Category Archives: Oil and Gas

Measured optimism, an observation

A week ago I attended a conference about the future of the regulatory environment for the pré-sal oil developments in Brazil.  High-level oil executives, former directors at Petrobras and ANP, top journalists, and industry analysts, as well as one of the key government planners for the new regime were in attendance.  In the interest of candor, participants were instructed not to quote anyone directly.

All I will say is that those with the most experience in the oil business were the most measured in their enthusiasm for the regulatory changes.  Some were outright pessimistic about the ability of Petrobras and the incipient Petrosal to coordinate the hundreds partners involved in every block of pré-sal development.

Similarly, a few weeks ago, I met with numerous attorneys in São Paulo with experience negotiating cross-border investments for some of the largest businesses in South America.  The attorneys with the most experience in Brazil did not believe that foreign investments were going to meet all of the expectations of foreign investors.

As a young, soon-to-be attorney, I have comparatively little experience in Brazil.  In the sea of information about foreign investment and the pré-sal oil fields, I find myself looking to those with more experience for guidance.  And while many are measured in their big picture expectations for Brazil, all believe that on a personal-level developing experience and contacts here will prove useful.

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Dollars and Sense

My guess is that most seasoned Brazil observers have a mental model that they use to think about exchange rate movements.  And no, I’m not talking about the Mundell-Fleming model.  I mean a softer, more intuitive model, depending in part on their memory (or lack of memory) of hyper-inflation, whether they are part of producer/exporter/tourists sectors of the economy and benefit from a weaker Real against the dollar, or part of the consumer/importer sector of the economy and benefit from a stronger Real.  The model is not much more than a set of assumptions about how short-term movements in the exchange rate affect the fortunes of various sectors of the Brazilian economy.

Underpinning that mental shorthand, is another set of assumptions about how currency markets and economies work.  The New York times prints rumors of the potential for a fundamental shift in currency markets:  The move away from the dollar as the both The Reserve Currency and The Oil Currency (the currency in which oil is priced and traded).  What is interesting is not the specific report and “secret talks” referenced in the article.  What is interesting is that many economists and political scientists believe such a move is inevitable.  The article notes:

“But the report caught the attention of investors because several economists had been predicting that at some point, the world’s oil exporters would start moving toward other currencies to limit exposure to the dollar.

“It won’t be easy to make such a shift; it’s a pretty unrealistic idea in the near term,” said Qu Hongbin, an HSBC economist in Hong Kong. But in the years to come, he added, China would be delighted if it could print its own currency to pay for oil, instead of having to earn dollars through exports.”

If such a move towards trading oil using a “currency basket” happened in the medium term, it would coincide with the development of the pré-sal oil fields and Brazil’s projected rise as a significant oil exporter.  Brazil’s oil would be traded using a currency basket.

It is hard to tease out how, and if, such a currency shift would affect Brazil and its oil sector.  One thing to keep in mind, however, is that the under the current government proposal, the pré-sal fields are to be developed by producers using Production Sharing Agreements, in which producers are paid in barrels of oil as a percentage of the total take.  That at least puts some of the currency risk (and upside) on producers.

There is a lot of uncertainty here.  It is, however, certainly something to watch and ponder.  Someday, perhaps sooner than we like, those mental models will need revisiting.

*** Update:

Dean Baker, writing for Foreign Policy, pushes back.  His point: the dollar is just a unit of measurement, and the unit of measurement doesn’t really matter.  If oil were priced in bushels of wheat or Euros,  it would not make a difference to the fundamentals of the oil market.

That much, anyway, I agree with.  But he goes on to imply that if Oil were priced in Euros, it wouldn’t make much of a difference in the currency markets.  He reasons as follows:

“… if all oil were sold for dollars, it would be a very small factor in the international demand for dollars, as can be seen with a bit of simple arithmetic. World oil production is a bit under 90 million barrels a day. If two-thirds of this oil is sold across national borders, then it implies a daily oil trade of 60 million barrels. If all of this oil is sold in dollars, then it means that oil consumers would have to collectively hold $4.2 billion to cover their daily oil tab.

By comparison, China alone holds more than $1 trillion in currency reserves, more than 200 times the transaction demand for oil. In other words, if China reduced its holdings of dollars by just 0.5 percent, it would have more impact on the demand for dollars than if all oil exporters suddenly stopped accepting dollars for their oil.”

This makes less sense to me.  One, he is comparing a flow variable (the $4.2 billion daily oil tab) with a stock variable (China’s $1 trillion plus currency reserves) to arrive at the conclusion that changes in China’s savings (a reduction in its stock of dollars) would affect the demand for dollars far more than the daily demand for oil.  Well, sure, it would. But only on the day that China reduced its dollar holdings.  On the next day, Oil would be king again.

Second, this doesn’t seem to take into account the basics of the currency or oil markets.  One, oil is the most traded commodity in the world (number two is coffee).  So if you need dollars to trade oil, you need dollars to participate in the largest commodity market in the world.  That increases the demand for dollars.  A single barrel of oil may be sold 40-50 times before being consumed.  So multiply that $4.2 billion by 40-50.  And in the countless oil trades that occur everyday, people are surely hedging their currency risk associated with any oil-related trade using options and futures, some of which are necessarily priced in dollars (whether they are buying or selling the dollars in the trade).  There is a lot of reason to think that the secondary hedging markets surrounding oil are substantial.  Global GDP is a little less than $50 trillion.  Yet daily turnover in the currency markets approaches $4 trillion.  What is that $4 trillion being spent on?  A good portion should be spent in relation to the largest commodity market in the world, certainly more than 4.2 billion or 1 percent.

And with that last fact — $4 trillion daily turnover in currency markets! — I realize that neither of us has any idea what is going on in the currency markets.

Readings on the pre-sal oil fields

World Politics Review provides an excellent English language introduction to proposed changes in Brazil’s oil exploration and production regime in the context of the presidential campaigns.

Exame, a leading Brazilian newsweekly, offers this Portuguese language summary of the investments necessary to exploit the Pre-Sal fields.

Update:  Foreign Policy magazine provides a special report on the future of oil in its Sept/Oct 2009 issue.