How to Trade Oil and the Loonie DollarSeptember 14, 2018
No other product changed our society the way oil did. Petroleum, more precisely, sits at the core of almost everything we do today. Besides its prominent influence in our lives, the price of oil dictates the value of currencies too. In this article, we aim at explaining how to trade oil and the Loonie dollar as correlated markets.
Also, we’ll explain the oil’s influence in central banking decision-making process. The price of oil drives inflation and makes it difficult for central banks fighting deflation too.
Before arguing about the oil’s role in our day-to-day life, just think of what a single barrel of oil produces:
- distillate fuel to drive a truck for forty or fifty miles
- more than sixty Kilowatt-hours of electricity
- about five Kg of charcoal briquettes for barbeque
- over a hundred and fifty wax birthday candles or about thirty crayons for children to use at school
- gasoline for a medium-sized automobile to have for over four-hundred kilometers
We’ll stop here, but that’s not all. The petrochemicals left by refining petroleum products are used to manufacture t-shirts, toothbrushes, plastic drinking cups and so on. Virtually, anything you can imagine made of plastic.
One.Single.Barrel.Of.Oil! Do I have your attention now?
But the oil’s influence goes far beyond that. It drives the prices of all goods and services in our day-to-day life. Hence, it influences central banks’ decisions as they all target certain inflation levels.
Perhaps there’s no other currency in the developed world that depends on the oil market as the Loonie Dollar. That’s the trader’s nickname for the Canada Dollar. Or, CAD.
How To Trade Oil and the USDCAD Pair
Canada oil reserve is one of the largest reserves in the world. Only Saudi Arabia and Venezuela have larger ones.
What’s interesting is that over ninety-percent of Canada’s oil comes from one region only: Alberta. Moreover, all of these reserves are in the oil sands deposits.
The thing is that almost all Canada oil exports go to the United States. Hence, the USDCAD flows depend mainly on fluctuations in the oil market and U.S. oil inventories.
In other words, the USDCAD pair and the price of oil trade in a correlated manner. While the CAD and the price of oil have a direct correlation, the USDCAD has an inversed reaction to the changes in the price of oil.
Forex Correlations - USDCAD and the Price of Oil
The USDCAD and oil correlation dictates the CAD movement. Bank of Canada policy depends on the changes in the price of oil as well as on the Canadian oil production levels.
Because the oil industry creates many Canadian jobs, both upstream and downstream, the jobs data (e.g., unemployment rate) depends on its evolution. As such, interest rates in Canada are set by the central bank considering the oil industry problems, WTI (West Texas Intermediate) oil futures, OOTT developments, OPEC (Organization of Petroleum Exporting Countries) meetings, and so on.
The correlation between the two markets (USDCAD and oil) is powerful. When oil, for instance, dropped to $30 from above $100, the USDCAD surged accordingly. It reached the 1.46 mark, in a vertical move.
As such, any oil industry news sparks a move in the USDCAD pair, too. That’s particularly true when the news comes from the United States.
For instance, take the U.S. oil inventories. On their release, the CAD reacts instantly.
On a surge in inventories, the market players expect a decline in Canadian oil imports in the United States. Hence, traders sell the CAD (buy the USDCAD).
When the oil inventories in the United States drop, it triggers a bearish reaction on the USDCAD (lower oil inventories lead to traders buying CAD as exports to the United States will rise).
OPEC meetings and what’s happening with the overall oil industry plays a role on the CAD too. The evolution of the shale oil industry in the United States, the emergence of new technologies (e.g., fracking), they all have the power to change the balance in the oil market.
But oil isn’t just a commodity. Some countries use oil as a weapon to gain influence and negotiating power.
Oil and Inflation – Key Role in the Currency Market
So, for a currency trader, the question of how to trade oil is secondary in importance. More correct would be how to trade the market’s reaction due to changes in the price of oil.
As already mentioned in this article, oil has an extraordinary inflation component. Put it simply, higher oil prices lead to a rise in inflation.
A rise in inflation gives nightmares to any central bank. That is if inflation exceeds the mandated target.
Economists around the world agree that for capitalistic economies to grow at a steady pace, moderate inflation helps. But how much is too much?
The consensus built around the two percent target. Hence, central banks like the Fed in the States or ECB (European Central Bank) target inflation below or close to two percent.
Obviously, they consider the price of oil when setting the monetary policy. Because of that, the core inflation (inflation that excludes energy prices) is more relevant for their decision. However, no central bank in this world would act on pure core inflation if the price of oil doesn’t support the decision.
Consider the last years. The 2008 financial crisis made it challenging for all economies around the world to continue growing.
But, the things almost got out of control when the price of oil collapsed to $30. The move sparked a drop in inflation as a result of consumers postponing the purchasing decision.
In some cases, deflation kicked in (negative inflation or when inflation drops below zero). The economic engine doesn’t work anymore, as low inflation or deflation grips everything.
So yes, the central banks may look at the unemployment rate, jobs creation and changes in inflation. But all of them, absolutely all of them depend on what’s happening with the price of oil.
How to Trade the Loonie Dollar – Tips and Tricks
From now on, when thinking of what is WTI oil price’s influence on the EURUSD pair, for instance, you know the answer. Or, what Brent oil’s price drop has to do with the JPY?
As we started with how to trade oil and the Loonie Dollar, let’s focus a bit on the USDCAD pair. Because it has the USD in its componence, automatically is a major pair.
Unlike other currency pairs, this one travels on Monday’s. While other major pairs like the EURUSD typically make a false move (breaking Asian highs, reversing for the lows and settling in the middle), the USDCAD does no such thing.
Just watch it over a few Mondays’ price action and take notes in comparison with other currency pairs. You’ll see that the Loonie Dollar has an interesting pattern on Mondays.
Liquidity may be a problem. This is the less liquid major pair of them all.
Brokerage houses take advantage of this issue and increase the spreads significantly when positions roll over to the next day. Because their liquidity pool only feeds on one or a few providers (talking about regular FX brokerage houses), the spreads increase almost unjustifiable. Trading big on the USDCAD pair with a regular FX brokerage house is a nightmare too.
A real puzzle is how to trade the USDCAD pair when jobs data from both the United States and Canada comes out. Trading algorithms react on both sides, sending the price up and down in huge swings that trigger most retail traders’ stops.
The thing to do is, on such a Friday, look at the bigger picture. Use a timeframe like the daily or above, where the jobs data swing does no harm to the technical picture.
Or, if trading has a macro-component, stick to it, despite being ahead or behind the curve.
An article about the oil market and the price of oil may come as a surprise for many Forex traders. But, it shouldn’t.
The price of oil tells you how to trade the Loonie Dollar. Instead of doing technical analysis on the USDCAD, for example, just have a look at a Brent oil chart. You’ll know more about CAD than otherwise.
Moreover, the world of global central banking keeps a close price on the oil market. FX traders should keep an eye on the oil market and learn how to trade oil rather than any currency pair due to the inflationary component oil has on all economies.
As our society changed since the oil’s discovery, it’ll continue to change moving forward. People arguing that electric vehicles will affect oil demand should go back to the start of this article. And, check what humankind produces from a single barrel of oil.
Unless central banks modify their mandate and won’t focus on inflation anymore, the price of oil dictates monetary policies around the world. If history tells us something, the petrodollar’s birth brought enormous benefits to the United States economy.
At the time of the Kissinger’s deal with Saudi Arabia, the U.S. offered military protection in exchange for the Saudis to sell their oil in American Dollars. Just like that, oil as a weapon became a reality.
From influencing politics, central banks decisions, and the currency market, oil is a critical element of every trader’s journey. Any trader having multiple trading screens on his/her desk, should have one dedicated to the most essential commodity of them all: oil.