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Insight: Petrodollar tsunami to hit the euro and dollar

By Stephen Jen

Published: March 3 2008 16:39 | Last updated: March 3 2008 16:39

With crude oil at $100 a barrel, there is going to be a massive transfer of global financial wealth from oil consuming countries to oil exporters. Some of these windfalls will be absorbed by the economies of the oil producers, but a far larger amount will be invested outside them. Indeed, a petrodollar tsunami is coming, with significant consequences for global financial markets.How big are petrodollars? They are big and getting bigger with the rise of oil prices. We can look at this in terms of the financial worth of the stocks of proven oil reserves  underground, or in terms of flows – ie the value of the annual oil exports. At $100 a barrel, the total proven reserves of the oil exporting countries is about $104,000bn – equivalent to the combined total value of publicly-traded equities and bonds in the world. About $48,000bn of this belongs to the Gulf Co-operation Council member countries – which include Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. The rest of Opec owns another $44,000bn, while non-Opec countries (Canada, Norway, Mexico and Russia) own some $12,000bn worth of oil reserves.The flows are massive too. At the current pace of production and exports, and at $100 a barrel, collectively, oil exporters are projected to earn a total of $2,100bn in oil export receipts annually.Such large windfall receipts/profits could in theory be invested in domestic physical infrastructure. However, the size of the GDP of most of these oil exporters is relatively modest. What would be considered ‘significant’ investment, equivalent to 5-10 per cent of GDP, would amount to only about 5-10 per cent of their annual oil revenues. Thus, the bulk of the petrodollar windfalls for most oil-exporting countries will still not be spent, but will be saved and deployed in the global financial markets.There are two key implications. First, the deployment of petrodollars is likely to favour equities over bonds. Second, they should favour emerging market currencies at the expense of both the dollar and the euro. These two themes are identical to the financial market implications of the emergence of Sovereign Wealth Funds, because about half of the petrodollar receipts may be invested through SWFs, and close to three-quarters of all assets under management by SWFs are derived from petrodollars.

Over the past 20 years, spot crude oil has significantly under-performed global equities, by a factor of one to three in cumulative returns, and by a factor of two to one in terms of volatility. In other words, crude oil has had a much lower return and much higher volatility compared with global equities. Calculations using data from the past 100 years yield a similar result.

Thus, from the perspective of maximising the risk-adjusted long-term return on the combined underground wealth (crude oil) and above-ground wealth (financial assets), an exporter should be expected to embark on a multi-generational transformation from crude oil to equities.

Since most oil exporting countries have a much higher propensity to invest in equities than do Asian reserve holders, because petrodollars are deployed in the financial markets, there will be a bias in favour of global equities.

At the same time, if we assume that SWF/petrodollar portfolios have benchmarks of 25:45:30 on bonds, equities, and alternative investments, the currency composition of these portfolios will look significantly different from that of the official reserves. In fact, some 95 per cent of the world’s official reserves are held in only three currencies: the dollar, the euro and the pound.

While many observers focus on the shift in reserves between dollars and euros, the deployment of petrodollar investments will in fact likely tilt the balance in favour of emerging market currencies, at the expense of both the dollar and the euro. Specifically, we calculate that the theoretical share of emerging market assets in total petrodollar portfolios could be as high as 25 per cent, compared with the current exposure of official reserves to emerging market currencies of zero.

Stephen Jen is Chief Currency Economist at Morgan Stanley

 

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