Why Do Oil Prices and the Canadian Dollar Move Together?

Q: I've noticed that the Canadian Dollar and Oil Prices always move together. If the price of crude oil goes down, the Canadian dollar goes down (relative to the U.S. Dollar). If the price of crude oil goes up, the Canadian dollar is worth more. What's the mechanism at play here? Why does it happen?

A: Thank you for your terrific question!

Before we begin the analysis, there are two facts we need to keep in mind:

1. Since oil is an internationally traded commodity and since Canada is so small relative to the United States and the EU, price changes in oil are caused by international factors outside of Canada.

2. Since the demand for both oil and gas are quite inelastic in the short run, a rise in oil prices causes the dollar value of the oil sold to rise. (That is, while the quantity sold will reduce, the higher price will cause the total revenue to rise, not fall).

Canada exports around 2 million barrels of oil a day to the United States. If the price of a barrel of oil is $50 U.S., that is $100 million (U.S.) in purchases that occur every day. Because of the magnitude of sales involved, any changes to the price of oil has an impact on currency market.

Higher oil prices drive up the Canadian dollars through one of two mechanisms, which have the same end impact. The difference is on whether or not the oil is priced in Canadian or American dollars, but the final impact is identical.

The Oil is Priced in U.S. Dollars

This is the most likely of the two stories. If this is the case then when the price of oil goes up, Canadian oil companies receive more U.S. dollars. Since they pay their employees (and taxes and many other expenses) in Canadian dollars, they need to exchange U.S. dollars for Canadian ones on foreign exchange markets. So when they have more U.S. dollars, they supply more U.S. dollars and demand more Canadian dollars. Thus, as shown in A Beginner's Guide to Exchange Rates and the Foreign Exchange Market, the increase in supply of the U.S. dollar drives the price of the U.S. dollar down. Similarly, the increase in demand for the Canadian dollar drives the price of the Canadian dollar up.

The Oil is Priced in Canadian Dollars

This is a less likely scenario, but easier to explain. If oil is priced in Canadian dollars, and the Canadian dollar rises in value, then American companies need to buy more Canadian dollars on foreign exchange markets. So the demand for Canadian dollars rises along with the supply of U.S. dollars. This causes the price of Canadian dollars to rise and the supply of U.S. dollars to fall.

I hope I have successfully answered your question.

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