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Tight Relationship of Oil Industry and Foreign-Exchange Market

By Cesar Zambrano

22 July 2010

In our current economic age of globalization, asset classes are becoming increasingly correlated.  Movements in the equity markets affect currency values, which affect economic growth in corresponding countries, which affects other assets such as real estate, and the correlations go on and on.  One of the most clear asset correlations that currently exists in financial markets is the relationship between the oil industry and the foreign-exchange market.

The price of oil is extremely volatile.  Its price movements are subject to a vast range of factors including economic growth, geopolitical events, supply and demand, and host of other factors.  The volatility in oil prices can wreak havoc on oil industry leaders such as refineries and producers, but it is a haven for speculators.  Individual traders and hedge funds alike have been speculating on the price volatility of oil for decades.

Understanding the relationship that oil has with specific currencies and nations can help investors take advantage of these volatile movements.
Among developed nations, Canada is a leading producer and exporter of oil.  In fact, among developed nations, Canada is one of the few net exporters of oil.  This means it exports more oil than it imports.  And Canada is not going to become less of a net exporter anytime soon.  In fact, according to current measurements, Canada has the second largest reserves of oil in the world behind oil giant Saudi Arabia.  Canada’s primary trading partner is, of course, its good neighbor to the south, the United States of America, but as the economy of China continues to expand at a ferocious rate, China’s demand for Canadian oil is also rising steadily.

Due to its large oil operations, Canada’s economic growth is heavily dependent on the oil industry.  As demand for oil increases, Canada’s economic growth tends to increase as well.  As demand for oil decreases, Canada’s economic growth tends to decrease as well.  Thus, there is a tight correlation between the price of oil and economic growth activity in Canada.  Furthermore, since the Canadian economy is so dependent on the oil industry, the Canadian currency also tends to be heavily affected by volatility in the price of oil.  As the price of oil increases, the Canadian Dollar tends to strengthen in value and as the price of oil decreases, the Canadian Dollar tends to decrease in value.  As many forex trading guides discuss, the correlation is extremely tight.

As evident in the chart above, the correlation between the price of oil and the strength of the Canadian Dollar is very strong.  Since Canada is the only developed nation that is a very strong net exporter of oil, the Canadian Dollar is really the only major currency that is affected positively when the price of oil rises significantly.  However, on the flip side of the coin, there are developed nations that are heavy net importers of oil.  What do you think happens to their economy during times of high oil prices?

Although Japan is a major exporter of goods and services, it definitely does not export oil.  In fact, Japan is one of the world’s largest net importers of oil.  Due to the fact that Japan is heavily dependent on importing oil in order to meet its domestic energy demands, its economy tends to be sensitive to extreme volatility in the price of oil.  As the price of oil increases significantly, the Japanese economy will suffer since it is required to pay higher prices for the same amount of oil.  Conversely, as the price of oil falls significantly, the Japanese economy will tend to be boosted since it can now purchase more oil for the same price.  In the latter example, Japan’s purchasing power of oil increases, which in turn boosts its economy.

A fascinating way to play the correlation between the oil industry and foreign-exchange markets is to take these two currencies, the Canadian Dollar and the Japanese Yen, and pair them together.  If the outlook for oil is positive over the next year, then the Canadian/Yen should appreciate significantly.  Conversely, if the price of oil is expected to decrease over the next year, the Canadian/Yen should depreciate significantly.  This is one way an investor can position himself or herself to take advantage of the tight correlation that exists between the oil industry and the foreign-exchange market.

About the author: Cesar Zambrano is a writer for ForexFraud.com, a website devoted to educating investors in the subject of frauds and scams. He has been interested in the stock market, investments, and spreading the word about fraudulent activities for much of his life, but has most recently fulfilled this passion by working for ForexFraud.com

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