Monday, October 5, 2009

Oil and The Ugly Currency Contest

A story in the UK Independent claims that an international agreement ("confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong" - from the news story) is in place among many nations to begin a nine year transition toward trading oil in currencies other than the US Dollar.

However, once again, and as I mentioned here and here, I tell you that the inefficiency of trading a global commodity in many different paper currencies (crossing many currency bid/offer spreads) is far worse than the current USD oil trading system.

Every time this debate arises because some confuse a transactional currency decision with a reserve currency decision. First, the transaction currency decision: the currency in which oil is traded should be the one which is most liquid and widely traded. This minimizes costs for consumers and maximizes revenues for producers.

What consumers and producers do once they own this highly liquid currency after the oil transaction has been completed is a completely separate second decision - a reserve currency decision. Countries are free to sell their liquid currency reserves and immediately buy anything they want, including other currencies or hard assets. This is a separate decision which has nothing to do with why it is best to trade oil in dollars - the most liquid and widely traded currency.

I am not blindly biased in favor of the US Dollar. All paper currencies tend to lose value over time. As Anatole Kaletsky put brilliantly in a Times article a few months back:
"The currency game is not a beauty contest but an ugly contest, in which investors must choose the currency that is least ugly."
For oil trading, the least ugly currency is still the US Dollar.
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