Introduction to the Petrodollar and How Its Changes Could Impact Financial Markets

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KEY POINTS

1. The petrodollar refers to the agreement, born in 1973, between the United States and the oil producing countries of the Middle East -- collectively referred to as OPEC -- to denominate their international oil transactions in US dollars.

2. Furthermore, the OPEC countries would take the surplus dollars they've acquired via oil exports and invest them in US Treasuries.

3. Denominating transactions in US dollars, and recycling dollars into US Treasury bonds, created ongoing demand for US dollars. This was meant to replace the demand for US dollars that was lost when the US abandoned the peg from the dollar to gold. Creating the petrodollar thus re-stabilized the dollar as the world reserve currency, and allowed the US economy to continue functioning as an import-driven economy focused heavily on financial services (i.e. selling US Treasury bonds and related financial assets).

4. In exchange for OPEC nations agreeing to denominate in dollars and recycle into US Treasuries, the US agreed to provide military support to OPEC nations.

5. Over the years, political leaders that have threatened to denominate oil transactions in other currencies have faced US military intervention; the two most notable examples include Saddam Hussein of Iraq and Omar Gaddafi of Libya.

6. In recent years, China has become a major oil importer, and Russia has become a major oil exporter. As oil exports have increasingly occurred outside of OPEC nations, oil transactions have increasingly escaped the petrodollar agreement, and have been priced in yuan. Thus, the petrodollar is increasingly being displaced by the petroyuan.

7. Moreover, the decline in oil prices has resulted in fewer dollars available for OPEC nations to recycle into US Treasuries.

8. Is the petrodollar system dying? If so, will it result in a long-term devaluation in the US dollar? Will the long-term trend of a falling US dollar/Chinese yuan exchange rate continue? Will the US transition from being import-driven and financialized to becoming more export-oriented and with a focus on other industries? These are questions being asked by those who think a major transition away from the petrodollar is in progress.

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