Ditching the Dollar
Marin Katusa, Chief Energy Investment Strategist
There's a major shift under way, one the US mainstream media has left largely untouched even though it will send the United States into an economic maelstrom and dramatically reduce the country's importance in the world: the demise of the US dollar as the world's reserve currency.
For decades the US dollar has been absolutely dominant in international trade, especially in the oil markets. This role has created immense demand for US dollars, and that international demand constitutes a huge part of the dollar's valuation. Not only did the global-currency role add massive value to the dollar, it also created an almost endless pool of demand for US Treasuries as countries around the world sought to maintain stores of petrodollars. The availability of all this credit, denominated in a dollar supported by nothing less than the entirety of global trade, enabled the American federal government to borrow without limit and spend with abandon.
The dominance of the dollar gave the United States incredible power and influence around the world… but the times they are a-changing. As the world's emerging economies gain ever more prominence, the US is losing hold of its position as the world's superpower. Many on the long list of nations that dislike America are pondering ways to reduce American influence in their affairs. Ditching the dollar is a very good start.
In fact, they are doing more than pondering. Over the past few years China and other emerging powers such as Russia have been quietly making agreements to move away from the US dollar in international trade. Several major oil-producing nations have begun selling oil in currencies other than the dollar, and both the United Nations and the International Monetary Fund (IMF) have issued reports arguing for the need to create a new global reserve currency independent of the dollar.
The supremacy of the dollar is not nearly as solid as most Americans believe it to be. More generally, the United States is not the global superpower it once was. These trends are very much connected, as demonstrated by the world's response to US sanctions against Iran.
US allies, including much of Europe and parts of Asia, fell into line quickly, reducing imports of Iranian oil. But a good number of Iran's clients do not feel the need to toe America's party line, and Iran certainly doesn't feel any need to take orders from the US. Some countries have objected to America's sanctions on Iran vocally, adamantly refusing to be ordered around. Others are being more discreet, choosing instead to simply trade with Iran through avenues that get around the sanctions.
It's ironic. The United States fashioned its Iranian sanctions assuming that oil trades occur in US dollars. That assumption – an echo of the more general assumption that the US dollar will continue to dominate international trade – has given countries unfriendly to the US a great reason to continue their moves away from the dollar: if they don't trade in dollars, America's dollar-centric policies carry no weight! It's a classic backfire: sanctions intended in part to illustrate the US's continued world supremacy are in fact encouraging countries disillusioned with that very notion to continue their moves away from the US currency, a slow but steady trend that will eat away at its economic power until there is little left.
Let's delve into both situations – the demise of the dollar's dominance and the Iranian sanction shortcuts – in more detail.
(The continual erosion of the dollar could well be the tipping point that causes oil prices to skyrocket. But investors who get positioned before that happens could make life-changing gains.)
Signs the Dollar Is Going the Way of the Dodo
The biggest oil-trading partners in the world, China and Saudi Arabia, are still using the petrodollar in their transactions. How long this will persist is a very important question. China imported 1.4 million barrels of oil a day from Saudi Arabia in February, a 39% increase from a year earlier, and the two countries have teamed up to build a massive oil refinery in Saudi Arabia. As the nations continue to pursue increased bilateral trade, at some point they will decide that involving US dollars in every transaction is unnecessary and expensive, and they will ditch the dollar.
When that happens, the tide will have truly turned against the dollar, as it was an agreement between President Nixon and King Faisal of Saudi Arabia in 1973 that originally created the petrodollar system. Nixon asked Faisal to accept only US dollars as payment for oil and to invest any excess profits in US Treasury bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi oilfields from the Soviet Union and other potential aggressors, such as Iran and Iraq.
That agreement created the foundation for an incredibly strong US dollar. All of the world's oil money started to flow through the US Federal Reserve, creating ever-growing demand for both US dollars and US debt. Every oil-importing nation in the world started converting its surplus funds into US dollars to be able to buy oil. Oil-exporting countries started spending their cash on Treasury securities. And slowly but surely the petrodollar system spread beyond oil to encompass almost every facet of global trade.
The value of the US dollar is based on this role as the conduit for global trade. If that role vanishes, much of the value in the dollar will evaporate. Massive inflation, high interest rates, and substantial increases in the cost of food, clothing, and gasoline will make the 2008 recession look like nothing more than a bump in the road. This will be a crater. The government will be unable to finance its debts. The house of cards, built on the assumption that the world would rely on US dollars forever, will come tumbling down.
It is a scary proposition, but don't bury your head in the sand because countries around the world are already starting to ditch the dollar.
Russia and China are leading the charge. More than a year ago, the two nations made good on talks to move away from the dollar and have been using rubles and renminbi to trade with each other since. A few months ago the second-largest economy on earth – China – and the third-largest economy on the planet – Japan – followed suit, striking a deal to promote the use of their own currencies when trading with each other. The deal will allow firms to convert Chinese and Japanese currencies into each other directly, instead of using US dollars as the intermediary as has been the requirement for years. China is now discussing a similar plan with South Korea.
Similarly, a new agreement among the BRICS nations (Brazil, Russia, India, China, and South Africa) promotes the use of their national currencies when trading, instead of using the US dollar. China is also pursuing bilateral trades with Malaysia using the renminbi and ringgit. And Russia and Iran have agreed to use rubles as a means of currency in their trades.
Then there's the entire continent of Africa. In 2009 China became Africa's largest trading partner, eclipsing the United States, and now China is working to expand the use of Chinese currency in Africa instead of US dollars. Standard Bank, Africa's largest financial institution, predicts that $100 billion worth of trade between China and Africa will be settled in renminbi by 2015. That's more than the total bilateral trade between China and Africa in 2010.
The idea of moving away from the dollar is also finding support from major international agencies. The United Nations Conference on Trade and Development has stated that "the current system of currencies and capital rules that binds the world economy is not working properly and was largely responsible for the financial and economic crises." The statement continued, saying "the dollar should be replaced with a global currency." The International Monetary Fund agrees, recently arguing that the dollar should cede its role as global reserve currency to an international currency, which is in effect a basket of national currencies.
There is also a host of countries that have started using their own currencies to complete oil trades, a move that strikes right at the heart of US-dollar dominance. China and the United Arab Emirates have agreed to ditch the dollar and use their own currencies in oil transactions. The Chinese National Bank says this agreement is worth roughly $5.5 billion annually. India is buying oil from Iran with gold and rupees. China and Iran are working on a barter system to exchange Iranian oil for Chinese imported products.
Speaking of Bartering for Oil… How about Those Iranian Sanctions?
The United States and the European Union based their Iran sanctions on the financial system behind Iran's oil trade. The country uses its central bank to run its oil business – the bank settles trades through the Belgium company Swift (Society for Worldwide Interbank Financial Telecommunication) and the trades are always in US dollars. Once they take full effect in July, US and EU sanctions against Iran will make transactions with the Iranian central bank illegal. When that occurs, this official avenue of trade will shut down. In fact, Iran was shut out of Swift a few weeks ago, so that road is already blockaded.
But the arrogance in the sanctions is the assumption that Iran can only use this one, dollar-based avenue. In reality, the Islamic Republic is considerably more agile than that; removing its ability to trade in the official manner is only encouraging the country to find imaginative new methods to sell its oil.
Since the sanctions were announced, Tehran's official oil sales have certainly declined. Iran actually preemptively halted oil shipments to Germany, Spain, Greece, Britain, and France, which together had bought some 18% of Iran's oil. But covert sales have curbed or perhaps even reversed the reduction in shipments. It is impossible to know the details, as buyers and sellers involved in skirting the sanctions are being very discreet, but the transactions are undoubtedly happening.
As mentioned above, Iran is selling oil to India for gold and rupees. China and Iran are working on a barter system to exchange Iranian oil for Chinese imported products. China and South Korea are also quietly buying Iranian oil with their own currencies.
The evidence? Millions of barrels of Iranian oil that were in storage in Iranian tankers a few weeks ago now seem to have disappeared. Officially, no one knows where the oil went. Was it rerouted? Has production been shut in? Is the oil being stored elsewhere?
Oil is fungible, which means one barrel of crude is interchangeable with another. Once it leaves its home country, it can be nearly impossible to know where a barrel of oil originated, if its handlers so desire. And it's not just barrels that are hard to track – even though oil is carried on ships so large they are dubbed "supertankers" it is surprisingly difficult to keep tabs on every tanker full of Iranian oil.
And the Iranians are using every trick in the book to move their oil undetected. In the last week it became apparent that Tehran has ordered the captains of its oil tankers to switch off the black-box transponders used in the shipping industry to monitor vessel movements and oil transactions. As such, most of Iran's 39-strong fleet of tankers is "off radar." According to Reuters, only seven of Iran's Very Large Crude Carriers (VLCCs) are still operating their onboard transponders, while only two of the country's nine smaller Suezmax tankers are trackable.
Under international law ships are required to have a satellite tracking device on board when travelling at sea, but a ship's master has the discretion to turn the device off on safety grounds, if he has permission from the ship's home state. Some tankers turned off their trackers to avoid detection last year during the Libyan civil war in order to trade with the Gaddafi government.
And Iran is about to gain even greater flexibility in disguising the locations of oil sales, as the National Iranian Tanker Company (NITC) is about to take delivery of the first of 12 new supertankers on order from China. The new tankers will add much-needed capacity to NITC's fleet at a time when the number of maritime firms willing to transport Iranian crude has dwindled significantly, forcing Iran's remaining buyers to rely on NITC tankers. Thankfully for NITC, the 12 new VLCCs – each capable of transporting two million barrels of crude – will significantly expand the company's current fleet of 39 ships.
Sanctions or no sanctions, Iran is moving its oil. But even having your own, off-radar ships to transport oil bought in renminbi or rupees or won doesn't mean all these tricks and maneuvers don't have a cost.
Freight costs for each voyage add up to nearly $5 million, a sizeable hit for Tehran. Iran is often also shelling out millions of dollars in insurance for each oil shipment, because the majority of international shipments are insured through a European insurance consortium that is backing away from Iranian vessels because the EU sanctions will make such transactions illegal.
And since business is business, buyers are also demanding much better credit terms from the National Iranian Oil Company (NIOC) than normal. Traders are reporting agreements giving the buyer as much as six months to pay for each two-million-barrel cargo, a grace period that would cost Tehran as much as $10 million per shipment.
For Tehran to cover freight costs, insurance, and the cost of generous credit terms wipes out as much as 10 percent of the value of each supertanker load. Beyond that, customers are also negotiating better prices. For example, the flow of Iranian oil to China did slow in the first quarter of the year, but not because China endorsed the sanctions. Rather, Chinese refiner Sinopec reduced purchases to negotiate better prices with the National Iranian Oil Company. The country's imports from Iran are expected to climb back to the 560,000 barrel-per-day level in April.
That trade, along with non-dollar-denominated deals with India, Turkey, Syria, and a long list of other friendly nations, will keep Iran's finances afloat for a long time. The sanctions may be preventing Tehran from banking full value for each tanker of oil, but there is still a lot of Iranian oil money flowing.
The mainstream media is avoiding all discussion of the demise of the US dollar as the world's reserve currency. Even fewer people are talking about how sanctions based on Iran's supposed need to use the US dollar to sell its oil leave loopholes wide enough for VLCCs to sail right through.
Without acknowledging the elephant in the room, articles about Iranian tankers turning off their transponders or India using gold to buy Iranian oil invariably sound like plot developments in a spy thriller. Much more useful would be to convey the real message: The world doesn't need to revolve around US dollars anymore and the longer the US tries to pretend that the dollar is still and will remain dominant, the more often its international actions will backfire.
Additional Links and Reads
How Mexico's National Price Hinders Goal of Tapping its Oil (The Globe and Mail)
March 18 is a national holiday in Mexico, in remembrance of the day in 1938 that its president kicked foreign oil companies out of the country. Today, however, that 72-year-old achievement has left Mexico in a straitjacket. As the article explains, Mexican oil production is sagging so rapidly that the country, long one of the world's top oil-exporting countries, could begin importing oil within the decade. Mexico still has plenty of oil, but state oil company Pemex lacks the technology to produce from the deep waters of the Gulf of Mexico or the complex geology of the Chicontepec field. To develop these new fields, the country needs to open its oil sector up to foreign investment, but that is a very touchy subject in Mexico. In 2008 federal reform opened up the sector to more private contracting, but further liberalization will require constitutional reforms. Mexico's presidential front-runner is not shying away from the issue, arguing that Brazil's Petrobras is a good example for Pemex. Enrique Pena Nieto of the centrist opposition Institutional Revolutionary Party wants to help Pemex grow and thinks Brazil's Petrobras provides a good example of how to do so.
Australian Shipment to Mark LNG Milestone (Financial Times)
The first shipment of liquefied natural gas (LNG) will leave the new Pluto facility in Western Australia later this month, marking a major milestone for both Woodstone, Australia's largest oil and gas company, and for the country's gas industry. Australia is poised to surpass Qatar as the world's biggest LNG exporter by the end of the decade, adding a third leg to the country's resources boom, which until now has been all about coal and iron ore. There are currently only two active LNG projects in the country, with a combined capacity of about 20 million tonnes per year. By 2018 that figure should rise to 80 million tonnes, as no fewer than eight huge projects come online. However, not all of those projects are guaranteed – given continued cost inflation, potential changes to the tax system, and increased competition, it is uncertain whether the biggest green-field projects will materialize.
The members of Sudan's parliament voted unanimously to brand South Sudan an enemy, and the speaker of parliament called for his country to overthrow the South Sudanese government, bringing the countries essentially to war after several weeks of escalating violence. Last week South Sudan pushed 40 miles into Sudanese territory to seize the Heglig oilfield, which accounts for 55% of Sudan's oil production. In response, Sudan sent several bombing raids into South Sudan, killing at least 15 people and hitting a UN peacekeepers' camp. When Sudan was one nation, the Arab Muslim north and the black African south fought the continent's longest and bloodiest civil war, which ended in 2005 with a settlement that allowed the south to secede. However, the neighbors never agreed on the exact position of the border nor on the division of oilfields, many of which lie along the disputed frontier.
US Company Plans Billion-Dollar Expansion of Trans Mountain Pipeline (The Globe and Mail)
The Canadian government's desire to increase oil exports to Asia got a big boost from news that Kinder Morgan Energy Partners is embarking on the official regulatory review process to almost triple the capacity of its Trans Mountain oil pipeline, but the plan will almost certainly run into significant opposition from Vancouverites worried about increased tanker traffic in Burrard Inlet. Trans Mountain runs from Edmonton to an oil-loading facility in Burnaby, a suburb of Vancouver, and currently carries 300,000 barrels of oil a day. Kinder Morgan confirmed its intent to expand the pipe after receiving enough commitments from customers to fill the proposed new volume of 850,000 daily barrels. Current volumes require one tanker to pass through Vancouver's Burrard Inlet about every four days; the expanded pipe would increase that to a tanker every day.
Japan Nuclear Restart Set to Lift Uranium (Financial Times)
Uncertainty over the future of Japanese demand for nuclear energy has overhung the uranium sector since the Fukushima disaster more than a year ago, but now Japanese Prime Minister Yoshihiko Noda says units at two reactors in western Japan should be turned on after they pass computerized stress tests. Even though no one expects a rapid rollout of nuclear power station reopenings in Japan, restarting two reactors is a good start to what will likely be a gradual resumption of nuclear-power generation in the country. Erasing the uncertainty over Japan's nuclear future could act as a catalyst for uranium stocks.
Shale Gas Unlikely to Reignite US Economy (Financial Times)
Last week the price of natural gas tumbled below US$2 per MMBtu for the first time in a decade, depressed by a flood of production. As this article explains, academics, analysts, and journalists are celebrating America's newfound gas riches and the clear benefits: lower heating bills, cheaper electricity, and reduced US gas imports. But perspective is important. The natural gas boom will create jobs and stimulate the economy in certain areas, but it is no magic elixir. The US economy has become much less energy intensive than in the past decade, meaning that energy cost savings have less impact than they once did… and those savings could easily evaporate if the US becomes a natural gas exporter.