Petrodollars and the System that Created It

Will the Petrodollar Collapse?

Dollar sign in oil
•••  Photo by Batareykin/Getty Images

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. Most of them own their oil industries. That makes their national income dependent on the dollar's value. If it falls, so does their revenue.

As a result, most of these oil exporters also peg their currencies to the dollar. That way, if the dollar’s value falls, so does the price of all their domestic goods and services. That helps these countries avoid wide swings in inflation or deflation.

Petrodollar System

The petrodollar system is tied to the history of the gold standard. The 1944 Bretton Woods conference established the U.S. dollar as the world's reserve currency. 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.

On February 14, 1945, President Franklin D. Roosevelt formalized an 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. It also cemented the relationship between the dollar and oil. The petrodollar was born. This alliance was so critical that it survived differences of opinion over the Arab-Israeli conflict. 

In 1971, U.S. stagflation prompted the United Kingdom to redeem most of its U.S. dollars for gold. President Nixon removed the dollar from the gold standard to protect the remaining U.S. gold reserves.

As a result, the value of the dollar plummeted. That 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 revenue 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.

Petrodollar Recycling

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 the U.S. companies. 

Since then, oil-exporting countries have become more sophisticated. They now 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 largest petrodollar recyclers ranked by assets

  1. Norway Government Pension Fund --$1.073 trillion.
  2. U.A.E. Abu Dhabi Investment Authority--$696 billion.
  3. Kuwait Investment Authority--$592 billion.
  4. Saudi Arabia SAMA--$494 billion.
  5. Qatar Investment Authority--$320 billion. 
  6. Saudi Arabia Public Investment Fund--$223.9 billion.
  7. UAE Abu Dhabi Mubadala Investment Company--$125 billion.
  8. UAE Abu Dhabi Investment Council--$123 billion.
  9. National Development Fund of Iran--$91 billion.
  10. Russia National Welfare Fund--$66.3 billion.
  11. Libyan Investment Authority--$66 billion.
  12. Alaska Permanent Fund--$61.5 billion.
  13. Kazakhstan Samruk-Kazyna JSC--$60.9 billion.
  14. Kazakhstan National Fund--$57.9 billion.
  15. Brunei Investment Agency--$40 billion.
  16. Texas Permanent School Fund--$37.7 billion.
  17. UAE Emirates Investment Authority--$34 billion.
  18. Azerbaijan State Oil Fund--$33.1 billion. 

Where 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. The oil-producing countries used these funds to provide a cushion to fall back on. They also learned from the recession of 1998 when demand for oil fell and prices declined. These actions helped to lower volatility in their economies and in the global economy.

Up to 70% of the $700 billion in OPEC's investable reserve funds could not be accounted for by the Bureau of International Settlements.

The BIS only reported OPEC members, so non-OPEC funds were unaccounted for. The Treasury said that oil exporting countries purchased about $270 million in U.S. securities. Based on other information, they suspected that 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, which are untraceable.

These hidden petrodollars increase global volatility. That’s due to their sheer size of $400 billion. If it is in U.S. Treasurys, a withdrawal of that size could trigger both a decline in the dollar and higher interest rates. That probably will not happen, since the United States is also one of OPEC's best oil customers. 

The Coming Collapse of the Petrodollar?

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.

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 is worth $20 billion. Critically, it is not priced in dollars, and it includes the sale of Iran's oil.

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 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 good alternative. The euro is the second-most circulated currency. It has undergone attack from within, thanks to the Eurozone crisis

But there is a threat to the petrodollar as the world shifts from oil to renewable energy.

Nations are limiting greenhouse gas emissions to fight global warming. As they shift to electric vehicles and solar or wind power generation, it threatens the profitability of oil-producing nations. The United States has lost its competitive edge in these technologies to China and the European Union. As a result, the petrodollar may lose its role as the world's dominant currency.