History of the petrodollar

Faced with mounting inflation, debt from the Vietnam War, extravagant domestic spending habits, and a persistent balance of payments deficit, the Nixon administration decided in Aug. 1971 to suddenly (and shockingly) end the convertibility of U.S. dollars into gold. In the wake of this “Nixon Shock,” the world saw the end of the gold era and a free fall of the US dollar amidst soaring inflation.

Through bilateral agreements with Saudi Arabia beginning in 1974, the US managed to influence members of the Organization of the Petroleum Exporting Countries (OPEC) to standardize the sale of oil in dollars. In return for invoicing oil in dollar denominations, Saudi Arabia and other Arab states secured US influence in the Israeli-Palestinian conflict along with U.S. military assistance during an increasingly worrisome political climate, which saw the Soviet invasion of Afghanistan, the fall of the Iranian Shah, and the Iran-Iraq War. Out of this mutually beneficial agreement, the petrodollar system was born. 

Since the most sought-after commodity in the world—oil—is priced in US dollars, the petrodollar helped elevated the greenback as the world's dominant currency. With its high status, the US dollar enjoys what some have asserted to be the privilege of perpetually financing its current account deficit by issuing dollar-denominated assets at very low rates of interest as well as becoming a global economic hegemony.

For instance, countries like China, who hold vast quantities of U.S. debt, have voiced their concerns in the past about the possible dilutive effects to their asset holdings should the dollar depreciate.

However, the privileges associated with being able to run persistent current account deficits come at a price. As the reserve currency, the United States is obligated to run these deficits to fulfill reserve requirements in an ever-expanding global economy. If the United States were to stop running these deficits, the resulting shortage of liquidity could pull the world into an economic slump. However, if the persistent deficits continue indefinitely, eventually, foreign countries will begin to doubt the value of the dollar, and the greenback may lose its role as the reserve currency. This is known as the Triffin Dilemma. 

Petrodollar Recycling

The petrodollar system also creates surpluses of U.S. dollar reserves for oil-producing countries, which need to be "recycled." These surplus dollars are spent on domestic consumption, lent abroad to meet the balance of payments of developing nations, or invested in U.S. dollar-denominated assets. This last point is the most beneficial for the U.S. dollar because petrodollars make their way back to the United States. These recycled dollars are used to purchase U.S. securities (such as Treasury bills), which creates liquidity in the financial markets, keeps interest rates low, and promotes non-inflationary growth. Moreover, the OPEC states can avoid currency risks of conversion and invest in secure US investments.

Recently there have been concerns of a shift away from petrodollars to other currencies. In fact, Venezuela said in 2018 that it would begin selling its oil in the yuan, euro, and other currencies. Then, in 2019, Saudi Arabia threatened to abandon petrodollars if the US moved forward with a bill—called NOPEC—that would allow the US Justice Department to pursue antitrust action against OPEC for manipulating oil prices. In short, the changing landscape of the global energy market could result in a de-facto end to the U.S.-Saudi petrodollar agreement. 

Meanwhile, the US is becoming a major exporter of energy for the first time since the 1960s. This, along with a strong domestic energy sector that focuses on exports, could help a smooth transition away from the petrodollar as energy exports replace the capital inflows from Saudi purchases of US assets and uphold global demand for the U.S. dollar. An added advantage for the United States is that it will ensure domestic energy security, which was the main reason for the petrodollar agreement in the first place. 

Nevertheless, while it will not happen overnight, a drying up of recycled petrodollars could drain some liquidity from American capital markets, which will increase the borrowing costs (due to higher interest rates) for governments, companies, and consumers as sources of money become scarce.

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