Another threat to Canadian energy producers: The U.S. dollar-oil price correlation has broken down

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The U.S. dollar over the past year has been generally moving in the same direction as the oil price, a break from its past relationship with the commodity and a trend that could pose an economic threat to Canadian producers – and possibly Canada itself, according to Pavilion Global Markets' global macro strategist.

The unexpected correlation began in the second half of 2016 and hasn't broken down yet, Pavilion's Aidan Garrib said.

As most commodities are priced in U.S. dollars, a rise in the greenback generally makes it more expensive for foreign purchasers, leading to a weaker outlook for demand.

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Yet, the oil market of late hasn't been reflecting this, and Mr. Garrib believes this could have consequences for not only Canada, but other major oil exporting and importing countries.

One explanation for the correlation, he said, could be the United States' shift from oil consumer to oil producer.

"The most vulnerable to this shift are oil exporters with floating exchange rates," Mr Garrib said in a note. "Canada is a good example: production costs are in Canadian dollars, but oil-sale receipts are in U.S dollars, so the inverse relationship between oil and the U.S. dollar helped cushion the impact of low prices on margins. This isn't the case any more."

Most recently, the Canadian dollar has appreciated against the U.S. dollar as oil prices have fallen, in large part because of the less dovish shift in monetary policy at the Bank of Canada. "This is a double-whammy for Canadian producers: they receive less U.S.-dollar per barrel (because of lower prices) and less Canadian-dollar per barrel because of the stronger loonie."

The Canadian dollar was trading at 77.29 cents (U.S.) at midday Tuesday, up about 5 cents from lows back in May. West Texas Intermediate crude oil was trading near $47 per barrel.

The recent movement in the price of oil in relation to exchange rates also puts pressure on producing countries – like Canada – to reconsider their reliance on oil.

"Because we've been unable to get pipelines to go east or west, it's really increased our reliance on the U.S. market," he said in an interview. "Not only does Canadian crude oil trade at a discount to [West Texas Intermediate] but now you have these added pressures on top of that. From an export perspective, I definitely think that it does put additional pressure on oil exporters to diversify their economy away from oil."

With oil prices significantly below fiscal break-even prices – the value of oil required for major oil producing countries to balance their budgets – "this pain is likely to increase quite dramatically," Mr. Garrib said, until oil prices rise, "which seems pretty unlikely." As a result, policy changes or production cuts from the Organization of the Petroleum Exporting Countries could be in the cards some day soon.

The research note also highlighted oil's threats to "petro-dollar recycling," in which producing countries such as Saudi Arabia reinvest their U.S.-dollar profits into U.S. treasuries, pushing down yields and encouraging broader investment. With less cash available in these countries to invest into the U.S. because of low oil prices, this could put upward pressure on yields worldwide.

Canadian oil producers, he said, could try to hedge against the oil-correlating U.S. dollar, but they could run into costly problems with that, too. With a flattened oil curve, hedging with oil futures might not be as lucrative as it was even a few months ago. And to hedge against the U.S. dollar with a cross-basis currency swap – converting U.S.-dollar exposure to Canadian dollars – has become expensive, too.

"Going forward it's going to be difficult to see how they navigate this, to be honest," Mr. Garrib said.