This is a guest post by Paul Tulloch, of LivingWork.ca and frequent commentator on this blog, reporting on some significant and timely work he prepared for the northern gateway pipeline review panel, analyzing correlations betwen the price of oil and the Canadian dollar.
Exchange Rates, the Price of Oil and the Enbridge Northern Gateway Project Joint Review Panel
There is a large red hot poker of economic irony, stabbing away at the final remaining arguments the Enbridge Northern Gateway Project Joint Review Panel provide in support of the project. What’s ironic is just as this pipeline would take Canada further down the tunnel of resource dependency, the review panel’s analysis of the net benefits of this project are based on a calculation of exchange rate that completely ignores our increasingly turbocharged petro-currency.
Within a massive pile of reports and research submitted by the fifty plus lawyers, economists and policy advisors that Enbridge Oil and the rest of the pro-pipeline forces have arrayed in the fine print of the footnotes on methods, you will find something like this:
To estimate the net benefit of the proposed pipelines requires an estimate of the long run exchange rate between the Canadian and US dollar- and to that end, the methods assume an exchange rate close to the long run Purchasing Power Parity (PPP), which equates to approximately $0.82 US.
Say what!? We are building a bitumen super highway that will ultimately produce a massive acceleration in the extraction and shipment of raw bitumen from the northern tar sands of Alberta – and these experts are using the PPP as an estimate of long run exchange rate equilibrium at $ 0.82 US to calculate overall net benefits?
We currently have an exchange rate near $1.02 US. Every serious economist in Canada and elsewhere concluded long ago that Canada’s currency has been transformed over the past decade into a commodity currency or petrodollar. Quite simply- the long run exchange rate of the Canadian dollar cannot be estimated using purchasing power parity values. Our long run exchange rate has been distorted away from the theoretical PPP equilibrium, with an anchoring to the price of oil pulling it some 20 cents above PPP.
Given that the raison d’etre of this Gateway project will substantively increase the extraction capacity of the tar sands and perpetually move Canada further into the resource extraction economy- we must conclude that this “oversight” in methods is the ultimate economic death by irony. However, It is such a Shakespearean drama unfolding in the economic decision making hallways of our future- and history. Yet sadly the stage of this drama is hidden away in a footnote – with very limited seating capacity- closed off to critics by the threat of the loss of charitable status for many monetarily challenged critically focused perspectives.
Theoretically, empirically, and practically major financial institutions peg the Canadian dollar in the short, medium and long term as a commodity currency. Given the importance of this project in Canada’s national economic trajectory, the assumptions of the review panel should be held to a lot closer scrutiny. Sadly, the stakeholders submitting these reports know full well what they are doing and what and who they have violated.
Recently, I was invited to serve with the Alberta Federation of Labour’s (AFL) working group that served as an official intervener into the review panel process. As pointed out by the AFL,
“Each of these studies allege vast benefits without due recognition of costs and promise enormous economic gains from new pipeline access to the U.S. Gulf Coast and B.C.’s West Coast. The benefit figures developed in these studies are misleading and misrepresentative of economic reality.”
There is a long history in Canada that focuses on the empirical research of the relationship between the Canadian dollar and the price of commodities with specific study on the price of oil. We should refer back to Innis’s Staples theory for a refresher on how important commodity extraction was and still is on the health of the Canadian economy and the dollar valuation process. However, as pointed out by Bank of Canada researchers Amano and van Norden in 1995, the price of oil has played a leading role in the determination of the exchange rate. They developed a robust model that has been used over the years to explain Canada/US Dollar movements in terms of energy and non-energy commodity prices as well as short-term interest rate differentials between the two countries. This simple model provides quite powerful explanatory power for Canadian dollar exchange rate movements and therefore has become a fixture in the financial industry. Originally their research showed oil prices had a negative correlation with exchange rate fluctuations, over the years this relationship changed direction and became positively correlated in the mid 90s.
For example, in a monetary policy update- dated June 29th 2010, the C.D Howe Institute stated, “we revisit the factors that affect the exchange rate. By updating and fine-tuning an equation developed by Bank of Canada researchers – which, with rather small modifications, has been tracking the exchange rate for close to two decades – we find that commodity prices are still the main long-term drivers of the Canadian dollar.”
A pivotal study conducted by Cashin, Céspedes, and Sahay (2003) explored the evidence further, and making use of cointegration analysis to test on 58 countries for exchange rates and commodity prices, found evidence of significant cointegration results for 19 countries. The authors showed that this relationship can explain why PPP has limited explanatory power for the long-run real exchange rates of commodity exporting countries. Subsequently they showed that the long-run real exchange rate of commodity currencies is not constant but time-varying, being dependent on movements in real commodity prices.
I prepared a short report for the AFL that derived the recent history of the correlation coefficient for the Canada- US exchange rate as compared to the West Texas Intermediate (WTI) price of oil. The model used a 12 month moving average and demonstrated that over the last decade, the correlation coefficient and hence the strength of the relationship between the two factors has doubled. That is, the price of WTI oil and the monthly exchange rate reached a recent unprecedented high of over a 0.8 correlation coefficient from approximately 0.4 in 2002 (see chart below). While correlation and OLS regression may not be as robust as cointegration techniques, when there is a general linear trend the differences are not significant in most cases. These high levels of correlation of 0.8 between oil prices and the exchange rate are staggering.
Of course correlation is not causation and the devaluation of the US dollar has played a role in the rising Canadian dollar. The Bank of Canada estimates that as much as 40% of the appreciation in the Canadian dollar since 2002 is due to devaluation of the US dollar. Given the evidence, even accounting for this 40%, the relationship between oil prices and the value of the dollar still demonstrates a strong correlation.
After a review of the literature, I would suggest that for every devaluation in the US dollar, oil prices show a smaller tendency to increase because oil is priced and traded in US dollars and producers will attempt to maintain their domestic purchasing power. That would imply that of the 40% appreciation in the Canadian dollar that the bank estimates, a smaller component is related to a rise in the price of oil rather than merely a drop in the value of the US dollar.
In effect, this further suggests the Canadian dollar is a turbo-charged petro-currency in relation to devaluations of the US dollar: it rises directly as a result of US dollar depreciation and then again as oil prices rise in response to US dollar depreciation. The Bank of Canada didn’t take this factor into account and I haven’t seen any analysis of this in relation to Canada, but I’d welcome comments.
In conclusion, there remains an undeniable linkage between the price of oil and the exchange rate, and the evidence suggests that the Canadian dollar in the foreseeable long run will remain well above PPP. Much of the deviance from PPP values is caused by changes in the price of oil. Hence any serious study that attempts to quantify net benefits of the Enbridge Pipeline shouldn’t be modeled by such a simplistic assumption as using the PPP as a surrogate for long run exchange rates.
These results demonstrate it’s absurd for the Northern Gateway pipeline review panel to use purchasing power parity as a basis for the exchange rate in their analysis of the net benefits – and if they do, the supposed benefits of this project now being heavily promoted by proponents are simply not credible.
If this project proceeds, Canada’s dollar will become even more of a turbo-charged petro-currency, which will result in even more job loss and decline for our other manufacturing and export industries.
- Dutch Disease is Dead … Long Live Dutch Disease!!! (March 4th, 2013)
- The IMF and the Canadian Manufacturing Crisis (February 15th, 2013)
- Oil Prices and the Loonie Again (August 30th, 2012)
- Spinning Mr. Carney (August 28th, 2012)
- Broadening the Bank of Canada’s Mandate (August 21st, 2012)