No Nonsense
Oil price and dollar reserves
SPEAKING at the 29th ministerial meeting of the Opec Fund for International Development in Isfahan on June 17, Iran's President Mahmoud Ahmadinejad dropped a bombshell -- no, not a nuclear one -- although many wished it might as well have been.
Ahmadinejad reiterated his prior proposal, made in the November 2007 Opec heads of states meeting in Riyadh, to convert member states' cash reserves into a basket of currencies rather than holding them in the dipping US dollar. He derided the US dollar as "a worthless piece of paper." Not surprisingly, his ally, President Hugo Chavez of Venezuela, echoed a similar rhetoric.
What is really surprising is the absence -- for the first time ever -- of any rebuttal from the key US petrodollar comrades. In fact, countries like Saudia Arabia, Kuwait and others reserved their concerns, as if they were acquiescing with Ahmadinejad and Chavez.
Instead, Opec members coalesced to team up a working group to study the dollar's impact on oil prices and to "investigate the possibility of a currency basket" as a means of off-setting declining dollar-denominated reserves.
Oil price and the value of dollar have recently been moving inversely. This phenomenon is threatening the global economy, and there are several factors for this quandary. Numerous estimates have suggested that global oil production will peak and go into terminal decline within the next five years or so -- if it hasn't already.
Andrew Gould, CEO of the giant oil services firm Schlumberger, for instance, recently stated that "an accurate average decline rate of 8% is not an unreasonable assumption." Some industry analysts are anticipating decline rates as high as 13% per year, which would cause global production to drop by 75% in less than 11 years.
If a 5% drop in production caused prices to triple in the 1970s, what do you think a 50% or 75% drop is going to do?
Estimates by oil industry indicate that this fall in production has already begun. The fallout of this production shortfall is almost unimaginable. As the world slides down the slope of the global oil production curve, civilisation may find itself gliding into something best described by an analyst as a "post-industrial stone age."
Some recent estimates show that a 15% shortfall may spike oil prices by 550%. One expert has suggested that gasoline may soon reach near $12 to $15 per gallon in the US.
The US imports nearly 70% of its oil, paying over $700 billion annually. China's and India's oil consumption has grown steadily for more than a decade now -- a major dynamic driving up prices. But China uses about 9% of the world's oil compared to 25% used by US. Given that oil is priced in dollars, it is no surprise that oil price and the value of the dollar show a close relationship.
No one is expecting to see oil production going up substantially and prices going back to 2002 levels. Persistent higher oil prices have recently caused a worldwide concern about the value of the US dollar against the euro and other major currencies.
The dollar is plunging for several reasons -- and they all reflect a more negative view of the US economy relative to the rest of the global economy. Investors are selling greenbacks because of concerns about rising inflationary pressure, uncertainty about the solvency of many US banks, and a looming recession (which many think is already underway) -- plus the on-going disquisitions in foreign countries about where to hold their foreign exchange reserves.
What's happening with oil prices is, in part, the flip side of that same financial coin. Since oil is priced globally in dollars, it's usual for any high markdown in the dollar to be reflected in a high markup in oil prices.
A pertinent question though, is whether the dollar's decline, in the long term, will be healthy and desirable globally. Some economists argue that an overvalued dollar in the recent past has made the global economy imbalanced -- and that some economising by US consumers is the price to pay to restore market discipline and economic order.
Others argue that the dollar's sustained decline -- and the daily record highs of the rival euro -- is the open economy's warning that the Federal Reserve (US Central Bank) is failing to keep inflationary pressures at bay. Don't forget: an inflating currency is perceived as a declining currency.
The rising oil prices and plummeting dollar add a new measure of uncertainty to the US and global economy, and in the short-run exerts volatility in financial markets worldwide. As a matter of record, Opec members have long groused about the declining dollar and receiving payment in euros. In fact, China already pays for Iranian oil in euros; added to that, both Venezuela and Russia joined the "euros-for-oil" deal, as have Libya, Indonesia and Malaysia.
One may wonder why many Opec countries peg their own currencies to the dollar. The answer is straightforward: pricing crude oil and pegging domestic currency in dollars helps them have their own variety of economic benchmark. Should these countries realign away from dollar, each will have to reset its own economic yardstick and begin pricing oil on the free market, which the Opec cartel has struggled to shun since 1978.
The intricacy is that the outcome of such a "realignment" could result in radically higher oil prices as larger producers press the smaller producers out, resulting in even further nose-dive of the dollar.
Many around the globe ask: "How high will crude oil soar?" Some predictions suggest as high as $197 per barrel. Estimates show that a run-up in crude oil prices of nearly $200 a barrel would imply a dollar tumbling of another 25% from present levels.
Should that realignment away from dollars into other currencies consummate, the dollars will no longer be required for oil purchases, causing the demand for dollars to plunge globally, sending the greenback into a freefall.
Whether the cartel members eventually desert the dollar entirely -- or minimally shift to a currency basket -- isn't an issue of much concern now. The real issue is that Opec and non-Opec producers may have to boost oil price as a way of compensating for both the consequent loss in immediate cash payments they receive and the decline in value of the dollar-denominated reserves they hold.
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