Q+A - Any switch to non-dollar oil remains distant

Thu Oct 29, 2009 11:04am EDT

By Barbara Lewis

LONDON, Oct 29 (Reuters) - The weakness of the U.S. dollar and surging oil prices have fuelled speculation the world might eventually shift away from trading and pricing oil in dollars.

Quoting unnamed sources, Britain's Independent newspaper reported early in October that China, Japan, Russia and France were in secret talks with Gulf Arab states on a shift over nine years to oil trade based on a basket of currencies.

Top officials of Saudi Arabia, Russia and France denied the report, which helped to weaken the dollar in foreign exchange markets. OPEC officials and CEOs of major oil companies also said no such talks were under way. [ID:nSYD421795]


ARE THE DENIALS CONVINCING?

It is relatively simple to settle individual oil contracts on a non-dollar basis.

But a global shift in oil pricing would face huge technical and diplomatic obstacles, and risk destabilising the dollar. Most governments are thought to be far from confronting these issues in any formal talks on changing the international system.

"There are a lot of intermediary steps, and I get the sense most of the policymakers either have not yet or are unwilling to seriously consider the fuller implications of a move away from the dollar," said David Kirsch, director of market intelligence at PFC Energy in Washington.

But the financial crisis is making countries think harder about reforms to the global economy and markets, and about the possibility of the dollar eventually losing its status as the top currency in central banks' foreign reserves.

Officials from many countries may therefore be chatting informally about the long-term possibility of reforming oil trade, with a view to being prepared if a change in the dollar's status occurs.

The idea of pricing oil with a currency basket was aired even before the financial crisis. Iran and Venezuela, diplomatic foes of the United States, raised the issue at a summit of the Organization of the Petroleum Exporting Countries in Riyadh in late 2007. Saudi Arabia discouraged discussion of it.

Iran takes payments for some of its oil in euros rather than dollars, in common with some other producers of oil and gas.

After Russia clinched a deal to supply natural gas to China this month, Russian Prime Minister Vladimir Putin said he did not oppose the idea of selling energy resources for roubles rather than dollars. [ID:nLE187972]

OPEC's smallest producer Ecuador, which adopted the U.S. dollar as the country's official currency nine years ago, said this week that it would "in principle" support pricing oil in euros or a basket of currencies. [ID:nLR527363]


HOW MIGHT THE SHIFT WORK?

Any change would likely take many years, because adjusting long-standing trading practices would be complex, and since countries involved would want to avoid destabilising markets.

An increasing share of physical trade in oil might be done in currencies other than the dollar, through bilateral deals between producing and consuming nations.

This might be part of a general effort by big developing nations to reduce their dependence on dollar-denominated trade. China, for example, is cautiously using pilot programmes to promote the use of the yuan rather than the dollar in settling its foreign trade. [ID:nHKG293990]

"I will not be surprised if, in the next three to five years, around half of China's annual cross-border trade will be settled in renminbi rather than U.S. dollars," Qu Hongbin, HSBC's chief China economist, wrote in August -- although other analysts do not expect change to be so rapid.

Non-dollar oil trade can easily expand even if countries still use the dollar price as a benchmark when calculating payment in other currencies.

A far more fundamental shift, to pricing oil in currencies other than the dollar would require a move away from using the highly liquid, dollar-denominated oil futures contracts that are the world's accepted benchmarks.

At present, there are no significant rivals, and no exchange comes close to threatening the predominance of U.S. crude futures CLc1 and Brent LCOc1 traded on NYMEX, part of the Chicago-based CME Group (CME.O: Quote, Profile, Research, Stock Buzz), and the Atlanta-based IntercontinentalExchange (ICE) (ICE.N: Quote, Profile, Research, Stock Buzz).

So far attempts to launch non-dollar contracts on other exchanges have failed to drain away liquidity from the global benchmarks.


WHO WOULD WIN AND LOSE?

All countries might benefit if the price of oil became less volatile, allowing producers and consumers to plan better and reducing swings into overvalued or undervalued territory.

A basket of currencies might reduce volatility by limiting the impact of a big fluctuation by any individual currency.

The oil price has been closely linked with the euro/dollar exchange rate for much of this year, so speculation about the dollar's direction may be encouraging speculation in oil, and vice versa. Breaking this link could reduce price swings.

Removing the dollar as the main currency for oil trade would also mean countries no longer needed to incur the currency risk of holding large amounts of dollars in their reserves to buy oil -- though they would still have to hold some foreign currency.

The big loser from an oil trade shift would probably be the United States, since the shift would help to undermine the dollar's role as the world's main reserve currency.

This role has given the United States -- which is the world's biggest oil consumer by far -- large economic advantages. These include the ability to borrow internationally in its own currency, which has allowed it to amass huge debts abroad without facing a balance of payments crisis.

WHAT CONDITIONS WOULD NEED TO BE IN PLACE?

Global currency and oil markets might have to stay very volatile for longer, at least several more years, for countries to become motivated to tackle the difficult task of changing the oil trading system. Otherwise they may feel they can live with the current system.

Geopolitics might have to change. The United States could be expected to oppose a shift that would undermine the status of the dollar. It is closely allied to Saudi Arabia, the top oil exporter, through economic, political and security interests.

Given China's growing economic power, it is hard to imagine a new oil trading or pricing system that did not involve the yuan. But for other countries to become willing to hold large amounts of yuan or include it in any oil pricing basket, the currency would probably have to be freely exchangeable, in the same way that the dollar is.

China has said it intends to liberalise its currency regime but is moving very slowly because it does not want to destabilise its economy. Many analysts think it may be five or 10 years before major capital controls are removed.

Greg Priddy of consultants Eurasia Group said of the idea of reforming global oil pricing: "It's quite possible 10 years from now, we might be talking about this seriously, but I don't think it's a serious possibility now." (Additional reporting by Andrew Torchia, Sujata Rao and Adrian Croft in London, Simon Webb in Dubai and Robert Gibbons in New York; editing by Sue Thomas)