Petrodollar History and its Implications

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Saudi Arabia has been in the news lately.  “Crown Prince Mohammed bin Salman is leading a sweeping crackdown against what he has labeled ‘corruption’” among family members in the House of Saud.  The net has ensnared at least 11 princes and maybe as many as 500 people, according to a November 8, 2017 New York Times article.

 

Saudi Arabia’s oil deposits are believed to be second only to Venezuela in size.  According to Ron Chernow in The House of Morgan, Saudi Arabia’s link to the United States and to US oil companies goes back at least to 1933, when Standard Oil of California (SoCal) negotiated the first oil concession with the Saudi finance minister. At that time gold was the only Saudi currency, so they agreed to an initial 30,000 British pound gold loan, plus 5000 British pounds for the first year’s rent.  The deal was nearly scuttled, because President Franklin D. Roosevelt had embargoed gold exports, and the Treasury denied SoCal—an American company—permission to ship gold from the US.  To bypass the injunction, SoCal bought 35,000 gold sovereigns from a Guaranty Trust branch in London to seal the deal.  By the 1940s, SoCal had brought Texaco, Standard Oil of New Jersey (later Exxon), and Socony Vacuum (later Mobil) into a partnership christened the Arabian-American Oil Company, or Aramco. 

 

Saudi Arabia started buying shares in the company, and in 1980 took full control, renaming the company the Saudi Arabian Oil Company, or Saudi Aramco.  Now, the crown prince Mohammed bin Salman has indicated he wants to sell five percent of the company on the stock market, and President Donald Trump is encouraging him to offer the first IPO on the NYSE.  Saudi Aramco is the largest company in the world, with estimated value between two and ten trillion dollars.

 

Flashback to the events of July, 1944.  As World War II was coming to an end, a financial conference was held at Bretton Woods, New Hampshire.  Seven hundred thirty delegates from 44 allied nations attended, to plan for the reconstruction of a war-torn Europe.  At that famous meeting, The International Bank of Reconstruction and Development (IBRD)--also known as the World Bank--and the International Monetary Fund (IMF) were established.  The conference also designated the US dollar as the international reserve currency.  At that time, the US held 80% of the world’s gold.  By agreement, other currencies would be pegged to the dollar, which was pegged to gold at $35/ounce. 

 

However, the US ramped up deficit spending after World War II, including spending $200-500  billion on the Vietnam war, instituting Lyndon B. Johnson’s “Great Society” programs in the 1960s (including Medicare/Medicaid, among others), and generally creating a “warfare state” and “welfare state.”  The growing imbalance of US gold reserves to debt worried other nations.  Britain, France, Germany, and others began cashing in their dollars for gold. 

 

This depleted US gold reserves, so on August 15, 1971, US President Richard M. Nixon unilaterally ended the international convertibility from US dollars to gold, effectively breaking the Bretton Woods agreement.  Nixon and Secretary of State Henry Kissinger knew going off the gold standard would reduce the international artificial demand for the dollar and would antagonize oil exporting nations, which suddenly were receiving less valuable dollars for their oil.

 

On October 17, 1973, Arab members of the OPEC imposed an embargo against the United States, partly in retaliation for the US decision to re-supply the Israeli military during the Arab-Israeli war (the Yom Kippur war).  That same year, in 1973, the Nixon administration negotiated a deal with Saudi Arabia to ameliorate the situation by creating the “petrodollar.”  Under this arrangement, every barrel of oil purchased by anyone from Saudi Arabia would be denominated in US dollars.  In return, the US offered weapons and protection of oil fields from the neighboring nations, including Israel, according to Jerry Robinson, an economist at ftmdaily.com..  In addition, the Saudis were encouraged to deposit oil profits in Western banks, and to buy US Treasuries.  This is called “petrodollar recycling,” as much of the money is returned to the US.

 

The oil embargo ended in March, 1974.

 

By 1975, all OPEC nations agreed to price oil only in US dollars, in exchange for weapons and military protection.  Most also invested profits in US Treasuries.  This created an immediate artificial demand for dollars worldwide, as any country wanting to buy OPEC oil had to procure US dollars to do so.  This increased the incentive for foreign countries to export products to the United States, in order to receive dollars to buy Mid-East oil.

 

The US remains a major military presence in the Persian Gulf, in Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Egypt, Israel, Jordan, and Yemen. 

 

Robinson suggests that President George W. Bush’s insistence on invading Iraq in 2003 was the result of Iraq’s trying to denominate its oil price in euros in 2002.  The result of the Iraq war was to re-establish the petrodollar system there.  Robinson also notes that while the US claims to be a friend of Israel, its sworn enemies get eight times more US foreign aid than Israel does.

 

However, the petrodollar system is shaky.  As of October, 2017, Venezuela and Iran have refused to accept US dollars for oil.  China, which has now surpassed the US as Saudi oil purchaser, is pressuring Saudi Arabia to accept yuan for oil.  Both Russia and China are backing at least part of their currencies with gold. 

 

Iran has also refused to trade in US dollars.  Economic sanctions—especially from Europe—have been lifted, and Iran is increasingly influential in Iraq, Syria, and Lebanon.  According to Federico Pieraccini of globalresearch.ca, the continued presence of the US in Afghanistan is a move to interfere with Eurasian integration by China, Russia, and Iran.  As soon as Vladimir Putin took power in Russia, he started moving to de-dollarize oil trade.  Pieraccini says the Russo-Sino-Iranian strategy is to render the US irrelevant and to rein in the uncontrolled Federal Reserve spending.

 

These events raise several questions.  First, if countries like Russia and China are moving back toward a gold standard, what will that do to the dollar, which is now merely fiat money?  If major countries trade in other currencies—like a currency “basket” including yuan, ruples, and euros, such as Venezuelan president Nicolas Maduro has suggested—it will drastically reduce the artificial demand for the dollar.  What if foreign investors start cashing in their US Treasuries?  What currency will the Fed pay them in, if the dollar is worthless?

Even a superficial understanding of how the petrodollar system works may do more to explain US military involvement in the Mideast than all the chest-thumping about terrorism.

Comments

Thomas Napers Added Nov 29, 2017 - 2:32am
It’s like you’ve written six or seven different articles here and mashed them up into one.  From petrodollars to US deficit spending to the gold standard to several other unrelated things, the article needs a lot of work.  At the very least I would take it down, focus on one thing and then release your other subjects at a later date. 
 
As for deficit spending, outside of a few short years when Clinton was President and Republicans controlled the House, we’ve always run major deficits.  If anything they ramped up following Obama’s presidency as during his reign, he added $9 trillion to the total, which now stands at $20 trillion.  In other words, in 8 years Obama nearly doubled a debt that took over 200 years to accumulate.  As for war spending, since World War II, as a share of GDP it’s been trending down.  So the reason for our National Debt has very little to do with war. 
George N Romey Added Nov 29, 2017 - 6:57am
Good article. The conflicts in the Middle East have always been about oil. Furthermore, Iran the so called evil empire is nothing more than keeping them on the Petro Dollar and as usual too many Americans are duped,
Dino Manalis Added Nov 29, 2017 - 8:46am
We should all go back to the gold standard, while Trump has to focus on careful deficit reduction and elimination that President Clinton credited for prosperity in the Nineties.  Like Sisi in Egypt, the rest of the Arab World needs to restore stability to stop the chaos and refugee crisis, while the world should pressure regimes to protect human rights and democratic reforms without destabilizing these countries ever again.
Even A Broken Clock Added Nov 29, 2017 - 9:46am
Katharine, excellent article. I have questioned what will happen when (not if) the US loses its reserve currency status. To me, that is what will happen if the policies of Donald Trump are fulfilled - we will lose that privilege, and we will then learn the true cost of running trade and budget deficits. It will not be pretty.
George N Romey Added Nov 29, 2017 - 10:57am
The world is already in the midst albeit slowly of dumping the dollar as the world's currency.  What most people are clueless about is that there are few takers for our debt, hence the Federal Reserve monetizing our debt.  In previous countries this practice did not work so good.
wsucram15 Added Nov 29, 2017 - 12:18pm
You know I actually saw something on the Crown Prince.....in the House of Saud. Putting his own family in jail..jeeze.
Ignore Thomas..its a good article, I knew where you were going with it as I read it. Its was about the dollars stronghold and how we are losing it.
I studied that in two classes I had to take, with China and Russia so heavily invested in the US and both now financially stronger, what do you expect to happen?
 
Dave Volek Added Nov 29, 2017 - 12:24pm
Katherine
 
On one hand, this is a nice summation of history and a worthy read. On the other hand, it seems to impose questions on a handful of issues that beg answers. I think the history would have been sufficient. The other issues could have dealt with later.
 
One future article may be the importance (to the US) of having the US dollar as the dominant world currency and what will happen if this economic parameter changes.
 
 
Katharine Otto Added Dec 1, 2017 - 10:08am
Thomas,
You're right.  I did cover a lot of ground, but I was trying to show the progression over time of the petrodollar.  The situation is too complex to deal with in a single article.  Also, I don't have answers.  
 
War has always led to deficit spending, not just in the US, but in France and England, among others, before the US was established.
 
I don't blame specific presidents for this.  They are pawns for the defense industry.  Creation of the Federal Reserve in 1913 put Congress into the debt creation business, with the income tax to guarantee perpetual interest payments to the Fed.  And John D. Rockefeller, scion of Standard Oil, was among the secret planners of the Federal Reserve Act, creating a banking cartel that endures today.  The bankers profit by lending money to all sides of a conflict.
 
Katharine Otto Added Dec 1, 2017 - 10:13am
George,
 
After writing the article, I began to wonder if the industrial age has created an artificial demand for oil, too.  Think of the major users of oil, including military and shipping, and, of course, plastic.  How much of that is really necessary?
 
I'm not so sure the "global economy" benefits anyone, and I'm not sure bigger is better.
 
Katharine Otto Added Dec 1, 2017 - 10:16am
Dino,
I believe we should return to the gold standard, too.  Maybe it would curtail some of this excessive spending.
Katharine Otto Added Dec 1, 2017 - 10:21am
Clock,
Thank you for the compliment,  We are losing the reserve currency status already.  I, for one, will be grateful when it happens.  The US needs to get its own act together before we can dictate to anyone else.
Katharine Otto Added Dec 1, 2017 - 10:26am
George,
I'm glad you mentioned that the Fed can't sell its debt so has to buy it back.  What happens if the Fed defaults?  No one wants to think about that, but it seems the US "economy" is teetering.  We may have to "go local," which would probably be a good thing.
Katharine Otto Added Dec 1, 2017 - 10:30am
Jeanne,
Thanks for the support.  I suspect we are in an economic war, to our own detriment.  
 
You've probably read that China, among other countries, is cashing in US Treasuries.  Haha.  We may have more military strength, but we are maxed out on credit, as individuals and a nation.  This whole consumerist mindset needs to be examined.  How much stuff do we really need?
Katharine Otto Added Dec 1, 2017 - 10:38am
Dave,
I asked those questions intentionally, because I don't have answers.  Anything can happen.  I believe to solve a problem you first need to understand it.  You introduced me to the concept of the petrodollar, here on WB.  I'd never heard of it before, so I figured other people hadn't either.  This article represents my initial foray into the history, especially as other countries are ganging up to make the US irrelevant.
Dave Volek Added Dec 1, 2017 - 1:11pm
Katherine
I don't think it was me that introduced the petrodollar concept on WB.
 
I recall when I used to subscribe to The Economist, they were predicting the fall of the dollar as well. It seems absurd that Germany has sell Euros to get dollars to buy oil and gas from Russia who will then sell dollars to get rubles. I know there are benefits to America for these international transactions, but I can't remember what they are.
 
It may very well be that Germany and Russia are already dealing in Euros. I don't know.
 
I think it is a natural fall, something that was going to happen anyways.
 
 
Jeff Jackson Added Dec 2, 2017 - 4:09am
Nice article Katherine. There is little doubt that the U.S. has sacrificed blood and treasure to make sure the oil firms kept their money flowing along with the oil.
Jeffry Gilbert Added Dec 3, 2017 - 2:55pm
especially as other countries are ganging up to make the US irrelevant.
 
Bwahaawwww!
 
DUHmerica is doing an excellent job of doing that to itself.