A Bourse, of Course

There's no lack of news or opinion on the Iranian oil bourse set to open in a March. Like the M3 story back in November, this story seems to have brought out the wild-eyed conspiracy theorists and disbelieving economists in the now familiar five-to-one ratio.

Here's a sampling of theories predicting dire consequences for the 'ol greenback:

Will Iran’s oil kill the U.S. dollar?

Tehran has lately confirmed its plan to create a euro-based exchange in oil—to compete with the London and New York dollar-denominated oil exchanges, both American-owned.

If proved successful, the Iranian oil bourse (IOB) is expected to give the euro a foothold in the international oil trade, solidifying its status as an alternative oil transaction currency. This would eventually lead to a major currency flight from the dollar to the euro—and a disaster for America.

Iran oil bourse: a threat to the petrodollar?

Some observers consider Iran's threat to the petrodollar system so great that it could provoke a US military attack on Iran, most likely under the cover of a preemptive attack on its nuclear facilities, much like the cover of WMD America used against Iraq.

In November 2000, Iraq began selling its oil in euros, its Oil For Food account at the UN was also transferred into euros and later it converted its $10 billion UN held reserve fund into euros.

At the time of the switch many analysts were surprised and saw it as nothing more than a political statement, which in essence it may have been, but the euro has gained roughly 17% over the dollar between then and the 2003 US invasion of Iraq. Perhaps unsurprisingly, since the US led occupation of Iraq its oil sales are once again being invoiced in dollars.

The Proposed Iranian Oil Bourse

In 1971, as it became clearer and clearer that the U.S Government would not be able to buy back its dollars in gold, it made in 1972-73 an iron-clad arrangement with Saudi Arabia to support the power of the House of Saud in exchange for accepting only U.S. dollars for its oil.
The rest of OPEC was to follow suit and also accept only dollars.

Because the world had to buy oil from the Arab oil countries, it had the reason to hold dollars as payment for oil. Because the world needed ever increasing quantities of oil at ever increasing oil prices, the world’s demand for dollars could only increase. Even though dollars could no longer be exchanged for gold, they were now exchangeable for oil.

Petrodollar Warfare: Dollars, Euros and the Upcoming Iranian Oil Bourse

Candidly stated, ‘Operation Iraqi Freedom’ was a war designed to install a pro-U.S. government in Iraq, establish multiple U.S military bases before the onset of global Peak Oil, and to reconvert Iraq back to petrodollars while hoping to thwart further OPEC momentum towards the euro as an alternative oil transaction currency (i.e. “petroeuro”).

However, subsequent geopolitical events have exposed neoconservative strategy as fundamentally flawed, with Iran moving towards a petroeuro system for international oil trades, while Russia evaluates this option with the European Union.

A Story About Oil You NEED To Hear

While oil can be drilled and refined and transported anywhere, there's only two places where it can be officially purchased. One is in New York City on the NYMEX stock exchange and the other in London on the IPE exchange.
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This means that every single country which wishes to buy oil has to own dollars to do it. Since these dollars are held overseas, they are referred to as Eurodollars, although once again they don't have to be in Europe. A dollar in China is a dollar in America too - they aren't valued any differently.

The world sells and buys billions of barrels of oil per day, and every single one of those billions is in the form of an American dollar. The effect of this is that every single country in the world which holds large reserves of dollars (for the purpose of buying oil) is essentially propping up the American economy on a huge scale.

Representative of the other side of the debate is Tyler Cowen of Marginal Revolution fame, who, like other economists commenting on the M3 debate, thinks this is much ado about nothing.

Should we fear the proposed Iranian oil bourse?

As a first-order approximation, it doesn't much matter whether Iran prices its oil in terms of dollars, Euros, or some other currency. At the beginning of each day, investors (including the OPEC nations) are holding their preferred bundle of currency positions. You might need to hold or receive Euros for a moment to make a transaction, but moving from the dollar to the Euro, or vice versa, can be done easily.

Two qualifiers: First, some investors will hold more Euros to begin with. They don't know their periodic demands for oil, and they don't want to be bothered paying a bid-ask spread and calling a broker when the time comes to pay for oil. But this is likely to be a small effect. Major market players generally do not regard these conversion costs as a decisive investment factor. Bid-ask spreads in the dollar-Euro market are small, and if the dollar fell by a large amount it would be worth buying dollars cheaply and bearing subsequent transactions costs of a later reconversion at a superior rate.

Second, the dollar's status as reserve currency depends in part on perceptions. If pricing oil in terms of Euros altered those perceptions, the value of the dollar could fall. But most of all those perceptions depend on relative economic performance. An Iranian "oil bourse" is likely to be, in psychological terms, a non-event, especially if Iran continues down its path as international pariah. Note that Saddam's efforts to price oil in terms of Euros did not end up as a big deal.

As with the M3 debate, the truth is probably somewhere between the two extremes of "This is the end of the world!" and "There's nothing to see here - move along - go about your business". That leaves quite a wide margin, actually, but it really seems to come down to two questions:

1. Will this negatively affect the status of the U.S. dollar as the world's reserve currency?
2. What benefits, provided as a result of reserve currency status, are in jeopardy for the U.S.?

Addressing the second question first, we find that Wikipedia disappoints for the first time in a while now with their entry for reserve currency, positing these advantages to the issuing country:

• Ability to purchase commodities at a significantly cheaper rate
• Ability to borrow money at lower interest rates
• Ability to run significant trade deficits financed by seigniorage

Well, it was a hard question ... more comprehensive answers are certainly not known here. It appears that the unstated degree to which these advantages exist is the big unknown.

Going back to the first question, since Iran exports fifteen percent of all Persian Gulf oil, the majority of oil will still be paid for with dollars, so that in itself doesn't seem like such a big deal.

But, surely the fear is that other oil exporting countries will follow suit, and in no time much more of the Eastern Hemisphere (and maybe parts of South America) might decide they don't need so many U.S. dollars to more easily transact their oil purchases and sales.

While exchanging currency is certainly easy these days, it does seem much more natural to hold more of the currency which is needed for purchasing the world's most heavily traded commodity.

As importers of nearly all of their energy needs, this concern would immediately apply to both China and Japan, who collectively hold well over a trillion U.S. dollars.

That could be a problem for the dollar - a gradual de-emphasis of its importance on the world stage, adding to the negative effects of increasing budget and trade deficits. As time goes by and more oil is sold for Euros, more countries may find that they prefer to hold more euros than dollars.

So, if any of the advantages of world-currency status were to be withdrawn for the dollar in an appreciable way - cheaper commodities, lower borrowing rates, and easier trade deficits - that could make things a bit more difficult for the U.S. economy.

Maybe a lot more difficult.