Relationship between Oil Pricing and the US Dollar - Assignment Example

Relationship between Oil Pricing and the US Dollar Introduction In recent years, the price of oil has risen steadily much to the chagrin of consumers worldwide. Coincidentally, the American currency (dollar) has seen a steady depreciation trend during the same period. For example, between 2007 and 2008, the price of oil rose from $65 to $120 a barrel; during the same period, the dollar depreciated by 12% and 15% to the euro and the yen respectively (Feldstein, 2008). While the rise of oil prices and the depreciation of the dollar could be seen as a coincidence, most analysts believe it is not. The relationship between the dollar and oil is however clear-cut. For example, while Feldstein (2008) argues that the oil prices would remain the same regardless of the currency used to trade the resource, other analysts such as Ramady (2010) argue that the impact that oil has on the dollar is undeniable. The price of oil and the dollar Some observers argue that there is a “direct cause and effect relationship” between the dollar’s international exchange value and oil prices (Jackson, 2010, p. 2). Such an argument is founded on the fact that oil is priced in dollars and hence any depreciation in the dollar’s value erodes oil producers’ purchasing powers. This argument is supported by the International Monetary Fund (IMF, 2008), which notes that a change in the dollar’s value has an effect on commodity prices. The oil-dollar link explained above is not always accepted in all quarters. Grise (2010) for example argues that any changes in the values of the dollar affects the demand of the oil by either causing consuming countries to purchase more (i.e. when the dollar depreciates), or less (i.e. when the dollar appreciates). Faced with an increase in demand, the oil producing and exporting companies often adjust the oil prices upwards and vice versa (Grise, 2010). Actions by the Organisation of Petroleum Exporting Countries (OPEC) are also cited as having an effect on the oil-dollar link (see figure 1). Writing for the Congressional Research Service, Jackson (2010, p. 3), observes that OPEC’s main objective is to secure “a fair and stable price for the oil the member countries produce”. Faced with reduced purchasing power, OPEC, which commands more than 40% of the global crude oil output capacity, could deliberately drive up the prices of oil by reducing production. According to Jackson (2010), OPEC could also hold down any increases in oil production in order to stabilise or raise oil prices (see figure 1 below for OPEC’s interventions between 2001 and 2005). Such an action corresponds with the standard economic theory, which states that a reduction in supply of a specific commodity relative to a particular demand level will result in higher prices for the commodity since the demand will outweigh supply. Additionally, if OPEC’s actions have any impact on the oil-dollar relationship, it must be because market observers, participants and speculators have become accustomed to acting on the stylised notion that a link exists between the value of the dollar and the price of oil. Figure 1: OPEC’s interventions (highlighted in colour) Source: Williams (2011). Pricing oil in dollars supports the value of the US currency, and by so doing, extends the support to the country’s political and economic power (Ramady, 2010). Based on the advantages that the US gains from the pricing arrangement, there is no doubt that the country would be opposed to any attempts to trade oil in any other currency. Most of the literature by American institutions e.g. the Jackson (2010) report and the Feldstein (2008) submission are against such a decision. Yet, one cannot ignore the voices calling for a change in dollar dealings in the oil industry. In a Business Week article for example, Fisk (2009) reports that some of the big oil exporting and importing countries are hatching a plot to move away from dollar dealings in oil by 2018. Notably, this will not be the first time that such an attempt has been made since Iraq had done the same just a few months before US’s invasion (Clark; 2005; Shipley, 2007). In fact, it has been hypothesised that the invasion of Iraq had more to do with protecting the hegemony of the dollar, and the United States than to the country’s alleged links to terrorism. That aside, and if the opposition of the countries mentioned above (i.e. China, France, Russia, Japan, Saudi Arabia, Qatar, Abu Dhabi, and Kuwait) to the US dollar’s hegemony in the oil market is anything to go by, the threat this time is much more profound that it was under Saddam Hussein’s Iraq. Some of the countries in the group that reportedly wants to abandon trading oil in dollars are four Middle East states namely Saudi Arabia, Qatar, Abu Dhabi, and Kuwait. China on the other hand is a major oil importer, which according to Fisk (2009), “uses more oil incrementally than the US...” (para. 5). This means that China’s bargaining power with oil producing countries may be relatively higher than that of the US, since the Asian country is slowly becoming a major export market for the oil producers (see figure 2 below). America’s position in the situation is further worsened by the fact that its economic power was greatly dented by the 2008/2009 economic crisis; the ‘anger’ among oil-producing, and oil-consuming countries at US’s power and dominance in the global financial system; and the risk posed by emerging powers such as China and India and their influence on the oil producing regions (Fisk, 2009). Figure 2: Change in oil demand in different regions between 2004 and 2008 Source: Jackson (2011, p. 11). Does the dollar really affect the price oil or are people (and countries) simply buying into a seductive theory? According to Vergis (2008), the fact that oil contracts are priced and traded in dollars makes it easy for oil producers to increase prices whenever there is a depreciation in the value of the dollar. Whether the price increase is justified or not is something different altogether especially if one was to consider that the dollar depreciation and the oil prices do not always coincide. For example, Vergis (2008) notes that the dollar has lost 29 % and 14% against the euro and the British pound respectively since 2003; in the same period however, oil prices have increased by 256% (see table 1 below). Such lack of correlation between the depreciation of the dollar and the increase in oil prices hence indicates that there is more to the rising prices than the dollar. Another reason, though not explicitly stated, that may make some players in the oil industry to prefer using currencies other than the dollar may include the fact that the ‘lax’ monetary policy by the US especially starting in 2003, which has been blamed for the explosion in oil and commodity prices (Vergis, 2008). With many countries pegging their currencies on the US dollar, they have had to maintain their exchange rates parity by being in synchrony with the US’s monetary policy. Notably, the same monetary policy is defined as “undeniably quite loose” since 2003. Specifically, government encouraged credit growth by fostering an environment where interest rates were as low as 1 percent. Consequently, the US and other countries whose currencies were pegged on the dollar stocked monetary expansion experienced a great deal of liquidity in their respective markets. In other words, this meant that there was too much cash chasing a limited number of products. When such happens, inflation, which is accompanied by a rise in commodity prices, is inevitable. If this was indeed true, the rise in oil prices can then be partly blamed on the US monetary policies, which by causal effect triggered high liquidity in not only the US but other countries whose currencies are pegged on the dollar. Oil being one of the highly-demanded commodities throughout the world was one among other products that were impacted by the excess liquidity in the market (Vergis, 2008). Speculation in the futures market is also partly to blame for the rise in oil prices if observations by Williams (2011) are anything to go by. However, the speculation is cited as just a component that leads to the increase in oil prices rather than a major cause of the same. The 2008 scenario illustrates the speculation effect on oil quite well. During the economic recession, the demand for oil was relatively low, and normally, this should have driven down the prices. However, the IEA spreadsheet below shows how a 25% rise in prices (i.e. form $87.79/barrel to 110.21/barrel) was experienced at specific times in the recession period. See table 1 Table 1: World Oil prices in Q1-Q4 of 2007 and 2008 Source: https://spreadsheets.google.com/pub?key=pzwCfOsv_9YmYXCdXbN0rdQ According to EIA, investors perceived the oil market as a safer investment option compared to others like the stock or real estate markets. The sudden interest in oil futures drove up the prices, as speculators tried to cash in on the influx of funds diverted from other investment markets. According to Vergis (2008), there are a number of other important factors that contribute to the rise in oil prices, but which fail to get as much attention as the dollar-oil relationship, or the speculation surrounding the oil futures market. Such include the heightened level of demand from emerging economies such as India and China coupled with inadequate oil refining capacities. To explain how this affects the oil prices, Vergis (2008) argues that limited refining capacities puts a limit to just how much refined oil is available for use in the respective markets. When the demand outweighs supply, a shortage occurs thus driving up the prices. Admittedly however, Vergis (2008) argues that it is not so much of the demand and supply dynamics that affect the prices in such situations; rather, it is the speculation that comes when markets are not assured that they can get specific quantities of oil if and when they need it. Is it possible to move away from petrodollars? When Clark (2005, p. 5) recommends for the “immediate reform of the global monetary system to include a dollar/euro currency trading band with reserve status parity, a dual-OPEC oil transaction standard, and a UN-Sponsored multilateral project regarding broad-based energy reform...” he is answering the above question affirmatively. In other words, Clark (2005) is saying that oil can be traded in other currencies, but this can only happen if the global monetary system is reformed for purposes of enhancing currency reserve parity. According to Clark (2005, p.5) using other currencies in oil trade will shield the world from a possible “devastating outcome of global warfare over oil currency and oil depletion”. Clark’s view is objectionable to the likes of Feldstein (2008) who argue that replacing the dollar would not have any effect on the price of oil. Notably, there is a probability that Clark’s opinions have some merit especially if one was to consider that he goes beyond the price of oil under different currencies, to deeper issues such as the US hegemony and the depletion of oil in future. Clark’s position is supported by Shipley (2007, p. 8) who argues that if dollar-dominated oil sales were to change to another currency, the “US dollar’s position as a reserve currency” would be greatly affected and this would no doubt have political, economic, and strategic consequences for the US. Notably, Rude (2005, p. 103) posits that moving away from the dollar is not an easy task as some people may believe; specifically, the author argues that the dollar still remains the most trusted currency among central banks and international financial institutions. Others on the other hand argue that toppling the US dominance is no small matter, and would take a great deal of international cooperation and goodwill to do (Cooper, 2006). Following the oil-dollar debate, it is apparent that the US government has over the years strategically dug the dollar in to the oil market in the full knowledge that the use of dollars in the trade would give it economic benefits when compared to other countries as indicated by Oppenheim (1976). When Iraq switched from dollars to Euros in trading its oil, several things were observed. For starters, the switch “netted windfall gains for Iraq spurred on by rapid growth of the Euro against the dollar” (Shipley2007, p. 11). Secondly, the success of the Iraq oil trading in Euros acted symbolically to alert other oil producing and exporting countries that indeed, oil can be traded in other currencies. A switch from dollars to other currencies, for example the Euro would have significant economic effects not only on the use but on countries which hold reserve funds in dollars. For example Clark (2003, para. 14) argues that “oil-consuming nations would have to flush dollars out of their (central bank) reserve funds and replace these with Euros... the dollar would crash anywhere 20% to 40% in value”. Another country which is reportedly actualising switching from the dollar to other currencies is Iran (Press TV, 2012). It is also reported that other countries that intend to go the ‘dollar-free’ way include Japan, Russia, China, and other countries in the Gulf region (Warden, 2009). How can businesses benefit from the oil-dollar link? Oil literally fuels most economies. In most economies, and more so in developing countries such as China and India, oil is the major source of energy and is hence responsible for running a significant sector of the economy. Aside from providing business opportunities for the oil importers and those who deal directly in oil products, the oil business also affects a broad range of economic activities. Indeed, according to Jackson (2010, p. 8), a change in the price of oil affects commodity and consumer prices and this in turn undermines the dollar’s exchange value relative to other currencies. One of the plausible areas that businesses can benefit from the dollar-oil link is by utilising the opportunities created by the demand and supply sides. For example, when the dollar depreciates, oil importers can utilise the strength of their respective currencies against the dollar to purchase more oil. This would however create a situation such as the one defined by Grise (2010) whereby the affordability of oil triggers increased demand and by so doing prompts the oil producers to adjust their prices upwards. According to Strange (1998), there are three main players in the oil business: markets, governments, and companies. While markets are essential platforms to gauge the demand and supply sides and price the commodity, Strange (1998, p. 197) argues that even governments do not play an essential in the oil business as companies do. Accordingly, oil companies manage the market, and governments often have to make decisions based on the market dynamics. Notably, Strange (1998, p. 198) observes that “both companies and government have been, at different times and different degrees, at the mercy of the market”. This effectively means that companies, despite their strong business positions, have to contend with the market forces at some point. Opportunities for companies are usually found in oil exploration, transport services, refinement and marketing the same to consumers. For downstream companies, the refining business has opportunities that can earn them margins estimated to be between $10 and $15 per barrel (Mahalakshmi, 2008, p. 46). The indicated figures are however not static and are bound to change depending on the price of crude and the changes in the dollar. Business opportunities in the oil sector often require overcoming substantial amounts of red tape. In addition to the huge amounts of capital needed to invest therein, one needs to consider the strict regulations in the sector. Understandably, oil is perceived as a national resource, and in some countries, only local businesses (especially in oil exploration) are allowed to venture in the same. A case in point is Saudi Arabia where foreign investment in “oil exploration, drilling and production” is prohibited (Saudi Arabia, 2010, p. 3). Other indirect areas that could benefit depending on the oil-dollar relationship include the petrochemical industries and others like the pain manufacturing sectors, which rely on crude oil as a major input in their processes (Mahalingam, 2008, p. 49-50). As the dollar and the oil link continue to cause dissatisfaction in the market, businesses in the alternative energy sector have an opportunity to flourish. For example, businesses can invest in solar and wind energy systems as a means of providing cheaper and more environments friendly energy sources to the consumer markets (Garcia-Sanz & Houpis, 2011). Such business prospects are bound to prosper in future as more people avoid paying the high price of oil both in monetary terms and in environmental degradation-related costs (Burton, et al, 2001; Hau, 2006). Notably the interest in renewable energy was triggered in earnest by the 1970’s big oil crisis. According to Camacho, Samad, Garcia-Sanz, and Hiskens (2011), the renewable energy interest is increasing by the day especially as consumers are pressed by the rising oil prices, the environmental challenges of using fossil fuels, and the fact that oil is a finite resource whose sustainability is still in question. Conclusion As the IMF puts it, a change in the dollar’s value affects the cost channels and the purchasing power of oil producers; asset channels especially if such channels are dollar-dominated; and other effects which could include monetary policies (IMF, 2008). Simply explained, the oil-dollar relationship is derived from the fact that any depreciation in the dollar means that the exporters have lesser revenues from the same quantity of oil. To bridge the deficit, ostensibly to cover expenses in the home market and make profits, the oil producing countries adjust the prices upwards. In other words, it means that a weaker dollar equals fewer revenues from oil exports and this eventually leads to price adjustment by the oil exporters. The resulting factor is higher prices. While this may be true in some cases, the relationship between oil and the dollar however might have resulted from an informal rule of thumb, where participants and speculators in the oil market acted in anticipation that any changes in oil production would correspond with a change in the value of the dollar. Whatever the case, it seems that the link between oil prices and the dollar is bound to continue in the foreseeable future, unless the dollar’s use in oil trade is replaced by other currencies. Even if that were to happen, there is no guarantee that oil prices would not react to changes in value of such currencies. Not using the dollar would only shift the balance of power from the US hegemony. References Burton, T, Sharpe, D, Jenkins, N & Bossanyi, E 2001, Wind Energy Handbook, Wiley, London. 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