What is Petrodollar?

Petrodollars are simply US dollars that have been used to purchase crude oil. The term petrodollar should be considered as a system rather than a distinct currency. The petrodollar system has seen oil exporting countries predominantly accepting payments in US dollars, essentially earning petrodollars. The US dollar is the most powerful and widely used currency in the world. As such, for many oil exporting countries, receiving payments in US dollars is very convenient.

The term ‘petrodollar’ gained notoriety in the 1970s when the oil crisis saw the prices of the commodity increase sharply. At the time, most oil exporting countries depended on petrodollars to finance their budgets, and suddenly, they had huge budget surpluses. But the origin of petrodollars goes a little way back.

In the early 20th century, most countries around the world used the gold standard; which meant that their currencies were backed by their gold reserves. Following the end of World War II, the US held most of the global supply of this precious metal. At a Bretton Woods conference in 1945, many countries agreed to peg their currencies to the US dollar instead of the unstable gold commodity. That same year, the petrodollar was born when Saudi Arabia struck an agreement with the US to accept US dollars as the sole payment currency for their oil in exchange for military and business training. The Bretton Woods system was abandoned in the 1970s, but by that time, the US dollar had cemented its status as the most dominant currency in the world.

Petrodollar Recycling

Recycling is essentially a process of converting ‘waste’ into useful products. It is absurd to say that any petrodollar is a waste, but over time, oil exporting countries literally accumulated US dollars in amounts that they could not use fast enough. This ‘excess’ needed to be recycled back into the world economy so that it could be useful.

In this case, usefulness means that it can generate interest so that it does not diminish away due to inflation. One of the earliest forms of petrodollar recycling was a deal between the US and Saudi Arabia that allowed the oil-producing country to invest their petrodollars in US treasuries.

Many oil-producing countries have established sovereign wealth funds that are in charge of recycling their petrodollars. These funds have been invested in various financial instruments around the world such as treasuries and stocks. The petrodollar system has had a massive impact on the global financial markets. To start with, it has created a huge demand for US dollars throughout the world. As a result, the US dollar has become too entrenched in global trade and investment. This has also fueled the demand for dollar-denominated investments. For instance, in the forex markets, it is estimated that the US dollar-based pairs control over 80% of daily trading volumes.

The Petrodollar Collapse?

It is evident that the US dollar has dominated the petrocurrency scene, but in recent years, it has faced challenges. To start with, many oil-producing nations are concerned about being overly dependent on the petrodollar. This is because the United States has exploited the petrodollar system to assert its dominance in foreign policy.

The implications of US sanctions on countries, such as Iran and Venezuela, have provided clues on why this overreliance can be very dangerous. Already, some oil-producing countries have started selling their oil in their local currencies. In 2007, the Dubai Mercantile Exchange (DME) was instituted with the primary goal of providing an alternative benchmark for oil price denomination. The intention was clear, but the impact on the petrodollar was not really significant.

However, the biggest threat to the petrodollar is the potential of the petroyuan.

In early 2018, the Shanghai International Energy Exchange was instituted, marking the birth of the petroyuan. The exchange has increasingly gotten favour from countries that are favouring the de-dollarisation of the oil markets. Such countries include Venezuela, Russia, North Korea, and Iran. These are examples of countries that have been on the wrong end of US sanctions.

Other countries such as Iraq, Syria, Libya, and Yemen have also witnessed how US political interference can destabilise them and probably will not mind being ‘rescued’ from the dollar. As a country, China has famously adopted a foreign policy of political non-interference, something that will appeal to some oil-producing countries.

A recent case of US sanctions has been on Russia in 2022. The country has been in military conflict with Ukraine, and after a series of US sanctions, Russia has deepened its relations with China. Russia is a major supplier of oil within Europe and has already started receiving payments in its local currency for the commodity.

Russia-China relations also give the petroyuan impetus in its quest to fight the petrodollar. Already, Saudi Arabia has indicated that it is willing to price at least a small portion of its oil in currencies other than the US dollar. Saudi Arabia has been a major US ally, but it recently started buying arms from Russia. This does not bode well with the future of the petrodollar because Saudi Arabia’s de-dollarisation can only encourage other oil-producing nations to ‘free themselves’ from the US dollar.

Petrodollar’s Impact

The petrodollar system has propelled the US dollar to be the most dominant currency in the global economy. Oil is the most important commodity in the international markets, and this has made the United States automatically become the most decisive player in the global economy. It has allowed the country to consistently run trade deficits as well as have a high inflow of investment capital through petrodollar recycling. The US can also finance its budget deficits using low-interest financial instruments, and so the importance of the petrodollar to the US is obvious.

But deficits also come with some challenges. The global economy is constantly growing, which essentially means that the country must run deficits to prevent any potential slowdowns. However, running deficits also pose the threat of a potentially weaker US dollar.

Final Word

The petrodollar system has been very dominant in the international oil markets and has consequently led to a strong and influential US dollar. However, its future also hinges on the nature of relations that the US has with major oil producers such as Russia and Saudi Arabia, as well as major consumers such as China.

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  • What is the petrodollar?

    Petrodollars are US dollars used to purchase crude oil.

  • What is petrodollar recycling?

    Petrodollar recycling is the investment of surplus petrodollars around the world by oil-producing countries.