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Trading World Tour (Pt 3): Canada's Crude Oil & Resources

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July 23, 2015
Trading World Tour (Pt 3): Canada's Crude Oil & Resources

Editor’s note: North America is the third stop in a seven-part tour of each continent’s economic and market outlook. Here, we’ll drill down on Canada’s natural -resource-driven economy as it relates to North America’s rebound. Read our coverage of Europe and Asia, too.

The Canadian economy looks to plod along at a 1.6% pace in 2015, TD Bank says, down from a 2.4% clip in 2014. That means the U.S. and Mexico are expected to outperform their neighbor, with both forecast to grow 2.5%. For comparison, European Union growth is pegged at 1.9% this year, meaning it, too—Greece uncertainty and all—could outrun Canada. So what's the hangup for the northern reaches of the continent? It boils down to a couple of words: crude oil.

The price of West Texas Intermediate (WTI) crude oil futures has tumbled over 50% from a peak at around $112 per barrel in March 2014 to a low near $42 per barrel in March. It’s up to just below $60 a barrel early this summer.

That’s a painful dive for Canada, the planet's fifth largest oil producer. The nation sells C$85 billion of oil and gas exports annually to the world, notes Robert Palombi, managing director at Standard & Poor's Rating Services.

James Marple, senior economist at TD Bank Group in Toronto, called the drop in oil prices "a huge income shock" to the Canadian economy. "When the price of energy collapses as it has, the value of what we are selling to the world is cut in half," Marple says.

But the oil drag may be changing course. Looking ahead, TD Bank forecasts the price of WTI crude oil to continue to climb over the next 12–24 months, nearing US$70–80 per barrel. And as oil prices rise, profits in the oil sector are forecast to climb with them.

"It is our view that the worst is likely behind us. Although the impact of lower oil prices on corporate profits and business investment are forecast to persist in the near term, the anticipated boost to exports from a lower Canadian dollar and resurgent U.S. economy should pave the way to better growth numbers," says TD Bank research.

The Shiny Stuff, Too

The Canadian economy is also closely tied to metals and mining. Canada exports metals products to the tune of C$55 billion annually, says Palombi. Canada is the home to many gold mining companies, several of which are listed on U.S. stock exchanges.

This summer, nearby Comex-traded gold futures stood near $1,200 per ounce, up from a low at around $1,135 in November 2014. For 2015, TD Bank forecasts an annual average of US$1,198 per ounce for gold, with an increase to $1,269 pegged for 2016.

Currency Boost

It's no accident that the Canadian dollar, affectionately called the "loonie" by foreign exchange traders, is referred to as a commodity currency, its fortunes often tied to the whims of resource prices.

The U.S. dollar/Canadian dollar (USD/CAD) rate surged significantly higher over the past year, with the greenback strengthening roughly 15% versus its northern counterpart. USD/CAD increased from $1.06 in July 2014 to a multi-year high at $1.28 in March 2015. In June, the exchange rate fell back to the $1.22 area (figure 1). 

Chart of USD/CAD

FIGURE 1: WHAT’S NEXT FOR THE LOONIE? USD/CAD increased from $1.06 in July 2014 to a multi-year high at $1.28 in March 2015. The dollar pared its gain against its Canadian counterpart and other major currencies this spring, but most economists are predicting continued interest rate gaps between the two nations. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The rising USD/CAD rate makes Canadian exports more competitive, or less expensive, for American buyers. "It means a 15% discount for Americans buying Canadian goods," Palombi says. "We are likely to see non-oil-export activity increase to the weakening in the Canadian dollar. This will have an important impact driving growth in Canada," he says.

The U.S. is Canada's largest trading partner, with roughly 80% of all exports heading to the United States. Stronger U.S. economic growth in turn should help support a rebound in Canadian growth in the second half.

"U.S. consumers have improved their balance sheet and they are in a position to spend. Interest rates are still low, which is likely to drive durable goods consumption like auto sales. The housing market is coming back, which will also support Canada," Palombi says. In addition to natural resources exports, Canada is also a large exporter of motor vehicles and parts, totaling C$75 billion annually and lumber and building materials at C$37 billion annually, he adds.

Interest Rate Differential

Foreign exchange traders, in part, drive currency prices based on so-called “interest rate differentials," or the difference between central banks’ official policy rates. The U.S. Federal Reserve's official policy rate—the federal funds rate—currently stands at zero to 0.25%. Looking ahead, it is widely expected the Fed will pull the trigger on one or two quarter-point rate hikes this year and continue with tighter monetary policy in 2016.

Meanwhile, the Bank of Canada's (BOC) official overnight target rate currently stands at 0.75% and is expected to stick there until late 2016. TD Bank says the BOC monetary policy outlook is likely on hold until Q4 2016, when an expected quarter-point hike would nudge the target rate to 1%. Comparatively, TD Bank expects the U.S. funds rate to climb to 1.25% by Q4 2016.

Looking ahead, the impact of a weaker currency, a forecast for higher crude oil prices, and expectations for stronger demand for Canadian exports from the U.S. should support a solid recovery in the second half of this year.

"The Canadian economy should improve alongside better U.S. growth. After such a big hit, you sometimes get resulting value opportunities," Marple says. 

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