Oil priced in crypto

It is my view that the role of the US Dollar as the world’s reserve currency is under threat from a variety of factors:

• Ongoing massive US trade deficits financed by sale of dollars to foreigners.

• Significant fiscal imbalances in the US-financed by the Fed leading to the risk of inflation.

• Political gridlock in the US impeding the ability of US Government to solve problems.

• Use of the dollar as the long arm of US foreign policy forcing other countries to consider reducing their dollar exposure in order to maintain freedom of maneuver.

In this mix is the role of the US$ as the principal currency in which major commodities such as oil are priced. In the past it has been speculated that oil could alternatively be priced in Euros, Yuan or Yen but due to the lack of liquid derivative markets, these alternatives have not taken off.

It would be straightforward to create a smart contract (self-executing contract) that represented one barrel of oil; i.e. it legally owned a barrel of oil. These could then be traded with stable coins; i.e. smart contracts that legally own fiat currencies such as the US$, Euro, Yuan Yen, etc or Central Bank Digital Currencies (CBDCs) of same countries. Since the underlying price of oil is determined by supply and demand factors this switch from the US$ as the primary pricing vehicle should mean no change in pricing assumptions.

In practice there isn’t one single oil price but rather dozens of quoted prices. Crude oil contains varieties of impurities when it emerges from the ground and these determine the cost of refining. Then there is distance to market. Thus, there would be individual tokens corresponding to each type of oil. An adjustment mechanism enables different grades to be assessed to a standardised specification in term of quality.

A major factor in oil markets are the derivatives markets for forwards and futures contracts and the volume of trading in these secondary markets is estimated at some 14 times the value of the underlying physical oil. One of the reasons given for the Yuan not being a credible alternative to the US$ for oil is that China lacks open capital markets and the accompanying derivatives markets. However, there is now a high volume of sophisticated derivatives products traded daily on crypto markets and there is no reason these could not be extended to the crypto oil market.

In the oil markets producers presell their crude based on their expected production, and buyers can lock in a price today that protects them from possibly paying more in the future, while speculators can take advantage of contract volatility and use futures to bet on their market view for the oil price over the course of the forward contract. The quoted spot price of oil, e.g West Texas Intermediate, Brent etc represents supply and demand. Futures contracts were created that didn’t require physical delivery.

Companies such as airlines and transportation companies want to lock in prices for the next year to reduce volatility.

The derivates market trades buy and put options on the different grades of crude as it passes along the chain. If the forward price is locked at $60 and the spot price is trading at $80 then an option to buy at $60 would have a gain of $20.

This trading ecosystem could easily be replicated on the crypto exchanges such that there would be no reason to be bound to the US Dollar going forward.

Arithmetic

Daily oil output – say 80m barrels.

Average price – say $80.

Total daily value of output = $6,400m (80m*$80).

Daily value of derivatives traded = 14* 6400m = $89,600m

Thus, our back-of-the-envelope calculation gives about $90bn of oil futures traded every day.

There are indications that crypto trading volumes are running above $100bn a day with crypto futures representing about one-half.

Note the huge volumes of stablecoins traded. The main FX markets may, in the future, migrate to crypto exchanges due to their lower transaction costs and instant settlement once fiat stable coins are approved for regulatory purposes or once CBDCs become established.

To conclude, it is only a matter of time before blockchain and tokenization become the main platform for trading not just cryptos, but also currencies, securities and foreign exchange. This will also extend to commodities such as oil, copper, gold etc and tokenization of these commodities would be the next logical step such that they would no longer be quoted and traded in US$.