Energy and the US Dollar by Bill Powers

Canadian Energy Viewpoint
March 1, 2004

Despite the recent rally in the US dollar against the Canadian dollar and nearly all major currencies, we are still in the early stages of a monumental decline in the value of the US dollar. The collapse of US dollar hegemony will be felt in nearly every corner of world over the next decade. Perhaps no other industry will be impacted more by the dollar’s decline than the energy industry.

Since the signing of the Maastricht Treaty, which created the Euro zone in 1992, there has been much speculation that the oil exporting world would one day consider pricing oil in euros. The world did not have to wait long after the birth of the euro in 1999 to witness Iraq’s pricing its oil in euros. Australian environmentalist Geoffrey Heard provided some unique insight into fellow OPEC members’ reaction to Iraq’s decision to price its oil for export in euros in a 2003 article entitled “Not Oil, but Dollars vs. Euros”:

“In 1999, Iraq, with the world's second largest oil reserves, switched to trading its oil in euros. American analysts fell about laughing; Iraq had just made a mistake that was going to beggar the nation. But two years on, alarm bells were sounding; the euro was rising against the dollar, Iraq had given itself a huge economic free kick by switching.

Iran started thinking about switching too; Venezuela, the 4th largest oil producer, began looking at it and has been cutting out the dollar by bartering oil with several nations including America's bete noir, Cuba. Russia is seeking to ramp up oil production with Europe (trading in euros) an obvious market.

The greenback's grip on oil trading and consequently on world trade in general, was under serious threat. If America did not stamp on this immediately, this economic brushfire could rapidly be fanned into a wildfire capable of consuming the US's economy and its dominance of world trade.”

After the US invasion of Iraq, the country’s oil exports were priced in US dollars. While Mr. Heard may have overestimated the role of the euro in the war in Iraq, there is no doubt that the falling US dollar has raised concerns over whether it is prudent for oil exporting countries to price a significant portion of their GDP in a depreciating currency.

While many have argued that pricing oil in euros will lead to higher oil prices, not much attention has been given to the possibility of oil being priced in gold. While this might seem like a fringe idea, those who have an appreciation for gold’s place in many Muslim oil exporting countries believe the pricing of oil in gold is inevitable.

The launch in late 2000 of the e-dinar, a Muslim currency that is backed by gold held in a vault in the Dubai International Airport, has allowed many Muslims an alternative to Western currencies. The e-dinar program is an electronic form of the historic Muslim gold dinar. The gold dinar dates back as far as 700 A.D. and was in circulation until 1924 A.D. when the Ottoman Empire collapsed.

One e-dinar is backed by 4.25 grams of 24K gold. E-dinars account holders can have their account balances exchanged into any major currency or take physical possession of an equivalent amount of gold. To learn more about the e-dinar program, visit website www.e-dinar.com. What I found most educational about the site is its extensive history of the dinar in Muslim society. The following was quoted from the website’s “history of the dinar” section:

“Since paper-money is a promise of payment, can it be permitted to trust the issuers while they hold the payment (our property) outside our jurisdiction? History has also demonstrated repeatedly that paper money has been a permanent instrument of default and cheating the Muslims. In addition, Islamic Law does not permit the use of a promise of payment as a medium of exchange.”

The use of e-dinars, while still very small at this time, is likely to grow rapidly as doubts over the US dollar’s value grow. Recently, Malaysia’s former Prime Minister Mahathir Mohamad visited Saudi Arabia and encouraged the country to begin pricing its oil in gold (dinars) since he felt the Saudi’s were being shortchanged due to the slide in the US dollar. (It should be noted that in 2003, Malaysia was the first country to introduce the dinar as a form of settlement for international trade.)

I am rather confident that several Muslim countries will price their oil in gold before the end of this decade. The simple reason behind this change is that the US dollar and the euro are going to steeply depreciate against the value of gold.

The oil market is not the only part of the energy complex that will be affected by the decline of the US dollar. The North American natural gas market is already witnessing the fallout from a devalued

US dollar. In limited instances, the weakening dollar is helping some energy consuming companies. For example, according to third quarter results of Agrium International (NYSE:AGU), North America’s largest producer of natural gas based fertilizers, the price of ammonia and urea are up 54% from Q3 2002 levels. High fertilizer prices, coupled with a weak US dollar, which has made imports more expensive, have allowed fertilizer producers to operate profitably despite historically high natural gas prices.

The falling US dollar will have many unforeseen consequences with regard to the increased US importation of liquefied natural gas (LNG). While a falling US dollar will certainly increase the price which LNG exporters demand for their product, the inevitable falloff in Russian natural gas exports to Europe will further boost prices. With Europe relying on Russia to provide 25% of its natural gas consumption, there is a strong likelihood that Russia's increased domestic demand and aging fields will not be able to meet Europe’s growing natural gas demand. Contrary to the widely held belief that increased reliance on LNG will allow the US to import vast amounts of cheap natural gas from overseas, I believe a combination of a falling US dollar and increased world demand will force the US into importing large amount of expensive natural gas.

It is clear that a falling US dollar contributes to higher energy prices. Astute investors should recognize this fact and adjust their portfolios accordingly.

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Run, Do Not Walk

Every now and then there comes a time when it really pays to take clear and decisive action. I believe we have reached one of those times with respect to the US dollar. The recent short-term strength in the US dollar offers investors another great opportunity to move into assets denominated in other currencies.

President Bush and the US Congress continue to grow the size of the US government and its debt

and budget deficit through various homeland security initiatives, prescription drug plans and visits to the moon and Mars. According to a recent Bloomberg article, the US Treasury plans on borrowing a record $177 billion from January to March in an effort to finance a part of a projected record $521 billion 2004 federal budget deficit.

As paper currencies continue to fall as nearly all nations attempt to devalue their currencies, I believe prudent investors should direct significant portions of their portfolios towards assets denominated in commodity currencies. The Australian, the New Zealand dollar and the Canadian dollar stand out as my three favorites. However, do not just take my word for it that these are going to be the best performing currencies for the remainder of the decade. Several of the most successful investors of our time, such as Sir John Templeton, Warren Buffet, George Soros, Jim Rogers and Fred Hickey, have all indicated that they have increased their exposure to the above mentioned commodity currencies. For investors who are interested in commodity currencies or bonds, I suggest visiting www.everbank.com for more information.

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Makings of an Energy Bull Market

If I were going to write a recipe for a bull market in energy shares or any investment class for that matter, I would start with three ingredients; fear, strong fundamentals and a catalyst. I believe all three are present in today’s energy market.

Fear
Investor fear over falling energy prices is the main ingredient for our energy bull market. Right now, there is tremendous fear that we have more than enough natural gas to get through the winter heating season without drawing US inventories down below the psychologically important one trillion cubic foot (tcf) mark. With the significant withdrawals we have witnessed since the last week of January, there is now substantial evidence that we will break the one tcf mark. With cold weather forecast for the US Midwest in early March, we are now nearly certain to see storage levels in the US approach the 900 billion cubic foot (bcf) mark by the end of this winter’s heating season. This should provide significant support for higher natural gas prices for the balance of 2004.

While I can understand the confusion over the equilibrium price for natural gas, based on the many conflicting data points, I am at a loss to explain the reason behind the fear that crude prices are headed lower. Despite the high prices of recent months, we have seen little to any supply response as inventories for crude and refined products remain at bottom-of-the-barrel levels.

Strong Fundamentals
Any bull market recipe must include a strong fundamental foundation. The fundamentals of the energy market (increasing demand/falling supply) are stronger now than at any time in recent memory. This has lead to a golden situation for the entire exploration and production industry. For example, until two years ago, the balance sheets of many of Canada’s junior E&P companies were highly leveraged. It was not uncommon to see debt to cash flow ratios of three or four to one. This made many investors very cautious about investing in the sector and rightfully so. A few dry holes or weak commodity prices could send a company into reorganization. Through a combination of strong commodity prices, capital discipline and low interest rates, the balance sheets of nearly every Canadian E&P firm are in excellent shape. In addition to great balance sheets, interest rates are likely to stay low and commodity prices are set to rise. This excellent situation has led to outstanding earnings and cash flow in 2003, and 2004 is shaping up to be more of the same.

Catalyst
The final ingredient for a successful energy bull market is a catalyst. On this front, we have several candidates. The most likely scenario that will form the catalyst is the continued tightening of world oil supplies as prices continue to spiral higher. With supplies at very low levels throughout the world and diminishing prospects for large new areas of production, it will soon become clear that world oil supplies will decline irrespective of price. As the calls for OPEC to increase production become deafening, the world will soon wake up to the fact that OPEC is already producing at maximum capacity and there is nothing that can be done to increase production or keep it from falling.

Another possible catalyst that is likely to set the energy bull running is the cessation of exports from Venezuela. In January, Venezuela’s embattled President Hugo Chavez devalued the country’s currency, the Bolivar, by 17% against the US dollar. This action is an unmasked attempt to support his outlandish spending programs aimed at currying votes with Venezuela’s lower income voters. Through the use of price controls, Chavez is able to temporarily hold down the pace of inflation. This has created a thriving black market for many items including US dollars. After watching the economy contract 11% in 2003, many citizens are loosing their patience with Chavez. The results of a signature drive by the opposition to force a presidential recall election are expected shortly.

The granddaddy of all catalysts would be the fall of Saudi Arabia. With growing disenchantment with the royal family and continued suppression of many freedoms, the likelihood of a change in power in Saudi Arabia is inevitable. Dr. Marc Faber has referred to Saudi Arabia as similar to France in the final days of Louis XVI. I could not agree more. One day in the not too distant future, everyone will wake up to CNN’s lead story -- the royal family has fled to London or Switzerland and the price of crude oil is trading over $100US on the NYMEX.

© 2004 Bill Powers, Editor
Canadian Energy Viewpoint