Exchange Rates, the Price of Oil and the Enbridge Northern Gateway Project Joint Review Panel

This is a guest post by Paul Tulloch, of 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

Paul Tulloch

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.



  • Well researched and well written. Thank you for your work.

  • The Canadian dollar is indeed overvalued. But what would you use as a long term equilibrium exchange rate if not PPP? My guess is we will revert to it, at least in the long term.

    PS It would be good to source the quotation from the application.

  • there are several sources to quote the one that caught me eye the most was one that Robyn Allan pointed out in the main Enbridge, Wood Mackenzie submission, “U.S. dollar denominated revenues from crude oil sales are translated into Canadian dollars in order to report them in the studies as Canadian dollar denominated benefits. The lower the value of the Canadian dollar assumed—the more exaggerated the benefits. For example, Enbridge and Wood
    Mackenzie assume an 85 cent Canadian dollar. The benefit they calculate automatically receives a
    minimum 18 per cent increase for no reason other than the exchange rate assumption.”

    from this report on p.4

  • I disagree with you Andrew, just because there is not an easy default to make assumption by, does not mean commodity currencies do not exist in the long run and we can ignore their seemingly trivial efforts to sabotage the PPP. Given the 15-20 point difference it seems ludicrous and quite error prone to make such faulty estimates, unless of course one is working on the political aspects, which undoubtedly Enbridge, Wood and MacKenzie report is up to.

    I do not see a strong argument to say PPP a good estimate given the empiral evidence and the pathway of a long run petro dollar.

    What could be used, well I would suggest at least doing a study and explore issue in-depth and argue that we should use something that factors in the commodity distortion In terms of a concrete figure, I would say to use some factor of the past distortion away from PPP as a realistic estimate- it can be modeled with some known parameters to guide the estimate. The Cashin camp basically concludes that there is a variability in the long run estimate, which can be modeled.

    I do however vehemently disagree with the usage of PPP especially in this case when it so utterly kills off the destructive aspects of the petro dollar. It is the long run I fear- where long run investment decisions are made, it is the loss of that value adding investment that gets hammered by this over valued dollar.

  • Actually that should read, using such a low value for the long run exchange rates merely silences the destructive aspects of the petro dollar.

    One can get onto a space of modelling an estimate but as Robyn points out in her paper, one must implement a dynamic model to allow for such mechanisms.

    I would also say to the authors of such papers estimating net benefits- we are caught in an economic space that I would call a uniquely Canadian currency trap- oil prices are causally
    linked to our dollar, and they will essentially remain elevated for quite some time, and secondly, our major trading partner is caught up in a currency devaluation race. That is what I would call a medium term economic trap, that has our recovery from this first recession in its death spiral, where the trap has went on so long now that we are now starting to suffocate from its death grip, I.e. Consumer debt, an increasingly difficult to manage housing bubble, and a continuing decline in the much larger sectors of the economy, being export oriented value added goods and services.

    So under reporting the losses by using such fictional accounting will only strengthen this uniquely Canadian currency appreciation trap. M aybe the recent bank downgrades in Canada may impact these trap like forces, however, much of the downgrading was due to an increasingly worrying Canadian balance sheet, which means it is not the trap we are caught in that is providing relief, it is merely our economic death bed that is doing it. Potentially then the dollar will decline. There are ways to manage these two forces, but not with the market engagement strategies within th harper policy camp.

  • Thinking about this again andrew, I most likely mis-interpreted your comment- as I do agree, given there is nothing out there, most in need of an estimate will use the PPP. Theoretically they are supposedly supposed to just that, however, it is the theory that needs to change here, as a country under such commidty currency pressures could ultimately be under those pressures for a long long time. I guess that raises another question, with an interventionist role, could government prevent such hijacking of ones currency, so that indeed one could use PPP as a long term estimate of exchange, and indeed there is a paper I ran across that suggests exactly that and documents how some countries have contained such pressures, to ensure PPP like economic forces do allow a long run exchange rate to functionally be given a chance to realize that level of the law of one price. But essentially I should retract my point and agree with you, that given the politics and the lack of a theoretical debate, (even though the empirical screams otherwise), most will just use PPP for a long run estimate.

  • This discussion is confusing me.

    I guess I’m a naive non-economist here, but . . . if you’re doing a study on whether some action is a good thing or not, and so you’re going to make some kind of projection about what you’ll get out of it, um . . . wouldn’t that involve projecting two different scenarios, one with the proposed action, and one without, and comparing them?
    It just seems as if the study must not be doing that, or the specifics of the exchange rate assumed would not be such an issue–I mean, if they assume exchange rate X with the pipeline, surely they must be assuming exchange rate X without the pipeline as well? And if that were true it wouldn’t matter if they were getting Z amount of economic benefits from a lower dollar, because the non-pipeline scenario would get those same benefits as well. But if they’re not doing that at all, then the real problem isn’t the specific exchange rate assumed, it’s that they’re comparing an explicit model to something unspecified and implicit which might be quite different–which is to say the whole exercise would be bollocks.

    If they were making the comparison there still would be a problem in that it seems there’s a persuasive case to be made that the scenario with pipeline should have exchange rate X (+ some amount) relative to the scenario without. The question still isn’t the precise rate, the question is how much higher with pipeline than without, yes?

  • Letter in Toronto Sun:

    Consider all costs

    Re “Time to put Canada first” (Editorial, Oct. 27): Yes, it’s time to put Canada first. But Canada is composed of all Canadian citizens, not just the business and financial elites. We need to factor in the dangers of oil spills to our lands and coasts, the loss of manufacturing because of a higher dollar, and more adverse climate change because of higher CO2 concentrations. When these are considered, and we subtract the profits that will flow to foreign owners, is it any wonder Canadians are hardly convinced that the benefits of oilsands developments outweigh the risks?

    Larry Kazdan


    Toronto Sun comment:
    (That’s quite a generalization of Canadians’ perspective on the oilsands)

  • @PLG

    there are undoubtedly several ways that the methods they used leave a lot to scratch the head with.

    You make an excellent point. I only chose my attack because of the data I had been researching led me down the my pathway.

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