Saturday, July 26, 2008

Case For The Long $USD/$CAD Trade, Canadian Energy Trust Massacre '06

I used to be bullish on the Canadian Dollar via the $CAD/$USD trade back when it was trading around 0.82 when oil corrected to $49, and natural gas to $6 in January 2007. Canada is a huge commodity exporter and if these commodities increase in value the $CAD/$USD should get a boost (if there isn't extreme monetary inflation for some reason, localized economic/employment issues, or other risks unrelated to free market forces) because these commodities are priced in US dollars (inverse relationship) around the world so Canada could buy more dollars with their commodities, hence the $CAD/$USD would increase in value.

Canadian Income Trust Massacre of 2006

So I took the contrarian view along with other analysts that oil/natural gas was headed higher because of foreign demand, middle east tensions, deficits, US recessionary talk and the inflated US dollar. At about the same time the Canadian Government decided to tax income trusts at the corporate rate of 31.5% starting in 2011 instead of using the flow through entity trust tax structure which transfers all income to the unitholders, which the company can deduct for taxes. With this new tax rate as a corporate entity the company would have less cash on hand to distribute as dividends, plus they'd have less cash to purchase existing oil fields to stay alive. Anyway, as a result there was a "Canadian Income Trust Massacre" on the Canadian exchanges and some Canadian energy trusts lost almost 1/3 of their values and they looked very attractive because not only would these trust securities rebound if their oil/gas assets increased in value, interest income would increase to US holders as the $CAD/$USD conversion would boost the Canadian denominated interest income.

This in fact occurred, the sell off was overdone because the tax would not take effect until 2011 and the underlying commodities were bottoming out. Today the Canadian Dollar is at about parity with the US Dollar 0.98, and the CAD/USD hit a high of 1.09 in late 2007. Oil recently hit a high of $147!

The tax decision was shocking because the Prime Minister Steve Harper said they wouldn't tax these trusts, and billions of retiree money was destroyed. Eventually these trusts were bought out or merged, and Canetic Resources got taken over by Penn West Energy Trust for $16.67. If you got in at the panic $12 lows you'd have a 41% gain in a year.

Canetic Resources 2006 Chart

Canadian Dollar/Oil Relationship 2005-2008

Income Trust Massacre Videos

The Case For The Long USD/CAD Trade

Now it appears that the oil/natural gas bull is correcting. A commodity correction would bring commodity induced inflation and producer costs down, which could enable interest rate increases down the road once housing stabilizes. If the new housing recovery bill gets signed by the President to help struggling home owners it could allow Ben Bernanke to increase rates, which would boost the dollar and cause oil prices to go down. Also today, in a Dow Jones recent article, OPEC was quoted saying that Oil may drop to $70 if Iran concerns ease and the US Dollar strengthens. All of this could be the reason why oil and natural gas are correcting at extreme levels and could hold well for a long USD/CAD trade.


drillbitcanuck said...

I remember the canadian energy trust story, it was a disaster. Looks like canadian dollar did correct directly with hard assets as the FXC showed, now with the US inflating dollars with all these bailouts I'd expect the dollar to decline vs. cad, my opinion of course.