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Deciphering the Dollar-Oil Relationship


Will it matter if crude ceases trading in greenbacks?

For the last half century the U.S. dollar has been the world's top reserve currency. Although it continues to maintain this status, the recent weakness in the greenback has many nations reconsidering their dollar pegs. Earlier this week, the United Arab Emirates announced that they have put together a task force to discuss de-linking their currency with the U.S. dollar.

This is not the first time that a country has considered that option. In fact, in May of last year, Kuwait surprised the markets by unhooking the dinar with the dollar. Since then, markets have watched the UAE and Qatar for any signs of a similar move. The main reason why this is happening is because the weakness of the U.S. dollar is driving up inflation and hurting the domestic economy.

However, threatening to de-peg their currency from the dollar may not stop the greenback from falling and exacerbating the rise in oil prices in the process. There is actually another option for many of these oil producing countries – which is to start selling or trading oil in currencies other than the U.S. dollar. Is this possible? If so, will it even matter?

Could Oil be Traded in Euros?

Is it possible for oil to be traded in euros? Of course. Anything is possible. In fact, I think that it will only be a matter of time before oil is traded in both euros and U.S. dollars. It doesn't need to be black or white, all or nothing. Many countries around the world have spent the last nine years since the euro's launch slowly adding the currency to their reserve coffers. With prices rising around the world, many nations will be scouring for ways to reduce costs. One of these ways would be to pay for oil in a currency other than the U.S. dollar, like the euro. This would be ideal for eurozone nations who already have a strong currency that is helping to offset the record highs in crude that are being hit on a near daily basis. But will it happen anytime soon? Probably not.

If the dollar remains weak for much longer oil will be traded in euros. It's not a question of if but a matter of when. The GCC countries are in a tailspin. They export oil in dollars but buy many goods and services in euros, including food and clothing. Meanwhile wages in those countries are pegged to the dollar and workers are rebelling as inflation is starting to run at double digit rates. What looked liked a great job opportunity for many citizens of Middle East, India and Pakistan is now turning into a sucker's bet. For now the GCC countries will continue to maintain their dollar pegs because of their foreign policy ties to the U.S., but if the domestic situation begins to boil over they will have no choice but to de-peg.

It's Political as Much as it is Economical

We all know that oil is a political asset. Now couldn't be a better time for countries like Iran, Russia and Venezuela to step up the pressure to sell oil in a currency other than the U.S. dollar. Just last month, Iran officially opened the Iran Oil Bourse, which trades oil in non-dollar currencies. In December 2007, they stopped accepting dollars for oil. This had a limited impact on the U.S. dollar at the time because the U.S. is by far the world's largest oil importer and Iran is only the world's fourth largest oil exporter. If Saudi Arabia made this announcement, things would be different. Saudi Arabia and the U.S. are allies so don't expect it to announce a similar change anytime soon, especially since the U.S. dollar is already this weak. To do so would be like kicking someone when they are already down. Russia on the other hand is the bigger threat. Back in 2003, Putin openly said that Russia could switch its trade in oil from dollars to euros. In 2006, they officially opened up an exchange to trade oil in rubles. Did it matter to the U.S. dollar at the time? No. So an announcement by UAE or Qatar will not matter for the U.S. dollar either.

None of these factors mattered because oil really trades in only two places in the world – London and New York. Iran's exchange efforts are a laughing stock because the country has no political clout or economic know how to establish a world class trading exchange. Dubai, however, is different. The emirate boasts some of the fastest growth rates in the world and some of the best infrastructure facilities anywhere. Furthermore, it has made a foray into the exchange business by buying stakes in Nasdaq and LSE. Having been there many times myself, I can tell you that Dubai has been tremendously successful at adopting advanced Western business practices and management methods. If the Dubai Mercantile Exchange (which is jointly owned by Dubai Holdings and NYMEX) were to one day decide to trade oil in euros, the landscape could change very quickly.

It Is All About Reserves

What currency oil is traded in matters less than what the central banks of oil importing nations will do with their reserves. Next to the U.S., China and Japan are the world's biggest oil importers. They also own the most foreign exchange reserves in the world. If oil is not priced in U.S. dollars, could China and Japan reduce their holdings of U.S. Treasuries and therefore U.S. dollars? Yes. But will they? Not at the pace that would trigger a significant sell-off in the U.S. dollar. In this day and age, the world has become very interconnected. Selling their holdings of U.S. Treasuries or U.S. dollars would trigger a significant rise in U.S. bond yields, which could stifle growth in the U.S. economy. Spillover into China and Japan in this case would be unavoidable. I doubt that China or Japan will be willing to risk a global slowdown, especially now when growth in many countries around the world is already slowing.

Oil trading in euros will matter for one reason and one reason only. Oil importers will no longer need to stockpile dollars in order to pay for their energy needs. China and Japan do not need to sell their current reserves, they simply need to stop buying any additional paper – something they are doing already as we can see in the latest TICs numbers. Aside from the fact that U.S. has the deepest, most liquid and most credit worthy capital markets which attract a massive amount of the worlds savings, the other major reason for the world to own dollars is because almost all key commodities from foodstuffs to metals to softs to energy are denominated in dollars. If oil is suddenly traded in euros, why not any of these other commodities? Therein lies the real problem. It's either a dollar denominated world or it is not. And if we lose our hegemony on the commodity markets of the world the greenback is in even more trouble than we think.

What Are the Currency Plays?

I would stay short U.S. dollars for the time, not because I think all of this recent talk about oil will matter, but because I believe that the U.S. economy will continue to weaken, forcing the Federal Reserve to bring interest rates as low as 1%.

If oil is traded in euros instead of dollars that will just be final chapter in dollar long suffering decline. Further, if this leads to a general re-pricing of all commodities in euros the EURUSD will only strengthen its new found dominance in the currency world as other nations will begin to stockpile euros instead of dollars. But this is a very long term scenario and by no means an assured conclusion. The euro while certainly performing far better than even its biggest boosters believed, is not without its own problems, not the least of which is that is still a currency without a country and therefore highly susceptible to political risk. Therefore I am not sure if it will be able to take away reserve status from the dollar, but if oil and then other commodities start trading in euros, who will want to hold dollars?

What Does This Mean for My Stock Positions?

The dollar's weakness and euro's strength continues to bode well for multinationals like McDonald's (MCD), Microsoft (MSFT) and Starbucks (SBUX) who source their goods in dollars but receive a substantial portion of their revenue in euros. For those traders not willing to incur absolute risk because they fear a bear market in equities, a relative bet of long U.S. multinationals against the S&P could be a interesting idea to pursue in 2008.
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