The Looniness Of The Canadian Loonie And Oil Sands

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Includes: BNO, DBO, DNO, DTO, DWTI, EWC, FCAN, FXC, HEWC, OIL, OLEM, OLO, QCAN, SCO, SZO, UCO, USL, USO, UWTI
by: Jeff Malec

Our neighbors to the north are facing a harsh reality these days… the ongoing devaluation of the Canadian Dollar, or better known as the Loonie. While it's hard to take the Loonie seriously given its loonie name, it's a major concern for Canadians and their economy. Despite rebounding around 10% from its 2016 lows, the Loonie is still down around 25% from its high 2011 highs.

Click to enlarge

(Disclaimer: Past Performance is not necessarily indicative of futures results)
Chart Courtesy:
Barchart

If you're familiar with the makeup of the Canadian economy, many are blaming this downward move on crude oil's recent drawdown, the largest drawdown in history. Just take a look at the 30-day rolling correlation of Crude Oil to the Loonie starting in 2014.

Canadian Dollar Crude Oil Correlation

The correlation currently stands at 0.69 but was as high as 0.72 back in January. This week, the Royal Bank of Canada (NYSE:RY) reported that crude oil's implosion is the biggest contributing factor to the fall in the Canadian Dollar.

Three Quarters: Proportion of the fall in the Canadian dollar's exchange rate attributable to the decline in energy prices, according to Royal Bank."

$25 billion: Cost of the plunge in oil prices to Canada's economy."

This makes sense when you consider that "mining, quarrying, and oil and gas extraction" made up 6.91% of Canada's total GDP in 2015, and 23% of the goods-producing industry. To understand that number, we need to understand the way Canada produces oil. The majority of that mining or extraction is not for oil itself, but extracting a mixture known as oil sands.

What are Oil Sands?

Surprising enough, oil sands isn't actually oil, but can be turned into oil. Oil Sands is an actual physical mixture of sand, water, clay and bitumen found primarily in Venezuela, The United States, Russia, and Canada. We can't do the explanation justice, so we'll let this quick 30-second video do the trick.

While many haven't heard much about it, in Canada, it's their biggest means of producing oil, per the Canadian Association of Petroleum Producers.

Oil Sands Canada Production

Source: CAPP

2016's Dilemma:

The issues lays in Canada's planned expansion in the oil sands. For starters, there were 17 cancellations or delays of oil sands projects due to the continuation of low oil prices, which isn't an optimistic outlook for a country that relies on oil production.

Currently, oilsands projects generally require oil prices of at least $60 to make money, although the facilities do have a long lifespan to recover capital investment and turn a profit.

With oil hovering around $40 a barrel, the market has a lot to make up before oil sands are able to make money again. Still, the Canadian government is planning on increasing oil production, while at the same time suggesting that the economy should find alternative ways to make up for that potential GDP gap.

Oil Sands Production Alberta

Source: CBC News

The thing that really stuck out for me is that none of the pathways that they describe really define a future where you are really going to see a lot of additional development in the oilsands sector," said Prof. Warren Mabee, an energy researcher at Queens University.

The Liberal government may, in Tuesday's budget, begin to introduce policy to help diversify the economy away from oil, Mabee suggests.

"What we are talking about is a continued transformation," said Mabee, who is director of the Queen's Institute for Energy and Environmental Policy (QIEEP). "We are going to need other parts of the economy to really start picking up the slack."

The Canadian Loonie and Oil

This growing correlation between the Canadian Dollar and crude oil is not an ideal situation for managed futures. Many trend-following programs rely on what's called market diversification, trading dozens of markets across the world to help control risk. However, the more the Canadian Dollar and crude flow in tandem, the less diversification there is in a portfolio, the harder it is to control risk. To be fair, we are talking about a single market out of dozens, so we don't want to put too much emphasis on the correlation, although as we talked about last week, it seems that crude oil is influencing more than just the Loonie. We'll have to see if this correlation persists, or if this could be a potential problem for diversification moving forward.