Wednesday, November 14, 2007

CAD, Crude and Risk Aversion... A conjecture

There is a whole lot of play in the financial press that claims the rising oil demands are due to (a) increased consumption by BRIC and EM (b) lack of refinery capacity (c) rising cost of production of crude in the Persian Gulf (d) geopolitical tensions etc., No doubt some, if not all of these forces are at play in the market.

However, it must be noted that the oil markets across the globe are quoted in USD. So, there is no doubt a linkage between crude, USD values. To think about this more visual, I have plotted the relationship here. Typical the Swiss franc is the defacto currency of choice, when global uncertainity rises. i.e., Investors tend to flock to the Swiss franc or Gold, when they assume the value of the USD is on a decline. I have used USD-CHF exchange rate along with Crude prices -- to arrive at the following. (Note correlation is not causation... but this is pretty interesting). A more formal analysis should control for risk-aversion (proxied by USD-CHF), growth in consumption etc.,

Nevertheless, on a trading floor -- I would be very surprised if the marginal gains from more sophisticated regression analysis are any better over a short period of time. In the long run, of course, more sophisticated analysis might reveal much -- but, by then the underlying structural parameters have changed...

In this simple case, fitting a simple straight line through the data points from 2006 onwards, we get the simple results. At a USD-CHF = 1, the crude prices are expected to be around 97.4. Today the Swiss Franc is around 1.123 and the crude (WTI Cushing) is quoted at 94.09.

Here is the key point. If one assumes that exchange rates tend to overshoot -- i.e., because of rigidities elsewhere in the economy (supply and demand of contracts done in the past), the fastest readjustments tend to happen in temporary misalignments of asset prices. So, if you think the USD-CHF has overshot in its depreciating trend, then one can make a plausible argument that the crude prices have shot through as well.

In essence, the tenuous (but I think, fairly justifiable) relationship is between global risk-aversion (vis-a-vis USD) and crude prices. If risk-aversion rises (i.e., USD appreciates) then crude prices must fall. If risk-aversion decreases, the crude prices must rise. If Jim O'Neill at Goldman is correct (rising capital flows into EM) -- I would read it as fall in risk-aversion.

Presumably then, Crude prices above 100 are to come soon; and ineluctably then the CAD is to rally again.

No comments: