The petrodollar is any U.S. dollar paid to oil-exporting countries in exchange for oil. The dollar is the preeminent global currency. As a result, most international transactions, including oil, are priced in dollars. Oil-exporting nations receive dollars for their exports, not their own currency.
In addition, most oil-exporting nations own their oil industries. That makes their national income dependent on the dollar’s value. If it falls, so does their government’s 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.
- The 1945 U.S.-Saudi agreement created the petrodollar.
- The purchasing power of a petrodollar relies on the value of the U.S. dollar.
- The shift from oil to other renewable energy sources could threaten the petrodollar.
The petrodollar system is tied to the history 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 in 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.1 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.2 To protect the remaining U.S. gold reserves, President Richard Nixon removed the dollar from the gold standard.
As a result, the value of the dollar plummeted.3 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.4 The cost of imports, denominated in other currencies, increased.
In 1973, Nixon asked Congress for military aid to Israel in the Yom Kippur War.5 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.6 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:7
- Norway Government Pension Fund Global–$1.187 trillion
- U.A.E. Abu Dhabi Investment Authority–$697 billion
- Kuwait Investment Authority–$534 billion
- Saudi Arabia SAMA–$494 billion
- Qatar Investment Authority–$328 billion
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 system.
For example, the United States sanctioned Iran for refusing to halt its development of potential nuclear weapons.8 Similarly, it hit Russia with trade embargoes for invading Crimea and creating a crisis in Ukraine.9
China called for a replacement of the U.S. dollar as a global currency.10 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.
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.
- U.S. Army Corps of Engineers. “Laying the Foundation: Roosevelt Meets with King Abdul Aziz,” Accessed April 7, 2020.
- Office of the Historian. “Nixon and the End of the Bretton Woods System, 1971-1973,” Accessed April 7, 2020.
- Bureau of Labor Statistics. “Consumer Price Index Database, All Urban Consumers,” Select “Top Picks,” Check “U.S. City Average, All Items,” Retrieve Data, Select “More Formatting Options,” Select “12-month Percent Change” and “Range between 1913 to present,” Retrieve Data. Accessed April 7, 2020.
- University of California, Berkeley. “1973-1974 Oil Crisis,” Accessed April 7, 2020.
- Israel Ministry of Foreign Affairs. “The Yom Kippur War (October 1973)” Accessed April 7, 2020.
- U.S. Government Accountability Office. “The U.S.-Saudi Arabian Joint Commission on Economic Cooperation,” Accessed April 7, 2020.
- SWFI. “Top 89 Largest Sovereign Wealth Fund Rankings by Total Assets,” Accessed April 7, 2020.
- Council on Foreign Relations. “International Sanctions on Iran,” Accessed April 7, 2020.
- NATO Review. “Sanctions After Crimea: Have They Worked?” Accessed April 7, 2020.
- Center for Strategic and International Studies. “Is China Ready to Challenge the Dollar?” Page 1. Accessed April 7, 2020.