One of the most significant sources of strength for the U.S. dollar since the end of the gold standard in the early 1970s has been the petrodollar standard. This standard came into being following the close of the gold window in 1971 when President Richard Nixon agreed to provide arms and protection to Saudi Arabia in exchange for the Kingdom denominating all sales of oil in U.S. dollars. As Saudi Arabia was and still is the largest producer of oil in OPEC and the largest exporter of oil in the world, other nations quickly followed suit and thus the petrodollar standard was born.
The petrodollar standard ensures a strong demand for U.S. dollars by countries all over the world as well as a strong demand for U.S. Treasury securities. This is because countries that import oil require large quantities of U.S. dollars to purchase all the oil that they import (because all purchases of oil are ultimately done in U.S. dollars). These dollars must be purchased in the open market, which creates demand for dollars. Many of these countries may not want as many U.S. dollars if they did not need to buy these dollars in order to purchase the oil imports that they need. Thus, the petrodollar standard creates artificial demand for U.S. dollars by creating demand in excess of what the market would normally desire. Because the importing countries are paying in dollars for their oil, the countries that are exporting oil are thus receiving these dollars, which accumulate on the balance sheets of their respective central banks when the companies that are actually conducting the oil sales exchange these dollars for their local currencies. Historically, the most logical thing for these central banks to do with all these dollars was to lend them back to the United States Federal Government through the purchase of Treasury securities. This was due largely to their convenience, liquidity, and perceived safety. Ultimately, the U.S. dollar's dominance in the oil trade led to it becoming dominant in all forms of trade. This led to exporting manufacturing powerhouses such as China and Japan amassing large quantities of dollars on the balance sheets of their central banks, which they also recycled back into Treasury securities just as the oil exporting nations had done. The recycling of all of these trade and oil dollars back into Treasury securities has generated artificial demand for Treasuries that would not have been present in the absence of this standard. This thus allowed the United States' governments, companies, and citizens (since most interest rates on loans are tied to Treasury rates) to borrow more money at lower interest rates than they would ordinarily be able to. We can see evidence of this by looking at the size of the total credit market, which is the total amount of debt owed by all governments, corporations, and individuals in the United States.
As the chart shows, the total amount of debt owed began to go parabolic in the early 1970s, which was right around the time that the United States left the gold standard and the petrodollar came to dominance. This provides evidence that the petrodollar standard was at least one enabling factor in America's ability to obtain massive amounts of debt over the past few decades. Further evidence of this comes from the fact that the United States as a whole accounts for approximately 26.86% of all total outstanding debt in the world. This figure is calculated from figures published by the Wall Street Journal last year that show that the total debt owed by every business, household, and government in the world is approximately $223.3 trillion. Not all of the United States' total $60 trillion in debt is government debt of course, but the U.S. Public Debt also began to go parabolic in the 1970s.
The United States is far from having the highest debt-to-GDP ratio in the world. That title goes to Japan which had the advantage of an extremely high savings rate that allowed its government to sell its debt directly to the country's own banks and thus hold interest rates down due to the demand for this debt from its own citizens. The United States does not have this advantage. Other countries that have higher public debt-to-GDP ratios than the United States include Italy, Portugal, and Greece. All of these countries had the advantage of artificially low interest rates due to their inclusion into a common currency block with stronger nations like Germany. The United States does not have this advantage either. In fact, the only thing holding down interest rates is the U.S. dollar's status as a reserve currency and this is largely due to the petrodollar standard.
Unfortunately, there are some signs that the petrodollar's dominance is beginning to be challenged. On April 24, officials from the Russian government held a secret meeting with executives from several of the country's largest companies (including some of the largest oil and gas companies in the world) regarding ways in which the country can reduce the use of the U.S. dollar in its export operations. As Russia is the largest exporter of natural gas and second largest exporter of oil in the world, that country's move away from the United States dollar would obviously significantly reduce the importance of the dollar in the international oil trade upon which the petrodollar depends.
The country's corporations have already made some moves to reduce their use of the dollar. On June 7, Zero Hedge reported that Gazprom (OTCPK:OGZPY), the largest natural gas company in the world, is no longer accepting payments from more than 90% of its customers. However, a critical read through the article, as well as other sources, reveals that it is not Gazprom that made this move. It was Gazprom's oil-producing subsidiary, Gazprom Neft (OTCQX:GZPFY), the fourth largest oil producer in Russia and one of the largest oil companies in the world. Gazprom Neft produces an average of 1.2 million barrels of oil equivalent per day, which is about 14% less than what ConocoPhillips (NYSE:COP) produces. According to ITAR-TASS, an official Russian news agency, nine out of ten consumers of Gazprom Neft's oil have agreed to pay for it in euro with one customer, Belarus, agreeing to pay in Russian roubles.
Although it was not Gazprom itself that moved away from using the dollar, it is important for investors not to get complacent. After all, Gazprom is majority owned by the Russian government and it is the Russian government that is pushing the country's shift away from use of the United States dollar in trade. Thus, Gazprom may soon begin working to get its customers to pay in currencies other than the United States dollar. As Gazprom is by far the largest producer of natural gas in the world, this may prompt other companies and countries to begin trading oil and gas in currencies other than the dollar.
In order for Russia to move away from using the U.S. dollar in its export operations, it would need to find trade partners who also support such a move. Fortunately, it has found such a partner in China. China is the world's largest importer of oil and so its desires can understandably command a major role in the international oil market. These desires are somewhat at odds with the continued dominance of the petrodollar. As fellow Seeking Alpha contributor Russ Winter points out, China is actively attempting to use the renminbi to pay for all of the oil and gas that it imports. Several of the world's largest energy exporters have already agreed to accept the Chinese currency including Russia, Iran, and the United Arab Emirates. There has been much speculation that Venezuela, another major oil exporter, will also begin selling oil in yuan. This is largely due to Venezuela having much better diplomatic relations with China than with the United States. However, this has not happened as of yet. Should it occur though, it would represent a further reduction to the petrodollar's dominance.
At this time, the petrodollar standard is still being supported by the largest exporter of oil in the world, Saudi Arabia. But even this support may be waning. The reason for this is quite simple. Saudi Arabia currently exports more oil to China than to the United States and as already discussed, China is actively working to conduct all of its international energy purchases in renminbi. When we consider that China is now the Kingdom's largest customer, it is easy to see how China may be able to exert more influence than the United States. Unfortunately, there are some signs that Saudi Arabia may be beginning to accede to the Chinese preference. One piece of evidence for this is a recent partnership between Saudi Aramco, the Saudi Arabian national oil company, and China's Sinopec (NYSE:SHI). According to an article in China Daily, the two companies have teamed up to construct a massive oil refinery in the Red Sea port of Yanbu. This refinery, expected to be completed in 2014, will process approximately 400,000 barrels of heavy crude oil per day, which will presumably be sold to China. The two countries have also entered into some other agreements together, such as one to work together on the peaceful usage of nuclear energy. This shows that the relationship between Saudi Arabia and China is growing stronger at the same time that the United States is growing its own oil production at home. This situation could lead to Saudi Arabia eventually abandoning its support for the petrodollar and beginning to sell oil in other currencies, particularly Chinese yuan. If Saudi Arabia abandons the petrodollar standard then the whole standard could collapse as the two largest oil exporters in the world would no longer be supporting it and the petrodollar's dominance largely depends on the support of oil exporting nations.
As already mentioned, the petrodollar standard has artificially increased the value of the U.S. dollar beyond where it would be in the absence of the standard as well as artificially held interest rates at a lower level than where they would be in the absence of the standard. In effect, these two factors mean that the American population has and is enjoying a higher standard of living than it would otherwise have due to the petrodollar standard. If the petrodollar standard could collapse then this would naturally no longer be the case. One thing that would happen is that interest rates would rise. This would likely cause increases in the cost of carrying floating rate debt and so both business and consumers would likely cut back on spending in order to pay down their respective debt loads. In the case of consumers, it is likely that some of these spending cutbacks will be forced upon them because the payments on their debts will go up but their incomes most likely will not. This will result in consumers having less money to spend at retailers which will likely lead to a slowdown in that sector. There is a chance that interest rates will not go up even if the collapse of the petrodollar standard reduces foreign demand for Treasuries, though, because the Federal Reserve could step in with further "quantitative easing" programs which essentially amount to it printing money and using the printed money to purchase Treasury securities.
The second thing that would likely happen should the petrodollar standard collapse is that the inflation rate in the United States would likely increase. This would be particularly noticeable in the prices of imported goods. This is simply due to the likely impact on currency valuations. In the absence of the petrodollar standard, there will be lower international demand for U.S. dollars because other nations will no longer have a need to hold huge amounts of dollars for use in the oil trade. This will cause the value of U.S. dollars to fall relative to other currencies. This means that it will require more U.S. dollars to equal the same amount of a given foreign currency. This means that even if a foreign company holds its prices steady, its American customers will need to pay more from their perspective because the foreign company needs to pay its employees and suppliers in their own currency. When we consider how many foreign-made goods are sold in the United States, it is easy to see how large of an impact this could have.
In fact, we may already be seeing some of the effects that this projected inflation could have. As I discussed in a recent article posted to this site, the real median household income in the United States has fallen steadily since the year 2000, with the only signs of improvement being a three-year period in the middle of last decade prior to the financial collapse. The real median household income currently stands at the lowest level that it has been since 1995. This chart, from the Federal Reserve Bank of St. Louis, confirms this statement.
The real median income is a particularly illustrative figure because it is adjusted for inflation. Thus, it tells us how the purchasing power of the median family has changed over the years. As the chart shows, the trend over the past decade has not been especially promising. Should the international demand for the U.S. dollar decrease due to a weakening petrodollar however, it is then likely that this purchasing power will continue to decline. This would clearly prove to be a negative for the United States economy as a whole. As the end of the petrodollar standard would also make it more difficult for the country as a whole to continue to fund its rapid acquisition of debt, it would greatly reduce the ability of the United States to continue to live beyond its means.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.