Does it matter what currency oil is priced in?

It’s a perennial question attached to a conspiracy theory. Does the United States reap some great advantage owing to the fact that oil is priced and traded in dollars?

The naive conspiracy theory is concisely described by Dave Chiang (commenting on Brad Setser’s blog):

World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world’s interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies.

This phenomenon is known as US dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. By definition, dollar reserves must be invested in US assets, creating a capital-accounts surplus for the US economy.

The standard rejoinder, described recently by Steven Kyle (and with which I mostly agree), is that it absolutely doesn’t matter what currency a commodity is priced in, so long as there are liquid FX markets. If the US prints dollars, that doesn’t result in creating new buying power for oil as the dollar hegemonists assert. The newly printed greenbacks simply reduce the value of a dollar in terms of oil and other currencies, driving up the dollar price of oil, but not its effective price in euro or yen. Rational third-parties with a need to purchase oil or commodities would not accumulate dollars under these circumstances. They would accumulate assets expected to hold their value, and purchase oil by converting to dollars transiently on an as-needed basis.

Brad Setser recently took up the question. While not disagreeing with the standard argument, his take is that it might, in fact, matter a bit that oil is priced in dollars, if one considers that oil exporting nations peg their currencies to the dollar. It is dollars that are wired into oil exporting countries; policymakers would have to proactively trade to convert those dollars into some other currency or commodity. They could sell those dollars for euros, for example. But that would weaken the dollar against the euro, and by extension the buying power of their own currencies for the European goods they consume. So they don’t, and hold more dollars than they might have, if they hadn’t been paid in dollars.

Brad’s argument is subtle and interesting, though it’s worth pointing out that it is fundamentally a political or behavioral-finance explanation rather than one based on rational actors. Dollar-pegged oil exporters who wish to maintain the buying power of the dollar against the euro ought to be indifferent to the currency for which their oil is initially sold. Receiving euros and selling hem for dollars would be equivalent to receiving dollars in the first place and just holding them. Brad’s argument hinges on status quo bias — that oil importers are willing to enhance the buying power of their currencies by not acting in ways that they would not if the same policy required affirmative market interventions.

There is another subtle reason why I think it does matter, some, that oil is priced in dollars: Firms who hedge oil price risk in public markets are required, by the fact that the contracts are written in dollars, to take on USD currency risk, which they may hedge by accumulating dollars. Consider, as an example, a medium-sized European firm in an energy-intensive manufacturing industry. The firm wishes to take on no speculative position with respect to the future price of oil, but it does wish to plan for profitable operations over the next year. To avoid the risk that a spike in the price of oil would send it into the red, this sort of firm is likely to purchase oil forward, using public futures markets, effectively locking in a known price today for the coming year’s energy needs. Since the futures contracts are USD denominated, though, the firm has locked in a price in dollars, although its accounts and expenses are in euro. The firm has exchanged oil price risk for USD price risk. It must now hedge the latter, either by purchasing and holding sufficient dollars to cover the USD prices it has locked in, or by purchasing USD/EUR futures (which only shifts the USD/EUR price risk to some other party, who will need to hedge by holding dollars).

So, in fact, I think the dollar hegemonists have a bit (but just a bit) of a point with respect the the denomination of oil and other commodity contracts. To the degree that commodities are purchased forward by actors primarily concerned with hedging risk (rather than maximizing return via speculation), the currency in which futures contracts are traded determines the currency they will have to accumulate to fund their purchases.

But I don’t think this argument holds much water as an explanation for central bank USD reserve growth. It only makes sense to the degree that entities have binding forward obligations in the currencies they are accumulating. Even if one considers nations as consolidated entities, and let central banks implicitly hedge the risks of private commodity consumers, I’m pretty sure that the scale of emerging-market reserve accumulation dramatically outstrips any plausible estimate of forward purchases. (If anyone has decent data, country-by-country foreign purchases of USD-denominated commodities, it would be fun to run some regressions, though.)

Update History:
  • 31-Mar-2007, 2:32 p.m. EDT: Small gramatical and punctuation clean-ups. Added the phrase “…and just holding them” to clarify the equivalence between oil-exporters buying dollars under euro-priced oil and holding dollars under dollar-piced oil.

6 Responses to “Does it matter what currency oil is priced in?”

  1. bsetser writes:

    mr. waldman — thanks for taking my argument seriously. your point on hedging demand is intriguing, tho i agree that it alone certainly cannot explain Chinese $ reserve growth. I think tho that my argument goes a bit beyond status quo bias and is really “peg to the dollar” bias … the core constraint in my argument is that CBs that peg to the $ care about the $’s value relative to other currencies, and if they are receiving a $ inflow when the $ is weak (And getting weaker) they may not sell their $ just ’cause they want to try to support the $ (And their currency) and they are big enough to matter.

    there actually is a test (in theory). suppose oil were priced in euros and an oil exporting economy still pegged to the $. That means that before buying oil, its customers have to buy euros — say selling $ for euros, and putting a tiny bit of pressure on the $. status quo bias implies the oil exporter would keep the money in $. $ peg bias implies the oil exporter would trade the euros for $, creating a bit more demand for $. And since the oil exporter pegs to the $, it would be indirectly supporting its own currency … in one instance, it supports its own currency by getting paid in $ and holding $; in the other, by getting paid in euros and selling euros for $. the net result is the same — it ends up holding $.

    my core hypothesis is that during times of $ weakness, oil exporters that peg to the $ and therefore worry about the $’s value (i.e. right now they don;t want further $ weakness) indirectly support the $ (keeping it from falling further) by holding more of the incoming flow in $ … and in effect waiting to sell when the $ isn’t under pressure. get paid in euro and sell euro for $ = same result. the CB does this b/c its reserve composition is one variable it can control … i.e. the saudis have to import $ interest rates, but they can try to avoid importing $ weakness by using their portfolio to prop up the $. of course, this also has risks

  2. dr. setser — though i’m allergic to titles and surnames, i take all of your arguments very seriously. your blog is an amazing resource, a masters degree in a website.

    i don’t think we’re disagreeing at all. rather, i think there are two separate questions implicit in your argument: 1) do CB manage their portfolio in part to sustain the buying power of their dollar-pegged currencies? and 2) does this mean that it matters that oil is denominated in dollars?

    if the answer to the first question is “no”, than your argument doesn’t hold. but i’m with you (i’m glad to defer to you really, ‘cuz you probably have much better information) that oil-exporting CBs are in fact likely to want to support the dollar to enhance their own currencies’ buying power. this is the “peg to the dollar” bias.

    so, if CBs do want to support the dollar, does it matter that oil is priced in dollars? as you say, it needn’t matter: oil could be priced in euros, but CBs could sell the euro for dollar, producing the same result as receiving and holding dollars directly. if oil-exporter CBs would, in fact, support the $ with euro sales, it simply wouldn’t matter which currency oil is priced in. all parties end up with the same portfolios with oil priced in $ as they would with oil priced in euros.

    if, however, oil exporter CBs “peg to the dollar” bias is sufficient to persuade them to hold dollars that passively pile into their accounts, but not sufficient to provoke an active trade to sell euros for dollars, then it really would matter that oil is priced in dollars. this is where i see the status quo bias implicit to your argument: for the denomination of oil in $ to matter, oil exporters have to be willing to hold $,but not willing to trade for them if they received euros instead.

  3. brad setser writes:

    i used mr. waldman mostly b/c i wasn’t sure if you go by steve or randy or something else!

    and as you frame it in your comment, we truly agree.

  4. (oh, i’m just steve. the middle-name thing is because there is a journalist steve waldman — the guy who runs “beliefnet” — who i prefer not to be confused with. anyway, i’m glad we agree, i feel like i’m in very good company.)

  5. Aaron Krowne writes:

    I’ve been thinking about this question for quite a while now, and I’d place myself in the “strong petro-dollar relevance” camp. That is, my position is that the standardization of the “petrodollar” and its continued use are very important, if not integral, to the continuance of the dollar’s relatively-high and relatively-constant value, if not the continuance and sustainability of the US economic system as a whole.

    I pretty much agree with the points you raise and discuss above. Going with the rational-actors assumptions, it seems like the dollar-pricing of oil is likely to matter some, but perhaps not much, to the dollar’s value and the health of the US system (which I think can legitimately be called “hegemony” — however controversial that may be).

    How then do I reconcile this with my “strong relevance” position? This is because I don’t think the rational actors, free-markets-based analysis is even close to complete.

    We already know that the US system is in an unstable state… with large quantities of capital flowing “uphill” to the US, as Brad has been insightfully documenting. We cannot even begin to imagine the severe adverse ramifications if this arrangement were to suddenly end.

    We also know that another competing currency and economic bloc — the Euro — is now available, gaining in popularity , and getting its financial sea legs. The economic zone underlying it is strengthening, while the US economy is weakening. There are already more euros in circulation than dollars, and though this situation doesn’t extend to financial assets in general, that arena is where the real fungibility is.

    In light of these important fundamental conditions, it seems to me that there is an acute risk that if a major seller of oil were to begin to require or prefer euros, a chain reaction could be set off whereby more transacting begins to take place in euros, and more official holdings are converted to euros, to take advantage of more favorable inflation and a larger trading bloc.

    Such “chain reactions” are hard if not impossible to model. But completing my point, in this case I think a significant factor is the political aspect. We are not looking at a free market of rational actors here, given the massive official holdings of dollars and dollar assets. Brad has extensively discussed the likely effects of petrodollar recycling on suppressing Treasury yields, with likely secondary effects on the mortgage market. Steve, you have discussed principal-agent conflicts, of which central bankers and national finance ministers are glaring examples.

    All of this complicates the formal analysis or eliminates hope of doing a meaningful, comprehensive one. But I don’t think it takes a rocket scientist to see where the risk is: the risk is that when and if defecting away from dollars and petrodollar recycling begins, it will quickly run away, because the political wherewithal is already missing from our allies and trading partners (c.f. Vietnam and the collapse of Bretton-Woods). In my opinon, that is what makes the current state of the system so incredibly fantastic, and therefore, unstable.

    Petrodollars matter, but in a way more symptomatic of the general situation with the US dollar as the global reserve currency.

  6. Aaron — I agree that in psychological and political terms, the fact that the most liquid markets for key commodities (and currencies) are priced in dollars is important, and that without this, the “reserve status” of the dollar would be subject to greater challenge. I also think it’s right that, should commodities broadly come to be priced in some alternative currency, that event would likely coincide with a great undoing of the dollar, in terms of perceived reserve status, central bank accumulation, and foreign exchange value. But I don’t think that the one causes the other — I don’t think that the dollar is the reserve currency because key commodities are priced in it, or vice versa. Rather I think it is simply the case that when there is a clear “reserve currency”, internationally traded commodities are usually priced in that currency. Liquid non-dollar commodity markets in other currencies would just be a sign that the dollar had lost its preeminence.

    That said, I don’t see the euro as a real challenge to the dollar as a reserve currency. Notwithstanding 500 euro bills for the convenience of the gangsters, Europe’s economy (with the glaring exception of Germany) seems more and more to resemble the United States’. I don’t see the EU or the Eurozone strengthening, economically or otherwise. I see the traditional West as a whole weakening, economically and otherwise, in the face of new emerging-market challengers. The little games between Wall Street and London (horrors! they’re stealing our IPOs and funds-under-management!) are all a grotesque side show.

    Also, I don’t really agree with the characterization of the current situation as “dollar hegemony”, nor that the consequences of current arrangements ending, suddenly or otherwise, would be adverse to the United States. It would feel that way, I grant you. Here’s an analogy:

    Suppose an athlete, through heart and sweat and sinew, becomes the world’s undisputed champ. In doing so, he gains fame and fortune, groupies, naysayers, and rivals. Suppose that among the groupies is an aspiring athlete who befriends the champ. One day, the younger athlete offers, “Champ, you work out so hard every day. Take a break today. Don’t worry… I’ll do your work out for you, wearing a mask! No one will know it isn’t you!” The champ thinks it over, and arrogant in his fame and ability, but tired of the endless toil, he takes his new friend up on the offer, and has a great time at the beach. The next day, the friend offers again, and the champ eagerly accepts. Meanwhile, everything seems great. The press comments that the champ seems to have gained a new sprightliness and energy. The champ is fawned over like never before. And day after day, the champ goes to the beach, while his friend impresses the world with ever more grueling workouts in his name.

    Is the champ “hegemonic” in this story? From one perspective, the champ is a hegemon — somehow he has compelled or persuaded someone else to do his work for him. No less prominent athlete would have had such a luxury. But, on the other hand, that luxury is not good for the champ from a long-term perspective, and the less powerful player, who seems to serve the champ in this story, acts not out of any compulsion, but because it is in the young athlete’s long term interest to serve, for the moment.

    Would it really be “adverse” if the friend stopped working out for the champ? It certainly would be unpleasant, as the champ would lose his beach days. Taking up a tough exercise regimen after not having worked out for a long time would be unpleasant. Nevertheless, this “adverse” result is really the best thing that could happen to the champ. If he wants to remain at all competitive — even if it’s inevitable that he lose his unusual preeminence — if he wants to remain relevant at all, he’d better stop letting others do his work for him, even if he gets to keep the fruit of that work and it seems in the moment like such a good deal.

    As usual, I don’t think we fundamentally disagree. I’m right with you on the political aspect of all of this. If a repricing of oil in euros or gold or yuan really would cause an unwinding of BWII, I’d be all for it. But if an Iran or Venezuela were to start an oil bourse in euro, even if they succeeded in attracting some liquidity, I don’t think very much would change. It’d be like Nike growing suspicious and firing the champ as a spokesperson. It’d be some bad press. Maybe, in retrospect, it would be seen as an important marker of the champ’s decay. But for now, so long as the champ is happy to go to the beach and the aspirant is willing to work out in his stead, the pleasant, dangerous arrangement would keep right on going.