from Follow the Money

Strong oil, weak dollar -

September 16, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The negative correlation between the dollar and the price of oil was much in evidence  last week –

The dollar hit a record low against the euro, and is quite weak against most of the major currencies 

Oil hit a record high in nominal terms, and not all that far off its 1979 high ($109 a barrel) in real terms …

Dean Baker – and OPEC – argue that the link between a weak dollar and a rise in the price of oil is almost mechanical.   When the dollar goes down, oil has to go up in dollar terms to stay constant in say euro terms.     There is something to that.   

But this isn’t the entire story either. 

Over the past few years oil has gone up v a basket of currencies while the dollar has gone down v a basket of currencies.   Oil isn’t up as much in euro terms as in dollar terms, but it is still way up. 

Plus there have been times – like 2000 – when oil rose in dollar terms even as the dollar was rising against the euro.  During that period oil rose very strongly in euro terms.  2005 is a more recent case.

So why then is oil going up when the dollar is going down? 

My answer: global growth is strong, while US growth isn’t.

Strong global growth – particularly in conjunction with a fairly limited supply growth – pushes up the price of oil.     If easy-to-produce oil is close to peaking (the FT reports that “global oil production is estimated to have shrunk by 650,000 b/d in the third quarter”), the price of oil should be rising in secular terms so long as global demand is going up.   Political constraints on more production  -- whether instability in key oil producing areas or a desire to limit production to keep prices up -- would have the same effect.  And if easy-to-produce oil outside of the Gulf and other less than stable areas has peaked (Both Cantarel and North Sea production are falling …), the geopolitical risk premium in the price of oil should also be trending up … 

And strong global growth and weak US growth – indeed, a growing risk of a recession – are a recipe for a weak dollar.

It should go without saying that the strong oil/ weak dollar mix creates real problems for all the Gulf countries that insist (still) on pegging to the dollar.   They are effectively importing a weak currency and low nominal interest rates when there economies are booming.   The result: massive inflation and very negative real rates that are adding to the boom now, but risk creating problems later. 

Pegging to the dollar has – at least in my view – been a recipe for macroeconomic instability in many oil exporting economies.

There also could be another reason why strong oil adds to dollar weakness – the investment preferences of the oil-exporting states.   

This is a bit more speculative, but here is the basic idea.

  • A rise in the price of oil, all else kept constant, reduces the current account surplus of Asia (and pushes Europe into a bigger deficit) while increasing the current account surplus of Russia, the Gulf, Norway, North Africa and a host of African economies (Nigeria, Gabon, Angola).  If the US responds by cutting into its savings to pay for its higher oil bill, the US current account deficit also rises. 
  • Let’s assume, for a second, that the rise in Europe’s deficit from higher oil is offset by rising spending on European goods, so there is no net change in Europe’s aggregate balance.   This is a bit disingenuous, since there is good reason to think that the oil-exporting economies spending on European goods would be going up even if the oil price had stabilized.    But it simplifies things, as it implies that the oil surplus trades off with the Asian surplus.  
  • Let’s also assume that Asia’s current account surplus shows up as Asian reserve growth, and the oil surplus shows up as reserve growth/ an increase in the assets of the world’s oil investment funds.
  • Now suppose that the oil states currently hold – in aggregate – a smaller fraction of their external wealth in dollars than Asia and that they are currently trying to lower the dollar share of their assets.  This isn’t totally implausible.  Norway has long held only about 35% of its oil revenue in dollars, Russia now has less than 50% of its reserves in dollars and a few Gulf states have also rather clearly trying to reduce the dollar’s share of their (growing) portfolios.  In 2000, for example, as much as 85% of the Kuwaiti investment authority’s assets may have been in dollars.   That total is now probably under 50% (KIA’s equity portfolio is certainly under 50%).  ADIA reportedly shifted toward emerging economies a few years ago.   And a host of Gulf funds now want to invest in emerging Asia …  

If all these conditions hold, a shift in the world’s current account surplus from Asia to the oil exporting economies might lead to less demand for dollars, and thus contribute to dollar weakness.    

In his now classic paper on the oil-exporting economies, Ramin Toloui of PIMCO calculates that if oil exporting economies invest 60% or more of their rising revenues in dollar assets, an increase in the price of oil is dollar positive (see figure 14).   And if they invest less than 60% in dollar assets, a rise in the price of oil is dollar negative. 

However, the idea that a shift in global savings from Asia (and potentially Europe) toward the oil-exporting economies is dollar-negative isn’t totally bullet-proof.  

There an obvious counter-example: both oil and the dollar rose in 2005, contrary to what the story above would suggest.   Of course, a redistribution of world savings toward the oil-exporting economies -- and specifically a redistribution of official asset growth toward the oil-exporting economies -- is just one of the factors that affects the dollar.  Other factors might have just overwhelmed the “oil exporters don’t like dollar assets as much as Asia” effect in 2005.    In 2005, Europe’s constitutional crisis, along with the perception of economic weakness left over from 2004, made the euro less attractive.   And the combination of the Homeland investment act and rising US rates (v Europe) made the dollar more attractive.     

Plus, back then at least one oil exporter (Russia) was putting a lot more of its rapidly growing reserves into dollars (roughly 70%) than it is now (a bit under 50%).   It is not inconceivable – given the shift in the composition of Russia’s reserves and ongoing changes in the way that the Gulf manages its money -- that a rise in the price of oil was dollar positive (i.e. more than 60% of marginal oil savings flowed into dollars) in 2000 and even in 2005, but not now …

That though leaves the question of why rising oil did help the dollar back in 2003 and 2004.     The obvious answer is that that interest rates also matter, and policy rates were low back then. 

I would add another component to the story.   While there is some debate over the impact of a rise in oil-savings on the dollar, there isn't really much doubt that a rise in oil spending results in a shift in demand away from US assets toward Asian and European goods, and that too has an impact on the market.   Work by the IMF indicates that the US current account deficit woudl rise even if the oil-exporting economies spent all of the increase in oil-revenue from higher oil prices, largely because the oil-exporting economies buy so few US goods. 

And then there is a final twist.   If the oil exporting economies are “diversifying” by investing in Asia, they just end up fueling Asian reserve growth.   The oil funds get a claim on an Asian economy – whether India, Korea or China – and the Asian economy gets a claim on the US …

Or some would.  India is probably less keen on the dollar than even Russia --  and Thailand and Malaysia aren’t much keener on the dollar than the big Gulf states.  A lot depends on where the money goes in Asia; not everyone is as wed to the dollar as China seems to be … 

Still, it would be rather ironic if the desire of some of the smaller Gulf states to diversify their external portfolios away from the dollar is adding to the dollar’s current weakness – and thus the activities of their investment funds are making it harder for their central banks to sustain their dollar pegs …

Or perhaps the word “sustain” is wrong.   So long as the GCC countries are willing to accept high levels of inflation and keep their nominal rates low – probably below US rates to deter speculation – their pegs are sustainable.   It is just isn’t obvious why all this is actually desirable.

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