Should OPEC Dump the U.S. Dollar?

Relevance: Mention of the U.S. dollar’s weakness was conspicuous by its absence from the joint declaration of the recent summit of OPEC’s heads of state (Nov 18). Iran and Venezuela (the main protagonists) failed in this endeavor, but continue to push to move oil sales to a stronger currency. Saudi Arabia, and others, sited a concern that mentioning the decline of the dollar may precipitate further falls. The summit agreed to direct oil ministers to study the issue. A wholesale change by OPEC (and other oil producers) to the currency of oil sales is both impracticable and unlikely in the short term. In any event, changing the currency of trade for oil probably has limited direct impact on price at any given time. The motivation for a move is political (Iran, Venezuela) and reflects a desire to further weaken the dollar. If this is so, oil exporters are playing with fire: it is commonly accepted that a weakening dollar increases oil prices (a weakening dollar makes oil relatively cheaper in Europe and Asia thus increasing demand, while at the same time dollar depreciation reduces the ability of oil-producing countries and oil companies to invest in additional capacity, therefore reducing supply) and these increases will add to the pressure to conserve and find energy alternatives in the U.S. – the world’s the biggest oil importer.

Analysis:  Many oil producers will claim that the incentive to increase production during the current period of high dollar oil prices has been reduced by the decline in value of the currency in which most oil is traded. After all, why sell more of a nonrenewable resource now when, by holding production steady, it may be possible to wait until the dollar recovers? 

Followers of this theory believe it has become less attractive now as many believe that the dollar’s weakness is permanent and may get a lot worse. Price hawks such as Iran even claim that the outlook for the dollar justifies increasing oil prices further. The issue was discussed at the recent OPEC heads of state summit, but tensions between members prevented its mention in the summit joint declaration.

The dollar has been in decline for over 40 years, as measured by its performance against the yen and euro (substituting the German deutschmark for the euro in earlier years). The Iraqi government showed that it was concerned about the risks of pricing a commodity in the weakening dollar market when it decided (prior to the Iraq war) to price its oil in euros. Iran has made similar moves, slashing the amount of dollar oil sales and transferring its oil pricing to the euro. Both initiatives will have undoubtedly have been politically motivated and seen as antagonistic to the U.S.

Indeed, many oil producers will be eyeing the euro as a suitable alternative to the dollar. The euro is sold as a stable and unexciting currency from an area that has a strong trade surplus and is not burdened by consumer debt. In addition, many oil exporters already have significant trade ties with the euro area, with a sizeable proportion of their imports being paid for in euros.

However, although a gradual move away from the dollar to a more balanced portfolio of oil price currencies is possible, wholesale change away from the dollar is unlikely and impracticable in the short term for the following reasons:

  1. It is not surprising that management of the exchange rate risk is a priority for oil exporters. But these days’ oil producers can manage their day to day currency risk through a range of sophisticated financial products, without removing the dollar as the currency of oil trades. If they do wish to have a part of their export portfolio paid for in euros (say) to avoid transaction costs or the price of currency hedging products, then this is appropriate.
  2. It is not clear that the price of oil is directly linked to the currency in which it is traded. A switch away from the dollar may be nothing more than a symbolic gesture with only marginal impact. The price paid by a customer is a reflection of the value that product brings to the customer (after currency adjustments) and not the currency in which the trade is made. In fact, oil sold in euros had a higher price in 2006 than 2007 – so the simple solution for OPEC would be to change the currency for its price targets, not the currency that oil is traded in (although it is recognized that a wholesale change away from the dollar to a new currency for oil would facilitate this).
  3. Many of the Middle East’s oil exporters have pegged their currencies to the dollar.
  4. OPEC’s biggest player, Saudi Arabia, whose currency (the riyal) is pegged to the dollar has suffered increased inflation with the dollar weakness and a revaluation is a possibility. However, pricing its oil in euros (say) would probably been seen as too drastic as it would not wish to negatively impact the U.S. (through weakening the dollar), its biggest customer and guarantor of its security. Nor would it wish to reduce the value of its considerable dollar-denominated assets.
  5. Many in OPEC will believe that the dollar’s weakness is not the most pressing issue facing the cartel at the current time. More important issues for them will be the high dollar oil price (adding to inflation in the major oil consuming market, the U.S., and increasing the chance of recession there), increasing capacity and reducing the twin threats of substitution and energy conservation in consuming countries.
  6. It would lead to a less efficient market for the trading of oil, due to the reduction in transparency of price and the need for currency transactions.

27 November 2007

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