On November 22nd, the US dollar fell to $1.491 to the euro –the lowest level since the euro started trading, in January 1999– after a high-ranking Chinese official’s statement that China should convert more of its enormous dollar reserves to euros.
It would seem that the dollar’s weakness would lead net oil importers with dollar-pegged economies to run to currencies with greater relative oil-purchasing power. However, most oil-consuming and oil-producing nations do not yet have enough cause to realign their currencies significantly or to take actions that would further weaken the dollar. Furthermore, there is no clear alternative in sight.
There is no economy ready to overtake the US the way the US overtook the British Empire as the economy upon which global traders relied for stability and the ultimate solvency of their economic transactions. Though the world is looking more at the eurozone to fill this role, the European economic bloc is in its infancy and its economic underpinnings are too tenuous to pose a challenge to the US. Furthermore, the first country to abandon the dollar could set off a chain reaction that would backfire and affect all countries and currencies that now depend on the US dollar. At this point, few nations are willing to take that chance.
A weaker dollar reduces the purchasing power of –and hence increases inflation in– oil-producing countries, since oil is traded in dollars. This is particularly acute in nations such as Saudi Arabia, which not only has a primary commodity traded in dollars, but also has a currency that is pegged to the dollar. The dollar’s weakness cuts into such nations’ ability to buy goods from countries with non-dollar-denominated currencies and thus decreases profits. This in turn weakens the incentives for oil-producing nations with dollar-pegged currencies to reduce oil prices through production increases. Oil producers are definitely getting rich from the surge in oil prices, but not as much as they would be with a strong US currency.
Dollar devaluation affects different Organization and Petroleum Exporting Countries (OPEC) members differently. Countries that import more from the US stand to lose less than countries that receive most of their imports from Europe and Japan, and thus the geographic location of some OPEC members is important in determining their purchasing power. For example, Venezuela stands to lose the least from dollar devaluation, as a large percentage of its imports come from the US. By contrast, Indonesia is far away from the US and close to Japan, which supplies a large percentage of Indonesia’s imports. Thus, dollar devaluation hurts Indonesia more than Venezuela.
Oil-producing nations continually toy with the idea of switching to other currencies; however, a complete change at this point would make little sense, as they would effectively be buying high and selling low. Switching to euros would entail locking oil profits into a currency that is at its peak and likely to fall – especially as several eurozone nations are seeking to devalue the currency. Furthermore, it is unrealistic for OPEC to price the majority of its oil in euros while the US remains its largest customer. Pricing oil solely in the euro will not solve the problem of declining purchasing power. When the euro declines, calls for an OPEC switch to the euro will fade. The use of any single currency in oil pricing –whether the dollar, the euro or the yen– will have the same effect.
Furthermore, as the dollar declines, so does the amount of investment available to drill for more oil, all other things being equal. Importing equipment from eurozone nations, for instance, becomes more expensive for Middle Eastern oil companies and the extra costs of importing goods from the EU cut into oil infrastructure investments. Ultimately, growth in drilling and exploration is slowed, reducing oil-producing nations’ ability to meet global demand. Also, the plethora of established contractual obligations and trading platforms completely independent of the US economy but denominated in dollars would be difficult –not to mention politically contentious– to get out of.
The Oil Importers
As the value of the dollar falls, oil becomes proportionately cheaper for nations whose currency is not linked to the dollar. This is giving such countries a bit of protection from higher prices, since their currencies’ purchasing power has strengthened against the dollar’s in the pursuit of oil. The converse applies to nations whose currency is pegged to or aligned closely with the US dollar. One such country, China, on Nov. 1st raised state-set fuel prices nearly 10%.
China has particular stakes in both rising oil prices and the status of the dollar. Rising oil prices dearly strain China’s resource-intense manufacturing economy, which has a long way to go toward becoming more efficient. There is a more obscure link between China’s energy needs and the strength of the US dollar. China –which aligns its currency with the dollar to maintain a reliable export market in its largest trading partner, the US– is suffering from high energy costs due to its currency alignment. Allowing its currency to appreciate would indeed lower China’s energy costs, but at the cost of making its exports to the US less competitive. And maintaining export competitiveness is key to Beijing’s ability to prevent mass unemployment and its associated social upheavals. Experiencing the strains of high energy prices now than rather than later, is more beneficial to Chinese economic growth, as Beijing will have to make structural adjustments –such as investing in alternative energies and liquid fuels, and taking energy efficiency measures– sooner rather than later.
The Indian rupee has risen to its highest level against the dollar since 1998 and has gained more than 12% against the dollar since January. However, India is already extremely vulnerable to oil price hikes, and a resurging dollar would not bode well for the country. It imports 70% of its oil and lacks overseas energy assets to feed its rapidly growing demand. India also lacks the strategic reserves to cope with rising oil prices. There are also serious social implications for India, as it is a major fuel subsidizer. Even with oil prices skyrocketing, India has yet to raise fuel prices for fear of the political repercussions. India is not forcing itself to make structural adjustments to permanent higher energy costs.
The European Union is currently benefiting from a strong currency that allows it to purchase oil competitively against America. However, it is difficult to determine whether a less-than-drastic reversal of its currency fortunes would significantly affect its economy. Heavy taxation of petroleum products insulates consumers from the effect of crude oil price fluctuations and higher prices, which will be important when the dollar eventually comes back.
The Dollar / Oil Relationship
Oil producers use their dollar-based incomes to invest in non-dollar assets, such as euros or commodities, to protect their cash against a failing dollar. This can create a reinforcing cycle that drives the dollar’s value even lower and the price of crude higher. This rule applies to all nations and financial institutions that are weary of the dollar: they will diversify into commodity markets, including oil, contributing to a rise in oil prices.
The high price of oil might also prevent nations from taking actions that would further devalue the dollar. While a weaker dollar benefits many nations that export non-oil commodities and manufactured goods, high energy prices could discourage nations with large cash funds, such as China, from further diversifying their currency reserves away from the dollar, as this will further weaken the dollar. China’s efforts to move its reserves away from dollars and into other currencies can only go so far. Yes, China has an interest in moving to stronger currencies, but a massive shift would indeed further weaken the dollar, sending oil prices and production into a tailspin –something China does not want at this point.
The weakness of the US dollar will not last forever and concerns from oil-producing and oil-importing nations about the price of oil will diminish when the dollar rebounds. Threats of diversifying into euros may be an attempt to pressure the US to strengthen its currency. However, the price of oil could remain high for quite some time and when the dollar rebounds, oil-producing nations will likely redirect significant portions of their huge oil revenues back to the US market, strengthening the dollar even further and ensuring its status as the currency in which oil is traded.
By: N. Peter Kramer
