By DailyFXThe 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 UN’s calls to halt any further development. Militant attacks are picking up in
Nigeria, – the number four exporter of oil for the US – while China’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 world’s third
largest holder of oil reserves and OPEC’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 world’s second largest holder of oil reserves. In 2000, Canada
surpassed Saudi Arabia as the US’ 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 country’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 Canada’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, China’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 US’
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 contract’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 “e-mini” 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.

Kindest Regards,

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com
By DailyFX

——————-
**Save the Date: June 3-4 FXCM Currency Trading Expo Over 40 Free Workshops, 22
Currency Trading Superstars www.fxcmexpo.com
——————-

FXCM, L.L.C.® assumes no responsibility for errors, inaccuracies or omissions in
these materials. FXCM, L.L.C.® does not warrant the accuracy or completeness of the
information, text, graphics, links or other items contained within these materials.
FXCM, L.L.C.® shall not be liable for any special, indirect, incidental, or
consequential damages, including without limitation losses, lost revenues, or lost
profits that may result from these materials. Opinions and estimates constitute our
judgment and are subject to change without notice. Past performance is not
indicative of future results