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The Petrodollar system, oil and geopolitical power

The Petrodollar system, Oil and geopolitical power

“Control oil and you control nations; control food and you control the people.”

Henry Kissinger

Most aircraft carriers, military vehicles and food-producing tractors have one thing in common. They all run on oil. Which is why the control of oil has always been at the epicenter of political world dominance. And perhaps no other event better symbolizes this than the creation of the Petrodollar system, in 1973.

Introduction

I’ve recently started to investigate how oil prices affects the economy at large, and the History behind oil as an energy source. Because ever since oil was first discovered as a valuable energy source, this “Black Gold” has been at the center of attention for the human race, and the engine of the World economy.

Oil has been the engine of the world economy for a long time. In the picture is an early Oil well.

New events to the same old game

The recent fall in oil prices have sparked speculations about the energy games, that are played by nations over oil, again. And these power struggles have shown how important this black liquid still is for our civilization.

The oil game is an old game. Oil prospectors and wildcatters have given their lives for this dark liquid, since time immemorial. It has been, and still is, the reason for countless wars and international games of power. But also for the great things that are the foundation of our civilization. Like cars, aviation, food surpluses and modern infrastructure.

An understanding of how oil affects the world is important to gain a deeper understanding of all markets. Especially for traders that are taking macroeconomic bets. The History of oil, as a geopolitical power tool, is an interesting one, if you are interested in that kind of stuff. As I am.

Background

The economic system that was created at the end of World War II is known as the Bretton Woods system. It was created in 1944 and was a Gold backed system, relying on the U.S Dollar as the global reserve currency of the world. The Dollar was pegged to Gold in this system, at a fixed rate. Other nations got a sense of financial security, in pegging their currencies to the Dollar, since the Dollar was convertible into Gold. Moreover, this created a demand for Dollars globally, which elevated the Dollar into reserve currency status.

The Dollar was a new and refreshing reserve currency at the time, which replaced the british pound, as the global reserve currency. The pound had reigned supreme before this. But Britain was now a war torn country and was not fit for world reserve currency status any longer. Further, America had acquired most of the world’s Gold, during the war, since it was the major lender to the warring countries of Europe.

He who has the Gold makes the rules

An old quote goes “He who holds the Gold makes the rules.” And since most of the world’s Gold ended up in American hands after the second World War, America made the rules when Bretton Woods was created. The Dollar became the reserve currency of the World, exchangeable for Gold, and the World became dependent on the United States for its growth.

The collapse of Bretton Woods

Later in the 1970s, after about 25 years in existence, the Bretton Woods system collapsed. The reason was that the United states was waging a war in Vietnam, which led to large deficits, debts, spending and inflation. And this led the other member nations to start to doubt the Bretton Woods agreement, and the robustness of the U.S. economy. But what was most concerning to the member states was that the U.S. Gold reserves in relation to debt levels were increasing at a rapid rate.

Since the agreement meant that member-countries could exchange their dollars for Gold, this started to happen at a rapid scale. And this made the U.S. Gold reserves lower and lower. Eventually this led the Nixon administration to abandon the Gold backed Bretton Woods system, in 1971. Which was when they finally removed the Gold convertibility of Dollars.

The Bretton Woods agreement was made for stability. But ironically it failed because its leader nation needed to spend money on war.

American leadership feared that the lost demand for U.S. Dollars globally would lead to a free fall of its currency and diminished power for the United States. The fear was that demand was going to evaporate without the linkage to Gold. They needed a new plan to keep their status, as the leader nation of the free World.

Enter the Petrodollar

To avoid a free fall inflation and collapse of the U.S. Dollar the American leadership created a new economic system. This agreement was negotiated between the Saudi royal family and the United States, led by Henry Kissinger.

To keep their global hegemony, after the collapse of Bretton Woods, the United States, heavily influenced by its geopolitical mastermind, Henry Kissinger, who was the National security advisor at the time, struck a deal with Saudi-Arabia in, 1973. This agreement created a system, which came to be known as the Petrodollar system.

Ingeniously brilliant

The Petrodollar system was brilliantly devised from a geopolitical standpoint. In this deal the administration managed to standardize the selling of oil into U.S. dollars. This meant that for every barrel of oil, that was purchased from the Saudis, it would be denominated and sold in exchange for U.S dollars. Hence, the United States managed to keep up global demand for dollars, since countries needed to pay for their imported oil with Dollars.

How it works

Without oil nations cannot fuel their economies, which is why oil is sometimes called “the engine of the world economy”. Everything runs on oil. Tractors, cars, you name it. Oil is easy to store and it can be used at any time of the day, in contrast to many other energy sources.

Simply put, a Petrodollar is a U.S. Dollar that is received by an oil producer, in exchange for selling oil, to another country.

The Petrodollar system is complex and the easiest way to think about it might be illustrated by an example:

If a country wants to buy oil from Saudi-Arabia let’s say, it has to exchange their own currency into U.S dollars first, to pay for that oil. And since the Saudis only accepts Dollars in exchange for oil it has to be exchanged for Dollars, and Dollars only.

This system creates a global demand for Dollars, because oil importing countries needs them as reserves, to pay for their oil-imports. The “Petrodollars” that ends up in circulation, received for the oil sales, then gets used to buy dollar denominated investments, from the United States. In exchange the Saudis gets U.S military protection of their oil fields, borders and protection from the United State’s ally, Israel.

Reigning in their power

A few years after the deal, by 1975, all OPEC nations had agreed to sell their oil for U.S dollars. Because as Kissinger and the american leadership had foreseen, the deal was mutually beneficial, which led other states to join the system as well.

The printing press advantage

Printing money is a convenient solution for all governments that wants to be viewed positively, in the short term, by its own population, but at the same time wants to increase their spending. Because inflation is not an obvious tax, as for example an announced tax raise would be. The Petrodollar system lets the U.S. government print excessive amounts of its own currency, compared to other countries, that cannot inflate as much, without bearing the negative consequences. This is possible because the Dollar is the reserve currency of the World.

The bureau of engraving and printing produces Federal reserve notes, also known as paper money, or physical Dollars, for the Federal Reserve. – Image by PublicDomainPictures from Pixabay

This system is good for the american currency, and inhibits inflation inside the United States. Because the United States can export its inflation to other nations that are in need of U.S. Dollars, to pay for their oil. This also promotes noninflationary growth within the United States.

Needless to say, this system creates an enormous power for the American central bank, the Federal reserve Bank, that prints the U.S. Dollars into existence. Also known as Fiat money, or Federal reserve notes.

Artificial demand

The U.S. government is in a better position to spend and create new money, than other nations. Because the increased demand for Dollars, in this system, makes its currency artificially strong. And since the demand for oil increases with rising population growth and industrialization around the world, the demand for U.S dollars has only become stronger, in the decades after 1973, and is still rising today.

Encouraging cheap exports

Another ingenious part of this agreement is that it encourages cheap exports, from exporting countries, to the United States. Because when a country is in need of Dollars, to pay for their oil, they have to obtain those Dollars in some way. And one way to do this is through the Foreign exchange market, or FOREX-market. But the best long term solution is to trade with the United States.

This encourages countries to export the goods that they produce, to the United States, in exchange for U.S. Dollars. Because they can then use those Dollars to purchase oil. This is one of the reasons why China, and much of Asia, has had an export based growth strategy, since the 1980s. Because they need Dollars to pay for their oil.


Higher living standard

This trade benefits the U.S. immensely. Because the producing countries are incentivized to exchange their Dollars cheaply, to the United States, to receive their much-needed Dollars. Further, this makes it possible for Americans to have a higher living standard, by increasing their purchasing power globally.

Buying oil with a reserve currency

This system lets the United States buy oil with an artificially strong currency, which it can print at will. It also creates a bigger market for the Dollar, since other countries need Dollars too. Let’s take an example to make this easier to understand.

A currency works like a business

Apple is profitable because it is a successful multinational company, operating in several countries, and not only in the United States. This creates an enormous market and a bigger demand for Apple products. It means that Apple can put out a bigger amount of supply, of Apple-products, on the market, because of the high demand. A currency works the same way.

If Apple were to get a competitor it would then have to buy out that competitor, crush the competitor in some way, or make them disappear by outcompeting them. If not, they would lose market share and profits. The same is true of the Dollar. If nobody wants Dollars all of a sudden, because a strong competitor has arisen on the scene, then only the American people would be left to hold those U.S. Dollars. The demand would then evaporate. The Federal Reserve would not be able to create as many Dollars, in that environment, without creating inflation. Also, those Dollars would buy a lot less goods globally, because of the lost demand.

Petrodollar recycling

Another benefit, that is often overlooked in this system, is that the Saudis agreed to invest their surplus from oil sales, into U.S. debt. This means that they lend money to the United States government. The increased demand for U.S. Debt securities leads to an even stronger U.S. Dollar. Because the more demand it is for a product, the better it is for the producer of that product, namely the United States government. Because the creator of a product, the Federal Reserve in this case, can then exchange that for other things more cheaply.

The reinvested surpluses from the Saudi oil sales is the “Recycling” part of this system. For example, the Oil producers often buy Treasury bills, for their surplus Dollars, and this part is the most beneficial part of the recycling, for the United States. Because the buying of Treasury bills provides liquidity to the U.S. financial markets and keeps interest rates low in the United States.

These funds are then deposited into Western banks, through the recycling. The benefits to oil producers is that they avoid currency risks and it gives them the opportunity to invest in U.S assets in a smooth way. The term “Petrodollar recycling” was coined by Henry Kissinger.

Buying cheap oil

Another benefit is that the U.S can buy oil directly with Dollars. A currency that it can print at will. That means that the United States, in contrast to other nations, can buy oil with money it creates out of thin air, without any extreme inflation taking place as a result. In that regard, the United States truly has a printing press.

Despite vast amounts of money printing the Dollar is still the reserve currency of the World, and the go to asset in times of economic crisis, like the one we are in right now. The crisis is currently strengthening the U.S. Dollar in 2020. Here is a weekly chart of the Dollar Index, spanning more than three decades. The trend is up and getting stronger. – Chart from TradingView

Israel

Another often overlooked part of the Petrodollar agreement is that America promises the producing countries protection from one of its closest allies, Israel. This ensures a good relationship with the oil producers, which is of course beneficial to the United States.

Giving the United States superpower status

The United States was already the leading global power before the Petrodollar deal. But the agreement really launched it into superpower status. Because the system gave it many benefits. The ingenious part of this deal was that Kissinger and the administration foresaw that other countries would want in on the deal, after seeing how it benefited Saudi-Arabia. And by 1975 all OPEC nations had joined the system and the United States now gets these benefits on a global scale because of that.

Conclusion

We can conclude that maintaining the Petrodollar system is of the utmost importance to the United States. And that leads us to another important subject regarding this system. American foreign policy, which I will research in part two of this article. In part two I will go deeper into Petrodollar warfare and the future of the Petrodollar system.

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