Friday, March 20, 2015

The times are changing – Canadian dollar about to rise?

It may seem sexy to invest in the U.S. these days because of its continuously rising stock market and the additional appreciation of the U.S. dollar versus other world currencies including the Canadian dollar. But those days may be over sooner than you think.  So what would the impact be of a falling dollar on our investment strategy?

Well if you used a bit of leverage rather than Canadian dollars to buy your recent U.S. investments, a falling U.S. dollar would reduce the value of your U.S. dollar denominated loan and you would appreciate along with the U.S. stock market and along with the decreasing value (in terms of Canadian dollars) of any U.S. denominated assets.  So buying U.S. stocks on margin in your U.S. dollar brokerage account would nearly act as a hedge for your U.S. dollar currency exposure.
If you are more aggressive you could increase your margin in the U.S. dollar account but rather than buying U.S. stocks you transfer the cash into your Canadian dollar account. Personally, I wouldn’t do this until the U.S. dollar has actually started to fall.
So, then there is the effect on the U.S. share prices of the multinationals.  One of the effects of the rising dollars is when multinationals report their earnings, those earnings are for a significant part in various local currencies which are converted into a strong U.S. dollar denomination. Thus these earnings are understated and the effect is that the earnings seems to be falling. In such a setting, investors are not likely willing to pay as much for multinational company shares. This may explain why multinational companies like Microsoft, JNJ, Exxon-Mobil and so on have been underperforming lately.  The high U.S. dollar would also affect U.S. competitiveness less favorably. It nearly acts as a rising interest rate.
A falling U.S. dollar would of course do the opposite – it would help increase multinational earnings and make the U.S. more competitive (i.e. more exports). Consequently share prices of U.S. based multinationals would rise. If you look at commodity prices that have dropped so dramatically over the last year, their prices are expressed in U.S. dollars as well. So because the dollar rose 20 to 30% over the last year, commodity prices, regardless of demand, should haven fallen by a similar amount. For example, the price of gold. On the other hand when the dollar starts to fall gold prices should rise independent of the supply-demand fundamentals.  The same should be the case for the price of many other commodities, including oil.
The main reason for falling oil prices is not necessarily oversupply but rather the U.S. dollar  However, since here in Canada operating and capital expenses are paid for in Canadian dollars, our costs in terms of U.S. dollars has fallen accordingly - our companies should thus have been hit somewhat less than U.S. companies. To top that of, there is real oversupply as well as reported in terms of U.S. storage numbers and North American oil production.  But this oversupply maybe a lot less severe than you think.
In the meantime, especially in the U.S. current oil prices have made drilling in oil shale a lot less economically attractive and consequently we see that the number of drilling rigs employed for drilling new oil wells has dropped significantly. In Canada, which is somewhat less affected, drilling budgets have been cut by nearly 30%.  Only the most economically attractive (not necessarily most prolific in terms of daily oil production rates) plays continue to receive capital for drilling and enhanced recovery techniques such as water flooding.
When horizontal wells go on production in oil shale or older conventional plays, the highest production rates are achieved in the first three months where after production rapidly declines by 60 to 80% in the first year. When oil prices crashed in December, oil companies finished their drilling programs for the year and often completed 1 quarter drilling as planned as well.  Drilling programs are often planned a year or sometimes even two years ahead and thus don’t change instantaneously. To expect that production drops off right away is kind of naïve. It will take at least 4 months after the December crash to see the effect of decreased drilling on production. Chances are that we will only see production fall after May 2015 at the earliest.  So ignore alarmist reports about increased U.S. production which is probably just a short term blib.
Also, the scenario for oil prices is likely quite different from what happened with natural gas prices. Even with the decline in gas well drilling, a lot of gas is also produced from oil wells. Don’t look further than the flare stacks in Montana, where due to the lack of pipeline infrastructure a lot of gas produced along with Bakken oil is burned off (so much for opposition to new pipeline construction – the environmental activists cause more damage to the environment than good and that is not even counting the increased risks of oil transport by rail). Thus, gas production associated with increased oil drilling offset and even increased natural gas production overall in spite of the fact that less and less gas wells were drilled.
When the oil rig count falls off, so will oil production as there is no other production form that produces oil as a by-product. Don’t count on oil prices to stay low for long. Combined with a falling U.S. dollar, oil could easily be up 30 to 40% by year end. That would be $65.00.  This takes not into account the effect of an improving world economy.Price speculation has driven oil to excessive cheap levels and the opposite is likely to happen as well. Speculator action seems to exaggerate oil price movements in both directions
Canada’s oil industry will recover and is near or at the bottom in the stock market. Right now, don’t give up on our stock market, nor on any other stock market in the world. Although it is prudent to be cautious and build up cash, don’t sell your stock portfolio yet. And Canada may well be the best performing stock market in the world over the next year or two.  B.T.W. Don’t forget gold! Similar story.

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