The Downside Of Cheaper Oil

If the flow of foreign oil profits into U.S. Treasuries slows, interest rates could rise

Nobody expected interest rates to be as low as they are today. With durable goods orders falling and a slowing U.S. economy, many forecasters expect rates to drop even further.

But here's something to consider: One reason long-term interest rates are so low is that oil producers, enjoying a spike in fuel prices, raked in petrodollars and put much of their profits in U.S. Treasury bonds. Now, as oil prices fall and fuel-producing nations find more ways to invest and spend within their borders, fewer petrodollars may flow into U.S. government securities. That could put upward pressure on America's long-term interest rates. "It will be the sting in the tail," says George Magnus, senior economic adviser at UBS (UBS ) in London.

To understand how this could happen, witness how oil-producing countries have been investing their billions of petrodollar profits over the past year. When the price of a barrel jumped from $66 on the New York Mercantile Exchange this January to $75 in July, the trade surpluses of oil-producing nations jumped along with them. In 2006 their surplus is projected to eclipse that of Asia, according to the International Monetary Fund, with fuel exporters expected to generate a $505 billion surplus, vs. $462 billion from Asian nations.

Much of that money ended up in U.S. Treasuries. Banking officials can't pin down the exact total of petrodollars invested in these notes and bills since purchases made through financial intermediaries in London and elsewhere are not counted toward the fuel exporters' share. Although oil exporters' aggregate holdings of U.S. paper are dwarfed by those of Asia, data show that oil-exporting countries have recently taken the lead in buying U.S. bonds and Treasury bills. The rate of petrodollar purchases of U.S. Treasuries jumped by 61% from July, 2005, to July, 2006, Treasury Dept. stats show, while Chinese investment in Treasuries grew by only 12% during the same period. "The oil exporters are outpacing China," says Paul Ashworth, senior international economist at Capital Economics, a London consultant. He argues that it is oil exporters' additional spending, not the ir total purchases to date, that affects the direction of long-term interest rates.

A "CONUNDRUM"

The problem is that oil prices have begun to fall. If they tumble to $50 per barrel, the boom in petrodollar purchases of U.S. securities could evaporate. That would affect long-term interest rates more than almost anything the Federal Reserve could do. The Fed, after all, sets only overnight bank-lending rates. Lately those short-term rates have had less to do with determining U.S. long-term interest rates than has the influx of foreign purchases of Treasuries -- a phenomenon former Fed Chairman Alan Greenspan last year called a "conundrum." High demand boosts the price of Treasury bonds. Then, because they pay a fixed interest rate, their rates of return fall.

Still, few would cry over sinking fuel prices. After all, it puts more change in the pockets of American companies and consumers. And because those businesses and consumers pay less to oil-exporting nations for fuel, the U.S. trade deficit with those countries shrinks. What's more, in a weak or uncertain economy, U.S. investors will fill some of the gap by buying government bonds, as they have been recently.

But don't expect countries that have been major investors in U.S. Treasuries to continue their buying spree, experts warn. China, for one, is attempting to slow its export-led growth and plans to spend more of its trade surplus on domestic consumption. Fuel-exporting nations will likely follow suit, says IMF senior economist Nikola Spatafora. They are already planning to boost domestic investment and economic development at home. Oil-producing Russia, which more than tripled its holdings of Treasuries from 2005 to 2006, has a large domestic economy that would also benefit from the return of petrodollars.

By Catherine Yang

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