The Petrodollar System

To explain this situation properly, we have to start in 1973. That’s when .President Nixon asked King Faisal of Saudi Arabia to accept only US dollars as payment for oil and to invest any excess profits in US Treasury bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi Arabian oil fields from the Soviet Union and other interested nations, such as Iran and Iraq. It was the start of something great for the US, even if the outcome was as artificial as the US real-estate bubble and yet constitutes the foundation for the valuation of the US dollar.

By 1975, all of the members of OPEC agreed to sell their oil only in US dollars. Every oil-importing nation in the world started saving its surplus in US dollars so as to be able to buy oil; with such high demand for dollars the currency strengthened. On top of that, many oil-exporting nations like Saudi Arabia spent their US dollar surpluses on Treasury securities, providing a new, deep pool of lenders to support US government spending.

The “petrodollar” system was a brilliant political and economic move. It forced the world’s oil money to flow through the US Federal Reserve, creating ever-growing international demand for both US dollars and US debt, while essentially letting the US pretty much own the world’s oil for free, since oil’s value is denominated in a currency that America controls and prints. The petrodollar system spread beyond oil: the majority of international trade is done in US dollars. That means that from Russia to China, Brazil to South Korea, every country aims to maximize the US-dollar surplus garnered from its export trade to buy oil.

The US has reaped many rewards. As oil usage increased in the 1980s, demand for the US dollar rose with it, lifting the US economy to new heights. But even without economic success at home the US dollar would have soared, because the petrodollar system created consistent international demand for US dollars, which in turn gained in value. A strong US dollar allowed Americans to buy imported goods at a massive discount – the petrodollar system essentially creating a subsidy for US consumers at the expense of the rest of the world. Here, finally, the US hit on a downside: The availability of cheap imports hit the US manufacturing industry hard, and the disappearance of manufacturing jobs remains one of the biggest challenges in resurrecting the US economy today.

There is another downside, a potential threat now lurking in the shadows. The value of the US dollar is determined in large part by the fact that oil is sold in US dollars. If that trade shifts to a different currency, countries around the world won’t need all their US money. The resulting sell-off of US dollars would weaken the currency dramatically.

So here’s an interesting thought experiment. Everybody says the US goes to war to protect its oil supplies, but doesn’t it really go to war to ensure the continuation of the petrodollar system?

The Iraq war provides a good example. Until November 2000, no OPEC country had dared to violate the US dollar-pricing rule, and while the US dollar remained the strongest currency in the world there was also little reason to challenge the system. But in late 2000, France and a few other EU members convinced Saddam Hussein to defy the petrodollar process and sell Iraq’s oil for food in euros, not dollars. In the time between then and the March 2003 American invasion of Iraq, several other nations hinted at their interest in non-US dollar oil trading, including Russia, Iran, Indonesia, and even Venezuela. In April 2002, Iranian OPEC representative Javad Yarjani was invited to Spain by the EU to deliver a detailed analysis of how OPEC might at some point sell its oil to the EU for euros, not dollars.

This movement, founded in Iraq, was starting to threaten the dominance of the US dollar as the global reserve currency and petro currency. In March 2003, the US invaded Iraq, ending the oil-for-food program and its euro payment program.

There are many other historic examples of the US stepping in to halt a movement away from the petrodollar system, often in covert ways. In February 2011, Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF), called for a new world currency to challenge the dominance of the US dollar. Three months later a maid at the Sofitel New York Hotel alleged that Strauss-Kahn sexually assaulted her. Strauss-Kahn was forced out of his role at the IMF within weeks; he has since been cleared of any wrongdoing.

War and insidious interventions of this sort may be costly, but the costs of not protecting the petrodollar system would be far higher. If euros, yen, renminbi, rubles, or for that matter straight gold, were generally accepted for oil, the US dollar would quickly become irrelevant, rendering the currency almost worthless. As the rest of the world realizes that there are other options besides the US dollar for global transactions, the US is facing a very significant – and very messy – transition in the global oil machine.