For years, the loonie has had a strong negative correlation with crude prices. When oil goes up, the Canadian dollar strengthens. When oil falls, it weakens.
The relationship makes sense given such a huge portion of the Canadian economy is either directly or indirectly exposed to movements in the energy markets. For example, in 2009, when oil prices plummeted to US$30 a barrel, the loonie weakened to its lowest levels in years. After oil staged a rebound to US$100, the Canadian currency normalized completely.
The latest oil crash, which began in 2014, has pushed the loonie to even weaker levels. While the rebound to US$50 a barrel has provided some relief lately, it looks like oil prices have a good chance of falling yet again.
Oil may fall again
The oil collapse originated from a supply glut provided by cheap, low-cost U.S. shale projects. After a price war broke out, most of these new suppliers continued pumping for far longer than most thought. Finally, this year investors started to feel some relief; U.S. and Canadian crude production fell enough to push oil prices back towards US$50 a barrel.
However, the next shale production wave could be just around the corner.
According to a report by the Bloomberg Intelligence, nearly half of the wells located in the Permian Basin and Eagle Ford can remain profitable even when crude prices fall below US$30 a barrel. A whopping 85% can maintain profitability with prices at US$50 or below. Areas such as DeWitt County and Reeves County break even at prices below US$25 a barrel. True operating costs may be even lower, warns the report.
With shale production costs consistently lower than the market expects, don’t count on U.S. crude production to continue falling at current prices levels. It’s very possible we’ll see sustainable oil production growth at or even below US$50 per barrel. That would be bad news for both oil prices and the loonie.
U.S. rate hikes could provide extra pressure
The Canadian dollar will almost certainly take a hit versus the U.S. dollar if its southern neighbor decides to continue raising key interest rates. Typically, currencies with higher interest rates tend to have stronger values versus those with lower borrowing rates.
The two countries are currently on very different tracks. The Bank of Canada’s key lending rate stands at 0.5% after it cut the figure twice earlier this year. Meanwhile, the U.S. raised rates to 0.5% last December, and according to Goldman Sachs Group Inc. (NYSE:GS) analyst Jan Hatzius, “The chance of a rate hike by year-end is 80%.” His new report called the latest payroll report “just enough” for the U.S. Federal Reserve to raise rates this month
With oil prices set to drop and the U.S. likely raising rates, there isn’t much hope for a strengthening loonie anytime soon.
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Fool contributor Ryan Vanzo has no position in any stocks mentioned.