News about the expiration of a Washington-Riyadh deal may be fake, but an arrangement that is key to the dollar’s success has eroded.
It is said that works of fiction can often convey certain truths better than a newswire. That is perhaps the light in which to view reports circulating around the internet recently about the expiration of a 50-year ‘petrodollar’ treaty between the US and Saudi Arabia.
The agreement is a piece of fiction. The spurious reports appear to have originated in India or in the murky tangle of websites aimed at crypto investors. There was an official agreement between the US and Saudi Arabia signed in June of 1974 and another, secret one reached later that year according to which the Saudis were promised military aid in exchange for recycling their oil proceeds into US Treasuries. The deal whereby Riyadh would sell its oil in dollars was informal, and there was no expiration date. The petrodollar system as we have come to known largely grew organically.
However, this fiction points to an underlying truth: the petrodollar has entered a long twilight from which there will be no return. No other economic arrangement has done more to ensure American preeminence over the last half-century. Yet in its essence it represented an implicit oil backing to the dollar that would be maintained. To borrow an idea originally expressed by financial analyst Luke Gromen, it is ultimately America’s inability and unwillingness to maintain this backing that is gradually dooming the system.
Origins of the petrodollar
When the US abandoned the dollar’s gold peg in 1971, thus ending the Bretton Woods arrangement, the international financial system was thrown into chaos. What ensued was a turbulent period of high inflation and major adjustments to the new reality of free-floating currencies. Untethered from even the pretense of a gold backing, the dollar unsurprisingly devalued and inflation ran rampant. By the summer of 1973, it had lost a fifth of its value against other major currencies.
This should have marked the end of the two and a half decades of post-war dollar primacy. And yet quite a peculiar thing happened: the dollar’s role as reserve currency and primary instrument of trade only expanded. The reason is that the Americans managed to steer the oil trade into dollars, starting with the Saudis in 1974 and soon thereafter extending to all of OPEC. This established a de facto commodity backing for the dollar. Since the oil market is much larger than the gold market, it actually gave the dollar even greater scope.
In exchange for agreeing to sell their oil in dollars, Saudi Arabia became a protectorate of the US military. Many have seen this deal as a Godfather-like “offer you can’t refuse” for the Saudis. After all, Secretary of State Henry Kissinger and Defense Secretary James Schlesinger attracted considerable attention in early 1975 by refusing to rule out the possibility of taking over foreign oil fields using military force in the event of a “strangulation” of the West by oil-producing countries. Although the US-Saudi oil deal predates these remarks, it’s not a stretch to imagine that the Kingdom regarded coming under the US tent as a safer move than waiting around to find out how the word “strangulation” would be defined.
It probably was a good bet. Many things have transpired in Saudi Arabia in the intervening half century, but one thing that has resolutely not happened is a color revolution or US regime-change operation.
The de facto oil backing and the exception that proved the rule
The dollar thus went from being pegged to gold under Bretton Woods to being unofficially backed by oil. And indeed, after the shock in 1973-74, oil traded in a remarkably stable range of roughly $15-30/per barrel for the next 30 years. This remarkable stability lies at the heart of the success of the petrodollar arrangement. There was one important exception to this stability, but even it ended up only buttressing the system.
That exception is the oil shock of 1978-79, sparked by the Iranian Revolution, when oil surged well above the upper end of this range. This coincided with (and partly caused) a deep crisis in the dollar and raging inflation in the US. It was at this time that Fed chairman Paul Volcker embarked on his famous series of aggressive rate hikes.
Volcker’s tough medicine was aimed at breaking the back of the worst US inflation in history, but no less important was the effect it had on bolstering the frayed credibility of the dollar. A New York Times article from the time complained that the Fed chairman’s moves “make clear that international considerations, and specifically the defense of the dollar, are now influencing American economic policy to a degree unparalleled in the postwar period.” In other words, Volcker was being accused of prioritizing the functioning of the dollar system over domestic considerations.
It’s important not to get too bogged down in untangling cause and effect here, or in seeking in Volcker’s actions an explicit petrodollar angle. The oil market during those years was responding to a host of factors, and it was by no means within the power of the Fed to manage it. Nor was Volcker explicitly trying to do so. But he was very aware of the pain high crude prices caused oil importers and the threat to the stability of the system it posed.
Volcker’s decisive action restored the dollar as the world’s most preferred currency, and the stronger greenback did help keep oil cheaper in the greenback than in other currencies. Most importantly, however, the perception was created that the US was willing to subject its own economy to pain (Volcker put the US through two punishing recessions) in order to preserve the value of the dollar for all global players holding or transacting in dollars.
Oil prices came down in the early ‘80s and basically stayed within the $15-30 range for the next twenty or so years. A lot of this had to do with major new sources of oil coming online, such as the North Sea, Alaska, and Mexico. However, the bottom line is that the dollar preserved its value against oil. It doesn’t even really matter how much of this is an actual achievement of US policy and how much is just a confluence of favorable circumstances. What matters is that the dollar was seen as equivalent to oil, and the Volcker years had created the impression that the US would actually defend it in a time of crisis and manage it fairly. That made holding dollars (or US Treasuries) a reasonable proposition for all.
A 30-year range breaks and the rest is history
Fast forward to 2003, and the oil price began a long and steady ascent. This is largely attributable to rising Chinese demand and the geological realities that many of the world’s major legacy fields were peaking and starting to turn over, meaning the easy-to-extract oil was becoming scarce (It’s more accurate to think about peak ‘cheap’ oil than the actual geological peak.) The dollar also weakened substantially against other major currencies over 2003-2008, a circumstance economist Steve Hanke believes caused 50% of the oil price surge during that period.
Importantly, when oil moved to the top of its 30-year range, it didn’t stop. Over the next couple of years, oil prices would rise steadily before peaking at $145 per barrel in July 2008. Again, another way to think about this is a drop in the value of the dollar against oil, an ominous development for those holding dollars and buying oil.
This is the moment when a fatal crack appeared in the foundation of the petrodollar edifice. With oil surging and the dollar weak, where was a new swashbuckling Paul Volcker to come in and tighten policy, strengthen the dollar at whatever cost, and preserve its implicit oil backing? The answer: nowhere to be found. In fact, quite the opposite happened. During the crucial period when crude was rising in 2007 and early 2008, the US actually cut interest rates in response to a weakening economy, thus exacerbating the problem.
Luke Gromen sees this episode as causing an important epiphany for many nations who had been aggregating foreign currency reserves with a belief that the dollar would continue to be managed to be as good as gold for oil, and that the US would not pursue policies that would have the effect of impoverishing energy importers.
Making matters worse was the deluge of bailouts and trillions in quantitative easing in the aftermath of the 2008-09 financial crisis, which contributed to the sense that the US would spare no effort to stabilize its own faulty banking system – the dollar be damned. It had also become apparent that the US economy was now too financialized and too leveraged to endure Volcker-like treatment.
Now it should be noted that oil prices did plummet in 2009, and the dollar did (perversely) strengthen amid the global financial crisis. But this owed directly to the economic carnage caused by the meltdown itself and the ensuing recession. Nobody confused Ben Bernanke for Paul Volcker.
Oil prices also plummeted in 2014-2016 amid the shale boom, which made the US the de facto marginal cost producer globally. It can even be argued that for much of the decade of 2010-2020, the dollar fell into a new (albeit higher) range against oil, thus reinstating a pale reflection of the previous dollar-energy tie. But the system was already malfunctioning by then; the short-lived shale miracle only delayed and obscured the consequences.
It’s important not to seek in any fluctuation of the dollar or crude an affirmation or refutation of the idea of an oil backing to the greenback. What is key to grasp is that starting in the mid-2000s with the run-up in oil described above, the implicit promise of the petrodollar system began to break down. This break-down has been playing out ever since.
China wants to print yuan for oil; the US inadvertently obliges
One country that took early notice of the declining credibility of the dollar is China. Merely days after Fed chairman Ben Bernanke announced the largest money-printing escapade in history, in March 2009, the head of the People’s Bank of China issued a boldly titled white paper called ‘Reform the International Monetary System’, calling for a neutral reserve asset to replace the dollar-centric system.
In the ensuing years, China, the world’s largest importer of oil, made clear its desire to be able to purchase oil using its own currency. It has also cut back on buying US Treasuries and been acquiring gold at a blistering pace, both clear votes of no-confidence in the dollar.
Many interpret these moves in overly geopolitical terms, as Beijing’s desire to flex its muscles and undermine the US-led unipolar world for its own sake. However, it’s important to understand that for the Chinese, who are short oil and long US Treasuries, this is a matter of national security. Relying on a currency which is being debased by the day and overseen by an increasingly belligerent fading hegemon for buying the modern economy’s most critical commodity – whose overall price trajectory is upward – is no solution.
China introduced yuan-priced oil contracts in 2018 as part of an effort to make its currency tradable globally. Although this initially didn’t make much of a dent in the dollar’s dominance of the oil market, it showed where Beijing was headed. What got the needle moving was the Ukraine conflict – or rather Washington’s unhinged reaction to it. And here we arrive at the meeting point of a deep-seated economic trend and a geopolitical flashpoint.
With Moscow limited by sanctions in where it could market its oil, China significantly ramped up purchases of discounted Russian crude, with settlement in yuan. Legendary analyst Zoltan Pozsar called this development “dusk for the petrodollar… and dawn for the petroyuan.”
It goes beyond China. The BRICS group as a whole has, as a stated objective, increasing trade in local currencies, an objective that has gained urgency in light of Washington’s capricious and overbearing use of sanctions. India, the world’s third-biggest oil importer and consumer, has become the biggest buyer of seaborne Russian crude since 2022, paying for Russian crude in rupees, dirhams, and yuan. As the BRICS group consolidates and new financial infrastructure and trade networks coalesce, the non-dollar oil trade will only grow.
In January 2023, Saudi Arabia even openly stated that it was willing to sell oil in currencies other than the dollar, the first public acknowledgement of what had been a source of speculation for years. In November of that year, the Kingdom sealed a currency swap deal with China, a surefire precursor of plans to do future business in local currencies.
The petrodollar arrangement has been very good for the Saudis and historically they have not shown a strong eagerness to give it up. No doubt contributing to this is a certain hesitancy about breaking with the Americans. Things do not tend to end well for the leadership of oil-producing countries who stop doing the bidding of the US. Yet the times are changing and Riyadh seems to sense that.
Washington wants all the benefits but none of the responsibility
We are now accustomed to the proliferation of unbacked currencies, so it’s hard to appreciate just how unusual the petrodollar arrangement was for a world long used to dealing with some form of gold standard. It’s one thing for a government to insist that a currency be accepted within its own borders, but to propose that another country part with real goods – such as oil – for money backed by absolutely nothing would have been a tough sell in past eras. Yet the US managed to do that and more.
But such an arrangement would never have been sustainable for so long – longer than the gold-backed Bretton Woods lasted – based on military power and backroom dealings by cabals of diplomats alone.
While Washington has always acted with a certain sense of impunity, believing there to be no viable alternative to the dollar, for the several-decade-long golden age of the petrodollar there was at least an economic justification for it. It worked well enough for the rest of the world that, until recently, no major bloc emerged to oppose it. There also was the long shadow of Paul Volcker to give it credibility.
However, just as the US reneged in 1971 on its obligation to convert dollars into gold, it later reneged on its implicit obligation to maintain the value of the dollar against oil. Since then, Washington has shed all semblances of fiscal restraint and any pretense of managing the dollar in the best interests of everyone. Instead, it now wields the greenback as a weapon in a desperate bid to roll back the very events it helped set in motion by not preserving the integrity of the currency in the first place.
The US is now fighting to maintain all the benefits of this broken system, the responsibility for which it is neither equipped nor willing to take any longer. If the dollar isn’t pegged to gold and isn’t even implicitly backed by oil, and Washington won’t preserve its integrity, then it is hardly up to the task of facilitating trade in critical resources. A system as deeply entrenched as the petrodollar won’t disappear overnight, but when its economic foundation has eroded, it can only be maintained for so long by bluster and smoke and mirrors.