Oil and the bullish case for Canada

My son is working on a history project where he has to answer the question, “Was the assassination of Archduke Franz Ferdinand of Austria a cause or catalyst to World War I?” I can barely remember my WWI history, so when asked my opinion, I offered an honest and only response I could: “I have no idea, but it sounds like an interesting question.”

Let me be blunt. We will leave commentary to the geo-political fallout of last weekend’s events to those that have better knowledge and insight into the tenuous relationship between the United States and Iran. In truth, we have no idea, and to claim otherwise would be disingenuous. What we can do is measure the potential impact on those asset classes that we do have better insight into. In other words, let us focus on answering the question of where the potential investment opportunity exists. To that end, we offer the following: We believe the current environment could benefit the Canadian equity market and the Canadian dollar through further appreciation of oil prices.

As we highlighted in our “20 charts for 2020” Investment Note, crude prices move on supply and demand fundamentals (we will get to that shortly) but also on speculative positioning. Short sellers have been covering their positions rather aggressively since the middle of October to the lowest short position in 10 years. In December, we started to see long positions increase — well before the latest news over the weekend. We can only assume that we will continue to see this shift in sentiment to higher oil prices over the next number of weeks as tensions mount. Should the shorts continue to exit and longs build as we expect, we anticipate the price of crude to further appreciate. Ahead of the recent move, there was a general consensus that crude (WTI or Brent) did not have any geo-political risk premium priced in. As such, if our thesis holds, US$70/bbl for WTI is well within reasonable expectations.

The Chart shows the net speculative interest in oil options compared to the price of oil. The two lines tend to move in the same direction. If speculators are buying more long contracts, that suggests they are bullish on oil prices, which usually results in higher oil prices. The converse is true as well. If speculators are buying more short contracts, it shows that they are bearish on oil prices, then the price of oil tends to fall. Currently, the number of long contracts is moving higher, near 600,000, and oil, as measured by West Texas Intermediate, is breaking above $60.

On supply and demand fundamentals, here too, we have noticed the potential for further appreciation of oil prices, as the data would suggest we are currently in a supply deficit. Again, with the geo-political tensions mounting in the Middle East (and its significance as the largest aggregate oil-producing region), we doubt the supply side is going to start to increase. Borrowing a page from our economist colleagues, price is a function of supply and demand. If supply continues to tighten up, price is likely to trend higher.

The chart shows the difference between global oil supply and demand and the twelve-month moving average. Currently, there is an oil supply deficit and the twelve-month moving average is near zero, or equilibrium between supply and demand, but it has been declining since the beginning of 2019.

The potential for higher crude prices holds a couple of consequences to equity and currency markets. First, higher crude prices tend to translate into higher earnings growth for the S&P/TSX Composite Index. The relationship isn’t as strong as that between crude futures and price; nonetheless, an increase in the price per barrel of oil, all else being equal, should be a positive catalyst for S&P/TSX earnings growth. A conservative estimate for the price of crude (WTI) to average US$65/bbl would suggest accelerating earnings growth for the S&P/TSX Composite Index through 2020.

The chart shows the year-over-year earnings growth of the S&P/TSX Index compared to the price of oil, as measured by West Texas Intermediate, on a three-month lag basis. This means that December 2019 year-over-year earnings growth would be influenced by the year-over-year change in oil prices, as of September 2019. Earnings growth was unusually strong in 2019 despite a weak year-over-year change in oil prices. The area shaded in blue is an estimate of the year-over-year change in oil prices for the next 12 months if oil is $65 per barrel. If oil stays at $65 over the next 12 months, earnings growth should be strong.

Lastly, we wrote about the asymmetric risks of the CADUSD in December. We would re-emphasize our view that the risk to the Canadian dollar vis-à-vis the US dollar is largely to the upside. Our fair-value model would suggest that the CADUSD should be trading much closer to US$0.82 (CAN$1.21) on both interest rates and crude prices. The only justification for the current value of the loonie would be an expectation for the Bank of Canada to cut by 50 bps. We are less convinced that will happen near-term (3–6 months) given recent commentary by Bank officials. Even if the BoC did cut by 50 bps in the first half of the year, our model would suggest, at the current price of oil, the CAD would return to approximately US$0.76 (CAN$1.31), for a move of about 1% from its current level. The greater risk is to the upside appreciation of the loonie.

Taken as a whole, it would appear that the current environment is starting to favour Canadian assets.

The chart shows our modeled fair value for the CAD/USD exchange rate based on oil prices, and our modeled fair value for the CAD/USD exchange rate based on the difference between the Canadian and US 2-year bond yields versus the current CAD/USD exchange rate. In a rare occurrence, both fair value models suggest a higher value for the CAD/USD exchange rate. Our fair value models would suggest that the CADUSD should be trading much closer to US$0.82 (CAN$1.21), based on both interest rates and crude prices.

By Philip Petursson, Chief Investment Strategist, Manulife Investment Management

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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