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.

A Market Yen for Kiloliters

As mentioned in Oil 101, oil is traded in US dollars because it most efficient for everyone (consumers and producers) involved. Oil floats freely against the US dollar and all currencies. If the US dollar or other currencies weaken then oil prices rise in all those currencies. There is little economic reason for wholesale markets other than in US dollars.

Every once in while there is a suggestion to trade oil more often in Euro or other currencies. Trading oil in non-USD currencies makes comparing the price of oil across the world more difficult. If oil has risen by US$1 per barrel, how much should it have changed in Japanese Yen per kiloliter (the unit used on Japan's TOCOM exchange)? This may seem trivial but this causes an inefficiency which raises prices for Japanese consumers. The issue was discussed in the Wall Street Journal today:

"One of the reasons why oil around the world is traded not just in barrels, but in U.S. dollars per barrel, is because it allows the least amount of computation from one market to another," said Morgan Downey....author of 'Oil 101,' a book about the oil industry." (WSJ)

Great Wall, Currency Fall

People I met in China (the final country on my Asian tour) earlier this week are optimistic about growth. Chinese stores are bustling and general economic activity appears to be quite healthy. The Chinese have turned bearish on the US dollar and have slowed their purchasing of dollar assets such as US Government Treasury and Agency debt, as well as US equities and corporate debt. This is bullish for oil in dollar terms and a reason for recent strength in oil prices (in addition to the global physical oil market beginning to tighten and a recovery in equity markets).

The chart above shows the fall in the purchasing power of the US dollar since the 1920s. A chart of most other paper currencies would show a similar if not greater declines. As Anatole Kaletsky says in an interesting article in today's Times:

"The currency game is not a beauty contest but an ugly contest, in which investors must choose the currency that is least ugly."

Oil is a currency itself, a hard currency floating stronger against these more ugly paper currencies.

Oil as a Currency

Oil is a currency. It floats in relation to the US dollar and all other paper currencies. This is why it is ridiculous when some say that oil should be traded in other currencies or that the US government has an agenda to keep oil trading in dollars. As I describe in Oil 101 (page 323), the global oil market chooses to trade oil in dollars because it is most efficient that way. Nobody tells oil traders to use dollars, it is simply cheaper for everyone involved to do so.

When the dollar weakens, oil prices rally (all other things being equal). When the dollar strengthens, oil prices fall (all other things being equal).

This wasn't the case before the world moved to benchmark oil pricing. Oil prices used to be fixed in US dollar terms for very long periods of time and it was the the weakness of the dollar in the early 1970s that caused all sort of problems (page 13, Oil 101).

Anyhow, the US government (and by extension us, the people) have decided that we are going to devalue the dollar to reduce our dollar debt burden. Other countries are sure to follow. Inflation is the goal. Printing money ("quantitative easing") is the mechanism.

On Wednesday March 18, 2009, the US Fed announced they intend to release an additional sum of around US$1 trillion of new money supply . The money will be added via the mortgage market. The dollar weakened. Oil appreciated as a currency. Following are two stories I was mentioned in (WSJ - DJN).