The bull market for oil is back.  After falling 16 percent in the month of February, the general belief in the market was that the oil mania has hit a peak. Although there was a consensus that the long term trend of oil was up, most analysts thought that it was time for consolidation.  Correctly enough, a correction  did occur but only briefly  before commodity prices took off once again.  Between March and April of 2006, oil prices rose almost 25 percent while.  Back in the old days, a move like this if seen over the course of a year would have been considered impressive, but unfortunately we are far from the old days which mean that sharp moves in commodities may be here to stay.  Many analysts have been saying that fundamentals warrant a rise to $100 a barrel and given the current environment, these levels could be attainable sooner rather than later.  

Hot Spots Around the World Ignite

We are far closer to $100 oil than we thought we could have been at the beginning of the year, especially since the hot spots around the world are igniting while demand continues to grow. Iran has already pushed forward with its nuclear program despite the UNâ�,��"�s calls to halt any further development. Militant attacks are picking up in Nigeria, - the number four exporter of oil for the US - while Chinaâ�,��"�s thirst for commodities continues to grow unabated.  This combination of political risks and strong economic demand has a very high chance of tipping over, which poses a huge uncertainty for oil prices.  Oil will be impacted because Iran is the worldâ�,��"�s third largest holder of oil reserves and OPECâ�,��"�s second largest producer. Neither Iran nor the US, who has been at the forefront of calling for an end to the nuclear program is showing willingness to back down, which should keep oil prices lofty.  Meanwhile Russia has most recently said that they would supply air defense systems to Iran while China continues its plans to secure oil resources in the country.  With two big powers taking interest in this hotspot, any military engagement by the US could get complicated.  Each time there was a war that involved the Middle East, such as the Iraq * Iran war in the 1980s and the Iraq * Kuwait war in 1990s, oil prices skyrocketed.  In both scenarios, oil prices more than doubled in a matter of months.  Therefore if the commodity bull trend is set to continue, we must turn our attention back to the currency market, where we can use specific currencies to express our view on commodities, while at the same time being able to earn interest income on the position, which is a benefit that futures contracts do not offer. 

Currencies in Lieu of Direct Commodities

From our economics 101 textbooks, we remember that high oil prices act as a tax for consumers by slowing down consumer spending, which eventually takes a bite out of growth.  Yet the actual impact of oil prices on different currencies can be very mixed.  Some currencies stand to benefit significantly from rising oil prices while others suffer greatly.  Traditionally we know that commodity currencies rally when energy prices increase because those currencies represent countries that tend to be net exporters of commodities such as crude oil.  Therefore the oil producers within the country are simply reaping higher profits for the same barrel of oil as prices rise.  Currencies of countries that are net oil importers on the other hand face increasingly higher costs whenever energy prices rise.  So taking a look at this from a net oil exporter / importer perspective, the currency pair that should be impacted the most by changes in energy prices is the Canadian Dollar and the Japanese Yen (CADJPY). 

Why CADJPY?

There are many reasons why CADJPY should be on the top of list of currencies to trade for those who have a view on oil prices.  As indicated in the chart below, there is a clear relationship between both of these instruments. Since the beginning of 2004, oil prices and the Canadian Dollar / Japanese Yen (CADJPY) currency pair have had an 85% positive correlation.  In fact, for the most part, oil even acts as a leading indicator for CADJPY.  This relationship stems from the basic characteristics of each of these countries:

Canada is the worldâ�,��"�s second largest holder of oil reserves.  In 2000, Canada surpassed Saudi Arabia as the USâ�,��"� most significant oil supplier.  Unbeknownst to many, the size of their oil reserves is second only to Saudi Arabia.  The geographical proximity between the US and Canada as well as the growing political uncertainty in the Middle East, Africa and South America makes Canada the preferred importer of oil to US.  Yet Canada does not just service US demand.  The countryâ�,��"�s vast oil resources are beginning to get a lot of attention from China especially since Canada has recently discovered a new source of oil after a reclassification of their Alberta oil sands to the economically recoverable category.  China has begun to take stakes in Canadian oil companies including picking up a one-sixth interest in MEG Energy Corp.  PetroChina International also signed a cooperation agreement with one of Canadaâ�,��"�s largest pipeline companies.  China-Canada energy cooperation is only expected to increase further barring any huge protests by the US.  China currently imports 32% of its oil and according to a report by the International Energy Agency, Chinaâ�,��"�s import needs are expected to double by 2010 and match that of the US by 2030. This makes Canada and the Canadian dollar one of the best currencies positioned to benefit from a continual surge in oil prices. 

On the other side of the spectrum, Japan imports 99% of its oil (compared to the USâ�,��"� 50%).  Their lack of domestic sources of energy and their need to import vast amounts of crude oil, natural gas, and other energy resources makes them particularly sensitive to changes in oil prices.  There is an inherent fear that continual increases in oil prices could derail the Japanese economic recovery.  Although Japan has been able to better weather the fluctuations as time passes, they are still not immune to the drag that oil prices will have on the global economy.  If oil prices continue to rise, it will sap global demand, weakening purchases of Japanese exports, which is expected to eventually filter into weakness in the Japanese Yen.

Oil vs. CADJPY 

Yet even though it is now clear why CAD/JPY is correlated to oil, it may not be clear why it could be a more attractive trade than a straight oil futures contract.  Since the beginning of the year, CAD/JPY has increased 600 pips or points in value.  On a regular 100,000 position size, the margin needed for the position to earn interest would be $2000.  The point value of CAD/JPY is 8.56, which means that the 600 point rally translates to $5136 in gains.  However on top of that, CAD/JPY offers daily interest income of $8.70.  Multiply that by 110 days, and the interest income becomes another $957, bringing the total profit on the position to $6093 or 304 percent. 

In contrast, WTI crude oil futures on the International Petroleum Exchange (IPE) increased from approximately $60 to $73 since the beginning of the year.  The initial overnight margin according to the IPE for one oil contract is $5875.  Each point value is $1,000 which means that the gain on the oil contractâ�,��"�s appreciation is $13,000 which is a return of only 221 percent. 

If the trade was made using the oil contracts, the amount of necessary margin would be nearly triple that of the same trade in CAD/JPY.  If we applied $6,000 which is approximately the same as the $5,875 oil margin to buy 3 regular sized lots of CAD/JPY, the total profits on the trade using a similar amount of capital as one oil contract would be $18,279.  Even the e-mini contracts require an overnight margin of $2363, which is a sizeable amount of deposit.  The â�,��"e-miniâ�,� version of a CAD/JPY position which is a position size of 10,000 only requires $200 in margin (to qualify for earning interest). In addition, for both positions, a spread needs to be paid, but for futures contracts, on top of the spread you would need to pay commissions as well as worry about rolling over the contracts when they near expiration. 

Therefore if the correlations that we have seen over the past two years continue to hold, then as indicated in the chart above, CAD/JPY may be the better trade to make if oil prices continue to rally rather than the commodity itself.  Alternatively, CAD/JPY also offers mild diversification of the same view for traders who want to further leverage up their belief that oil will hit $100.

Kathy Lien is the Chief Currency Strategist at FXCM.