The upcoming petrodollar bifurcation risk?

One of the still to be appreciated side-effects of falling oil prices is a reduction in so-called petrodollar recycling by oil producers.

As we’ve already noted, there are analysts who believe petro-induced liquidity shortages may already be impacting certain eurodollar markets. Furthermore, there’s also the fact that as liquidity shortfalls manifest in external markets, the opposite could become true for internal US markets. So, just as the dollar liquidity tap gets switched off externally, it gets turned on with gusto back at home.

But Bank of America Merrill Lynch’s Jean-Michel Saliba gets to the same point somewhat differently.

As Saliba noted last week (our emphasis):

Lower oil for longer could imply material shifts in petrodollar recycling flows. Petrodollar recycling through the absorption channel has generally been USD negative, helping an orderly reduction of global imbalances though greater domestic investment. Although recycling through the financial account is less well understood, the bulk has likely, directly or indirectly, ended up in US financial markets and has thus been USD-positive. A prolonged period of low oil prices is thus likely to lead to lower petrodollar liquidity with, in time, an allocation shift towards more inward-looking repatriation and financing flows, in our view.

Saliba’s view is based on the presumption that the majority of petrodollars have always tended to be repatriated back into onshore US investments via the financial account, supporting the dollar in the long run and sterilising oil receipts domestically. Thus, fewer dollars going out to petrodollar nations most likely means fewer chances of those dollars being reinvested in US financial markets, leading to a weakening dollar effect in the long run.

From Saliba:

Lower oil for longer could imply material shifts in petrodollar recycling flows. Every US$10/bbl drop in oil prices shaves off US$70bn (4.2% of GDP) from GCC current account balances. History suggests GCC fiscal adjustment only occurs with a variable lag, which would imply a sticky absorption channel through still elevated imports in the near-term. The GCC external breakeven oil price currently stands at cUS$60/bbl, which would only make the region a net external creditor to the extent our forecast of a material rebound in oil prices in 2H15 plays out. The regional fiscal breakeven oil price stands at cUS$85/bbl, suggesting the GCC is set to run a fiscal deficit on aggregate, the bulk of which is likely to be financed through a drawdown of foreign assets currently held abroad, we think.

If Saliba is correct then we can expect a drawdown of foreign assets held abroad by GCC states, which should lead to greater dollar absorption via the use of oil export receipts to finance imports of goods and services from DM states. Which means this chart could be begin to adjust the same way it did during the 1980s gluts:

As a reminder this is what the dollar did during that period:

So a pop first, and then a crash.

Whilst there were obviously different variables in place in the early 1980s, the point still stands that before we get any dollar weakness we’re likely to experience an external (eurodollar) dollar liquidity shortage that eats external reserves and pops the dollar on a trade-weighted basis, but at the same time creates an inflationary effect in the domestic US economy.

Cue Volcker?

Related links:
On the hypothetical eventuality of no more petrodollars – FT Alphaville
It’s not a liquidity crisis, it’s an energy crisis stupid - FT Alphaville
Dollar reserves as goodwill oil-product claims – FT Alphaville

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