what is the petrodollarEmerging in the 1970s, the petrodollar system is a global economic development that has changed the landscape of the oil industry. The petrodollar has allowed the United States to remain a dominant economic powerhouse and has cemented the dollar as a world reserve currency. Though many suspect the petrodollar system faces a legitimate threat due to oil-rich nations developing their own trading currencies, it is important to explore the history of the system to get a better grasp on how you can prepare your personal finances for the consequences of economic evolution.

What is the Petrodollar System?

The petrodollar system refers to countries using U.S. dollars for oil-exporting transactions. Oil exporters have been using U.S. dollars for their transactions for the past 50 years. The end of the gold standard in 1971 left the U.S. grasping for legitimacy. Without being backed by a tangible asset, the dollar was at risk of rampant devaluation. At the same time, oil-rich countries like Saudi Arabia faced embargos imposed by the Organization of the Petroleum Exporting Countries (OPEC) for showing Israel support during the Yom Kippur War. Since Saudi Arabia’s oil reserves were plentiful, it gave them the upper hand, allowing them to increase the price of oil to make up for whatever revenue was lost due to the embargo. Saudi Arabia also decided to conduct all oil-related transactions in U.S. dollars, keeping the country safe from further economic turmoil and allowing the dollar to remain hegemonically strong. Any surplus dollar earnings were invested in assets like U.S. Treasury bonds, creating a firm relationship between the dollar and the oil market.

“We’re not isolated anymore. We’re not a finite or discrete economy that can rely on itself and nobody else. Everybody’s interconnected.”
–Precious Metals Advisor John Karow

How Does the Petrodollar System Work?

The petrodollar system functions based on the premise of oil being traded in U.S. dollars. As a result, countries that import oil must use U.S. dollars to pay for the commodity, helping the dollar maintain its status as an essential form of currency.

Furthermore, the system includes “petrodollar recycling,” wherein oil-exporting countries invest their U.S. dollars in foreign assets like government bonds. This practice can potentially enhance economic ties between the United States and other countries.

Prominent stakeholders in the petrodollar system include major oil-exporting countries like Saudi Arabia, Russia, and the United Arab Emirates, nations that hold significant U.S. dollar reserves, and the U.S. government. The system’s impact on the global economy is substantial, and its significance is expected to remain strong in the foreseeable future as long as oil-rich countries continue to benefit from dollar-based transactions.

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With that said, the petrodollar system isn’t perfect. Oil prices can become volatile, leading to an excess of U.S. dollars in oil-exporting countries when prices increase significantly. This surplus can potentially trigger inflation, forcing the U.S. to find ways to offset domestic economic issues with temporary solutions like raising interest rates. This is where diversifying your investment portfolio with physical assets like precious metals can make sense. These assets, such as gold and silver, can perform well during times of economic volatility, making precious metals a safe investment against economic instability.

Global Benefits of the Petrodollar System

The petrodollar system, despite volatility and international controversy, has yielded numerous global advantages that have shaped the international economy and relations for an extended period.

Facilitation of Global Trade and Economic Activity

The petrodollar system has actively encouraged global trade and boosted economic activity across the world. By denominating oil in U.S. dollars, it has established a stable and widely accepted currency for oil transactions. This simplifies international trade as nations do not have to constantly exchange currencies for oil purchases. The widespread adoption of the U.S. dollar as the oil trade currency has facilitated seamless global transactions and contributed to the expansion of trade in other sectors as well.

Reinforcement of Strategic Alliances and Diplomatic Relations

The petrodollar system has been instrumental in fostering and strengthening strategic alliances and diplomatic ties between oil-exporting countries and the United States. The United States often has a vested interest in maintaining stability in oil-producing regions, and providing military protection and support in exchange for their commitment to the petrodollar system has bolstered these alliances. For example, in 1973, the U.S. deployed military personnel to assist Saudi Arabia during the Yom Kippur War, sending over wartime aircrafts and providing training for the Saudi Armed Forces.

Moreover, the reliance on the U.S. dollar as the primary currency for oil trade has created economic interdependence between nations. This interdependence incentivizes cooperation and diplomatic engagement, encouraging dialogue and collaboration in international affairs.

Threats to the Petrodollar System

Investment Shifts and Diversification

Given the shifting global economic landscape, oil-exporting countries may look to reduce their dependence on the US dollar and diversify their foreign exchange reserves. These countries may achieve this by reallocating investments to assets that aren’t denominated in US dollars, potentially affecting the stability and liquidity of the petrodollar system. This shift has already begun, with oil-producing nations taking steps to diversify their portfolios by investing in other currencies and assets. For instance, the Bank for International Settlements reports that between 2000 and 2017, central banks of oil-producing countries increased their investments in foreign exchange reserves from $5 trillion to $12 trillion. During that same period, OPEC countries amplified their investments in gold, rising from $260 billion to $1.2 trillion.

Additionally, as a petroleum powerhouse that is currently suffering from SWIFT sanctions, Russia is one of the few countries turning to the Chinese yuan to gain independence from the petrodollar. Should confidence in the dollar and the U.S. as a whole continue to decrease, more countries could potentially be inspired to conduct their trade of essential resources with perceivably less volatile currency.

Decreased Dependence on Fossil Fuels

Efforts on a global scale to address climate change and shift toward a low-carbon economy have the potential to reduce the world’s reliance on fossil fuels. As countries adopt more environmentally friendly policies and technologies, the demand for oil is likely to decrease. This decrease in demand could have implications for the petrodollar system, as it is closely tied to the global demand for oil and the US dollar’s role as the dominant currency for oil transactions.

Historically, countries with significant oil reserves have held substantial global influence due to their ability to supply oil. The petrodollar system has contributed to this power dynamic by ensuring a constant inflow of cash to oil-exporting nations, promoting political stability and economic well-being.

However, as the world transitions towards greener alternatives, the significance of the petrodollar system may diminish. A decrease in global demand for oil could lead to a reduced reliance on the US dollar and potentially shift the balance of power away from oil-exporting countries.

“[Big oil producers] don’t need us anymore. The result is…an erosion of the power of the dollar as a reserve currency.”
–Precious Metals Advisor John Karow

Development of Cryptocurrencies

The rise of cryptocurrencies, such as Bitcoin and Ethereum, poses a challenge to the longstanding dominance of traditional fiat currencies like the US dollar. While cryptocurrencies are not yet widely utilized in the oil trade, their disruptive potential in the financial system should not be underestimated. If cryptocurrencies gain widespread acceptance, they could serve as an alternative form of payment in the global oil trade, thereby diminishing the influence of the petrodollar system.

Cryptocurrencies operate on blockchain technology, which is a decentralized network of computers that verify and record transactions without the need for intermediaries like banks. This characteristic makes cryptocurrencies attractive for international trade, as they eliminate reliance on financial institutions to facilitate transactions.

Cryptocurrencies are not just an alternative to the U.S. dollar or other fiat currencies, but also offer a way to sidestep the World Bank and International Monetary Fund (IMF). These institutions have long been criticized for their role in imposing economic sanctions on countries that do not follow U.S. foreign policy objectives, such as Venezuela and Iran. The petrodollar system is another example of how cryptocurrencies could undermine the U.S.-led global order by removing the need for American banks to facilitate oil trade between buyers and sellers around the world.

👉 Related Read: The Rise of Digital Currency, and What it Means for Gold and the US Dollar

Protect Yourself from the Petrodollar’s Uncertain Future

Right now, the petrodollar remains strong, but the development of international digital currencies, global tensions, and shifts in the oil market can have a huge effect on the health of the U.S. dollar. When it comes to managing your investments to protect your wealth, you need to choose an ever-valuable asset that will serve you well should the economy take a turn for the worse. At Scottsdale Bullion and Coin, we’ll help you navigate your precious metals investments to keep your portfolio in line with your goals. Download our FREE petrodollar report today for more details on how to prevent a weakening dollar, inflation and global tensions from affecting your savings.