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The Petrodollar

The Petrodollar system, Oil and geopolitical power – Part II

The creation of the Petrodollar system in 1973 was propelled by the elevation of the United States into superpower status. Which takes us to the next subject surrounding this system. The weakening of the system, Petrodollar warfare and the American foreign policy in the Middle East.

Energy and the financial system

The relationship between energy, power and the economy is as old as human civilization. And the Petrodollar system is a good example of this. Because it might arguably be the most important factor behind U.S. foreign policy in the Middle East, in the last few decades. Theory holds that the United States needs to maintain this “Oil for Dollars” agreement, because a lot of its power lies in its ability to export Dollar based inflation outside of its borders.

Maintaining reserve currency status

What leads countries to keep reserves of a currency is that the country, that produces that currency, export goods that the other countries wants to buy. Therefore, they will have to buy those goods from that country, in that country’s currency. And therefore, they need to keep reserves of that country’s currency. But this is where the Petrodollar system differs. Because exports from the United States are not necessary to maintain the status of the Dollar as a reserve currency.

The Petrodollar system is such an ingenious system because the U.S. don’t have to export any Oil themselves. Because the demand for Dollars is created by the sale of that commodity, by another country. Not through american exports. Therefore, the Oil does not have to be sold by American companies, to foreign countries. Not if the member countries use Dollars when trading amongst themselves.

Replacing yellow Gold with black Gold

The ingenious part of the system is to replace Gold with Oil. Because Oil is the engine of the world economy, which keeps the economy going. All countries need Oil, which means that they are also in need of Dollars. At least for as long as America can ensure that Oil is sold in Dollars. Which leads us so to the next subject of this discussion, Petrodollar warfare.

Petrodollar warfare

This is the conspiracy part, that surrounds the Petrodollar system. Because every time a country sells Oil, in exchange for another currency, than the U.S. Dollar, they seem to end up on a bad footing with the United States. For example, when Iraq started to sell Oil in Euros, instead of Dollars in 2000, America was suddenly threatened by its “weapons of mass destruction”. In 2003, after they had invaded Iraq, America actually re-established the Oil for Dollar standard in Iraq. A coincidence perhaps. Or not.

Another example is Iran. Iran announced that it would no longer settle Oil trades in U.S. Dollars, around 2012. After this announcement they were hit by sanctions by the United States because of their “plans to create weapons of mass destruction”. There are several other examples. But were they all coincidences? It is impossible to know if there is any truth to these theories. But it sure is interesting to speculate. And one thing is for certain. If the Petrodollar system works like the conspiracy theorists say it does, it is a very smart system, that would probably warrant protection from its benefitor nations.

The United States don’t have to do any exporting, because of how the Petrodollar agreement works. Because the important part is that the currency is used in transactions. For example, Saudi Arabia sells Oil for Dollars, even though the United States don’t produce that Oil. – Image by Welcome to all and thank you for your visit ! ツ from Pixabay

The dilemma of the Petrodollar

The United states needs to run large deficits in an ever-increasing global economy to fulfill its global reserve currency requirements. If the U.S. stops to run these deficits the world could fall into a recession, since those Dollars are needed globally. But if these deficits continues in eternity it might eventually lead other countries to start to lose confidence in the U.S. dollar. Because it is continually printed on a large scale, and it might then ironically lose its status as a reserve currency, because countries lose confidence in it. This dilemma is called the “Triffin dilemma”.

Post Petrodollar system – Massive inflation?

Critics argue that this system is unsustainable. They argue that it has led to a distorted demand for U.S. government debt. And this has enabled the U.S. to maintain artificially low interest rates. Many argue that the end of the Petrodollar system could lead to massive inflation within the United States.

When more and more countries stop using the U.S dollar as the preferred payment system, in exchange for Oil, those dollars might be coming home to roost. Because they have to circulate back into the U.S. economy at that point. And this could lead to massive inflation within the United States. Which is another reason why the United States wants to preserve this system. To avoid massive inflation.

New players on the block

Several countries have questioned, and moved away, from this system in recent years, thinking that the U.S. might not be as strong as it used to be in its most dominant phase from the 1950s, up until the 1980s. For example, Russia, North Korea, Syria and Venezuela. China, India and Russia have all used their own currencies to pay for, and sell Oil.

The countries above all have one thing in common: they don’t seem to be best friends with the United States at the moment. And for a long time it has been looking like more and more countries are abandoning the Dollar for other currencies. For example, the Chinese Yuan, even though it is still a small player. But the United States should not be written off completely from this geopolitical power game. Because it might have found a new ace in its sleeve.

The shale revolution

Back in 2000 the Unites States was dependent on imports for much of its Oil supply. This made the country vulnerable to a high Oil price and to changes in the power balance of energy globally. But the high price of Oil along with better technology, in the late 2000s, led to the profitability of an old extracting technique, known as “Fracking”. And these hydraulically fractured wells has propelled an Oil boom within the United States.

The shale boom within the United States, and the rise of fracking, has radically altered the power balance of Oil once more, in the last twelve years or so. Because the United States is now a net exporter of Oil again. The U.S. is not as vulnerable to being cut off from Oil supplies anymore and a higher Oil price is mostly seen as a net positive.

Transitioning away from the Petrodollar

The hope is that since the United States has become a major exporter of Oil, for the first time in 60 years, it might be able to transition away from the Petrodollar system in a smoother way. The hope is that exports of Oil and gas could replace the capital inflows that are received by the Saudi, and OPEC, purchases of U.S. assets. Thereby it might be able to keep up demand for the U.S. Dollar, and keep liquidity in the U.S. capital markets.

Therefore, the shale boom ensures self-sustaining energy security. But it could also replace the demand for Dollars, that are supplied by the current Petrodollar system. The only issue for the United States is that shale Oil is capital intensive and expensive, and reliant on a high Oil price. Which shows the complexity of the oil space. The recent oil war, that is ongoing when I write this in 2020, and the drop in Oil prices is going to be bad for frackers and shale-companies in the United States. What that will bring about long term remains to be seen.

Before the United States became a leading shale Oil producer a high Oil price was generally considered a negative for its economy. Because it raises costs for transport companies and manufacturers. But the high price in the last two decades has led to a shale boom in the country. And today the United States is a leading Oil producer and a net exporter of Oil, and its Shale industry booms when the Oil price goes soaring higher. Which has given it renewed strength in the power struggles over Oil. The current downtrend in Oil is going to hurt U.S. Shale. – Chart from TradingView

Recent changes in the global Petrodollar agreement

As previously mentioned countries have been moving away from the Petrodollar agreement in the last two decades. Most recently in 2019, Saudi-Arabia threatened to abandon the system if the United States went ahead with its NOPEC bill. The NOPEC-bill would supposedly allow the U.S. to pursue antitrust against OPEC if they manipulated Oil prices.

Other countries have been making similar threats in recent years. The changing geopolitics of the Oil markets might lead to an end to the Petrodollar standard in the long to medium term. But only time will tell when this happens. Moreover, the United States is not likely to give the system up without a fight.

Critique against the Petrodollar theory

There are people who argue that the “Petrodollar system” and “Petrodollar warfare” hypothesis are conspiracy theories and just fantasies. According to these critics, the origins of the Petrodollar-theory is very different. They argue that the elevation of the Dollar as a reserve currency happened because the U.S had to avoid negative effects, in its balance of payments in the 1970s. Because of the increasingly high Oil price.

According to this narrative the United States was worried that it might have to pay for Oil with vast sums of foreign currency. Therefore, it had to secure that it could always buy Oil with Dollars, which it accomplished through a deal with Saudi-Arabia. This deal had the Saudis accumulate large reserves of Dollars and investing them back into the U.S. economy.

According to this school of thought, the reason for the Dollar’s rise to reserve currency status took place because of the investment potential, strength, liquidity and dynamism of the U.S. economy. Having large piles of Dollars also lowered exchange rates for Oil producing countries.

What to think?

Regardless of whether this theory is correct, or if the more commonly held belief of the Petrodollar system is correct, or if it is a combination of the two, it has resulted in the hegemony of the United States and the Dollar as the global reserve currency. The United States is the World’s leading superpower, and it has benefited immensely from its reserve currency status. Therefore, it is only logical that it would want to protect this system. Moreover, competitors to the United States likely want their own currencies to be the reserve currency, because of all the benefits.

The Saudi-Russian Oil war and the Corona virus

The recent Oil war, between Russia and Saudi-Arabia, has once more shone light on the extreme importance of Oil in regard to geopolitics. The full extent of the seriousness, regarding the Corona virus, was actually only fully understood after the oil war broke out. They are now interconnected. The slowdown of economic activity, resulting from the Corona virus, is going to decrease demand for Oil in the near to medium term future. And this could tank the price of Oil even lower.

Conclusion

In April 2020, when I write this, the World is in crisis, and only time will tell when this will end. What the long term effects will be on the Petrodollar system is shrouded in mystery. But one thing is for certain, the World will never be the same again.

The doomsdayers are saying that the U.S. Dollar is going to lose its reserve currency status, and that the United States is finished as a superpower. But what they forget is that the reserve currency is backed up by the military might of the most powerful military industrial complex in all of human History. And the last time the United States had its economic status seriously threatened it created the Petrodollar system. What it will do the next time remains to be seen.

Disclaimer: I am not an expert on the Petrodollar system and these articles should be read as entertainment, since I am studying geopolitics from a layman’s perspective and want to learn more about it. All information found on this site, ideas, opinions, predictions, commentaries are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. While the information provided is believed to be accurate, it may include errors or inaccuracies. I will not and cannot be held accountable for any actions you take as a result of what you read in here. Use the information at your own risk. I am not your investment advisor. Consult a licensed financial advisor before making any investment decisions.

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