The Dollar and Oil Connection

By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks, Thursday, 24 July 2008, 7.50 am and 7.20 pm)

It’s like a scene from the movies. A young girl goes out for a walk. She is followed by a dark figure. Faced with a mortal threat, she tries everything to shake him off, by walking faster and turning corners.

Then she dashes into a building and desperately slams the door shut, and barricades it. But, it is in vain. The dark figure bangs the door relentlessly and inches ever closer.

That probably sums up what’s been happening to the global markets this past year. Despite the best efforts by US policy makers, the situation is still desperate.

The latest threat is Fannie Mae and Freddie Mac. Some people think they should not be saved. After all, Wall Street is supposed to thrive on capitalism. And capitalism without failure is like religion without sin, or satay without meat.

Unfortunately, both Fannie and Freddie must be saved because they play two critical roles. They have bought or guaranteed nearly half the US$12 trillion dollar US mortgage market. They must continue otherwise US banks can’t lend, and the US housing market would freeze.

There’re critical for another reason. Both have packaged about US$1.5 trillion dollars of their mortgages into bonds and sold them to global investors, mainly Asians.

The US government has stepped in to guarantee these bonds. If not for this, foreign investors would be facing massive losses today. It is not far-fetched to imagine that they would be very sad. In response, they could sell off their trillions of dollars of US government bonds. One can imagine the pandemonium.

While saving Fannie and Freddie means that the US housing market would be supported, it also means that the US Fed cannot really raise interest rates to fight inflation. In other words, expect more dollars to be printed.

When a central bank prints too much money, its currency should plunge. Indeed, the greenback has fallen. But the surprising thing is that it has not fallen much more.

This is due to the dollar’s connection to the international trade for oil. At US$130 a barrel, a global consumption of 87 million barrels a day, the annual trade in oil easily exceeds the size of the US housing market.

Currently, the bulk of the world’s trade in oil is carried out in two exchanges, in London and New York. Both exchanges, which are owned by US interests, quote oil prices only in US dollars.

This is the key. We need the greenback because it is the only channel to secure our addiction to oil. This has been the situation since the 1970s, after OPEC was persuaded to sell their oil only in US dollars. So long as this cosy arrangement is kept, the greenback has a solid backing, just like before 1971 when the dollar was backed by gold.

In year 2000, Saddam Hussien broke this cosy arrangement by selling Iraqi oil in euro dollars. Within a few years, he was toppled, and Iraqi oil was quoted back in US dollars. In February this year, Iran opened its oil exchange which quotes only in euro dollars. Although this Iranian oil exchange deals only in oil by-products, its long term plan is to compete with the oil exchanges in London and New York.

Some people think that the current fuss over Iran’s nuclear program is a smokescreen. The real reason is to stop the Iranian oil exchange from undermining the US dollar. For the same reason, it is not in the US interest for the world to find an alternative to oil, as it would also undermine the US dollar.

Who knows? One day, the US government could default on its debt, as it defaulted on its promise to convert dollars to gold in 1971. Perhaps, the world could find another currency for oil trading, or a good substitute for oil is found.

Any of these factors would trigger the collapse of the dollar. But before the dollar hits the ground, remember that dark figure banging at the door in the movie? It would have broken through and inflict damages that make the latest Batman movie tame in comparison.