Beginning in 1944 with the ratification of the Bretton Woods Accords, the United States dollar (USD) has served as the world's predominant reserve currency. It is held in vast stores by central banks around the globe and is a universal pricing mechanism for many commodities. As the backbone of the international monetary system, the USD is involved in roughly 87% of all foreign exchange transactions.
When it comes to economic development, the most influential commodity on earth is oil. Oil is viewed as the lifeblood of economic growth, with its availability being a key driver of a nation's prosperity. Advanced geopolitics, robust energies commerce and military conflict are commonly found in oil-rich regions.
Through the petrodollar, the USD facilitates the trade of crude oil to the world.
The Petrodollar Defined
A petrodollar is any U.S. dollar that is exchanged for oil. Producing nations—such as those of the Organisation of Petroleum Exporting Countries (OPEC), Canada or Russia—are paid for their resources via the USD. Proceeds are subsequently transferred into the domestic currency and "recycled" back into the energy industry or local economy.
Aside from production and exportation, numerous financial instruments are used to actively trade crude oil on the world's markets. The leading indices and futures products associated with oil are denominated in the USD. The most significant are as follows:
- West Texas Intermediate (WTI) Crude Oil Futures
- North Sea Brent (Brent) Crude Oil Futures
- OPEC Basket Index
- Canadian Crude Index
- DME Oman Crude Oil Futures
In addition, several related contract-for-difference (CFD) products are valued in dollars. USOIL and UKOIL are both priced using the USD, reflecting the markets of WTI and Brent crude oil futures.
The petrodollar system is the global standard for the trade of oil. Because oil products are bought and sold exclusively in terms of the USD, transactions between foreign entities are seamless.
Origins Of The Petrodollar
The post-WWII confirmation of the Bretton Woods Accords is the starting point for the U.S. dollar becoming the world's reserve currency. Subsequently, Bretton Woods also serves as the foundation for later development of the petrodollar.
In 1944, delegates from 44 nations convened at Bretton Woods, New Hampshire to address the global economic situation. In the aftermath of WWII, many international currencies experienced duress due to the strain of wartime. World leaders sought a monetary system that ensured exchange rate stability, prevented competitive devaluations and promoted economic growth.
To address these issues, the Bretton Woods Accords created and implemented the following devices:
- International Monetary Fund (IMF)
- International Bank For Reconstruction and Development (World Bank Group)
- Gold Standard
Perhaps the most significant result of Bretton Woods was the reinstitution of the gold standard. The dollar was fixed to gold at a price of US$35 per ounce, with all other member countries consenting to hold the value of domestic currencies within 1% of the USD. In effect, the global financial system was dependent upon the USD, backed by gold.
Bretton Woods remained viable until 1971, when the convertibility of U.S. dollars for gold was terminated. Faced with inflationary pressures, high unemployment and a potential gold run, U.S. President Richard Nixon exited the gold standard in favour of a fiat-based monetary system. The result was catastrophic for the dollar, with the event earning the moniker "Nixon Shock."
Rise Of The Petrodollar: The Yom Kippur War
The U.S. abandonment of the gold standard in 1971 had a profound impact upon oil-producing regions, specifically members of OPEC. At the time, a majority of contracts securing oil products were denominated using the USD. The sudden devaluation of the dollar in the wake of exiting the gold standard reduced the value of existing agreements and contracts. Efforts were made by OPEC officials to value oil exports in gold instead of dollars, but no major changes were enacted.
The situation remained fluid until the breakout of the Yom Kippur War in October 1973. At that time, the Arab members of OPEC raised the price of crude oil by 70% and placed an embargo on exports to the U.S. and other allies of Israel. This action, along with later cuts in production, prompted the Oil Crisis of 1973-74.
The fallout from the Yom Kippur War and OPEC's response shook global oil markets. By January 1974, oil prices were four times higher than pre-crisis levels. Subsequently, international leaders sought to restore order and adopt a more rigid structure to oil pricing.
One of the primary steps taken to end the Oil Crisis of 1973-74 was an alliance between the U.S. and Saudi Arabia.
In June 1974, the U.S. and Saudi Arabia signed a milestone agreement that laid the groundwork for the petrodollar system. The agreement was developed in close cooperation between U.S. Secretary of State Henry Kissinger and President Richard Nixon, and Prince Fand Ibn Abdel Aziz and King Faisal of Saudi Arabia. The partnership outlined the creation of four major working groups that were to foster cooperation between the two nations in several areas:
- Economic Council
The 1974 agreement made no official mention of the term "oil." However, U.S. dignitaries were open about a desire for Saudi Arabia to increase output levels from the ongoing 8.6 million barrels per day. While not official historical doctrine, the 1974 U.S./Saudi Arabia pact is widely accepted as the inception of the modern petrodollar system.
The Petrodollar: A Point Of Contention
Since its outset, the petrodollar has been a hotly debated issue. Some view it as being unfair to producing nations, while others contend it is necessary to bring structure to the global oil trade. The argument over the validity of the petrodollar system can be summed up accordingly:
- Against: Detractors cite dependence on the USD as being inherently risky to oil-producing nations. Oil products are universally bought and sold in terms of dollars, so the purchasing power of revenues generated from the trade is directly correlated to the value of the USD. In the event that inflationary pressures devalue the USD, producers lose market share. In order to reduce this risk, many oil rich nations have pegged the value of their domestic currency to that of the USD.
- For: Proponents of the petrodollar cite stability and security as primary advantages to the system. For a commodity with the importance of oil to be valued in terms of the world's reserve currency provides a benchmark for valuations. In addition, proceeds are liquid and able to be reinvested directly into the global economy through a process known as "recycling."
The Future Of The Petrodollar
The future viability of the petrodollar has always been a grey area. Over the course of its existence, there have been many high-profile challenges to its status as the standard for the global oil trade. The following are a few of the most recent:
- Euros: In 2016, Iran sought payment for signed oil contracts in euros instead of dollars.
- Rubles: Ongoing commitments from Premier Vladimir Putin to sell more of Russia's oil output in rubles (RUB) and yuan (CNY) threaten to reduce the dominance of the U.S. dollar in the oil trade.
- Petroyuan: China's launch of an oil futures contract denominated in CNY marks an attempt to bring a new valuation model to the oil markets of the Far East.
The development and launch of alternate forms of oil valuation have been a regular occurrence since the petrodollar's origins in the early 1970s. While none of the attempts have been successful, many in the international community view it as being only a matter of time before a new approach to the global oil trade is adopted.
Although controversial, the petrodollar remains the predominant means of trading oil internationally. Producers and consumers around the globe conduct trade using dollar-denominated oil as the industry standard.
Coming years are likely to pose new and unique challenges to the petrodollar system. As various international oil players look for ways to insulate against the exchange rate risk associated with the USD, alternate forms of valuation may take root. Ultimately, only time will determine the future viability of the petrodollar.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…