Wednesday, Oct 24, 2007

After a generation on the sidelines, the US dollar has re-emerged as a central issue in the pricing of oil. Since the credit crunch in August, when the dollar has gone down, oil has gone up, by an average ratio of more than 5 to 1. Since August 21, the greenback has declined 4 per cent versus the euro; West Texas Intermediate crude, the global oil benchmark, meanwhile, is up 25 per cent.

Why are commodities traders fixated on the dollar? Like other oil market puzzles, the answer may lie in Saudi Arabia.

With a booming economy and inflation ticking higher, some speculators worry that Riyadh will de-peg its currency from the dollar. And they see such a step as having the effect of re-pricing oil in euros and yen.

That's because if Saudi Arabia de-pegs and does nothing else, it will be sitting on two rapidly depreciating assets: $20,000bn in oil reserves and $800bn in US dollar reserves.

But if it were to diversify its currency reserves or oil pricing regime, then it is almost certain that the dollar would weaken. As a result, oil prices in dollar terms would have to jump to keep oil demand growth from Asia in check. For speculators with this mindset, oil at almost any price looks cheap, especially when the market is pricing in another dollar-weakening Fed cut this month.

Speculators do have it right that the US and Saudi business cycles are increasingly out of sync, and that it will become more difficult for Riyadh to maintain its currency peg to the dollar without exacerbating inflation. Inflation has crept higher, from 2.3 per cent in 2006 to an annualised 3.8 per cent this July.

But betting on a break in the peg may be premature. Inflation remains modest in comparison to Saudi Arabia's neighbours, most of which have inflation in the vicinity of 10 per cent. Additionally, the components driving the jump in inflation - food and rents - are unlikely to be significantly affected by a shift in exchange rate regime, the former driven by global agricultural demand and the latter by the influx of foreign workers into the country.

Finally, Saudi Arabia will not want to jeopardise its FDI inflows (Like China, Saudi Arabia's peg to a weak dollar makes it a cheap investment destination versus other emerging markets whose currencies have already appreciated). As a result, we expect any break with the currency peg would likely be measured and managed, with a relatively insignificant impact on the dollar.

While the Saudis may break their dollar peg as the US Fed eases monetary policy, they are unlikely to re-price oil in other currencies and break their "dollar alliance" with Washington.

Dating back to the aftermath of the oil crisis of 1973, the US negotiated the original alliance with the Saudis to assure petrodollar recycling. As oil prices have risen this decade, economists including ourselves have argued that the re-investing of oil export revenues into the US by Saudi Arabia and its neighbours has contributed to keeping interest rates low and equity valuations high. Often referred to as the "central banker" of oil, the Kingdom has proven on multiple occasions that it is focused on protecting a buoyant outlook for the global economy, as much to assure itself of a buyer as to preserve its political alliance with the United States. That usually means supplying enough oil to the market and holding spare capacity for use in the event of a disruption. Today, however, given mushrooming dollar reserves and the weakening US economy, it also means that Saudi Arabia must hold off on reserve diversification or doing anything that would initiate an attack on the dollar.

As risks to the Saudi economy increase, however, the Kingdom is not likely to stand idle. We don't doubt that Riyadh's increased leverage in Washington due to higher oil prices and a declining dollar will be put to at least subtle use. It is difficult to imagine exactly how that leverage over Washington will manifest itself, but it may include higher technology weapons at greater discounts or higher consideration of Riyadh's concerns in other areas, including regional security. Thus, while we may actually never witness the Kingdom using its enhanced leverage, the fact that speculators perceive it to exist may push up the price of oil.

Adam Robison is an energy research analyst at Lehman Brothers. This piece was co-authored by Edward Morse, chief energy economist.

Adam Robison and Edward Morse of Lehman Brothers