What is the Petrodollar?

19 Jun 2019

No, this isn’t yet another cryptocurrency. Petrodollars are US dollars that are paid to oil exporting countries for the sale of crude oil. In other words, it is a system of exchange of oil for US dollars between the countries that purchase it and the ones that produce and sell it. Initially, these were referred to as the money that the Organization of the Petroleum Exporting Countries (OPEC) and the Middle Eastern countries received. The definition has broadened in recent years and now includes several other nations as well. Since petrodollars are represented as USD, their purchasing power depends on the value of the currency and the core rate of US inflation. So, petrodollars are impacted by economic factors in the same way as the US dollar. When the value of the dollar plummets, so does that of petrodollars and, in turn, the government’s revenue.

Why was the Petrodollar System Introduced?

The petrodollar system came into existence as a result of the oil crisis of the mid-1970s, when oil price touched record high levels. It helped increase the stability of oil prices, which were denominated in USD. The term gained popularity again in the early 2000s, when oil prices started rising once more. The origins of this system can be traced back to the Bretton Woods Agreement, which replaced the gold standard with the USD as the reserve currency. Under this agreement, the dollar was pegged to gold and other currencies were pegged to the dollar. But due to large stagflation, it was announced by US President Nixon, in 1971, that the greenback would no longer be exchanged for gold to drive US economic growth. This led to the introduction of the petrodollar system, under which Saudi Arabia and the US mutually agreed to set oil prices in USD. It meant that in order to purchase oil from Saudi Arabia, a country would first have to convert their currency into US dollars. The remaining OPEC countries followed suit and priced their oil in USD as well.

Recycling of the Petrodollar

The petrodollar system can lead to the generation of surplus, which is known as petrodollar surplus. Since petrodollars are just US dollars, such surplus can raise the US dollar reserves of oil exporting nations. This, then leads to a need to recycle the extra petrodollars, which can be done in a number of ways. They can be used for domestic consumption or investment, for lending to other countries or for the purchase of bonds and T-bills from the US. This increases the liquidity of the American financial markets. Through the investment of petrodollar surpluses, oil exporters can decrease their dependence on oil revenues. Many countries have actively recycled their surplus petrodollars in one or more of the ways mentioned above. Here are some of the largest petrodollar recyclers in the world.

Saudi Arabia SAMA
UAE Abu Dhabi Investment Authority
UAE Abu Dhabi Mubadala Investment Company
Russia National Welfare Fund
Qatar Investment Authority
Kazakhstan Samruk-Kazyna
Alaska Permanent Fund

Decreasing Acceptance of the Petrodollar

Due to the decline in the purchasing power of the petrodollar, some countries have started to doubt the benefits of the system. Countries such as India, Iran and Russia have considered using their own currency as the base value of their exports, instead of the US dollar. In 2017, China announced that it was considering moving the price of oil to the yuan. As China is the biggest importer of oil in the world, it seemed logical to price the most important commodity in its own currency. Venezuela has also stopped using the petrodollar system since 2017 and has started pricing oil in yuan and euros.

The Ongoing Debate

Since its introduction, the petrodollar has been a widely debated issue. Some think of it as being unjust to the oil-producing countries, while others consider it necessary to give global oil trade a proper structure. The detractors of the system state that there is a big risk to oil-producing nations due to their dependence on the USD. Since oil and oil products are universally sold and purchased in terms of USD, the purchasing power of the revenues generated from trade is directly connected to the value of the US dollar. If inflation or any other policy changes reduce the value of the USD, the producers will lose their market share. So, to decrease this risk, a lot of oil producers have pegged their domestic currency to the USD. Proponents of the petrodollar system say that it brings security and stability as its main benefits. The valuation of an important commodity, such as oil, in terms of the world’s reserve currency gives a benchmark for valuations. Apart from this, the surpluses provide opportunities for reinvestment in the global economy.

The Road Ahead

There has always been a cloud of uncertainty over the future of the petrodollar. Over time, there have been a number of challenges to the petrodollar’s status as the standard for the world’s oil trade. In 2016, Iran sought payment in euros in place of US dollars, for its signed oil contracts. The commitments by Vladmir Putin to sell more and more of Russia’s oil in rubles and yuan have threatened to decrease the dominance of the US dollar. The launch of an oil futures contract in terms of CNY by China is being seen as an attempt to introduce a new valuation system in the markets of the Far East. Although there have been many similar attempts to set up alternate forms of oil valuation since the 1970s, they haven’t been very successful. However, the international community sees it as only a matter of time before the petrodollar is dethroned and a new approach is adopted.

To Sum it Up

Despite being controversial, the petrodollar has remained the most active means of trading oil around the world. The coming years are expected to bring in new challenges for this system. As a number of international oil players search for methods to avoid the exchange rate risk connected with the USD, different types of valuation may come into existence. Only time will tell whether the petrodollar remains viable.

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