Thursday, March 02, 2006

What Happens When Oil Trades In Mongolian Tugriks

“Suppose oil is traded only in Mongolian tugriks. So, you take your currency to the forex, exchange it for some tugriks and buy all the oil you need – and then the seller immediately converts tugriks to euros or yuans or whatever. Net benefit for Mongolia? Exactly zero. What difference does it make? It seems to me that as oil exchange currency the US dollar is no more more significant than a subway token.” —abb1, writing a comment on blog Crooked Timber

This post brings up the very good question: what difference does it make what currency oil trades in, anyway? So, lets follow the admittedly absurd proposition that oil may only be traded in tugriks. A single crude oil contract (one thousand barrels) is worth almost 62 thousand bucks today. That converts to 73.5 million tugriks. Given a week or two, a banker might be able to come up with that sum. Don't forget that currencies are commodities, subject to supply and demand equations like any other. Some have a vary large, liquid market with small spreads between buy and sell quotes, others, like tugriks, don't. Maybe a Canadian mining and exploration company would want a lot of tugriks now and then. But overall, it is not a huge market.

How many oil contracts can the tugrik support? Total supply is not that large: M2 in 2004 is 847 billion tugriks (stats here). That will buy only 11 thousand oil contracts. Clearly, if the world traded oil only in tugriks, the Mongolian central bank would have to get busy issuing bonds. Bankers all over the world could buy these bonds and lend out the cash to those who want to buy oil. Mongolia would have to issue a lot of bonds. This amount of cash would completely change Mongolia as a nation, because many of those petro-tugriks would come back to Mongolia. What would the Saudi princes do with their tugriks? They would probably buy beautiful ranches in Mongolia and breed racehorses (they probably already do that). Canadian oil-sand barons, Venezuelan oil rich bureaucrats, Russian KGB tycoons, all would have mountains of tugriks. Eventually that Mongolian cash would come home to roost like loyal hunting falcons on the high steppes of Asia. Because if the oil sellers don't buy Mongolian property with the tugriks, then they will have to sell them - the principal buyer would be the Mongolian central bank.

Mongolia would be flooded with their own cash. Real estate values would soar, stock market values in Ulan Bator would skyrocket. Domestic industries such as mining, farming and manufacturing, would produce so little money in comparison to the huge currency trade that they would be declared unprofitable and irrelevant. Because the money would come in through international banks instead of broad based domestic industry, it would be an extremely unequal distribution of wealth. This is not unlike what has happened to the United States in recent decades. But the US economy, being the world's largest, can absorb such huge quantities of money much better than the tiny economy of Mongolia.

The real question in my mind is why does oil have to be traded in a single currency? It was Henry Kissenger who formalized an agreement with OPEC, that in return for military protection, OPEC would agree to trade oil only in dollars. Kissenger foresaw the long term structural benefits to this arrangement. It need not be so. A sensible system would be to peg oil to gold. Oil exporters could ask for bullion, or, for countries that have stable currencies, could accept any national money at the rate gold trades for in that currency. Since every nation needs oil, it makes sense to trade it in a way that is internationally equitable.

2 comments:

Judas said...

Interesting and well written.

http://judaspenrose.blogspot.com/

Aaron said...

Very good points. But I'm not sure that you directly addressed the question, "what difference does it make what currency oil trades in, anyway?" You seem to have merely described the current environment realized by the Nixon administration's deal with the Saudis to price oil in dollars.

The currency that oil trades are denominated in makes the following difference: in order to protect the purchasing power (to buy oil) of their native currencies, countries must hold foreign reserve currencies denominated in the currency that oil trades in - if they don't, they may be subject to speculative currency attacks which will diminish their ability to buy oil.

See my post at:
http://combatraccoon.blogspot.com/2006/02/i-read-post-by-paul-craig-roberts-on.html

Obviously, this is not so much of an issue for countries like China who have a (relatively) pegged currency. They have their own obvious reason for holding dollars. But there are many countries out there that import oil - and they have to hold dollars (despite being such a liability) to protect their own currency's ability to purchase oil. Otherwise, someone like Soros might come along with a major smackdown.