Judging by the popularity of the previous article: “Explain To Me Like I’m 10: Why Is The Stock Market Crashing" I decided it would be helpful to also explain an important issue. Why is the Canadian Dollar falling so low compared to the American Dollar? (Believe it or not, this article is MUCH simpler than the previous one). Well, the best thing about these articles is that they are extremely quick to read, so let’s dive right in. No time to waste!
Like usual, we need some PREREQUISITES!
- Supply And Demand:
a) When lots of people want something, the price of that thing goes up! (Because sellers can charge more)
b) When very few people want something, the price of that thing goes down (Beggars can’t be choosers)
c) When the supply of something goes up, the price of that thing goes down (Not enough buyers, too much stuff)
d) When the supply of something goes down, the price of that thing goes up! (Too many buyers, not enough stuff) - Currency Movements: The price of most things is dictated by what we call the “Open Market”. You and I are both part of certain markets. If every girl wants Yoga Pants or Starbucks, and there is only a certain amount of Yoga pants and coffee, the price of Yoga pants and Starbucks will go up because there is demand in the “open market”. If teenage boys all of a sudden stopped wanting greasy long hair and baseball caps, the prices of Haircuts and Baseball caps would go down because there would be less demand in the “open market”. Just like yoga pants and baseball caps, currencies like the Canadian Dollar, US Dollar, British Pound, Euro, Swiss Franc, etc, are all dictated by supply and demand forces in the open market! When everybody wants to buy products in Euros, they start trading away their local currency for Euros. Because there is open market demand, the price increases. Whenever people purchase something in a foreign country, the currency must be converted! If you want to buy a Dishwasher from the United States, you must SELL your Canadian Dollars and BUY U.S. Dollars. In this process, you are creating DEMAND for US Dollars and You are creating SUPPLY Of Canadian Dollars. Can you guess what this process does?
- OPEC: Organization of Petroleum Exporting Countries. This is a very powerful club that contains most of the worlds highest oil exporting countries. They get together to discuss supply and demand of Oil products worldwide. The members in this club include Saudi Arabia, Iran, Iraq, UAE, Kuwait, Venezuela, Nigeria, Libya, Algeria, Angola, Qatar and Ecuador. Notice how neither Canada nor the USA are involved in OPEC.
Using these three prerequisites, we have all the information we need to know in order to understand why Canada’s Dollar is now only worth $0.75 American.
On the 27th of November 2014, OPEC held a meeting to discuss the oil trade, as they normally do. Most of the world had expected that OPEC was going to CUT PRODUCTIONto a smaller amount (decrease supply). This was because there was weaker global demand for oil for numerous reasons, one of which was the “slowdown” in China. (Because China is so huge, is growing so fast, and uses a lot of oil, if their economy slows down it decreases the demand for oil, and thus the price goes down). By cutting production (reducing supply) it would naturally raise the price back up as more users of oil worldwide would be forced to fight over less oil. Below is the price chart leading up to the meeting:
As you can see, the price of oil stayed within a band from the lows of $75 up to the highs of $115. Slowing demand for oil pushed the price downward. Since the price was beginning to move quickly to the downside, the world assumed that OPEC would cut production, thus sending the price back to a sustainable level. Everyone expected OPEC to cut production, but:
NOPE!
REMEMBER! The price of any asset is dictated by what events unfold relative to expectations. It doesn’t matter what events unfold. It matters if the events deviate from the market’s expectations. Surprises cause big price changes.
OPEC Surprised everyone! What unfolded was very different than expectations. OPEC decided NOT to cut supply. Meaning that demand would continue to fall and supply would remain the same. This is equivalent to knowing that no greasy young men want baseball caps anymore, but still continuing to produce the same amount of baseball caps! If you continue to produce the same amount while demand is falling, the price will fall indefinitely. So here’s the price chart of what happened after the meeting.
So Josh, I get it:
- Global Demand for oil was falling.
- Most people thought OPEC would cut production (reduce supply) to keep the price stable.
- OPEC surprised us and didn’t cut production, so the oil price plummeted.
But how does this affect our Canadian Dollar? And Why did I just pay 25% more for Drinks in Vegas?
Well here it is:
In essence, the price of our currency is dependent on how much other people in other countries want it. Many factors such as high interest rates, political stability, high investment returns, low inflation (these are all beyond the scope of this article) dictate how much other people want Canadian Dollars.
Canada is one of the largest OIL EXPORTERS in the world (mostly exporting to the USA). The U.S. is one of the largest OIL IMPORTERS in the world. When oil prices go down, it is cheaper for the U.S. to import oil. But when oil prices go down it is much harder for Canada to stay competitive in its pricing. It is for this reason that low oil prices are beneficial for the United States, but are detrimental for Canada.
Things are going quite poorly for Canada, all the while things are going quite well for the USA. It’s a double whammy, pushing the demand for the U.S. Dollar higher meanwhile pushing demand for the Canadian Dollar lower. Below is a chart showing the correlation between oil prices and the CAD/USD exchange rate. As you can see, they move together.
The reason the dollar is so low is because there is currently a huge global demand for U.S. Dollars AND because the price of oil is hitting our economy. The flow of money into Canadian dollars is lower.
So you may be asking the question: “If OPEC includes most of the largest oil producers, why on earth would they decide not to cut supply. Doesn’t it hurt them too?” Can you guess?
The answer is contained in the chart below which shows the Marginal Production Cost of a barrel of oil depending on the country:
As you can see, it costs a lot more in to produce oil in North America than it does in places like Africa or the Middle East. This is because shale and oil sands petroleum is much more expensive to extract than surface oil or basic drilling. The reason OPEC is okay with a lower oil price is because they can still produce profitably, whereas North American manufacturers cannot.
This concludes the short summary on the Canadian Dollar.
