollar exchange rate is discussed. In our next post, the global supply and demand paradigm with consideration to OPEC cuts and US shale production will be dissected.

Oil (as measured by the US$ cost of a barrel of West Texas Intermediate crude, which is the global benchmark most relevant to Canadian producers) bottomed below US$30 at the beginning of 2016 and climbed steadily before being range bound between US$50-55 per barrel.

The strength of the Canadian Dollar against the US Dollar has historically had a strong positive correlation with the oil price. As such, it took ~$1.45 loonies to purchase one US Dollar when oil was below US$30. In contrast, when oil was closer to US$100 per barrel, the Canadian Dollar traded close to parity with the US Dollar.

To explain why this is, the trade relationship between the US and Canada must be considered. Canada is a net exporter of oil. Canada has one of the largest oil and gas resources in the world and one of the sparsest populations in a developed nation. Canada therefore produces much more oil and gas than it consumes and exports it to the USA. Oil is traded globally in US$. When Canadian producers sell their oil in US$, they must exchange this US$ for C$, boosting the demand for C$ and strengthening the C$.

As such, given a certain amount of Canadian crude exported, there will be an appropriate USDCAD exchange rate, all things equal. However, there are other interesting components related to oil and the exchange rate.

• Almost all Canadian exports are to the US. Given Canada’s low level of energy infrastructure development versus the USA, namely in the form of pipelines and rail with crude carrying capacity, and difficulty due to red tape in getting approval for infrastructure to tidewater (the ocean is where oil tankers can transport oil globally), Canadian oil is restricted to sale to the US. When pipeline capacity to the US is constrained, this creates a bottleneck that will depress the price of Canadian oil. Oil production off the coast of Newfoundland realizes global pricing, but the absolute volume of oil produced there is tiny compared to that of Alberta.
• Due to the advances in technology pertaining to shale and tight oil, American oil production has skyrocketed and is likely to continue to grow by millions of barrels per day in the coming years. This pushes out demand for Canadian oil, exacerbating the bottleneck and further depressing Canadian oil prices.
• Although Canada pumps out more oil than it uses and exports the oil, Canada is a net importer of refined products. Crude is not a finished good and needs to be sent to refineries to be transformed into end products such as gasoline, kerosene/jet fuel and diesel. The economics for constructing downstream assets such as refineries and upgraders in Canada are poor due to labor and manufacturing costs and political posturing, so oil is often sent to refinery capacity in the US and re-imported as gasoline to Canada.
• The characteristics of most Canadian oil is different from what refineries closest to Canada are designed to service. Canadian heavy, sour crude is best treated in complex refineries which are predominantly in the Gulf Coast (Texas/Louisiana). If a complex refinery goes down for maintenance, this depresses the price of Canadian crude.

As illustrated, the physical characteristics of Canadian oil and the bottlenecks in infrastructure give way to a differential in the WTI benchmark price and the actual dollar value realized by Canadian producers. The wider the differential, the weaker the Canadian dollar regardless of the benchmark price of oil. If the price of oil rises but the differential widens, there can be a decoupling of the C$-oil correlation.

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