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Outlook 2006 | What to watch | Oil change
Despite the current slowdown, oil prices have been rising steadily over the past year. Will they continue to climb, stay the same or decrease? We, as consumers of fuel, want to know, given our dependency on oil for heating, electricity generation, manufacturing and industrial needs. We also want to make wise transportation decisions in terms of the best vehicle to buy or lease. As investors, we need to understand the financial implications so that we can position our future investments accordingly. The bad news for consumers and the good news for investors is: Do not expect oil prices to fall significantly in the near future. There are global economic and financial reasons for the oil price frenzy to continue.
Remember the oil crisis of 1973? The Organization of the Petroleum Exporting Countries (OPEC) imposed an embargo and we had to accept it. Supply was manipulated for political goals, and everything was paid for in U.S. dollars, the only choice. The result was galloping inflation, massive unemployment, and for every country except the United States, the necessity of maintaining huge amounts of U.S. dollars as reserves to pay oil bills. These reserves became immobilized capital that hindered economic growth. The U.S. dollar became the de facto international energy currency–the “petrodollar”–and became the only viable currency to hold as a foreign reserve. By the mid-'80s, oil prices began to decline significantly, yet the United States continued to enjoy currency supremacy.
The question that many ask is whether we will have an oil crisis followed by an oil price decline. Again, do not expect that to occur, for today's economic and monetary environment is quite different. More specifically, there are two factors fundamentally affecting oil prices: current supply-demand conditions for oil, and new currency developments.
Nowadays, the price of oil is more a function of supply-demand factors, together with the usual dose of oil company profit objectives and government tax grabs. Oil prices are no longer determined by political motivations to the extent they were back in 1973. In fact, in the past 10 years in particular, OPEC has simultaneously reduced oil prices and increased production when it felt that the global economy was at risk from high oil prices.
Since the last major recession of 1990-91, however, the global economy has risen quickly, with increasing demand for oil, particularly from fast-developing Asian economies. At the same time, most large oil companies have put oil exploration in OPEC areas on the back burner, owing to exploration costs and political risk considerations. Furthermore, oil production in Iraq, the world's second-largest producer pre-Desert Storm, was virtually halted for a period of nearly 10 years due to the highly restrictive UN-imposed oil-for-food exchange. As a result, it was just a matter of time before growing demand and shorter supply would push oil prices up again.
Although oil companies are in exploration mode again across the globe, there is no sign that the supply-demand pattern will be altered in the short or medium term. It will take a few years for new oilfields to be operational and for Iraq to produce oil at full capacity. In addition, the impact of fuel-cell technologies and hybrid car engines is still far from being felt at the pump. Should a civil war erupt in Iraq (assuming the departure of U.S. forces) for ethnic or religious reasons or for oil control, world supply will be further affected. Oil prices do not have inelastic properties: they will respond positively or negatively to changes in demand and supply.
Another strong factor in the supply-demand pattern for oil is the burgeoning needs of China. With an economy growing by 8% to 9% a year, a population of 1.3 billion and a flourishing car industry, China's need for oil will continue unabated. Recent Chinese attempts and successes to take over foreign oil companies indicate that the awakening giant is oil hungry. That reality will maintain upward pressure on oil prices for some time. The same also applies to other fast-developing Asian economies, such as Malaysia, Indonesia and another oil-hungry giant yet to come, India.
Therefore, from a pure supply-demand perspective, oil prices are bound to stay high in the medium term. In addition, from a currency perspective, the rise of the euro has begun to challenge the supremacy of the dollar, which will have an upside effect on oil prices. Ironically, this challenge is not happening from oil considerations alone but from changes in global trade, particularly in Asia. Before addressing the currency issue, however, it is essential to examine the global position of the U.S. dollar.
Since 1975, the United States has officially benefited from the global use of petrodollars, owing to the fact that oil-importing countries must pay for oil in dollars. Oil exporters invest the dollars received in large amounts of U.S. securities in order to avoid currency fluctuation risks. Oil importers also have to buy dollars and U.S. treasuries in huge amounts to be able to pay their oil bills. This global demand for dollars has helped the United States not only to keep its currency strong, but also to allow American consumers to import goods for less than would otherwise be possible. Moreover, it has allowed each U.S. administration to borrow massively abroad to sustain larger and larger trade deficits. This situation has kept U.S. inflation down but has created a fiscal Leviathan. The current “dollar arrangement,” however, is eroding with the growing power of the euro in international finance.
What about oil-exporting countries? After all, it is mostly they who, over the past decades, have ultimately determined the rise and fall of currencies. Will they dethrone the petrodollar and crown a petroeuro? If so, what will happen to prices?
Some oil exporters have already begun the switch to euros. For example, Venezuela is in the process of liquidating its last U.S. treasuries and dollar reserves and has bought euro-denominated treasuries and euros instead. Of course, Venezuelan President Hugo ChÃ¡vez is doing so partly as an anti-Bush stance, but the effect is still the same on capital markets. Back in 2000, in articles published on the rise of the euro in the Canadian Investment Review and Avantages, I predicted that Iraq would take the opportunity to switch to payments in euros, again as a stance against America. In November 2000, Saddam did just that. Now, the U.S. military is in Iraq and the small oil flow coming out of that country is paid in dollars in order to preserve the oil-for-dollars arrangement and to allow American firms doing business there to be paid for their services. When and if the Americans leave, will an independent Iraq keep selling oil to the U.S. at a discount–that is, for dollars? Very unlikely, for other major suppliers are setting the euro trend.
Iran and Russia are building euro reserves with European gas and oil clients. Since they began taking payments in euros over the past two years, both countries have made more than 20% in currency gains alone. With respect to Iran, its government is nervous with the U.S. military at its doorstep, exercising influence in the region. Iran may thus wish to weaken the United States position any way it can, including through a weakening of the petrodollar. Economically, it makes sense for Iran to switch gradually to euros. France, Germany and the Netherlands are already Iran's main trading partners. In addition, many European firms are currently undertaking gas and oil exploration there.
Russia is slowly introducing the euro for purely economic reasons. Western Europe gets most of its energy from there, and the EU has been pushing Russia to switch from the dollar to the euro as the standard of exchange for purchasing its oil and gas exports. Eastern European states that are in the EU or are applying for membership will also adopt the euro soon.
Of course, the wild cards are Saudi Arabia, Kuwait and the United Arab Emirates (UAE). Saudi Arabia had approximately US$200 billion in reserves before the 1991 Gulf War. However, the combination of a US$36-billion war contribution to the U.S. effort at the time (mostly by Saudi Arabia, but also by some of the other Gulf States) and other disastrous Saudi economic policies in the 1990s, led the country to a huge budgetary deficit. As a result, Saudi Arabia's U.S. dollar reserves have dwindled, given that a substantial portion of its budget goes to servicing its debt. However, Saudi Arabia stands firm behind the dollar because of its political relations with the U.S., which guarantees the survival of its current regime.
Kuwait also stands firm behind the dollar because of its special relationship with the U.S. Although the U.S. dollar reserves of Kuwait, Saudi Arabia and the United Arab Emirates are not very large, their strict adherence to the petrodollar is of great political significance. Saudi Arabia's influence within OPEC–as the world's largest oil exporter–is substantial, and every OPEC member watches what Saudi officials say and do. Nevertheless, pressure is mounting from within OPEC (particularly from Iran, Nigeria and Venezuela), and it is only a matter of time before Arab oil producers consider euros seriously.
The economic arguments for OPEC's conversion to the euro are very strong. The euro-area's trade deficit is minimal, and euro members are not heavily indebted to the rest of the world like the U.S. Interest rate differentials may be in favour of the U.S. at the moment, but that will change when the European Central Bank raises rates. Also, the euro-area has a larger share of world trade than the U.S. and is the Middle East's main trading partner. If OPEC were to convert its dollar assets to euro assets and then require payment for oil in euros, those assets would immediately increase in value, since oil-importing countries would also be forced to convert a portion of their assets to euros, thereby driving oil prices up. For OPEC, supporting the euro could bring huge profits, through currency appreciation, currency and bond trading, and, above all, higher oil prices, for at least a period of time.
Assuming that Saudi Arabia, Iraq and Kuwait were to switch to euros, the entire global oil industry would become temporarily unprofitable due to transaction and cost adjustments for both oil exporting countries and oil companies. That would also exert upward pressure on oil prices.
Let us look at two major oil consumers, China and Japan, which also happen to be the largest holders of dollar assets, both in currency and treasuries. It is common knowledge that America's annual budget deficit of more than US$400 billion is largely funded by Asian purchases of U.S. government bonds, mostly from China and Japan.
China has already substantially reduced its reliance on the dollar. For example, its dollar currency holdings alone may have dropped from 83% of its total foreign reserves in 2001 to as low as 60% now. That process began in 2002, when China sold large amounts of U.S. government bonds, shifting much of its reserves to euros, Australian dollars and Canadian dollars. Other Asian countries, such as India, Thailand, Indonesia, Taiwan and the Philippines, have also started a sell-off, despite a diplomatic show of solidarity for the dollar that was carefully designed to prevent a crisis of confidence in exchange systems. Ask any global bond and currency trader and they will tell you that it is quite unlikely that much of this outflow will ever return to U.S. dollars. Without a doubt, the growing economic interdependence within Asian countries and the widening presence of China's trading conglomerates are slowly but surely transforming traditional global trade market structures.
Furthermore, China has recently ended its currency peg to the dollar. Although largely symbolic, it nonetheless indicates that China does not wish to keep accumulating foreign reserves in U.S. dollars (it has, together with Hong Kong, more than US$800 billion, both in currency and treasuries, and over US$1 trillion, if we include Taiwan), which will clearly depreciate in value over time.
Japan is by far the largest foreign holder of U.S. treasuries–it has nearly US$700 billion. This compares with more than US$300 billion in treasuries held by China and Hong Kong. Japan will therefore play a critical part in any changes to the world's currency system. Of course, because of its close relations with the U.S., Japan has much more to lose from the demise of the dollar than China. As long as deflation continued to be a major economic concern in Japan, supporting the dollar was of paramount importance. With clear signs, however, of an end to deflationary pressure in Japan, strong domestic economic recovery there, and a diminishing dependence on exports for growth, the imperative to support the dollar is eroding.
In addition, it is conventional knowledge that China, and Japan to a lesser extent, are now increasing their exports to countries outside of the United States, especially to Europe and the Middle East, but mostly to other Asian economies. The dependence on American purchasing power will therefore diminish over time.
On the other hand, the ability of China and Japan to sell off large amounts of U.S. treasuries and dollars is not a riskless task. By selling paper assets in large volumes, their value will decrease as both bond and currency traders and arbitragers go in for the kill. Many economists agree that a large sell-off of U.S. currency and treasuries would exert significant downside pressure on the U.S. dollar. If the U.S. dollar were to decline by more than 10% over a short period, there would be panic in both capital and oil markets. Although China and Japan are in too deep to exit rapidly–as to do so would invite huge exchange losses–global events may precipitate a sell-off.
Should OPEC make an official, even gradual, shift toward the euro, the sell-off will accelerate, further precipitating the dollar's fall and increasing demand for euros. Other U.S. debt holders would have to sell their U.S. treasury holdings and bid for euro-denominated short-term fixed income instruments, while trading a rapidly devaluating U.S. currency against euros, pounds and even Chinese yuans (seen as a potential regional substitute in the future). Non-euro members would have to trade a devaluating currency for a stronger one, leading to large asset losses. As a result, the euro would increase substantially, panic would hit capital and oil markets, and the price of oil would spike.
Expect China and Japan, therefore, to remove their support of the dollar over time, regardless of whether OPEC's currency policy changes or not. That decision will gradually impact the dollar value, but, more importantly, will affect global confidence in the dollar. Loss of confidence in a currency that is the centre of oil (about 80% of transactions) and global trade (about 50%) will bring uncertainty in capital and commodity markets. And uncertainty will not help push oil prices down. Quite the contrary.
A Dollar-Euro Blend?
Some economists have spoken of a dual oil currency: a dollar-euro blend by which oil and other commodity transactions could be settled. We said earlier that if Arab countries made the switch to euros, the global oil industry would become temporarily less profitable. With a dollar-euro blend, the industry would still be in the same situation. To be profitable, the oil industry must have a deep and liquid market in which to conduct its global transactions. The use of one currency is practical, as it solidifies the market, equalizes prices worldwide, and allows for effective transparency in terms of costs and profits. With a two-currency blend, the market would be fractured, substantially increasing transaction costs. The overall effect would be to push oil prices up. It is therefore doubtful that a dollar-euro blend will ever be used by either OPEC or oil firms.
In the meantime, we need oil, and the U.S. dollar is cheaper than the euro. And you think oil is expensive? When the oil currency becomes the petroeuro–and the trend is underway–the U.S. dollar will decline further, and there will be a major confidence crisis in exchange systems with the potential upheaval of capital markets. If we move to a temporary dollar-euro blend, there will be a period of uncertainty with regard to currency adjustments. In both scenarios, the price of oil will increase. Add China's hunger for oil and Japan's eroding support to the dollar, and oil prices will edge up further. What are the alternatives then?
As oil consumers, we have no choice but to pay the price asked, as we need oil for transportation, heating, electricity generation and industry. As investors, we can protect ourselves by hedging our oil costs through investing in oil-related securities at least for the near future–and also by buying euro-denominated fixed income securities or euros with Canadian dollars.