Assuming oil prices decline to an average of $80 per barrel next year from the current $95 barrel, the dollar falls 5% next year (less than half of this year's 12% decline in the dollar index), the estimated loss to OPEC would be $166 billion. No surprise OPEC is showing signs of the early 1970s, when the falling dollar obliged the cartel to raise oil prices from their $2.00 per barrel lows. Since raising oil is alreayd at all time high, the choice of currency becomes the point of contention, rather than the price.
This weekend's separate meetings by the G20 and OPEC have elucidated a vital market reality in currency markets; the power in influencing the fate of the dollar lies increasingly with the oil producers as they struggle with a falling US dollar. The statement from Saudi Finance minister indicating we shouldn't mention the dollar [in the final communiquÃ©] because that would only endanger it more and aid its collapse was broadcast by mistake on a live TV feed from a closed-session meeting of OPEC foreign and finance ministers. While many commentators, analysts and media have wondered at which point the dollar's decline is considered at a dangerous level, it is precisely when the influential group of oil producers begin mulling plans to receive payments in currencies other than US dollars for their oil. Aside from the aggressive remarks made by the presidents of Iran and Venezuela that the dollar has no economic value, the power lies with Saudi Arabia, which produces 9.2 million barrels per day, well above the aggregate 6.7 million barrels produced by both Iran and Venezuela. At the end of the meeting, OPEC said it look into proposals suggesting a basket currencies that OPEC members will deal with.
OPEC faces high probability danger of falling oil prices and dollar weakness
Despite OPEC's surging wealth from the 73% rise in oil prices this year, the risk of falling oil prices and continued dollar declines next year are significant. OPEC made more than $370 billion in 2007 from rising oil prices alone. Assuming oil prices decline to an average of $80 per barrel next year from the current $95 barrel, and assuming that the dollar falls 5% next year (less than half of this year's 12% decline in the dollar index), then the estimated loss to OPEC would be $166 billion. The risks are particularly high for Arab Gulf nations suffering from rising inflation as a result of pegging their currencies to a falling dollar. Rising inflation and falling oil receipts will not only be economically damaging to these nations, but also politically untenable as prices every day commodities continue to surge. Chances of falling oil prices are significant given the increased probabilities of a US growth contraction and slowing world demand next year.
With the dollar losing 30% of its value in trade weighted terms over the last 5 years, the dollar decline has sent inflation soaring in the Gulf countries, prompting Kuwait to break from its dollar peg earlier this year and to revalue its currency twice after inflation hit an all time high of 14.8% in March. The UAE, another country maintaining its dollar peg, is also expected to either revalue its currency to a new peg or break off the currency system altogether after inflation reached a 19-year high of 9.3%.
Saudi Arabia's insistence to maintain interest rates unchanged is not only explained by its high inflation rate which hit a 7-year record of 3.8%, but also by the negative impact on the value of its mostly dollar-denominated investments in its central bank and sovereign wealth funds, totaling over $300 billion. There is also the political element as Saudi Arabia continues to obtain concessions in arm deals with the US. As the oil rich Gulf nations are paid in an increasingly falling US dollar, their purchasing power diminishes while their imported inflation surges. With US interest rates expected to drop by at least another 50 bps and the central banks of non-USD reserve currencies expected to maintain rates unchanged, the potential of portfolio losses from a currency value and yield perspective is significant. The UAE and Kuwait have already discussed reducing the proportion of their dollar holdings in their currency reserves. Qatar and Bahrain are expected to follow suit within the next 6 months. The strong political and trade relationship between the Gulf nations and the US is amid the reasons of maintaining the dollar-centric investments, but local pressure and economic realities are making the current arrangement increasingly untenable.
The choice for the remaining Gulf nations is to either follow Kuwait's decision by tying their currencies to a basket of international currencies (EUR, GBP, JPY, and the USD), or to revalue their currency against the US dollar. Moving towards a basket of currencies as well as reducing the dollar would be appropriate for these nations, which are major importers of European products. Moving towards a basket would also reduce upward speculative pressures on the local currency that would result from a revaluation.