Commodity Currency: Oil And The Loonie

For whatever reason, when Americans think of major crude oil exporters, they think of Saudi Arabia, Kuwait and other nations in the Middle East as the primary sources of oil consumed in the U.S. That assumption is wrong. The bulk of the imported oil consumed in the U.S. comes from Canada. In March 2009, the U.S. was consuming nearly 2.5 million barrels of Canadian crude per day, far more than the 1.9 million daily barrels the U.S. purchased from Mexico, the second biggest supplier of crude oil to the States.

Canada is one of the 10 largest producers in the world and has been rated as the one of the most energy-secure nations in the world by Energy Security News. Crude oil is Canada's most exported product to its southern neighbor and is tens of billions of dollars ahead of the next largest category - automobiles. The U.S. isn't the only loyal buyer of Canadian oil, either. Japan imports nearly all of its crude oil from Canada, and is another important buyer of Canadian crude.

Commodity Currency:

Canada's deep ties to the oil business make the Canadian dollar, or loonie, a favorite of currency traders to play on oil prices. They're right to do so, because the historic correlation between the loonie and crude is intimate to say the least. If you've ever heard the term "commodity currency," the Canadian dollar is the embodiment of that term. It's a great example of a correlation between commodity prices and currency movements.

Conventional wisdom says that if the price of oil is rising, the Canadian dollar will follow suit, especially against the greenback because oil prices are denominated in U.S. dollars. Likewise, currency traders are apt to buy the buck against its northern rival when crude prices tumble. Now this strategy doesn't work 100% of the time, no strategy does, but it works enough of the time to be extremely profitable for forex traders. So let's take a further look at crude oil prices and their impact on the Canadian dollar.

A Loyal Customer:
Canada's role as a chief oil exporter is bolstered by a friendly customer that is close by with a voracious appetite for crude. While the appetite for crude oil in the U.S. does fluctuate, American demand for oil has been on a steady upswing, historically speaking. Canadian oil producers’ benefit by not having exorbitant shipping costs to the U.S., and this keeps more dollars in Canada, benefiting the economy as a whole.

Of course, it's not cheap to get oil from Canada to Japan, but the market is still lucrative for Canadian producers. Overall, having two politically stable countries among your top customers for any export is a plus, and it certainly doesn't hurt the loonie's value that the U.S. and Japan are two of the largest economies in the world, and among the top 8 most tradable currencies.

Plenty in the Tank
another potential source of strength for the Canadian dollar, assuming worldwide oil demand flourishes in the future, is the fact that not only did Canada surpass Saudi Arabia as the top supplier of crude to the U.S., Canada has the second-largest proven reserves of crude, behind its rival from the Middle East.

Although Canada is a long way from Saudi Arabia in terms of proven reserves, new discoveries in the Kingdom have not been impressive in recent years, leading some industry observers to ponder if Saudi Arabia's reserves are as high as the royal family says they are. On the other hand, thanks to the booming tar sands, Canada is actually moving up the list of oil exporters. As new discoveries of note become harder to come by, Canada and its currency are poised to benefit by being able to meet demand for crude from the world's hungriest customers.

And we can't forget that among the nations expected to crave more and more crude in the future is China, which has already taken note of Canada's vast reserves, so it's not unreasonable to expect that Chinese demand for Canadian crude will grow as the Chinese economy grows. Chalk up another point in favor of the loonie.

How to Play This Profitable Pair
looking at a chart that compares crude oil and the performance of the Canadian dollar is like watching a pair of professional dancers. Oil is the leader and where it goes, its partner, the loonie, usually follows; at least about 80% of the time, according to the exact correlation figures. Therefore, a move in oil is a leading indicator that can be a tip-off for the astute investor to buy or sell short Canadian dollars.

Obviously, forex trading isn't for every investor, but there are other ways to play the crude/loonie pair and exchange-traded funds (ETFs) focused on the Canadian might be the best way. The Currency Shares Canadian Dollar Trust (NYSE:FXC) tracks the loonie's daily performance, so it gives investors direct exposure to the currency without risk of investing in the forex market. Another ETF to consider may be the iShares MSCI Canada Index (NYSE:EWC), which tracks a basket of some of the largest stocks that trade on the Toronto Stock Exchange (TSX).

Investors should note that the EWC tracks Canadian companies from a wide swath of industries, not just the oil patch. For those that prefer direct equity investments, Suncor Energy (NYSE:SU) is one of Canada's largest oil firms, a dominant presence in the oil sands of western Canada, and its stock is sure to pop as oil demand surges.

The Bottom Line
Next time the price of oil heads up, don't get angry and worry about how much your next trip to the gas station is going to cost. Get even by making a play on the Canadian dollar. After all, revenge on rising oil prices may be a dish best served Canadian.