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a blog from young economists at Nova SBE

The Canadian Dollar and the World Price of Oil

The Canadian economy is highly dependent on the export of domestic oil to countries with high demand, primarily the U.S. World prices of oil have a major impact on the economy of Canada, and further influences on the floating exchange rate of the Canadian Dollar (CAD) on international exchange markets. Many argue that the rising value of the CAD is attributed to a Dutch Disease scenario where increased revenue from natural resources damage other sectors (traditionally manufacturing) and increase the real exchange rate. Mark Carney, Governor of the Bank of Canada argued against the Dutch Disease case citing strong trade relationships and the multilateral depreciation of the U.S. Dollar (USD) accounting for 40 percent of the CAD appreciation since 2002. He argued that declines in Canada’s manufacturing sector came naturally rather than at the cost of increased revenues from natural resources in Canada.

Graph

Figure 1 highlights the relationship between West Texas Intermediate (WTI) world oil prices and the Canada to U.S. Dollar exchange rate, and suggests a relationship between the two. Both series follow similar trends, with the value of the CAD falling in the months following sharp drop in oil prices starting in 2008. Since Canada is an exporter of oil, increases in world oil prices (measured in USD) means the country would reap the benefits of higher nominal value of its oil deposits. Higher values of exports increase the terms of trade for the country, as defined by the value of exports as a ratio to the value of imports. The link is made between the higher value of exports of the country and the increased demand for the currency of the country. This increased demand in turn appreciates the value of the currency. The high correlation between the currency and price of oil has given the CAD a status of a commodity currency linked to oil.

Appreciation of a currency comes with a number of macroeconomic impacts. A stronger Canadian dollar relative to the U.S. means it is more expensive to buy commodities priced in CAD, increasing the cost of doing business in Canada. Further, the impact is not equal across all sectors of the economy with industries highly linked to oil (such as transportation and construction) becoming more expensive with higher input prices. Recent research has found however that not all oil prices have increased the same and a spread in prices is a detriment for Canada. It is estimated that the gap between the price of oil exported from western Canada and the price imported to central Canada is $30.50 a barrel, with annual estimated losses ranging from C$18 to C$19 Billion dollars [2].

Although there is a strong relationship between the price of oil and the value of the Canadian dollar, the final impacts that occur from higher oil prices are complex. It is difficult – if not impossible, to determine the true relationship between oil prices and the value of the CAD however the high correlation between the two carries significant policy implications for Canada’s macro-economy. The Bank of Canada concludes that [3]:

“high commodity prices, regardless of the cause, are good for Canada. Rather than debate their utility, we should focus on how we can minimise the pain of the inevitable adjustment and maximise the benefits of our resource economy for all Canadians.”

Jacob Macdonald
Nova SBE


[1] Dale Orr, “What is the Relationship Between the Exchange Rate and Oil Prices?”, May 2009, Economic Insights http://www.economicinsight.ca/economicpapers.htm

[2] Greg Quinn and Doug Alexander, “Canada Is World’s Biggest Oil Loser With Price Spread”,  May 8, 2012, Bloomberg http://www.bloomberg.com/news/2012-05-08/canada-is-world-s-biggest-oil-loser-with-price-spread.html

[3] Mark Carney, “Remarks on Dutch Disease”, September 7, 2012, Bank of Canada Spruce Meadows Roundtable

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Author: studentnovasbe

Master student in Nova Sbe

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