Friday, April 13, 2018 /10:33AM / FDC
For the oil producing cartel known as the Organization of Petroleum Exporting Countries (OPEC), it has become a rather familiar narrative. A strengthening US dollar causes oil, and all other dollar-denominated goods and services, to become more expensive to purchase for non-dollar holders. These buyers react by purchasing less oil; the waning demand puts downward pressure on oil prices. On the other hand, a depreciating dollar results in the ability to purchase more oil, increasing demand and putting an upward pressure on oil prices. While not as simplistic a cause-and-effect relationship, it is one that OPEC has had to navigate over the years.
After a 10% decline against a basket of other currencies in 2017, the dollar continued its decline in 2018 with a further 2% drop as of early February. The drop has been a bit of a mystery because the United States Federal Reserve (The Fed) raised interest rates for the past year. This has not gone down well with OPEC. Oil is priced in dollars on the global market, and the currency's depreciation alarmed OPEC and other oil producers because it contributed to rising crude prices and eroded the value of their foreign reserves which are also denominated in dollars. Not since 2007 has OPEC been faced with a depreciation of this magnitude in the value of the dollar. The implications may cause significant problems for its member states.
Given that the price of oil is so heavily tied to the dollar, and the value of the dollar is out of the control of OPEC, oil producers may have to consider other options to achieve best results from the resource. In recent times, Nigeria focused on cost reduction in its efforts to gain more revenue from oil. OPEC and its partners should consider this strategy to make the industry more profitable.
Dollar Déjà Vu
In 2007 the dollar fell 16% against a basket of major currencies, and 44% against the euro. Some OPEC members considered dropping the falling dollar in favor of pegging the benchmark barrel against another more stable currency. It wasn’t clear what the alternatives were then, but it was clear that they were thinking seriously about a plan of action that involved changing the way the price of oil was pegged. The US was not a significant customer of OPEC oil and a shift to a basket of currencies that was more reflective of OPEC’s trade relations would have been strategic. It was unclear how a move by OPEC to drop the dollar would be received by financial markets.
The move, led by Iran and Venezuela, was met with strong opposition from Saudi Arabia – OPEC’s de facto leader – whose resistance was not out of economic interests but out of sheer political will. Saudi Arabia had huge dollar-denominated reserves and any fall in the US currency impacted it negatively. It was also one of the hardest hit as its currency is pegged to the dollar.
OPEC: Enough on Its Plate
Today, OPEC arguably has bigger problems. It has restricted production to achieve the objective of oil market rebalancing. Member states have essentially agreed to forgo quantity of production in favor of pushing prices higher – not high enough to incentivize increased US shale production and not low enough to put a major strain on the coffers of member states. Throw a “dollar problem” in the mix and you might just have OPEC confronted with the same dilemma as it did about 11 years ago – this time, only worse.
However, it remains unclear how a move by OPEC to drop the US$ would be received by the financial markets. It may be interpreted as a signal that OPEC member states would move their foreign reserve holdings away from the US$. Nevertheless, such a move would not necessarily have a major impact on the dollar.
The consensus outlook for the dollar is that three projected interest rate hikes in 2018 by the Fed will trigger a currency appreciation as higher yields lure capital flows back. The stronger dollar will pressure oil prices and push them back to below the $65-70 per barrel range achieved recently. For OPEC members, this could mean missed revenue targets, fiscal and trade deficits, and even currency adjustments as the strengthening dollar triggers capital flow reversals.
Nigeria: Profit Maximization
This has compelled some members like Nigeria to think of more innovative ways to improve on the profitability and competitiveness of its oil industry. According to the Nigerian National Petroleum Company (NNPC), it drastically lowered the average production cost for a barrel of oil from $78 to $23 between 2014 and 2017 – a 70% reduction. It man-aged to achieve this feat not just by resolving the Niger Delta conflict which had significantly increased operating costs, but by domesticating the engineering, procurement, and construction processes in the oil and gas industry. The plan is to cut this even further to $15, a level of cost efficiency only surpassed by Saudi Arabia ($8.98), Iran ($9.08) and Iraq ($10.57). At an average production level of 1.8 million barrels per day, and an average oil price of $55 per barrel, Nigeria would earn an extra $54 million per month for every $1 in cost savings.
With the Trump administration clearly leaning towards more protectionist trade policies and a US export boom that has benefitted from a cheaper dollar, it would not be farfetched to assume that a weaker dollar has indeed become desirable for the US. OPEC, however, desires stability in the price of oil and in the value of the dollar. A 12% swing – either way – in the value of the dollar poses a problem. A problem that OPEC members can do nothing about except maybe drive down production costs. Luckily, Nigeria has already taken successful strides along that path.