The Myth of the Petrodollar

In the comments beneath this post, Bardon remarks:

But there is another complexity here the Kissinger instigated Petrodollar.

The US economy would collapse overnight if this mechanism stopped, hence they need the Saudis and they need that Aramco IPO on Wall Street. BRICS are anti petrodollar and are working very hard to undermine and replace it, its the kind of stuff that starts wars.

The systems is such that non oil producing countries that want to buy oil must buy it in US$. So lets say Greece wants to buy Kuwaiti oil, it will do this in US $ which is neither the currency of the seller nor the buyer, meaning that it has to have US$ in the first place.

If the petrodollar system collapsed and remember the US could not even touch the sides with supplying oil to meet market demand, and no one buys it in US$ anymore then the demand for US$ would stop and it would absolutely tank overnight. Iran can’t wait to sell it in anything other than US$ and it looks like the BRICS nations are a likely taker, so they had better be quick in stopping Iran making any trades.

This theory is frequently brought forward to explain geopolitical developments involving the United States, and while others (Mr Worstall, for example) has dealt with it in the past, I might as well do so again.

The reasoning goes something like this. The US needs to ensure a demand for its currency, and therefore insists all oil around the world is sold in USD. If a country were to switch to selling oil in euros or another currency, the USD would nose-dive and destroy the US economy. The reason the US deposed of Saddam Hussein and Muammar Gaddafi was because each were about to start selling their oil in euros or gold. This theory even beats “wars for pipelines” into second place as an explanation for American foreign policy, and it is a persistent one. Sadly it’s not just the preserve of cranks on Zerohedge, I’ve actually had an MBA graduate insist that a country trading oil in euros presents a serious threat to US financial hegemony. And here’s a recent article in The Huffington Post telling us:

Non-Dollar Trading Is Killing the Petrodollar — And the Foundation of U.S.-Saudi Policy in the Middle East

It’s nonsense of course, and here’s why. According to this site, the value of oil traded is $1.7 trillion dollars per year. Looked at another way, oil production was about 97m barrels per day in 2015; let’s call it 100m making 36.5bn barrels a year. Assuming a sale price of $100 per barrel, annual production is worth $3.65 trillion dollars. Assuming $60 per barrel, it’s worth $2.19 trillion dollars. The exact number doesn’t matter, we’re just after an order of magnitude here.

Now according to this site, total foreign exchange (FX) transactions are valued at $5.1 trillion dollars per day. Trade in USD accounts for a whopping 88% of that, i.e. $4.49 trillion per day. According to another site, total FX was $5.3 trillion per day in 2013 of which USD trades accounted for 87%, i.e. $4.6 trillion per day. Again, we only need orders of magnitude here.

So, the demand for dollars driven by oil sales equals around $2-3 trillion dollars per year. Meanwhile, the overall demand for dollars equals around $4.5 trillion dollars per day. From these figures alone one can conclude that the currency in which oil is traded makes no difference whatsoever to the value of the USD. Reasons for going to war and bringing about regime change vary, but it is unlikely anyone would do so to protect one-three-hundredth of its currency demand.

So what would happen if a country switched to selling oil in yuan or euros? Well, those who hold USD would go to the FX market and buy yuan or euros at the prevailing rate and then use them to buy the oil. No need for any wars when you have a large and functioning FX market. You’ll notice that those peddling the myth of petrodollars driving American foreign policy never go into details of how all it is all supposed to work. There are good reasons for this.

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11 thoughts on “The Myth of the Petrodollar

  1. You’re right, of course, but in the interests of fairness it should be pointed out that that oil trading figure is physical oil whilst that for the FX markets includes futures, swaps and all the panoply of derivatives available.

  2. My business isn’t directly oil related, but tanker operators form a chunk of our business. We trade almost exclusively in dollars. Even with non-tank business.

    The reason for this seems to be shipping runs on dollars.

    I suspect this is simply due to the fact the USD is still the de facto world currency. It’s the financial lingua franca. Why would that not also be true for oil? Why the need for a conspiracy?

  3. Everybody knows that the reason for the Iraq invasion was to get at their WMD’s.

    I just read my previous comments and some of the other comments and yes I lazily made the fatal mistake of trying to explain how it works, wrongly as well so at least I aint stupid enough to do that again. As MC said you just come across as some kind of Goldbug, and yes it looks that way, I am a very active investor in many asset classes but acquiring the shiny stuff has never appealed to me as an investment class, so other than the missuses jewelry I aint a goldbug. Dearimie doesn’t buy it either, and we all know that he kens a little more then he lets on, but he does acknowledged that things can change quickly. Tim flat out doesn’t and has offered up a classic rebuttal. No I wont debunk it Tim what you have said with exchange rates is fact.

    So here are my last two petrodollars on this are:

    Most mainstream economist dont really get into this kind of stuff and surprisingly when I actually looked for confirmation of the deal (not from a pro-Petrodollar or debunk Petrodollar source), and isn’t it a pain that we cant use books anymore, I only managed to find this Bloomberg full documentation of the system. It is short and it is definitely worth a read for anyone interested in the deal the last sentence reads.

    Doing the deal “was a positive for America.”

    https://www.bloomberg.com/news/features/2016-05-30/the-untold-story-behind-saudi-arabia-s-41-year-u-s-debt-secret

    Secondly, the scam is all perfectly well described here, and I encourage anyone interested to read the review, which is linked at the bottom.

    This is how they do it.

    “In order to entice the investment of OPEC capital, the U.S. allowed the Saudi Arabian Monetary Agency to buy U.S. government bonds without competitive bidding, which was purchased below the average market price paid by private firms. This arrangement was beneficial to the U.S. for at least two reasons; first, it gave the U.S. government access to a huge pool of foreign capital (essential for balancing trade deficits and creating trade surpluses), and secondly, it allowed the U.S. government to control where the investments should be deposited, by placing it on a central bank to central bank basis. Much of the secret financial arrangements with the Saudis by the U.S. Treasury Department served to insulate politicians and the Saudi monarchy from public scrutiny, embarrassment and criticism. As long as OPEC oil was priced in U.S. dollars, and so long as OPEC invested the dollars back into the U.S.government and economy, the U.S. profited from a double loan. The first part of the loan paid for the oil, because the U.S. Mint could simply print dollars to pay for oil, and the American economy did not have to produce goods and services in exchange for oil, until such time that OPEC used the dollars for purchases (at that time, OPEC couldn’t purchase enough goods and services even if it tried due to their extreme monetary surpluses). Secondly, other economies had to exchange goods for dollars, in order to pay OPEC. Consequently, as long as OPEC held dollars rather than spending them, the U.S. enjoyed a free ride.

    And as I said on the previous thread regarding the recent and sudden withdrawal of an equity investor into my firms shareholdings, because they had Saudi investors and we had Qatari shareholders, this is the bastardy, it works, it is real, it is happening now and it has hit my own wallet.

    The U.S. is like the head of a neighborhood gang, when threatened by bullies from another neighborhood, rallies all his gang together to fight the other neighborhood. The fight could be economic sanctions, military actions, or monetary prohibitions. While the U.S. needs the support of his gang members, he acts quite the leader by encouraging, pressuring, bribing, promising, bartering, negotiating, and even secretly acquiescing on certain issues to key members, to obtain support for U.S. directed actions, that respond primarily to U.S. interests.

    http://www.academia.edu/1773849/The_Hidden_Hand_of_American_Hegemony_Petrodollar_Recycling_and_International_Markets

  4. Some day the USD will go the way of Betamax. I’ve no idea when. But it will because it must, because “that too shall pass away”.

  5. The U.S is fast becoming the worlds largest producer of oil and all other types of energy and will continue to do so under Trump, in a few year nothing will touch them.

  6. I don’t understand this stuff as much as I should. I know that China and Russia announced a while back that they would work on trading with each other without dollars. I never heard if they succeeded. My guess is they could never muster enough trust between each other to make it viable. It’s also the case that there is a huge infrastructure in place already to make trading easy. Both lack of trust and barriers to entry likely foil most alternative methods.
    Still, I don’t see how the current system serves every need. Even the strong desire for sovereignty hasn’t overcome it. I’m amazed that it still continues. Perhaps it just works.

  7. I’m afraid this is an apples to oranges comparison. Consider the oil market. Can you estimate demand for crude from the number of WTI or Brent contracts traded in any given period?

    In the case of crude and other commodities, at least “demand” is relatively well-defined. It is shorthand for consumption, a point on the demand curve. We can estimate how much fuel the world burned and how much naphtha was turned into plastic bags last quarter, and from that, how many barrels of crude went into the oil products consumed. We also have a clear division of the actors into consumers and producers.

    This logic doesn’t work with currency in place of oil and breaks down altogether if you think of currency strictly as a means of exchange. Let’s say China buys a shipment of crude from Russia for dollars. Russia exchanges the dollars for Euros to import German machinery. Germany exchanges the dollars for yuans to buy Chinese toys. China buys more Russian oil with the same dollars, and so on. In this setup, the dollars never get “consumed,” merely passed around.

    Now, when the dollars get saved or invested in US assets – used as a store of value – things can get more interesting. Check out Bardon’s links: the Bloomberg story is not a conspiracy theory, more like common knowledge now. It helps to keep in mind that Saudi Arabia is a major holder of US government debt, along with China and Japan.

  8. In this setup, the dollars never get “consumed,” merely passed around.

    Now, when the dollars get saved or invested in US assets – used as a store of value – things can get more interesting.

    I have no doubt both of these are true. How either has any bearing on the volume of dollars being exchanged on the FX market isn’t clear.

    Here’s another way of putting it: does it matter if baked beans are sold in USD? Does it matter if wrapping paper is sold in USD? If not, why does it matter if oil is sold in USD? Because there is so much of it that to sell it in another currency would reduce demand for dollars? Okay, well let’s look at the total value of oil being traded (order of magnitude) and compare it with the volume of dollars being traded each day (order of magnitude). Yes, this is an apples to oranges comparison because I am trying to highlight that sales of apples have little bearing on the value of oranges.

  9. “why does it matter if oil is sold in USD?” Whether it matters or not, the ratio of the dollars traded to the value of oil consumed (per day or per year) only shows that the forex market is extremely liquid. The volume of USD bought and sold is enormous relative to the stock of dollars (M2 is only about $14 trillion). If you wish to call this turnover “demand” for the USD, it’s OK as long as you acknowledge that it’s a different concept than demand for a commodity, which is consumption at a given price.

    One way to answer your question is this: It doesn’t matter much if the USD is only used as a medium of exchange and this status quo never changes. As dearieme put it in a comment to the Trump and Putin post, “the dollars flow round and round.” The Fed’s policy will continue to have some impact on commodity prices but we can live with it.

    But, as dearieme added, “each company, or its bank, would hold some reserves to even out the bumps.” If the dollar gets dropped as the world currency, much will depend on how large these reserves are and how they will be used. At any rate, I would be comparing them with the total amount of USD in circulation (of which M2 is a proxy) rather than with the amount changing hands in any period.

    However, commodity exporters can also run large trade surpluses for years, piling up foreign currency and/or assets.

    In the case of Saudi Arabia, the sheikhs have said they own $750 bn in various US securities, including treasury bonds. According to Bardon’s theory, in the 1970s and the 80s, the US forced the kingdom to buy T-bonds with the dollars they received from oil exports. It’s plausible: in essenсe, the US was paying for Saudi crude with IOUs, so no wonder the Saudis are now major creditors of the Americans. I just don’t see why it is a greater threat than, say, China dumping its $1 trillion of treasuries in the market. First, the seller will take a major loss; second, $750 bn is probably a exaggeration.

  10. Whether it matters or not, the ratio of the dollars traded to the value of oil consumed (per day or per year) only shows that the forex market is extremely liquid.

    What it shows is that the value of the USD drives what people pay for a barrel of oil, and not that the barrel of oil drives what people pay for USD.

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