Quite a lot has been written about the relation between the Canadian dollar exchange rate (to US dollar) and the oil prices. The general consensus is that such a relation is present but not too many people have tried to quantify it.
Looking at a few correlation charts makes the point very clear, the correlation exists and it has generally been increasing over time. Observe, by clicking on the links below, how the data points more tightly align themselves around the regression line as we reduce the time interval. It is a clear indication that the correlation between the two values increased over time:
The correlation has really taken off in the past 8 years, a period where we have seen a significant increase of oil prices and of oil production at the Alberta oil sands. As the production of oil sands' oil increased, the correlation became stronger. From an economic theory standpoint this is quite logical: the sales of Canadian oil to other countries increase the demand for Canadian dollars as the other countries need to purchase Canadian dollars in order to purchase the Canadian oil. The more oil Canada has to sell, the stronger the impact.
So what is affecting the correlation through the demand for Canadian dollars is not the price of oil itself but the value of oil produced in Canada, a combination of the volume of oil produced in Canada times the price the oil is sold for. If you look at this graph you’ll observe that the value of oil exports has roughly tripled since the early 2000 (Note: To calculate the oil exports value, I’m taking the production of oil from oil sands times the price of heavy crude oil in Hardisty plus the production from conventional sources times the price of Par crude in Edmonton, this is not perfect but a good proxy.). This significant increase in the value of the production (and exports) explains why the correlation has strengthened so much.
I said at the beginning of this post that I would estimate the magnitude of this impact. If you run some more calculations what you would find is that for every 10% increase in the value of oil exports, the Canadian dollar increases by roughly 3%. Short term, it means that if the price of oil increases by 10%, the Canadian dollar value (vs. the US dollar) is likely to increase by 3% (or vice versa). Long term, everything else being equal (e.g. interest rate policy), this relation is likely to get stronger as the oil sands production increases.
Note that this relation between currencies of natural resources producing countries and commodity prices is not unique, check out the relation between the Australian dollar and metal prices for instance.
As for Canada, I'll talk about the potential impact of the oil prices' relation with its currency in future posts ...