OCCASIONAL PAPER SERIES; NO 77 / dece mber 2007
OIL MARKET STRUCTURE, NETWORK EFFECTS AND THE CHOICE OF CURRENCY FOR OIL INVOICING
by Elitza Mileva and Nikolaus Siegfried
"...The theoretical literature on trade invoicing explains the almost universal use of the US dollar in international trade in crude oil by means of the fact that petroleum is a homogeneous good traded in organised exchanges. Apart from serving as a medium of exchange, the US dollar fulfils the function of a unit of account by providing price transparency in the oil market. Thirdly, the macroeconomic stability of the United States and the depth of the US financial markets explain the role of the US dollar as a store of value and the low liquidity costs associated with holding the currency.
The literature makes a strong case for the use of one currency as a vehicle currency in the oil trade. However, a thorough review of the international market for crude oil points to several factors suggesting that the oil market is less homogeneous and global as commonly perceived, which indicates that invoicing in one currency may not be the only solution. A group of 11 developing countries highly dependent on petroleum exports dominates the international oil trade. The outflow of crude oil from most exporting countries is matched by an inflow of other goods and services from their trading partners – usually nearby developed countries. Similarly, the United States, the biggest importer of petroleum, relies mainly on western hemisphere sources. Thus, owing mainly to the specific features of the industry, the international oil trade is predominantly regional in nature. In addition, the introduction of trading in futures contracts for petroleum grades more relevant to local industry, with such contracts denominated in domestic currencies and traded in financial centres other than New York and London, has contributed further to the segmentation of the crude oil market.
To explain the dominant use of the US dollar in oil invoicing, the model developed in this paper treats currencies as network goods. Sellers in the market respond to the currency choices of buyers so as to minimise costs associated with the use of an established vehicle currency or a newly introduced currency. The model explains the possibility of multiple equilibria with one or two vehicle currencies.
When calibrated using actual values for the transaction costs of using US and/or euro dollars, together with a proxy for information costs, which decline as use of the new currency increases, the model identifies the preconditions for a possible switch to parallel invoicing: a) players have to expect that a certain minimum number of other players will also start using the new currency, or b) the information costs associated with quoting oil contracts in two currencies are low..."