What Is the Petrodollar and Why It's in a Crisis

Historically dollar is a uniquely useful currency for trade, but so many new ones are being created as to give doubt to its value. Some of the biggest earners of dollars are no longer storing them

Not all paper is equal

This is an excerpt from an article that originally appeared at The Huffington Post


THE RISE OF THE PETRODOLLAR

The dollar's role as the world's reserve currency was first established in 1944 with the Bretton Woods agreement. The U.S. was able assume this role by virtue of it then having the largest gold reserves in the world.

The dollar was pegged at $35 an ounce -- and freely exchangeable into gold at that rate. But by 1971, convertibility into gold was no longer viable as America's gold resources drained away.

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Instead, the dollar became a pure fiat currency (decoupled from any physical store of value), until the petrodollar agreement was concluded by President Nixon in 1973.

The essence of the deal was that the U.S. would agree to military sales and defense of Saudi Arabia in return for all oil trade being denominated in U.S. dollars.

As a result of this agreement, the dollar then became the only medium in which energy exchange could be transacted.

This underpinned its reserve currency status through the need for foreign governments to hold dollars; recirculated the dollar costs of oil back into the U.S. financial system and -- crucially -- made the dollar effectively convertible into barrels of oil.

The dollar was moved from a gold standard onto a crude oil standard.

U.S. interest rates were then managed so that oil exporters (who formerly looked to gold as the basis of their reserves) would be indifferent to whether they stored their currency reserves, earned from oil exports, in U.S. treasuries, or in gold. The value was equivalent.

According to Sprott Global, a specialist U.S. energy consultancy:

The Fed consistently managed Fed funds rates to keep oil prices steady, even when it required mid-teens interest rates and back-to-back recessions in 1980-1982.

Since U.S. Fed funds rates were managed to preserve U.S. creditors' and oil exporters' purchasing power in oil terms, the system proved acceptable to most nations.

While the petrodollar arrangement worked well for nearly 30 years, the arrangement began to wobble around 2002-2004. . .

Oil prices began steadily rising in 2002 and 2003 while Fed funds rates remained low to mitigate the fallout from the 2001 U.S. recession/tech bubble.

As a result, the number of barrels of oil that could be purchased for a face value U.S. Treasury bond declined sharply. . .

After maintaining a range of 55-60 barrels of oil per U.S. Treasury from 1986-1999, a $1,000 face value U.S. Treasury went from buying 60 barrels of oil in 1999 to under 30 by early 2004.

TOO MANY DOLLARS

But what may ultimately be seen to have proved fateful to the petrodollar system has been the policy of zero interest rate policy and "quantitative easing" pursued so unrestrainedly since 2008.

Effectively, energy producers saw that the U.S. economy had now become so dependent on low interest rates that it could never again manage to keep oil prices steady relative to U.S. treasuries without blowing up the global financial system.

The U.S. economy had now become too "financialized" to withstand anything more than a token interest rate hike.

The petrodollar system, which had allowed the U.S. dollar to supplant gold as the backing for the oil trade from 1973-2002, was broken.

Energy producers began to accumulate real assets (such as real estate), and returned to purchasing physical gold in lieu of U.S. treasuries.

Finally this year, the long established re-circulation of petrodollars back into the U.S. financial system came to an end -- according to BNP.

"The oil producers will effectively import capital amounting to $7.6 billion.

By comparison, they exported $60 billion in 2013 and $248 billion in 2012," Reuters reported.

"This will be the first year in a long time that energy exporters will be sucking capital [and liquidity] out," noted David Spegel, global head of emerging market sovereign and corporate research at BNP.


Alastair Crooke is a thirty year veteran of the British intelligence, former advisor to EU foreign minister Javier Solana and author of the book 'Resistance: The Essence of Islamic Revolution'