The U.S. dollar is the currency most used to purchase oil. Because oil has such a high level of demand, some oil-exporting countries could build up so many dollars they cannot spend them all. These dollars were historically called petrodollars. The term petrodollar now refers to U.S. dollars used by any country to purchase oil from an oil-exporting country.
Learn more about petrodollars, how the term began, and the issues petrodollars present.
What Is the Petrodollar?
The U.S. dollar is the standard currency used to pay for oil globally, prompted by an agreement between the U.S. and Saudi Arabia in 1945. This agreement led to other oil-exporting countries accepting the dollar as payment for oil, and the relationship between the dollar and oil began.
Some countries exported so much oil and accumulated such large amounts of U.S. dollars that they couldn't spend them all. If the country accepting U.S. dollars as payment can't spend them all, they are effectually removed from circulation. The dollars these countries could not spend came to be known as petrodollars.
History of the Petrodollar
The petrodollar came into existence following the elimination of the gold standard. After World War II, the United States held most of the world's supply of gold. It agreed to redeem any U.S. dollar for its value in gold if the other countries pegged their currencies to the dollar. Other countries signed onto this deal at the 1944 Bretton Woods conference. It established the U.S. dollar as the world's reserve currency.
On February 14, 1945, President Franklin D. Roosevelt initiated the alliance with Saudi Arabia. He met with Saudi King Abd al-Aziz. The United States built an airfield at Dhahran in return for military and business training. This alliance was so critical that it survived subsequent years of differences of opinion over the Arab-Israeli conflict.
The 1945 agreement between the United States and Saudi Arabia cemented the relationship between the dollar and oil. The petrodollar was born.
In 1971, U.S. stagflation prompted runs on the dollar. Many countries asked to redeem their U.S. dollars for gold. To protect the remaining U.S. gold reserves, President Richard Nixon removed the dollar from the gold standard.
As a result, the dollar's value plummeted, which helped the U.S. economy as its export values also decreased, making them more competitive. A falling dollar hurt oil-exporting countries because contracts were priced in U.S. dollars. Their oil revenues dropped along with the dollar. The cost of imports, denominated in other currencies, increased.
In 1973, Nixon asked Congress for military aid to Israel in the Yom Kippur War. The newly-formed Organization of the Petroleum Exporting Countries halted oil exports to the United States and other Israeli allies. The OPEC oil embargo quadrupled the price of oil in six months. Prices remained high even after the embargo ended.
In 1979, the United States and Saudi Arabia negotiated the United States-Saudi Arabian Joint Commission on Economic Cooperation. They agreed to use U.S. dollars for oil contracts. The U.S. dollars would be recycled back to America through contracts with U.S. companies. These companies improve Saudi infrastructure through technology transfer.
Oil-exporting countries use petrodollars to fund domestic consumption.
That increases imports, provides higher wages for government employees and boosts the local economy.
The rest is used to improve the nations' finances. They recycle their petrodollars through sovereign wealth funds. They use these funds to invest in non-oil-related businesses. The profits from these businesses make them less dependent on oil prices. Here are the world's five largest petrodollar recyclers ranked by assets:
- Norway Government Pension Fund Global—$1.34 trillion
- China Investment Corporation—$1.2 trillion
- Kuwait Investment Authority—$ 738 billion
- Abu Dhabi Investment Authority—$709 billion
- GIC Private Limited—$690 billion
Can the Petrodollar Collapse?
The United States uses the power of petrodollars to enforce its foreign policy. But many countries don’t fight back. They are afraid it would mean the collapse of the petrodollar system.
For example, the United States sanctioned Iran for refusing to halt its development of potential nuclear weapons. Similarly, it hit Russia with trade embargoes for invading Crimea and creating a crisis in Ukraine.
The effects a shift to renewable energy will have on the U.S. are unknown, although there is concern about the change in some circles.
China called for a replacement of the U.S. dollar as a global currency. Ironically, it is one of the largest foreign holders of the dollar. China influences the U.S. dollar by pegging its currency, the yuan, to it.
Will these rogue attacks cause a dollar collapse? No, at least not for the near future. That is because there is no alternative. The dollar is likely to remain the global currency because of its stability even as nations limit greenhouse gas emissions to fight global warming. The shift to electric vehicles and solar or wind power generation threatens oil-producing nations' economies, but it is unlikely that the dollar will lose its status as the dominant world currency.
- A petrodollar is a U.S. dollar paid to an oil-exporting country that cannot be spent on imports for that country.
- The 1945 U.S.-Saudi agreement created the petrodollar.
- The purchasing power of a petrodollar relies on the value of the U.S. dollar.