If Oil Were Priced in Euros by Steven Kyle

Steven Kyle has had a number of very good posts up recently. Here’s another:

If Oil Were Priced in Euros …

…. would it really make much difference? Not as much as some people seem to think. There are a series of myths out there, among them that quoting oil prices in dollars keeps the dollar oil price down, and another that it supports the value of the dollar vis a vis other currencies. Neither of these is true.

– Does quoting oil prices in dollars make a difference to the price of oil in dollars?

No. The price of oil is a relative price and the dollar price of oil depends on two things – the price of oil relative to other goods in the world market and the value of the dollar. The first is clearly not something that depends on which currency you measure value in since it depends on the actual supply and demand for oil relative to other goods. This is whatever it is on a given day and would be the same if we divided all prices by 1.32 or whatever the current dollar/euro rate is.

The real source of the fallacy is in the second part – the value of the dollar – since it might seem on the face of it that if the dollar falls then oil prices would stay the same if they were denominated in dollars. However, this gets the causality wrong. The relative price of oil as opposed to other goods is fundamental – the price in terms of dollars is just the result of the supply and demand translated into dollars. To believe otherwise is to believe that every time the value of the dollar drops the real value of oil drops by the same amount. This is simply not the case, as a look at a historical series of oil prices and the dollar will show you. Indeed, if any anything the LESS oil we buy (and the lower the oil price) the HIGHER the dollar will be since our balance of payments is less in deficit and we are sending fewer dollars out into the global economy.

– Does quoting the price of oil in dollars support the value of the dollar?

No. Some seem to believe that if the price of oil is quoted in dollars then you need to actually have dollars to buy it. This is not the case at all. Oil exporters and oil traders have those nifty forex quote pages on their computers just like economists do and are happy to accept an equivalent amount of euros or yen for a boatload of oil. Even if they take dollars (which, of course, they do) that is not what really counts for the value of the dollar at the end of the day. What really matters is what denomination they choose to HOLD their wealth in. After all, if an oil exporter accepts dollars and then converts them to euros 10 seconds later in order to hold them in that form it is the euro that ends up stronger and the dollar that gets weaker. So what really matters to the value of the dollar is whether the central banks of oil exporters like to have a portfolio heavy in dollar assets or heavy in other currencies. If the latter (as is beginning to seem to be the case – See for example, numerous posts on Brad Setser’s blog here) then the dollar will weaken even if the oil exporters are getting bucket loads of dollars from the US or other oil importers who would rather spend them than hold them.

So what is left? There may still be some transactions demand for dollars on the part of countries that don’t have hard currencies and need to buy some to engage in international trade. But that is a function of the ease and liquidity of the dollar market – a result of the dollar being the world reserve currency, not the numeraire for oil prices. And that is what is really at stake here – If we run our country in a way that pumps two billion new dollars A DAY into the international market then we are going to see a tendency for the dollar to decline if/when the various foreigners who are propping it up lose their appetite for yet more of our paper. And if one of the causes of that huge outflow of dollars is our huge appetite for oil then count on the price of oil going up in dollars as well as euros and yen while the value of the dollar goes down.

But that is because of plain old supply and demand and we can “blame” the Chinese and Indians as much as ourselves – It won’t be because of some numeraire or exchange rate effect. And we could well see the dollar replaced as the world reserve currency at some point in the future, which would have an effect on not just the world oil market, but everything we buy and sell from other countries – but that is a story for another day.