Garrabrant Final

Commodity Prices and Exchange Rates

In this time of extreme uncertainty, it would be a valuable asset for any trader to be able to predict the future movements of exchange rates and commodity prices. In order to accomplish this, a correlation must be found between the change in commodity prices and the change in exchange rates of the countries that these commodities come from. In this paper, I will show that there is a strong correlation between the change in commodity prices and the change in exchange rates of the countries that these commodities come from. I will do this through the use expert opinions, commodity and exchange rate data, and regression analysis.

In 2005, oil and gold set record highs and were two of the biggest drivers of currency movements. In the time period between 2003 and 2005, the correlation between the Canadian dollar and oil prices was approximately 80 percent. The Canadian oil sands are one of the world's largest sources of crude oil. (Lien, 2006) This would explain why the Canadian dollar moves so closely hand in hand with the price of oil. Figure 1 shows the movements of the CAD/USD exchange rate and price of oil from December 2002 to September 2005.

FX_commodities_1r.gif
Figure 1: Oil vs. CAD/USD from December 2002 to September 2005 (Lien, 2006)

However, this correlation begins to fall apart as crude oil prices drop below the break even cost to operate the Canadian oil sands. To make operating the Canadian oil sands worthwhile, crude oil must be selling for close to $50 per barrel. (Wulff, 2007) At any price less than this, it would not be beneficial for the sands to operate. This breakeven price for oil is different than breakeven prices from other sources around the world because of the more-complicated process that the oil must undergo. Since the oil is embedded with sand or clay, the mixture must be processed to extract the oil. What this means is that once crude oil falls below $50 per barrel, the Canadian dollar will not be as vulnerable to small changes in the price of crude oil since it would not be actively exporting at that price.
Japan is a country whose dependency on foreign energy makes its currency very susceptible to the changing oil prices. Japan imports 99 percent of its oil, as opposed to the United States, who only imports 50 percent of its oil. As a result, when oil prices rise, the Japanese economy suffers. (Lien, 2006) A paper by Guo Jin states that a ten percent increase in international oil prices is associated with a 1.07 percent decrease in Japanese GDP. (Jin, 2007) There is little that Japan can do to escape the dependency of its exchange rates on energy prices unless it is able to produce its own energy through the use of alternative sources. In 2003, oil provided Japan with 50 percent of its total energy needs, coal with 17 percent, nuclear power 14 percent, natural gas 14 percent, hydroelectric 4 percent, and renewable sources a mere 1.1 percent. Japan is currently in the process of trying to produce energy through wind turbines. (McLaughlin, 2007) If they are successful in this effort, the correlation between the Japanese currency and oil prices will decrease due to a decrease in dependency.

Australia is another country whose currency relies heavily on commodity prices. For Australia, gold is a big mover of its exchange rate since Australia is the world's third largest gold producer. The Australian dollar has an 85 percent correlation with the price of gold. (Lien, 2006) In a paper aimed at studying the long-term and short-term relationships between the AUS/USD exchange rate and the price of gold – Han, Xu, and Wang reported on a mathematical model that they developed. Using data from January 6, 2002 to February 10, 2008, both the indirect least squares and the ordinary least squares estimates represent a positive long-run relationship between the gold price and the exchange rate of AUS/USD. (Han, Xu, & Wang, 2008)

While the correlation between gold prices and the AUS/USD exchange rate is quite strong, a surprisingly stronger correlation is found between gold prices and the NZD/USD exchange rate even though New Zealand is not a large exporter of gold. The reason for this 90 percent correlation is that is that New Zealand’s exports are highly dependent on the health of the Australian economy since the geographical location of the two countries makes them strong trading partners. As a result, when the Australian economy suffers from decreased gold prices, New Zealand feels an even stronger hit. (Lien, 2006)

The problem with trying to use commodity prices as a leading indicator of exchange rates is that although there is a strong correlation between commodity prices and exchange rates, commodity prices are not the only driver. Fluctuations in exchange rates have many causes including differentials in inflation, differentials in interest rates, current account deficits, public debt, terms of trade, and political data. (Bergen, 2004) Another problem with using commodity process to predict exchange rates is trying to figure out to what degree a country is tied to a particular commodity. If a country is a major importer of a particular commodity, their exchange rate will be closely tied to changes in the price of the commodity. This is unless the country can easily move to a substitute commodity to offset the effect of the commodity price change. An example of this comes from the United States and their dependency on oil. To offset their dependency when oil prices rose, the US turned to biodiesel and ethanol. Derived from soy beans and corn, respectively, the US was able to dampen the effect of oil prices with commodities that they produce domestically.

There is no doubt that the use of commodity process can be a valuable tool in predicting exchange rates. The important thing to remember is that there is not a 100 percent correlation between the two. However, using a combination of commodity prices, differentials in inflation, differentials in interest rates, current account deficits, public debt, terms of trade, and political data will allow traders to formulate a good estimate of where the exchange rate of a given country is going.

Works Cited
Bergen, J. V. (2004, May). Investopedia. Retrieved April 2009, from Jason Van Bergen: http://www.investopedia.com/articles/basics/04/050704.asp

Han, A., Xu, S., & Wang, S. (2008). Australian Dollars Exchange Rate and Gold. The 7th International Symposium on Operations Research and Its Applications , 46-52.

Jin, G. (2007). The Impact of Oil Price Shock and Exchange Rate Volatility on. Graduate School of Economics, Osaka Prefecture University.

Lien, K. (2006, January 25). Commodity Prices And Currency Movements. Retrieved April 2http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp, 2009, from Investopedia.

McLaughlin, B. (2007, April 16). Associated Content. Retrieved April 2009, from Energy Made in Japan: Bright Alternative Energy Future: http://www.associatedcontent.com/article/203419/energy_made_in_japan_bright_alternative.html?cat=15

Wulff, K. (2007, July 16). Seeking Alpha. Retrieved April 2009, from Petro-Canada Announces New Oil Sands Breakeven: $50 a Barrel: http://seekingalpha.com/article/41128-petro-canada-announces-new-oil-sands-breakeven-50-a-barrel

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License