History’s lesson for the dinar

I used to think that rapid increases in Iraqi oil production would practically guarantee a significant strengthening of the dinar over the next ten years. Surprisingly, however, history suggests that this is far from a foregone conclusion.

While the Oil Ministry claims that Iraqi capacity will rise by 10 million barrels per day (mn bbl/d) to something like 12 mn bbl/d by the end of this decade, few analysts take this projection seriously. In fact, no country has ever achieved such a large incremental increase in a ten-year period. Historically, a recent study by the Energy Policy Research Foundation (available at http://www.eprinc.org/pdf/EPRINC-Iraq-FirstLook.pdf) found that Saudi Arabia came closest, with an increase of about 6 mn bbl/d (up 150%) from 1970 – 79, followed by Iran, which went from around 2 – 6 mn bbl/d from 1965 – 1974, and Russia, which raised production by some 4 mn bbl/d (68%) from 1998 – 2007.

But suppose for the sake of argument that Iraq was able to match these precedents and raised production from approximately 2 mn bbl/d at present to, say, 6 mn bbl/d by 2019. What would happen to the dinar if it followed a trajectory similar to the Saudi riyal, Iranian rial, or Russian ruble during the oil booms in those three countries?

Not much, as it turns out. If it’s like the riyal or the ruble, the dinar would actually depreciate in US dollar terms by 25% or 16%, respectively. And the rial appreciated by just 12% from 1965 – 1974. (See chart. As the indices are based on year-end US$/local currency exchange rates, increases/decreases in an index correspond to appreciation/depreciation against the dollar.)

The problem with the idea that increased oil production must be bullish for the dinar is that it is based on the assumption that nothing changes except the output of oil (what economists call a “ceteris paribus” assumption). In fact, however, many other things can be expected to change. In the case of a large country like Russia, for example, domestic demand for refined products may rise significantly as well so that exports don’t go up at the same pace as crude production volumes. In the Saudi and Iranian cases, oil booms led to import booms, with the result that demand for foreign exchange rose along with increased export earnings. There might also be scenarios in which an increasingly confiscatory taxation regime led to greater dollar demand due to capital flight. And of course exporting more barrels won’t necessarily lead to higher forex revenues during an oil-price slump.

History’s lesson for the dinar is that whether it strengthens or weakens over the next decade will depend not only on Iraq’s success in increasing oil production but also on the economic changes that this increased production induces. If Iraqi demand for imports and refined products were frozen for ten years at current levels, a 4 mn bbl/d production increase would be unambiguously dinar positive. But in a more realistic scenario, supply and demand for foreign exchange are likely to grow together, with the result that the exchange rate may not deviate dramatically from its current level.