Why does OPEC continue to price its oil in dollars?

May 31, 2005 02:00 AM

by A.F. Alhajji, PhD

Why do OPEC members continue to price their oil in US dollar despite their hefty losses from the decline in the value of the dollar relative to other world currencies? The answer is not as easy as some people think. OPEC has tackled dollar devaluation issues for more than 30 years, yet it still uses the dollar to price its oil.
Several economic, technical, and political factors have in the past prevented OPEC from switching the pricing of oil to another currency or basket of currencies. These same factors prevent OPEC today from switching currencies.

Economic factors
1- Pricing oil in the euro instead of the dollar or even in a basket of currencies will not change the world price of oil. Exchange rates will determine the price of oil in other currencies. For example, if the price of oil is $ 50/bbl and the exchange rate is EUR 1 to $ 1.30, the price of oil in euro would be EUR 38.46/bbl. In this case, the producing country is indifferent to whether it gets $ 50/bbl or EUR 38.46/bbl. The world price of oil would stay the same.
Supporters of pricing oil in euro cite the success of Iraq when it asked the UN to receive euros instead of dollars for its oil exports under the UN Oil-For-Food Program. Those supporters ignore the fact that as the euro started to appreciate the benefits to Iraq came from the money held in euro accounts, not from receiving euros for oil exports.

In other words, Iraq did not "price" its oil in euros. Iraqi oil was still prices in dollars, but the Iraqi government insisted on payments in euros.
The UN converted the dollar revenue from Iraq oil sales into euros and deposited them In Iraq’s accounts. Receiving euros did not change the price of Iraqi oil in the market.

2- Pricing oil in a single currency other than the dollar, such as the euro, will not solve the problem of declining purchasing power, especially when the euro starts to decline relative to the dollar. Once the euro starts to decline, those who have been calling on OPEC to switch to euro pricing instead of the dollar will then start calling on OPEC to return to dollar pricing.
The use of any single currency in oil pricing will have the same effect, whether that currency is the dollar, the euro, or the yen.

3- Benefits from pricing oil in a basket of currencies are limited, especially in the long run. OPEC will not benefit greatly from adopting a basket of currencies to price its oil, especially if the objective is to stabilize the purchasing power of its oil exports.
Given the share of the US trade in OPEC trade balances, the dollar will still have an influential role in such a basket.

4- Pricing oil in a basket of currencies will not benefit all members. OPEC members stretch from Latin America, to the Middle East, to Southeast Asia. Their trading partners are different, and the weight of each trading partner differs greatly. For example, the main trading partner for Venezuela is the US, for Indonesia is Japan, and for Algeria is the EU.
When the dollar declines relative to the euro and the yen, Algeria and Indonesia stand to lose more purchasing power than Venezuela.

5- Some studies indicate that a switch to a non-dollar pricing might cause a shock in the US economy and reduce US economic growth. Regardless of the political reaction, a decline in US economic growth would lower the demand for oil, and consequently lower oil prices.
The losses from lower oil prices could outweigh any benefits from switching to a new pricing mechanism.

6- The economic problems that the oil producing countries suffered from in the last three decades have nothing to do with the value of the dollar. However, these problems force governments to focus on short term rather than long term problems and solutions.
Dollar devaluation causes problems in the short run. But in the long run, it appears that these countries benefited from several years of dollar appreciation. In fact, dollar appreciation and deprecation in the last 30 years even out.In other words, the disadvantages of a single-currency pricing are limited to the short run. These disadvantages do not exist in the long run.

Technical factors
Which currencies should be included in the basket? What is the weight of each currency in the basket? What are the factors that determine the weight of each currency in the basket? How to monitor the basket and the price of each currency? How often should OPEC review the basket? How often should OPEC change the currencies in the basket or the weight of each currency?
Should OPEC become the Grand Marshal of world central banks to monitor their moves so it can adjust the weight of currencies in the basket before it is too late? What is the cost of such consistent monitoring? Do benefits of a basket of currencies outweigh the cost of establishing such a basket and the consistent monitoring?
These are some of the technical problems that OPEC will face if it decides to switch to a basket of currencies instead of the dollar to price its oil.

Efforts to insure the success of the basket pricing are costly. They require a long period of time of research, negotiations, implementation, and monitoring. Such a shift would require highly skilled experts from around the world who are expensive to recruit. In addition, pricing oil in a basket would complicate world oil markets and will reduce transparency.
Simply stated, the cost of using a basket of currency would outweigh its benefits. However, these technical issues may have prevented OPEC from switching to a basket of currencies in the past, but they may not be as problematic nowadays. Most technical analyses are handled by advanced computer programs that reduce the cost substantially. The main issue that may not be solved by such programs is the choice of currencies, which subject to several economic and political factors.

Political factors
Ultimately, the decision to price oil in a non-dollar currency or a basket of currencies is political. The decision of the deposed Iraqi president, Saddam Hussein, to receive euros instead of dollars for Iraqi oil exports under the UN Oil-for-Food Program was a political decision, not economic.
Iraq lost a massive amount of revenues in the beginning. At the time, the euro was declining relative to the dollar. Pricing oil in another currency would carry a political price that OPEC members cannot handle, especially if the switch to non-dollar pricing hurts the US economy.

We should not forget that even if the switch to non-dollar pricing does not affect the US economy, the US will not let OPEC members slap it in the face. It will not quietly accept such an insult in front the whole world.
The dollar is a symbol of America's strength, and the US will not let others disregard this symbol. OPEC members are part of the world community. Its leaders fully understand the political ramifications of pricing oil in a currency other than the dollar.

The economic benefits from switching to non-dollar pricing are limited. Political costs would be very high. Technical factors, while costly, might be resolved, but OPEC members may not agree on the contents of the basket.
Therefore, OPEC will not switch to a currency other than the dollar in the foreseeable future, even if the dollar continues to decline. The unexpected massive increase in oil revenues in the last two years provide another reason for OPEC members to do nothing.

The only way for OPEC members to reduce the negative effect of dollar devaluation is to diversify their imports. Import diversification will guarantee higher purchasing power than import concentration.
OPEC members can further improve their purchasing power by adopting flexible trade polices that will allow them to switch imports from one country to another as exchange rates change.

A.F. Alhajji, PhD, is Associate Professor at the College of Business Administration in Ohio Northern University. He can be reached at a@aalhajji.com

Source: A.F. Alhajji
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