Dollar drought poses emerging market risks

The surge in American oil production and the ensuing oil price drop have prompted a volatile, but ultimately positive, transfer of wealth from oil producers to consumers.

Its broader financial risks, however, have received less attention. For all its benefits to the U.S. economy, shale drilling – both for oil and gas – threatens to dry up the supply of dollars required by many emerging nations.

Indeed, America's energy bounty is likely to deal a triple blow to the availability of the greenback.

Pump jacks and wells on the Monterey Shale formation in California
David McNew / Stringer | Getty Images News
Pump jacks and wells on the Monterey Shale formation in California

The main impact is on the U.S. trade position.

For years, America's giant current account deficit was seen as a menace to global financial stability. However, a case can also be made that it was a global public good, boosting the supply of dollars used overseas to facilitate trade and foster credit creation.

The world will increasingly have to live with a far smaller U.S. deficit. Between 2008 and 2013, over 60 percent of the U.S.' current account shortfall was due to the country's need to import foreign crude.

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The most recent peak was 2011 when the U.S. spent $330 billion on net oil imports - 72 percent of the deficit for the year. As reliance on foreign suppliers declines, this shortfall is narrowing rapidly – and this looks set to continue.

Since the start of 2011, the U.S. has boosted crude output by around 3.5 million barrels a day (bpd) – equivalent to roughly the entire production of Iraq.

Even at today's low oil price, that shaves about $65 billion off the country's deficit. And even after the recent slide in prices, the U.S. is still on track to boost output by 700,000 barrels a day in 2015.

Shale supremacy

Fracking is also helping to downsize the U.S.' trade gap by improving the competitiveness of energy-intensive firms – especially manufacturers.

Abundant natural gas from shale has roughly halved the cost of U.S. natural gas since 2008. As a result, prices are now more-than twice as high in Europe and three-and-a-half times in Japan.

Low-cost manufacturers in emerging markets are also seeing their competitive position eroded.

Since gas also helps set the price of electricity, this has an impact for a wide range of businesses. Research firm IHS estimates that lower natural gas and electricity prices will boost industrial production in the U.S. by 3.9 percent by 2020, resulting in additional trade benefits of $180 billion a year by 2020, relative to 2012.

This shale supremacy puts at risk another source of U.S. dollars: capital flows.

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U.S. investors' exposure to emerging markets has risen sharply since 2008, from $450 billion (or 2.5 percent of emerging market gross domestic product) to $1.3 trillion (or 5 percent), according to figures from the Institute for International Finance.

By making the U.S. a more dynamic economy, and increasing the relative attractiveness of American assets compared with emerging market assets, the shale revolution may contribute to a structural flow of portfolio capital flows back to the country.

In fact, the 2013 "taper tantrum" may have provided a cyclical taste of a larger structural shift. In just one quarter, the exposure of U.S. investors to these markets dropped by $100 billion.

'Structural shortfall' of dollars

Even the third and final source of dollars – interest payments on U.S. government debt – may become less abundant than previously expected thanks to shale.

By 2020, IHS predicts that shale gas and tight oil activity will yield more than $125 billion a year in federal and state tax revenue. This is equivalent to a quarter of the roughly-$500-billion deficit the White House is currently forecasting for that year.

The upshot is that the world may be facing a structural shortfall of dollars over coming years.

That would crimp growth in many developing nations and heighten the risk of deflation. The jury is still out on whether shale drilling is likely to contaminate drinking water, but there is certainly a risk that it will end up being toxic for areas of the global financial system.

- By Curt Custard, head of global investment solutions at UBS Global Asset Management, and Simon Smiles, chief investment officer for ultra-high net worth at UBS Wealth Management.