In my last article on March 12, I used regression analysis to demonstrate that the NOK/EUR currency pair is significantly impacted by oil price movements. Specifically, a regression analysis for the time period February 2000 - March 2015 demonstrated that for every 1% change in oil prices to the upside, there was a corresponding change of 0.0584% in the NOK/EUR currency pair. Moreover, it was demonstrated that the NOK/EUR currency pair and Brent Crude Oil prices were significantly co-integrated, meaning there is a high chance that the regression results are not spurious.
In this particular article - given that we have already established the statistical relationship between the currency pair and oil prices - is to backtest the model over the past 50-day period to determine prices yielded by the model. Following from this, I then use various oil price scenarios of $30, $55, $75 and $100 to determine potential currency movements based on these oil prices.
On February 4, we see that the Brent Crude Oil price was initially trading at $55.07, having dropped to a level of $53.82. In the table below, we have the actual NOK/EUR price in the second column, along with a predicted NOK/EUR Spot Price in the sixth column that would have been determined by the model based on the Brent Crude Oil price for that day, taking into account the assumption that a 1% change in crude oil prices result in a 0.0584% change in the NOK/EUR currency pair. On February 4, the NOK/EUR was trading at a level of 0.1155. By March 23, this had decreased to a level of 0.1149, which is a -0.52% decrease over this period. The model had predicted a spot price of 0.1154, which represented a mean absolute deviation of 0.45% from the actual price and would have represented only a marginal drop from the original price of 0.1155. Given a low mean absolute deviation yielded by the model, I now use the regression to generate various price paths on the basis of potential movements in Brent Crude Oil.
Source: Author's calculations.
Oil Price Scenarios
Source: Author's calculations.
At a Brent Crude Oil price of $30, the model yields a price of 0.11159, which is a -2.88% drop from the current level of 0.1149.
At a Brent Crude Oil price of $55, the model yields a price of 0.11556, which is a 0.57% upside from the current price.
At a Brent Crude Oil price of $75, the model yields a price of 0.11769, which is a 2.43% upside from the current price.
At a Brent Crude Oil price of $100, the model yields a price of 0.11972, which is a 4.19% upside from the current price.
While oil prices have been on an upward trend, a target of $100 by the end of 2015 seems overly optimistic. Moreover, the analysis reveals that the NOK/EUR does not have a great deal of upside should there be a rise in oil prices - this would suggest that a long NOK position in hopes of an oil price rise would not yield the rewards investors might expect. Moreover, this model has only considered the impact of oil prices and not of other macroeconomic fundamentals. On March 10, the Norwegian Krone had hit a 12-year low against the U.S. Dollar as inflation came in at 2.4 percent, instead of the prior 2.5 percent expected by market analysts. After a cut in the policy rate by the central bank to 1.25 percent, there is now speculation of a 50 percent chance of a rate cut in June to curb low growth - any potential gains in oil prices could well be outweighed should a deflationary spiral and low economic growth similar to Europe develop.
In conclusion, the analysis shows that while some upside may be gained by the NOK/EUR as a result of higher oil prices, it is likely to be limited and for a country which depends heavily on oil revenues, the currency does not stand to benefit a great deal from higher oil prices. In this context, I would not take a bullish view on the NOK even if oil prices should increase as the upside is likely to be limited.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.