How Petrodollars Affect the U.S. Dollar

After the collapse of the Bretton Woods gold standard in the early 1970s, the United States struck a deal with Saudi Arabia to standardize oil prices in dollar terms. Through this deal, the petrodollar system was born, along with a shift away from pegged exchanged rates and gold-backed currencies to non-backed, floating rate regimes. 

The petrodollar system elevated the U.S. dollar to the world's reserve currency and, through this status, the United States enjoys persistent trade deficits and is a global economic hegemony. The petrodollar system also provides U.S. financial markets with a source of liquidity and foreign capital inflows through petrodollar "recycling." However, a full explanation of the effects of petrodollars on the U.S. dollar requires a brief synopsis of the history of the petrodollar.

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 U.S. dollar amidst soaring inflation.

Through bilateral agreements with Saudi Arabia beginning in 1974, the U.S. 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 U.S. 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. 

Benefits of the Petrodollar System

Since the most sought-after commodity in the world—oil—is priced in U.S. dollars, the petrodollar helped elevated the greenback as the world's dominant currency. With its high status, the U.S. 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 U.S 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 U.S. moved forward with a bill—called NOPEC—that would allow the U.S. 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 U.S. 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 U.S. 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. 

The Bottom Line

After the 1970s, the world switched from a gold standard and petrodollars emerged. These extra-circulated dollars helped elevate the U.S. dollar to the world reserve currency. The petrodollar system also facilitates petrodollar recycling, which creates liquidity and demand for assets in the financial markets. However, the cycle could reach an end if other countries abandon petrodollars and begin accepting other currencies for oil sales.