FX International Payments
By Frances Coppola
For over 30 years, the U.S. dollar has been the currency in which oil is priced. Oil producers have recycled their excess dollar revenues back to the U.S. by buying dollar-denominated assets, especially government bonds. This "petrodollar recycling" has given the U.S. influence that it didn't necessarily intend over the oil price via the dollar's exchange rate. For example, the Federal Reserve's quantitative easing (QE) program following the Great Recession was intended to support the domestic economy, but it also lowered the dollar exchange rate1 – and, subsequently, the price of oil jumped.2 Petrodollar recycling has also helped to ensure that the U.S. can borrow at lower interest rates than almost any other country.
The U.S.'s "exorbitant privilege" (as economists call it) tends to result in a strong dollar exchange rate, as international demand for dollars generally exceeds supply.3 As the U.S. is a net oil importer, this can have economic benefits: a strong dollar exchange rate means low fuel prices, which helps to keep business costs down and therefore helps to limit both inflation and unemployment. However, a strong dollar exchange rate tends to make U.S. exports less competitive globally, while encouraging imports. Consequently, the U.S. has persistently run a large trade deficit.4
Now, the U.S. government says it is changing its approach, partly driven by a desire to bring down the trade deficit and become globally dominant in energy production in order to enhance national security.5 The new approach would no longer indirectly influence the oil price via petrodollar recycling, but rather gain direct control over the market by becoming the largest producer of hydrocarbons (oil, natural gas, coal).6 This could have a significant effect on the dollar's exchange rate, discussed below.
Controlling the 21st century global energy market means more than just influencing the oil price. The soaring oil price in the aftermath of the global financial crisis had two effects: it encouraged shale oil exploration and development, since the returns on production could be considerable, and it encouraged diversification of energy sources. Environmental concerns have also driven the development of cleaner forms of energy than oil and coal, notably natural gas and renewables.
Thus the U.S. was at the forefront of the energy revolution, and already has a diverse energy supply, including renewables.7 It is the world's largest producer of natural gas.8 And because of booming shale oil production, its oil output is reaching highs not seen since the 1970s. The International Energy Agency (IEA) forecasts that the U.S.'s output will soon exceed Saudi Arabia's and will catch up with Russia by the end of 2018.9 U.S. net oil imports have been falling since 2005, partly due to high prices, and the import decline is now accelerating due to sharply rising domestic production and (since the U.S. government has now lifted 1970s-era restrictions on oil exports), increasing exports.10
The U.S. government predicts that the country will become a net energy exporter by 2022.11 But even before this, it could achieve "energy dominance" via its central role in the oil trading marketplace. The U.S. is the world's largest hub for oil trading, and although it is rapidly becoming one of the world's largest oil producers, the flows of oil through its trading hub vastly exceed its domestic production.12 The U.S. could become the world's "swing" oil producer, controlling the oil price by managing its own output, as it did in the 1960s.13 The U.S. government may additionally be able to pick and choose energy trading partners,14 thus helping to achieve energy security objectives.15
The consequences for the dollar's exchange rate of the U.S. becoming a net energy exporter are hard to predict. The petrodollar recycling mechanism that has kept the dollar strong may break down once the U.S. no longer needs to trade dollars for oil, which could mean a weaker dollar exchange rate and higher yields on U.S. Treasuries. This is suggested by the simple law of supply and demand: if oil is no longer priced in dollars, the international demand for dollars would diminish and the dollar would get weaker. Similarly, without the need for petrodollar recycling, demand for Treasuries would diminish and yields would have to rise.
There is also a possibility that dollar scarcity could encourage other energy producers to rotate away from USD towards other reserve currencies such as the euro16 or the Chinese yuan.17 If this were to happen, then the dollar's exchange rate could fall considerably.
However, if oil and other energy sources remain priced in dollars, international dollar scarcity may cause the dollar's exchange rate to strengthen rather than weaken,18 especially as the Fed continues to reverse QE. The IEA warns that although supply of oil is likely to outstrip demand in 2018, helping to keep the oil price low, international demand for oil could rise as the global economy improves.19 This could mean the dollar's exchange rate starts to strengthen.
Whatever happens to the dollar, though, fierce competition among the world's major energy exporters could mean lower energy prices for all, which would be good news for businesses.20
The prospect of the U.S. becoming a net energy exporter could have far-reaching effects on global energy markets. The end of the petrodollar recycling mechanism, or even the dollar's replacement as preferred currency for energy trading, could mean a weaker dollar exchange rate in future; alternatively, tighter international dollar liquidity as U.S. oil imports fall and the Fed reverses QE could cause the dollar exchange rate to rise. Businesses may wish to plan their FX risk management strategies to take account of significant dollar exchange rate moves in either direction.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Research, Economic Research, Dollar, Unconventional Monetary Policy, Federal Funds Rate, Exchange rate,” San Francisco Federal Reserve Bank; https://www.frbsf.org/economic-research/publications/economic-letter/2013/april/unconventional-monetary-policy-dollar/
2. “Oil Prices and QE,” The International Economy; http://www.international-economy.com/TIE_Sp15_Verleger.pdf
3. “An Exorbitant Privilege? Implications of reserve currencies,” McKinsey; https://www.mckinsey.com/global-themes/employment-and-growth/an-exorbitant-privilege
4. “Trade Balance: Goods and Services, BoP Basis,” FRED Economic Data; https://fred.stlouisfed.org/series/BOPGSTB
5. National Security Strategy of the United States of America, The White House; https://www.whitehouse.gov/wp-content/uploads/2017/12/NSS-Final-12-18-2017-0905.pdf
7. “U.S. Energy Facts – Energy Explained,” U.S. Energy Information Agency; https://www.eia.gov/energyexplained/?page=us_energy_home
8. “United States expected to become net exporter of natural gas this year,” International Energy Agency https://www.eia.gov/todayinenergy/detail.php?id=32412
9. “Oil Market Report (Feb 2018),” International Energy Agency; https://www.iea.org/oilmarketreport/omrpublic/
10. “US Net Imports of Oil and Petroleum Products,” U.S. Energy Information Agency; https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=mttntus2&f=m
11. “The U.S. is predicted to become a net energy exporter in most AEO2018 cases,” U.S. Energy Information Agency; https://www.eia.gov/todayinenergy/detail.php?id=34912
12. “US set to become swing oil producer,” Financial Times; https://www.ft.com/content/49354866-117d-11e8-8cb6-b9ccc4c4dbbb
14. “Geopolitical Benefits Spring From US Energy Dominance, Cabinet Secretaries Assert,” The Signal; http://dailysignal.com/2018/02/23/geopolitical-benefits-spring-from-us-energy-dominance-cabinet-secretaries-assert/
15. “Donald Trump Calls For Energy Dominance, Not Independence,” Time; http://time.com/4839884/energy-dominance-energy-independence-donald-trump/
16. “Switching to petro-euro, the new roadmap for Iran,” Market Plus; http://www.marketplus.ch/news/switching-to-petro-euro-the-new-roadmap-for-iran.html
17. “China’s Bid to Upend the Global Oil Market,” Foreign Policy; http://foreignpolicy.com/2018/01/18/chinas-bid-upend-global-oil-market-petroyuan-shanghai/
18. “The Death of Petrodollars,” Forbes; https://www.forbes.com/sites/michaellingenheld/2015/08/04/the-death-of-petrodollars/#4bd3695d6ec0
19. “Oil Market Report (Feb 2018),” International Energy Agency; https://www.iea.org/oilmarketreport/omrpublic/
20. “Trump ‘energy dominance’ policy pits Washington against Moscow,” Reuters; https://www.reuters.com/article/us-usa-oil-record-geopolitics/trump-energy-dominance-policy-pits-washington-against-moscow-idUSKBN1FT0OE