Tue, May 20, 2008 - Page 9 News List

Want cheaper oil? Then start taking the US dollar seriously

By A.F. Alhajji

Around the world, there is anguished hand-wringing about the high price of oil. But if political leaders and policymakers want lower oil prices, they should be promoting policies that strengthen the US dollar.

The implications of pricing oil in any single currency are more far-reaching than most people think. For example, some oil-producing countries ask their customers to pay in euros, but that does not mean that their oil is priced in euros. And even if US dollar prices were to be replaced by euro prices, the impact of single-currency pricing on the oil market would be the same.

While oil-exporting countries receive revenues in US dollars (or their euro equivalent), they use different currencies to import goods and services from various countries. Any change in the exchange rate of the US dollar affects the purchasing power of these countries, and therefore their real income.

Likewise, international oil companies sell most of their oil in US dollars, but they operate in various countries and pay some of their costs in local currencies. Any change in the value of the US dollar therefore affects their cost structure and profitability. In turn, it affects reinvestment in exploration, development, and maintenance.

The relationship between the value of the US dollar and oil prices is very complex. While they can feed on each other to produce a vicious cycle, their short-term relationship is distinct from their long-term relationship.

In the short-term, US dollar depreciation does not affect supply and demand, but it does affect speculation and investment in oil futures markets. As the US dollar declines, commodities — including oil — attract investors. Investing in futures becomes both a hedge against a weakening US dollar and an investment vehicle that could yield substantial profit, particularly in a climate of vanishing excess oil production capacity, increasing demand, declining interest rates, a slumping real estate market, and crisis in the banking industry.

OPEC might be correct to blame US policies and speculators for higher prices. It is also correct that if OPEC had excess capacity, it would have already used it to flush out speculators to bring oil prices down. OPEC can regain control in one of two ways: use its “claimed” excess capacity to flush out speculators, or use its financial surpluses to overtake them. Recourse to the latter option means that, even without excess capacity, OPEC can still be in the driver’s seat.

In the long run, however, statistical analysis of various oil industry variables indicates that a weaker US dollar affects supply by reducing production, regardless of whether oil is owned and produced by national or international oil companies. A weak US dollar also affects demand by increasing consumption. The result of a decrease in supply and an increase in demand is higher prices.

The lower US dollar also reduces the purchasing power of oil exporters. If nominal oil prices remain constant while the US dollar declines, the real income of the oil-producing countries declines, resulting in less investment in additional capacity and maintenance. The same is true of oil companies. Consequently, oil prices increase.

Indeed, because oil prices were rising while the US dollar was declining, capacity expansion by oil firms failed to meet forecasts for non-OPEC production in the last three years. Even oil production in the US has not matched the increase in oil prices, as rising import costs for tools and equipment — partly a reflection of the US dollar’s weakness and other factors — have forced project delays and cancelations.

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