A “Petrodollar” is a U.S. Dollar obtained through the sale of crude oil, i.e. it’s a term created particularly to describe the situation of the OPEC countries, where the sale of this commodity allows these nations to prosper and reinvest its USD in the nations which purchase it. It’s one of those unofficial axioms over which the World’s energetical, geopolitical, financial and economic system.

Any change to this system by default will generate significant effects, not just in prices, but also at the geopolitical and economic level. Nevertheless, some dismiss these effects as a mere trifle, while others claim them to be cataclysmic. Probably the truth lies somewhere in between.

How to have debt and get away with it

Imagine this scenario: you are a very wealthy individual with many properties and prestige, but you really have no free money in your bank account (you spent it all). But you still want that new Ferrari. What to do? Well you could write a cheque. Yes, that cheque is worthless in nature (since you have no free money to back it) but so long as the car dealer doesn’t claim it, you don’t have to pay. In the meanwhile: you have a free Ferrari. The question is… how do you prevent the dealer from cashing in the cheque?

Well, if you own all the gasoline stations in the region and you claim that “gasoline now has to be paid using my cheques” the dealer now must keep a stock of your cheques, so you can keep writing them and enjoy a free ride across the entire region, you can “buy” anything you want and put it on your tab (i.e. accumulate debt), as long as you have cheques to write and people need those cheques to get their gasoline.

But… what would happen to you if people no longer needed your cheques to buy gasoline?

The power of the Petrodollar

This is a long and complex topic, so forgive me any oversimplification you may encounter.

After World War II, the World’s economy needed rebuilding. Countries agreed upon the use of what’s known as the Bretton Woods system (where the IMF was born, and which defined a set of reserve currencies). Tying the currency to gold at a fixed rate, and leveraging the amount of its gold reserves and its position after the war, made the USD the de facto reserve currency. This state of affairs lasted until 1971, but after its collapse, the USD became a fiat currency (i.e. its value doesn’t arise from the material it sits on, like the paper it’s printed on, it arises from good accounting, pure “faith” but specially from a need to use that specific currency to make a specific purchase).

So now the U.S. could pursue any number of expansionist policies but, to avoid the side-effects, it needed to stimulate demand for the USD, i.e. it needed countries to hold and use USD. As we’ve seen in the Ferrari example, what better way to give value to a currency than to price a commodity every country needs with it?

Every country needed oil at this stage and this made it the best strategic option for the U.S. but the OPEC, which was created in 1960, could effectively annihilate this U.S. strategy and this could not be. So, after the Yom-Kippur War, the U.S. leveraged the USD position as a reserve currency and rebuilt its ties with Saudi Arabia.

And so, the “petrodollar alliance” was formed: in exchange for American military and political support to the ruling Saud’s House, the Arab Kingdom would use its leverage in OPEC to ensure all oil transactions would come in USD, it would reinvest its own “petrodollars” in U.S. products and services, it would regulate price levels and finally it would prevent any oil embargo from happening.

As a result, all oil-exporting nations must receive USD, which makes their national income dependent on the USD’s value. If it the USD falls, so does the countries revenue, therefore if the oil importers were to somehow undermine the USD to make their oil purchases cheaper, the suppliers would have to react (even if a lower dollar grants them some debt relief). It may seem artificial and baseless, but this system works wonders.

Geopolitically, it maintained the USD status as the world’s reserve currency per excellence therefore (theoretically) it’s in no country’s interest to undermine the USD. The U.S. uses this advantage to push their foreign policy agenda but it’s in the economic realm where it really shines, as it allows the country to constantly run an account deficit by issuing USD denominated assets at very low rates of interest: a true economic hegemony.

Source: ZeroHedge (modified)

Enters the conspiracy theory

In October 2000 Iraq threatened to halt its crude output and suspend oil exports if the United States objected to Baghdad’s demand to be paid in EUR instead of USD. As a threat, this one wasn’t even original, Saddam Hussein had issued it 3 times in 3 years, the difference this time was that the year before (October 1999) the U.N. cap on Iraqi oil exports was lifted. It could now sell as much oil as it wanted.

The credibility of the threat went in crescendo since under the U.N. oil-for-food programme, much of the trades were closed in EUR, which meant that between 2001 and 2003 the country had already received around 26 billion EUR worth of supplies in exchange for 3300M barrels of oil. Also, EUR was in a rising trend against the USD and the country was earning way more in interests by having their BNP Paribas escrow account in New York in EUR instead of USD.

Then, in 2003, the U.S. risked its international (and also internal) image by entering in a non-sanctioned, unilateral, brutally expensive, non-provoked invasion of Iraq. Why?

Well, according to some conspirators, the main purpose behind the 2nd Iraqi war of 2003 (the one with the big weapons no one could find and the photo in the Azores island), was to prevent Iraqi oil from entering the market in EUR, and therefore threatening the hegemony of the USD as a reserve currency – one of the founding pillars of the U.S.’s economic power and therefore fundamental when it comes to its national strategic interests.

You may think it’s a far-fetched theory, and there are many arguments against it nevertheless, as far as the quality of conspiracy theories goes, this one is far from the worst.

Make space for Iran

For years, Iran followed Iraq’s suite in pushing to have the EUR replace the USD as the currency for international oil trade, which makes total sense since their biggest market is not the U.S. This was exacerbated by the progression in its plans to create the Iranian Oil Bourse, which came to fruition in 2008, with which it wanted to trade oil in other currencies apart from the USD.

Now guess what: In March 2012 Iran announced that the Bourse would no longer trade oil in USD… 4 months later the EU followed the US into effectively blocking access to Iranian Oil, effectively creating a worldwide embargo that would devastate the country’s finances.

I agree with most in believing that this was just a coincidence, as the EU embargo was being planned for long, nevertheless it’s clear that there’s no interest by the U.S. to see the petrodollar replaced.

Nevertheless, this didn’t stop Iran. After the sanctions were lifted, the country said it wanted to recover tens of billions of USD it is owed by India and other buyers of its oil, not in USD, but in EUR, as it looks to reduce its dependence on anything North-American. Not just that, but it signed oil contracts in EUR with Total (France), Cepsa (Spain) and Litasco (Russia).

An agreement between China and Russia

Although it’s one of the World’s largest USD holders, China has always been vociferous regarding the hegemony of USD as a reserve currency.

Since the beginning of this decade (but especially in recent years), China’s crude oil imports have increasingly come from countries outside the OPEC, which made up 65% of the growth in China’s crude imports between 2012 and 2016. We all know: money talks. So let’s hear what it has to say.

In 2012, Saudi Arabia comfortably enjoyed around a 20% share of Chinese crude imports with Russia trailing far behind, with around 7%. Fast forward to May 2017: Russia is now the main exporter of oil to China (with 1.35M bpd) and Saudi Arabia (the World’s largest oil exporter) leads the fall in percentage, with shipments down more than 15% YoY amounting to little over 900k bpd, occupying now the 3rd position.

Source: EIA (U.S. Energy Information Administration)

Now let’s add a second factor. By the end of 2008 China’s gold reserves where around 600t and Russia’s little over 500t. Fast forward to May 2017 again and China’s reserves multiplied themselves 3x (!) to more than 1800t. Guess what? Russia’s reserves also multiplied themselves by 3x to 1700t. Curious numerology.

Source: World Gold Council

So what changed? According to some theories: Yuan-denominated Crude Oil Futures Contracts backed by (and fully convertible to) Gold on the Shanghai and Hong-Kong exchange. Gold brings a stable confidence frame to support what may very well become the new Asian Oil Benchmark, which will begin trading on the Shanghai International Energy Exchange (INE) later this year. The first commodity contract in China open to foreign investment funds, will effectively bring an official alternative to the hegemony of the petrodollar.

Altough the “Oil for Gold” or “Yuan for Gold” theory is not universally approved, this is not an unfathomable idea. Gold leasing is a big “thing” in China. How does that work? Well, a customer borrows the metal from the bank and simultaneously enters a forward agreement to hedge price risks, effectively allowing it to obtain cheaper credit because the lending fee is lower than the interest rate of a loan of the same tenure – in fact this led to much fraudulent use of gold as collateral in loans. If you want to read more and generate your own opinion on the matter, you can try these articles in favour of the idea – by Alasdair Mcleod and Dave Kranzler – and this article against the idea by Koos Jansen.

Enters Saudi Arabia…

A puritan U.S. defender may claim that this is a strategy by its “enemies” (after all we do have Iran, China and Russia in the same sentence) but the KSA cannot and will not afford to lose market share in China.

And there’s more: Saudi Aramco is in the middle of a planned IPO where the country is hopping to sell 5% of the company for a modest 100 billion USD. If the process was already far from clear (and clean?), it just got even more chaotic… as China is apparently interested in assuming that position solely by itself (!) which would scale to a whole new level the relationship between both nations).

It’s now clear that, although still phenomenally strong and unyielding, cracks are beginning to sound in the hegemony of the “petrodollar”.

What would the effects of large scale oil trading in EUR/CNY

Let’s suppose that a group of countries (say, for instance, Russia, Iran and Venezuela) decided to allow the sale of crude oil (not counting natural gas) in other currencies. Let’s factor in to that the possibility that all Chinese demand is covered in yuan. In other words, let’s consider that around 14 million bpd (or 15% of the entire global market) doesn’t trade in USD. At a price of 50$/bbl that means less 255 thousand million USD in trades now done in other currencies. If we added the EU to that equation, we’d double that amount.

The first thing to be said is that the very existence of some world class currencies implies that reserves must be held in all of them, central banks keep foreign currency in an account or have swap arrangements with other such entities around the world. Also, paradoxically enough, even though these countries fight the hegemony of the USD, it could be in their interest to hoard USD to purposely weaken their currency, which would contradict any side-effect somewhat.

Likewise, although a weaker dollar might relief some of their debt weight, many countries would still require USD to pay interest and principal on their huge USD-based loans (the World Bank and IMF help with that), not to mention “developing” countries which are cash strapped.

Nevertheless, one must consider the strong connection the USD has with its country’s culture. Any significant change in their status quo due to this issue, is bound to generate a strong (with Donald Trump perhaps even unproportioned) response.

Anyway, I do not share the vision of the “conspiracy theorists”, which suggest a change in the status quo of the petrodollar would lead to armed conflict. I do no think the scenario would be catastrophic per se, nevertheless it would origin a strong rebalance in the price of crude and increase its volatility. Also, some degree of financial opportunism by the market operators would be expectable. A decreasing demand for USD (in effect devaluating it against other reserve currencies) would result in an increase in interest rates of USD bonds, a rise which would cause severe budgetary issues to the U.S. Although “printing money” doesn’t allow you to do whatever you want, it does give you much laissez-faire.

It would also decrease significantly the effect of U.S. sanctions, which might impact somewhat the way the country conducts its foreign policy.

Whatever the outcome, it is about time the U.S. felt what “free market” means when it comes to currency and oil.

Hugo Martins | Analyst

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