Petrodollar: System, History, How It Recycles, Will It Collapse?

Will the Petrodollar Collapse?

petrodollars
The U.S. dollar owes much of its power to its role as a petrodollar. Photo: Comstock/Getty Images

Definition: The petrodollar is any U.S. dollar paid to oil-exporting countries in exchange for oil. Since the dollar is a global currency, all international transactions are priced in dollars. As a result, oil-exporting nations must receive dollars. That makes their national income dependent on the dollar's value. If it falls, so does the government's revenue.

As a result, most of America's trade partners also peg their currencies to the dollar.

That way, if the dollar falls, so does the price of all their domestic goods and services. That helps these countries avoid wide swings in inflation or deflation.

The Coming Collapse of the Petrodollar?

The United States uses the power of the petrodollar to enforce its foreign policy. When countries fight back, many worry that it means the collapse of the petrodollar.

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. As a result, these countries signed a five-year trade deal with each other that's worth $20 billion. Critically, it's not priced in dollars, and it includes the sale of Iran's oil. (Source: "Petrodollar Under Threat," Zero Hedge, August 6, 2014.)

Venezuela and Iran also signed oil contracts in their currencies instead of petrodollars.

China called for a replacement of the U.S. dollar as a global currency. Ironically, it's one of the largest foreign holders of the dollar. For more, see How Does China Influence the U.S. Dollar?

Will these rogue attacks on the dollar cause a collapse? No, at least not for the near future. That's because there is no good alternative.

The euro is the second-most circulated currency. It's undergone attack from within, thanks to the eurozone crisis

Petrodollar System

The petrodollar system originated at the 1944 Bretton Woods conference. After World War II, the United States held most of the world's supply of gold. It agreed to redeem any U.S. dollars for its value in gold if all other countries pegged their currencies to the dollar. That established the dollar as the world's reserve currency.  

On February 14, 1945, President Roosevelt met with Saudi King Abd al-Aziz to formalize an alliance. The U.S. built an airfield at Dhahran in return for military and business training. The alliance survived differences of opinion over the Arab-Israeli conflict. 

It would take another global agreement to replace the dollar with something else. For more, see Will the U.S. Dollar Collapse?

In 1971, U.S. stagflation prompted the United Kingdom to redeem most of its U.S. dollars for gold. President Nixon took the dollar off the gold standard to protect the remaining gold reserves. As a result, the value of the dollar plummeted. For more, see History of the Gold Standard.

That hurt OPEC countries whose oil contracts were priced in U.S. dollars.

Their oil revenue dropped along with the dollar. The cost of imports, denominated in other currencies, increased. (Source: "1973-1974 Oil Crisis," University of California, Berkeley)

In 1973, Nixon asked Congress for military aid to Israel in the Yom Kippur War. OPEC 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. (Source: "Yom Kippur War," History.com)

Petrodollar Recycling

The United States and Saudi Arabia negotiated the United States-Saudi Arabian Joint Commission on Economic Cooperation. They resumed their agreement to use the U.S. dollar to pay for oil contracts. The dollars would be recycled back to America through contracts with U.S. contractors. (Source: "Saudi Arabia: Background and U.S. Relations," Congressional Research Service, December 16, 2009.)

Oil-exporting countries have become more sophisticated since then. They now recycle their petrodollars through sovereign wealth funds. They use these funds to invest into non-oil related businesses. The profits from these businesses make them less dependent on oil prices.  Here are the world's largest petrodollar recyclers ranked by assets in 2016:

  1. Norway Government Pension Fund --$922.11.
  2. U.A.E. Abu Dhabi Investment Authority--$828 billion.
  3. Kuwait Investment Authority--$524 billion.
  4. Saudi Arabia SAMA--$514 billion.
  5. Qatar Investment Authority--$342 billion. 
  6. Saudi Arabia Public Investment Fund--$183 billion.
  7. UAE Abu Dhabi Mubadala Investment Company--$125 billion.
  8. UAE Abu Dhabi Investment Council--$110 billion.
  9. National Development Fund of Iran--$91 billion.
  10. Russia National Welfare Fund--$72.2 billion.
  11. Libyan Investment Authority--$66 billion.
  12. Kazakhstan National Fund--$64.7 billion.
  13. Kazakhstan Samruk-Kazyna JSC--$60.9 billion.
  14. Alaska Permanent Fund--$54.8 billion.
  15. Brunei Investment Agency--$40 billion.
  16. Texas Permanent School Fund--$37.7 billion.
  17. UAE Emirates Investment Authority--$34 billion.
  18. Azerbaigan State Oil Fund--$33.1 billion. (Source: "Sovereign Wealth Fund Ranking," Sovereign Wealth Fund Institute.)

Where Do Petrodollars Go?

A 2006 U.S. Treasury Report indicated that increased oil prices generated an extra $1.3 trillion in revenue for OPEC countries since 1998. Oil revenue was spent on increased imports, higher wages for government employees, increasing reserves, and retiring debt. Oil producing countries used these funds to provide a cushion to fall back on. They learned from the 1998 recession when demand for oil fell and prices declined. These actions helped to lower volatility in their economies, and the global economy.

Some Dollars Can't Be Accounted For

Up to 70 percent of the $700 billion in OPEC's investable reserve funds couldn't be accounted for by the Bureau of International Settlements. The BIS only reported OPEC members, so that the non-OPEC funds were also unaccounted for. The Treasury said that oil exporting countries purchased about $270 million in U.S. securities. Based on other information, they suspected the unaccounted-for funds were invested in construction loans, regional stock markets, private equity funds and hedge funds. An unknown amount of funds could have been invested in U.S. assets through foreign intermediaries, and, therefore, untraceable.

Impact of Hidden Petrodollars

Hidden petrodollars increase global volatility due to the sheer amount of $400 billion. If it is in U.S. Treasuries, a withdrawal of that size could trigger both a decline in the dollar and higher interest rates. That probably will not happen, since the U.S. is also oil's best customer. (Source: "Petrodollars and Global Imbalances, Occasional Paper No. 1," Office of International Affairs, Department of the Treasury, February 2006.)