The Petro-Dollar Standard In Crisis

–Boy, it sure isn’t a good look for the land of the free and the home of the brave that American-made F-16s and M1 Abrams battle tanks are out in force across Egypt now. But cosmetics and theatrics aside, there’s a bigger story here: the entire geopolitical arrangement that has grown up around the U.S. dollar standard is unravelling. The modest task of today’s Markets and Money is to figure out what that means for your investments.

–First we should probably back-pedal on our statement above about Middle East tyrannies being supported by American policy and American weapons. Or wait, should we? Hmm. The fact the Egyptian Army is now in the streets of Cairo and NOT firing on people is an argument that the Army itself may force out Egyptian President Hosni Mubarak and end his 30-year U.S.-backed rule.

–Whatever happens in the next few days, it’s getting clearer by the day that as global food and fuel prices rise (Bernanke exports), so does political instability. Of course if you’re in Egypt and have been living under the heel of the State for 30 years, a little instability might be welcome. In fact, the desire for stability—to freeze things as they are so we can control them and manage them just the way we like—is often the motivator for more State control in private and public life.

–Viva instability!

–Financial markets continue to operate when geopolitical tensions rise. But they shift to risk aversion. For example, spot gold was up $23.50 in Friday trading. Short-sellers must have taken one look at the pictures coming from Cairo and decided to cover their bet on falling gold prices. Over in America the Dow fell 1.39%.

–It’s obvious that in the short-term, a crisis in Egypt is bearish for stocks and bullish for oil and precious metals. But you are not paying for the Markets and Money to read what is obvious to everyone. So what is the un-obvious point to take away from the last few days? Well we actually count four separate points.

–Watch out Europe.  Energy is capital. A U.S. dollar rally cannot be ruled out. Seek out public companies with many years of energy reserves.

–Why should Europe watch out? Popular protests can spread like a bad cold. Egypt may not be experiencing a revolution so much as a changing of the institutional guard. And it’s unlikely, in our view, that the wave of anger/resentment/optimism spreading through North Africa will reach, say, Saudi Arabia and its 263 billion barrels of light sweet crude oil. But like a psychic tsunami, that wave could travel across the Mediterranean and into Europe.

–There are large populations of North African immigrants in Europe’s major cities. Many of them arrived at the end of World War Two. They provided cheap labour for Europe’s rebuilding economies. Are those large immigrant populations now a potential source of even more unrest in Europe?

–Well, the art of organising protests to take down the authorities is refined each time one of these “revolutions” takes place. Facebook, Twitter, YouTube, flash mobs, it’s all getting pretty sophisticated…and very difficult to shut down (even when the State does the ham-fisted thing and turns out the lights on the Internet.)

— Popular uprisings happen at the margin. A small, well-organised cadre of individuals can set a whole process in motion that reaches a tipping point. And after that, all bets are off. You never quite know where your revolution/uprising will take you.

–What’s happening in Egypt is not just something to watch on Sky News over dinner. It’s a preview of what may happen in the developed world too in coming years. The reasons will be different. In the developed world it will happen because of the corrupt and debt-laden financial system continues to reward the elites at the top at the expense of the Middle Class.  But the results (a deposed or decapitated leadership) may be the same.

–So good luck Europe and good luck the Euro!

–The second point is energy itself (especially crude oil) is a kind of capital in a world where there’s a bear market in paper money. Energy is normally just a commodity. It’s an economic input that, along with labour, land, and capital combines to bring you goods and services.

— But the urbanisation and population of the modern world would not be possible without cheap energy. These days, access to cheap and abundant energy is as important as anything else if you want to ensure your economic competitiveness. If you don’t have energy,  or at least a boatload of money to bid for it, you have nothing.

–You could further argue that the U.S. dollar is the world’s reserve currency because of its relationship with energy. The Saudis agreed to price oil in U.S. dollars in exchange for a U.S. security umbrella. But as the dollar is sabotaged from within by Ben Bernanke and Tim Geithner, all the geopolitical arrangements that evolved around the dollar standard—including the pricing of oil in dollars and the security of oil producing regimes—is slowly crumbling like the crust of a three-day old homemade apple pie.

–The unravelling of this strategic arrangement for energy puts a geopolitical premium on the actual ownership of oil, gas, coal, and uranium. Australia scores pretty well in three out of those four categories. But you still have to be careful. If you own a company that has large energy reserves, are those reserves located in politically risky areas?

–Point three: watch out for a U.S. dollar rally. You may disagree with your editor that the Euro could be a surprising next victim of the events in North Africa. But when S&P downgraded Japan last week, it was definitely dollar bullish. Betting on a dollar rally to contain inflation while U.S. deficits show no sign of getting smaller is admittedly pretty contrarian. But you shouldn’t rule it out.

–And keep in mind that dollar strength against the Yen and the Euro is only relative.  You don’t have to be a dollar bull to see that it could go up against other paper currencies in the next few weeks. The important price to watch is gold. If gold goes up against all paper currencies even as the dollar clobbers the Euro and the Yen, you’ll know the primary trend of the last ten years is still firmly in place.

–Finally, alluding to the point we made above, the big takeaway for investors is to look at your portfolio and find out if you have enough exposure to energy stocks. The oil price climbed over the weekend. It wasn’t because Egypt is a major exporter of oil (it’s not) or that the Suez Canal is critical to the flow of oil to Europe (it’s not, the canal was built in the 19th century and is not big enough to handle modern super tankers).

–But it’s the speculation that U.S.-backed authoritarian regimes in the Middle East may now be living on borrowed time…THAT’s what has oil speculators worried. As well they should be.


Dan Denning
for Markets and Money Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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3 Comments on "The Petro-Dollar Standard In Crisis"

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Chris in IT
Dan, this statement is not totally correct: “The Saudis agreed to price oil in U.S. dollars in exchange for a U.S. security umbrella.” The agreement was made between the house and the oil companies to settle in gold. This went on for about a decade before the companies had to visit the US gold window as the payments started getting too big. The US then made a deal to provide paper gold contracts for later delivery for a portion of the oil and to settle the balance in Dollars, giving the external apparency of a stable US dollar vs oil.… Read more »
Chris in IT

“The oil price climbed over the weekend. It wasn’t because Egypt is a major exporter of oil (it’s not) or that the Suez Canal is critical to the flow of oil to Europe (it’s not, the canal was built in the 19th century and is not big enough to handle modern super tankers).”

Excellent comment. I didn’t know the Suez could not move oil in modern scales.

Nalliah Thayabharan
At the end of World War II, an agreement was reached at the Bretton Woods Conference which pegged the value of gold at US$35 per ounce and that became the international standard against which currency was measured. But in 1971, US President Richard Nixon took the US$ off the gold standard and ever since the US$ has been the most important global monetary instrument, and only the US can produce them. However, there were problems with this arrangement not least of all that the dollar was effectively worthless than before it reneged on the gold-standard. But more importantly because it… Read more »
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