The Impact Of Dollar Devaluation On The World Oil Industry: Do Exchange Rates Matter?

Middle East Economic Survey

The Impact Of Dollar Devaluation On The World Oil Industry: Do Exchange Rates Matter?

By A. F. Alhajji

The following is a summary of a presentation by Dr Alhajji at the US Association of Energy Economics’ Annual Conference in Washington DC in July.

1. Introduction

Dollar devaluation creates several problems for the world oil industry. The US dollar is the currency of choice in global crude oil trade while consumers use local currencies to buy petroleum products. Oil producing countries receive their oil revenues in US dollars but use other currencies to buy goods and services from different nations. The situation becomes more serious for OPEC as a cohesive group: its members have different trade partners, a situation that makes the impact of dollar devaluation differ from one country to another. International oil companies sell their crude in US dollars while they operate around the world using local currencies to pay for wages, benefits, taxes, and various costs. Consumers in countries with non-dollar appreciating currencies enjoy cheap oil, while people in dollar-pegged countries pay a higher price for the same barrel of oil. Therefore, dollar devaluation affects world oil supply and demand.

Theoretically, dollar devaluation reduces drilling activities in areas where most of the costs are denominated in non-dollar appreciating currencies such as the North Sea. It also reduces drilling activities in the oil producing countries. Dollar depreciation reduces these countries’ purchasing power and increases domestic inflation levels, all other things being equal. Dollar devaluation increases demand for oil in countries with non-dollar appreciating currencies. It also increases demand for gasoline in the US as thousands of Americans spend their vacations at home instead of traveling to Europe where the cost of the vacation is at least 40% higher than three years ago.   Regardless of OPEC decisions, dollar devaluation on its own may tighten supplies, increase demand and keep oil prices high for an extended period of time. The following sections explore these points in details.

1. An Overview Of Oil Prices In Various Currencies

Oil prices are at record levels only in dollar terms, but not in other currencies. Figure 1 illustrates the trend in daily oil prices in US dollars and euros since the introduction of the latter in 1999. It shows that while oil prices in dollars are near record levels, oil prices in euro are almost 25% lower than those that prevailed in the summer of 2000. Oil prices in dollars have been increasing since November 2003, while those in euros started to increase a few months later, in February 2004. However, oil prices in dollars have increased by 54%, while those in euros have increased by only 31%.

The euro replaced most major European currencies at the end of 2001. The only major world currency to have survived the euro is the UK sterling.  Figure 2 illustrates the monthly trend in oil prices in US dollars and sterling since 1973. Although oil prices in sterling are not indicative of major changes in Europe in the last three decades, the figure shows that while US oil prices are near record, the UK’s oil prices are still well below the record of 1984. The current size of the gap between oil prices in dollars and those in sterling is the first since 1982.

Oil prices in Japanese yen are still low by historical standards as shown in Figure 3. This shows that while US oil prices are near to record levels, those in Japan are less than half the prices that prevailed between 1980 and 1982. They are also less than the prices between 1982 and 1985 and equal to the 1976 oil prices.

Figure 1

Oil Prices in US Dollars and Euros (1999-2004)

(US oil prices are near record but oil prices in euro are still lower than the prices in 2000)

Figure (2)

Oil Prices in US Dollars and Sterling (1973-2004)

(US oil prices are near record but oil prices in Britain are still low by historical standards)

Source: EIA and the Federal Reserve Bank of Saint Louis.

Figure (3)

Oil Prices in US Dollars and Yens (1973-2004)

(US oil prices are near record but oil prices in Japan are still low by historical standards)

Source: EIA and the Federal Reserve Bank of Saint Louis.

III.     The Impact Of Dollar Devaluation On The Supply Of Oil

Drilling activities are highly correlated with oil prices. As oil prices rise, the rig count increases and vice versa. Although drilling activities lag behind oil prices, the lag differs from period to period and from one region to another. However, looking at world total hides the impact of currency exchange rates and other regional economic and political factors. The trend in total world rig count follows that of the US rig count, which represents about half the world’s total.

Regional rig counts show a different picture from the world total. While recent trends indicate a positive correlation between rig count and oil prices in US dollars in North America, Latin America, and the Middle East (where most currencies are pegged to the US dollar), the rig count in Europe and Africa does not follow the same trend.  In fact, rig counts in Europe have been decreasing over the past 12 months, despite the increase in oil prices.   Rig counts in Africa have been declining since mid-2002 with few monthly spikes. Rig counts in Europe is negatively related to oil prices denominated in US dollars and positively correlated with oil prices denominated in euros. In Africa, the correlation between rig counts and oil prices denominated in euros is positive and three times the correlation between rig counts and oil prices denominated in US dollars. As oil prices in euros decrease (lower dollar), so do rig counts. In other words, as the dollar goes down, so do rig counts. Statistical analysis shows a significant -0.6 correlation, up to a lag of three-quarters, between rig counts in Europe and the dollar/euro exchange rate, that is, the number of dollars per €1. It also confirms that as the dollar value declines, rig counts decrease. The same applies to Africa with minor differences. These are the only two regions in the world that exhibit such behavior. For example, the correlation between dollar/euro exchange rates and rig counts, lagged one quarter, is positive and around 0.4 in each of the Middle East and the Far East. Causality tests confirm that oil prices in euros, not US dollars, affect decisions to drill in Europe. They also confirm that oil prices in US dollars, not in euros, affect the decision to drill in North America and the Middle East.

Statistical analysis indicates that the relationship between drilling activities and the price of oil denominated in US dollars has changed drastically since 1999. It is not clear whether this change is the result of the oil price collapse in 1998 and early 1999, or the introduction of the euro as a competing currency at the beginning of 1999. It could be both. Statistical evidence suggests a large role for the euro in this change. For example, oil prices denominated in US dollars affected drilling activates in Europe and Africa until 1999. Since then, oil prices in dollars have not affected the rig count in Europe, but oil prices in euro have. Canada’s drilling activities were not affected by oil prices denominated in European currencies until the introduction of the euro.  Higher oil prices in US dollars have historically caused rig counts to increase in the Middle East, but not after 1999. The introduction of the euro may not be the sole reason. OPEC started cutting production in 1999 and introduced the price band in 2000.

Dollar devaluation increases inflation in the oil producing countries. Statistical analysis indicates that, among 18 oil producing countries, inflation was associated with dollar depreciation in 14. The four countries that did not fit this pattern were those with diversified economies, other major sources of income beside oil, and currencies not pegged to the US dollar.

Statistical analysis also shows that dollar depreciation reduces the purchasing power of the oil producing countries – reports put recent losses at $50bn. Dollar devaluation affects OPEC members differently. OPEC states have different trading partners. Countries that import more from the US stand to lose less than countries that receive most of their imports from Europe and Japan. The geographic location of some OPEC members plays an important role in determining their purchasing power. Venezuela stands to lose the least from dollar devaluation. A large percentage of its imports comes from the US. By contrast, Indonesia is far away from the US and close to Japan. A large percentage of Indonesia’s imports comes from Japan. Dollar depreciation hurts Indonesia more than Venezuela.

The UN and US economic sanctions on Libya limited its trading partners. As a result, Libya benefited the most among OPEC members when the dollar appreciated, and lost the most when the dollar depreciated. While the settlement of the Lockerbie affair has resulted in the lifting of UN and US sanctions, allowing it to trade with the US and benefit from lower dollar, we must view the results with caution. Industrial countries’ export prices, along with exchange rates, play an important role in determining the purchasing power of the oil producing countries. From OPEC’s point of view, any increase in US export prices reduces the benefits of importing from the US during periods when the dollar is weak.

Both an increase in inflation and a decrease in purchasing power reduce real income, and, in turn, reduce the amount of investment available to drill for more oil, all other things being equal. If we relax the last assumption, a substantial increase in oil prices, like the current one, and other geopolitical factors may increase drilling activities despite the depreciation of the dollar. However, one can be certain that drilling activities would be even higher if the dollar had not declined by 40% against the euro over the past three years. For example, despite the continued increase in oil prices since 2002, the growth in the rig count in the Middle East has declined by half since 2002. In the last two years, or since that year it is difficult to know whether this was the result of the invasion of Iraq, the depreciation of the dollar, or both. In the first five months of 2000, nominal oil prices increased by about $4/B. The number of rigs in Latin America increased by 29. In the first four months of 2004, oil prices increased by almost $6/B and the number of rigs in Latin America increased by only 20.  Was this weak response of drilling activities to increasing oil prices in the Middle East and Latin America caused by a weak dollar? Is the association between the beginning of slow growth in drilling activities and the start of the decline of the dollar a mere coincidence? As mentioned above, drilling activities would be higher if current oil prices were associated with a stronger dollar. Therefore, dollar depreciation reduces supply.

1.  The Impact on Demand

Dollar devaluation makes oil relatively cheap in countries with non-dollar appreciating currencies such as the euro and yen (see Figures 1, 2 and 3). As real income increases, demand for oil in these countries continues to grow. Although recent demand forecasts by the IEA, EIA, and OPEC confirm this point, it is difficult to prove the immediate impact of dollar devaluation on some European countries. Heavy taxation of petroleum products insulates consumers from the effect of crude oil price fluctuations and higher prices. However, evidence from the UK indicates that the appreciation of the US dollar increases local oil prices and diminishes demand. It also indicates that dollar depreciation reduces local prices and increases demand. For example, demand for oil usually declines in December in the UK. It declined by 10% in December 2000, 6% in December 2001, and 3% in December 2002, but increased by 2.8% in December 2003. Demand usually stays low in January but it continued to increase in January 2004. One of the main variables that may explain the increase in demand in recent years is the dollar/euro and dollar/sterling exchange rate. However, causality tests do not confirm this observation.

Historical data indicates that dollar depreciation reduces the number of US tourists abroad. Although some experts may attribute the drop to security concerns, historical evidence suggests a positive correlation between the dollar exchange rates and the number of US tourists abroad. Spending the vacation in the US translates into higher demand for gasoline in the US, therefore increasing the demand for oil.

1. Conclusions

Dollar depreciation reduces activities in upstream through different channels including increased cost, higher inflation rates, lower purchasing power, and lower return on investment. Dollar devaluation increases oil demand in countries with appreciated currencies because of an increase in purchasing power. It also increases the demand for gasoline in the US as Americans spend their summer vacations driving in the US. Large dollar devaluation reduces the supply of oil and increases the demand for oil. Therefore, oil prices will stay high for a longer period than analysts expect.

Three more conclusions are relevant to future research. Studies that focus on the elasticity of demand for oil must use oil prices denominated in national currencies, not in US dollars. Studies that focus on the relationship between energy prices and economic growth must use oil prices denominated in national currencies, not in US dollars. Finally, exchange rates may explain several issues in international energy markets that researchers have been not able to determine or agree on.