Oil: The flip side - petrodollars
With oil prices touching new highs on almost a daily basis, inevitably the issue of petrodollars and their impact on financial markets has re-emerged.
Petrodollars (huge financial surpluses accumulated among oil exporters due to high oil prices) were a major feature of global capital markets in the 1970s and 1980s.
The dollar strengthened, and banks in OECD countries flush with these deposits went on a huge lending spree, leading ultimately to the Latin American debt crisis.
The capital surpluses generated during the 1970s and mid-80s among the OPEC countries rose dramatically and, being unable to absorb these windfall profits in their domestic economies, they were forced to redeploy them in western financial assets.
Given the size of these surpluses and the scale and sophistication of financial markets in the 1970s and 1980s, they had a significant impact. The question is: Will something similar happen again? Are the western banks and financial markets in for another period similar to the 1970s and mid-80s in terms of flows?
On the face of it, the answer seems to be a clear “no”. The US Energy Information Administration (EIA) has calculated that OPEC’s net oil export revenue in 2004 will amount to about $286 billion, more than double the 1998 level, but only slightly more than half the peak level of $556 billion in 1980 (real terms).
This calculation takes into account the current OPEC production of 30 million barrels/day (all-time peak) but assumes an OPEC basket oil price of $32.
If one were to assume that the current basket price of $46 were to sustain for an entire year, then OPEC’s net oil revenues would be about $410 billion, still much lower than the 1980 level.
In fact, oil prices would have to rise to over $60 per barrel and sustain there for OPEC net oil revenues to approach the previous peak in real terms.
While no longer inconceivable, oil prices sustaining at these levels is still a low probability event. Thus, the most likely scenario is net OPEC oil revenues in the region of $300–400 billion, significantly lower than prior peaks, a point not normally appreciated by commentators when discussing this issue.
Not only are the net oil revenues and corresponding financial surpluses likely to be lower, but in assessing their impact one must also take into account the fiscal and debt positions of the OPEC countries.
While they have improved since 1998, the fiscal and debt situations of most OPEC countries are significantly weaker than in the 1970s or mid-80s. Saudi Arabia, for example, will run a large fiscal surplus this year, but has had deficits in 17 of the last 20 years.
Combined with this weaker fiscal position, most of the countries in OPEC have had rapid population growth and high unemployment, leading to a need to increase investments in physical and social infrastructure. They also have large debt burdens, which they need to pay down.
A combination of all of the above means that these countries have a much greater capacity and need to absorb the majority of any financial surpluses generated, domestically. The windfall gains will be used primarily to meet pent-up demand for infrastructure and pay down debt.
Thus, not only will the absolute amount of surpluses generated (in real terms) be lower than in the 1970s and mid-80s, but a much higher proportion of these surpluses will be absorbed domestically. The magnitude of financial surpluses available for redeployment in financial assets globally is thus that much lower.
Another factor to be considered when looking at this issue is the huge growth in global capital flows since the mid-80s.
This makes the quantum of financial surpluses look very tiny when considered in a historical context. For example, in 1980 Saudi Arabia’s current account surplus of $41.5 billion was equivalent to 1.5 per cent of US GDP. However, in 2004 even if Saudi Arabia were to run a current account surplus of $50 billion, it would amount to just .4 per cent of US GDP (source: HSBC). Financial markets are also more globalised today than in the 1970s and mid-80s.
The amount of capital that is mobile is far greater, and thus the financial surpluses generated by OPEC are much less significant. The trading volumes across financial assets today are many multiples of what they were in the mid-80s, and the use of derivatives far greater.
The mushrooming of hedge funds has also significantly increased the number of market participants.
Looking at all of the above issues, it becomes clear that any petrodollar boom precipitated by high oil prices today will be far less significant than previous episodes in the 1970s and mid-80s.
The surpluses generated by the Middle East are unlikely to be a big factor in influencing financial markets or fuelling a lending boom by western banks.
Having said that, what however is true is that while the financial surpluses in need of recycling by the Middle East are lower, these surpluses are also being put to different uses in this cycle.
It seems quite clear that the Middle East countries are steering clear of US financial assets especially when compared to the experiences of the past. US data show almost no incremental net purchase of US treasuries by the Middle East countries.
Data on banks deposits (BIS reporting banks) also show very little of these petrodollars flowing into the western banking system. The assets of most of the OPEC countries have barely risen with the large western banks.
The question is of course, then where is this money going? While no hard data are available, anecdotal evidence seems to indicate a greater flow towards Asia and hard assets like property.
Therefore, while the current windfall experienced by OPEC is unlikely to have much impact on western financial assets, to the extent these surpluses move into the markets of Asia and other developing countries they have to be monitored.
Given the limited depth and liquidity of these markets, the flows from the Middle East could be quite impactful. As to whether they can be a sustainable incremental source of demand for emerging market assets, only time will tell.