PETRODOLLARS

Updated 11/13/2016



The rise of the "petrodollar" is a little understood phenomena that plays a great role in the Middle East from the 1970s on, but also, in preventing the dollar from turning into worthless little bits of paper.

The PETRODOLLAR trading system requires all oil sales be transacted in US dollars,a system established in the early 1970s by Kissinger in an agreement with Saudi Arabia. It is believe that when Nixon took the dollar off the gold standard, he and Kissinger decided to tie the dollar to barrels of oil, instead.

By 1975, all of the oil-producing nations of OPEC had agreed to price their oil in dollars and to hold their surplus oil proceeds in U.S. government debt securities.
In exchange, oil producing countries would receive US weapons, military aid and other forms of protection. See this graph, with ''oil exporters'' in 4th position holding US debt:
http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

Most of the Middle East has aligned itself  militarily with the US. -- see this map of US military bases in the Middle East (note how Iran is surrounded).

http://www.aljazeera.com/indepth/interactive/2012/04/2012417131242767298.html


Countries wanting to purchase oil, have to purchase it in US dollars, either by exchanging a national currency at high bank charges, or by producing and exporting consumers items to the US. For example, Japan must convert its yen in US dollars to buy and import oil. Japan ships Hondas to the US, receives US dollars and uses that to buy oil.Thus, countries that don't want high exchange rate charges, are dependent on an export strategy to grow their economies. In addition, countries take their excess profits and invest in (buy up) US debt, thus every global oil transaction increases the demand for US dollars and the demand for US debt securities (bonds). This allows the US to print money to buy oil, at which point interest is occurred by the Federal Reserve, which increases US debt, which is purchased by other countries.

This allows the US to print money indefinitely without fear of having to pay debt or, to suffer hyper-inflation.
 

Some countries are not happy and want to transact oil transactions on their own or other currencies such as the Euro. China, Iran, Syria, N Korea  and Venezuela are among those countries. Saddam Hussein pegged the Iraqi dinar to the Euro just before the US 2003 invasion. Gaddafi of Libya planned a pan-African gold based currency, before his demise at the hands of a Western-supported insurgency.

Update: In November 2014, China signed an agreement with Qatar to begin direct currency swaps between the two nations using the Yuan. Update: February 2016:
Reuters has reported that Iran is requesting euros for all new and outstanding oil payments

To sum up:
The world today needs dollars to buy oil, global reserve currencies are mainly in dollars, and most countries peg their currency to the dollar and buy up US debt, therefore the US can print as many dollars as it wants. China however in 2012 has started to buy oil in its own currency. China wants to be Iran's number 1 oil client and pay with the Yuan currency. This is the type of move that may one day remove US monetary hegemony and its ties to the Middle East.Sanctions against Russia may be a shortsighted policy because it will force Russia to deal bilaterally with China and create their own petro financing system.

WHAT HAPPENS TO PETRODOLLARS?

I've always found in hard to research petrodollars...they are immured in secrecy. Last week, I received a paper from student Justin Alpert, that cleared up some of the history connected with this elusive albeit crucial form of currency. Here are some excerpts from Justin's paper:

The term “petrodollar” means quite simply a dollar that has been traded for oil. The “petrodollar standard” refers to the US dollar’s historical role as the currency of choice for virtually all oil producing nations around the world.No official deal to promote the petrodollar standard is known to have ever been formalized with the Organization of Oil Exporting Countries as a whole...The protection of the US military and favored access to US markets were the basic conditions offered by Washington to OPEC in return for their pledge to only accept US dollars in return for oil shipments. Larger OPEC nations like Iran (then ruled by the pro-western Shah of Iran) and Saudi Arabia were happy to oblige and the dollar became the only currency they would accept. Smaller producer states followed the lead of the larger producer states and the value of the US dollar as the world’s reserve currency was saved from free fall. The added benefit of locking out the Soviets and their allies to OPEC oil reserves was also considered an important consequence of the agreement. (Gokay 2005)

In 1972, President Nixon sought to quell the possibility of a run on US gold reserves by removing the gold standard from the dollar completely. Shortly after the US floated its currency on the market, other developed nations followed suit leaving “EXCHANGE RATES TO BE GOVERNED BY RULES OF GOOD CONDUCT to STANDARDIZE CURRENCY EXCHANGE” per the IPE glossary. (Gokay 2005) While this prevented a loss to US gold reserves, it angered OPEC oil producers who were unhappy that the so many of their holdings had just been devalued. Already angry about the US rearming of Israel after the six day war, they demanded that oil be priced in relation to gold and implemented an embargo in protest.

While the resulting embargo crippled the world oil supply, the situation also presented both the US and OPEC with an opportunity. (Clark 2005) Rather than risk losing monetary credibility by creating “fiat” currency, a formal agreement was brokered between the US and Saudi Arabia (this was known as the U.S.-Saudi Arabian Joint Economic Commission and reputedly brokered by Henry Kissinger) at the end of the 1973 OPEC Oil Crisis that would give the US dollar a vital new role in the world economy and would prevent its collapse. (Gokay 2005) However, the rise of globalization, the current US deficit crisis, and the loss of the USSR and the bipolar hegemonic system turned what once was a very useful system to the US into an economic albatross. [It should be noted that Iran has opened its own oil bourse, PW, Ed]. As our IPE glossary (obtainable by emailing philippa.winkler@nau.edu) points out, “LIBERALIZATION PROGRAMS HAVE SPREAD WITH GLOBALIZATION.” This principal gave rise to the euro, which is now the chief competitor to the US petrodollar as the world’s favored petro-currency. This has created unfavorable complications for the US as oil producers and consumers no longer need to sustain American debt to procure this vital commodity. However, even oil producing nations not aligned with the cartel tend to follow the petrodollar standard, e.g. Brazil, Mexico, Post-Soviet Russia, and the US of course(Johnson 2008)...

The question at hand is whether the US can sustain the petrodollar standard in a liberalized economic climate and if so, would it be worth it to anyone else? To put it another way, the question in the 1970’s was how many barrels of oil could a dollar buy? Today, the question is rapidly becoming how many dollars can a barrel of oil buy?

Clark, William R. Petrodollar Warfare: Oil, Iraq and the Future of the Dollar. Gabriola Island, B.C.: New Society, 2005

Gokay, Bulent. "The Beginning of the End of the Petrodollar: What Connects Iraq to Iran." Alternatives - Turkish Journal of International Relations Winter 4.4 (2005). Print.

Update April 20 2013. This really brilliant essay by Justin is further substantiated by the rise of the PetroYuan. Both Russia and Iran are trading oil for Yuan. Other countries are sure to follow. China is building up its blue water fleet to ensure protection of its sea lanes against Obama's Pacific military build up in the Pacific  (the so called Asia Pivot).
Update April 3 2015    A year later, and we may be sighting the end of the petrodollar.  In 2014, Russian President Putin announced a gas deal with China The 30-year deal states that every year, the Russians will deliver 1.3 trillion cubic feet (TCF) of gas to China.  It is  safe bet that income and expenses will not be in petrodollars.