Dollar, Euro and the price of Oil

[Drogue]

Originally posted by Thue
Exactly. That is so obviously right. It seems so absurd to me that people who should know better keeps saying that it really makes a difference which currency oil is priced in.

Actually it does, for three reasons I can think of:

1) Demand for USD. If you want to buy oil, you need to buy USD. If you are selling oil, generally you keep the money in USD, as it's the way the money the world uses to trade. The bigger issue is, if oil is traded in Euros, will the USD stay as the world's benchmark? If not, the demand for USD will drop. Sure, it's a one time occurance, but it'll have a big impact on exchange rates, unless central banks step in, and thus don't use it to balance other macroeconomic factors.

2) Government debt. Currently many macroeconomic factors act in the opposite way with the US, since the US borrows in USD. Other countries also currently borrow in USD, which means if their exchange rate changes, so do their loan payments. If it became harder for the US to borrow in USD, it may cause a rise in the rate that has to be paid on government debt (since they wouldn't want the currency risk so would swap out of it). If things stop being benchmarked to the USD, then macroeconomic factors that would cause the USD to move now cause a relative movement with whatever the new benchmark is.

3) Perceptions. Things tend to follow perceptions, so if people feel a currency is strong, it will be. If there is a widely publicised move away from the USD by OPEC, this makes people think the USD is weak, and thus it becomes weak.

Actually, replying to DanS reminded me of a 4th reason:

Originally posted by DanS
It wouldn't be a big deal if OPEC switched to the Euro. I don't know why they would care in what currency they get paid, so long as the currency is stable and liquid -- such that you could trade out of it easily into your preferred currency. The dollar is and will remain a stable currency.

Stable? It's lost huge amounts to other currencies over the last 5 years. It's hardly stable. It's definitely liquid, but it fluctuates more against other currencies than some currencies. And if you're OPEC, you want your money in as stable a currency as possible. Which isn't the USD, at the moment.

[Drogue]

Originally posted by Thue
I don't see why it should make any difference. If you wanted to you could already today just agree on the purchase price in dollars, but then just do the purchase in euros, using the momentary exchange rate.

But most oil trading is done with futures. The greater the variation in expected future currency movements, the greater the premium of the future. You could do a trade as above, but what would the momentary exchange rate be in 6 months?

[DanS]

Yes, it's stable. The decline was orderly, despite an enormous current account deficit and attempts to manipulate local currencies relative to the dollar. The appreciation will be orderly as well.

[Drogue]

But that isn't stable. 15% inflation is orderly, but it shows your economy isn't stable. If it's depreciating, or appreciating, fast, then it's not stable. Or at least, it's not what you want to use as a benchmark currency. You want something that means if the price of oil in USD rises, it's primarily because of oil fundamentals, not currency ones.

[Geronimo]

Originally posted by DanS
Yes, it's stable. The decline was orderly, despite an enormous current account deficit and attempts to manipulate local currencies relative to the dollar. The appreciation will be orderly as well.

why would it appreciate?

[DanS]

Originally posted by Geronimo
why would it appreciate?

Because it's undervalued.

[Geronimo]

Originally posted by DanS


Because it's undervalued.

seriously, how do we tell? I hope it's not just historical record.

[DanS]

It's pretty easy in part an pretty tough in part.

The easy part is by looking at the deficit in trade of goods and services ("the trade deficit"). The US trade deficit continued to grow until 2006, but has been decreasing rapidly since then. The December 2007 trade deficit was $58.8 billion, of which $27.2 billion was unrelated to oil, the lowest ex-oil trade deficit in 6 years. This trend toward a lower ex-oil trade deficit is likely to continue in fits and starts.

Since the majority of the deficit is related to oil, the price of oil is self-reinforcing. If the price of oil starts to drop, then our trade deficit drops, then the value of the dollar increases, which in turn causes the price of oil to drop. Basically, the opposite of what has been happening to this point.

Beyond the trade deficit, there are capital flows. People buy dollars to purchase assets in the US. They sell dollars after they've sold assets in the US. The relative attractiveness of US assets is something of a mystery (the pretty tough part of telling), but a large part of it is wrapped up in US interest rates. Right now, the differential between US interest rates and the interest rates in other countries is near the greatest that it will be. There are some exceptions here, such as China. China's interest rates may continue to increase.

[Thue]

Originally posted by Drogue

But most oil trading is done with futures. The greater the variation in expected future currency movements, the greater the premium of the future. You could do a trade as above, but what would the momentary exchange rate be in 6 months?

But a future could be written in euros as in dollars. Give me x barrels of oil for €y in z days.

In either case, part of the result of the future would depend on fluctuations of the chosen currency. In neither case does it matter which currency happens to be used to list the price of oil in yahoo finance...

[Thue]

Originally posted by Drogue

Actually it does, for three reasons I can think of:

1) Demand for USD. If you want to buy oil, you need to buy USD. If you are selling oil, generally you keep the money in USD, as it's the way the money the world uses to trade. The bigger issue is, if oil is traded in Euros, will the USD stay as the world's benchmark? If not, the demand for USD will drop. Sure, it's a one time occurance, but it'll have a big impact on exchange rates, unless central banks step in, and thus don't use it to balance other macroeconomic factors.

Yes, there is probably an effect here, but it need not be that large. You only need enough dollars in hand for near-future buying.

2) Government debt. Currently many macroeconomic factors act in the opposite way with the US, since the US borrows in USD. Other countries also currently borrow in USD, which means if their exchange rate changes, so do their loan payments. If it became harder for the US to borrow in USD, it may cause a rise in the rate that has to be paid on government debt (since they wouldn't want the currency risk so would swap out of it). If things stop being benchmarked to the USD, then macroeconomic factors that would cause the USD to move now cause a relative movement with whatever the new benchmark is.

This is the dollar as a reserve currency, and this obviously has a large (positive) effect for the US.

But the use of a currency as reserve currency and as benchmark are separate issues. I was criticizing the statement that benchmarking alone was important.

3) Perceptions. Things tend to follow perceptions, so if people feel a currency is strong, it will be. If there is a widely publicised move away from the USD by OPEC, this makes people think the USD is weak, and thus it becomes weak.

Yes, a move away from the dollar could hurt the perception of the dollar's strength, and as a consequence its perception as a reliable reserve currency. If people would argue like that I could only agree. But some people are making statements that the dollars use as a benchmark currency is important in itself.

Like I think the Iranians (I think) who made statements to the effect that if the dollar was not depreciating then they would earn even more, because then oil prices would be higher. And changing oil benchmark currency would fix it. Which is just silly .

[Kidlicious]

Originally posted by DanS
It's pretty easy in part an pretty tough in part.

The easy part is by looking at the deficit in trade of goods and services ("the trade deficit"). The US trade deficit continued to grow until 2006, but has been decreasing rapidly since then. The December 2007 trade deficit was $58.8 billion, of which $27.2 billion was unrelated to oil, the lowest ex-oil trade deficit in 6 years. This trend toward a lower ex-oil trade deficit is likely to continue in fits and starts.

It think you mean it grew until 2007, not 2006. It has stopped growing because of economic slowdown, and the weakness in the dollar. I don't see how you can expect strength in the dollar from that.