The Decline And Fall Of The Petrodollar

by: WWS Swiss Financial Consulting SA
Summary

The Shanghai oil futures market is a challenge to the dominant role of the US dollar in the oil market.

Saudi Arabia is a key player and now has good relations with Russia.

The US has imposed sanctions on Iran, Russia and Venezuela.

Weaponization of the US dollar by the Obama and Trump administrations has led to accelerated dedollarization. Freezing accounts in dollars and blocking dollar transactions are economic weapons.

China and Russia have developed payment systems that allow them to dispense having to employ US dollars.

Edward Gibbon`s classic work The History of the Decline and Fall of the Roman Empire covers a period of time that is more than one thousand years. US dollar dominance in global trade is not going to last even one century. It started off in July 1944 thanks to the Bretton Woods Agreement, was helped in February 1945 with the agreement between Roosevelt and King ibn Saud, and the petrodollar got another boost in 1973/1974 due to the informal agreements Henry Kissinger managed to arrange with Saudi Arabia. A Commission was formally formed in 1979.

The dominance of the US dollar can be measured by the percentage of central bank reserves in dollars, which is 62%, and the by the percentage of transactions in Forex markets, which is 85%. That means that of all Forex transactions, 85% of the trades involve US dollars combined with another currency. The euro is second with 20% and the yen third with around 10%. It should also be noted that international loans are often denominated in dollars even though the parties are not American.

The petrodollar is already in decline. The institution of the Shanghai oil futures market early in March 2018 marked the beginning of a frontal onslaught upon the dominance of the US dollar in the oil market. The institution of the DME (Dubai Mercantile Exchange) in 2007 with the goal of setting a Middle Eat/Asian benchmark did not really have much effect on the petrodollar and has not reached significant volumes. The CME (Chicago Mercantile Exchange) still has a far greater volume than the INE (Shanghai International Energy Exchange) , but as of 19th October 2018 the INE had fifteen market makers, and it is to be expected that the Chinese will help to diminish the demand for dollars. This exchange has already been able to get 14% of short one-month future contracts. This percentage will most likely increase as time goes on. This is a new development that changes the oil market.

The list of countries that favor de-dollarization includes China, Iran, North Korea, Russia and Venezuela. The economy in Venezuela has practically been ruined by the US embargo and the blocking of dollar payments. Weaponization of the US dollar in this case serves as a lesson for other countries. there are several other countries that have been destabilized by the US, including Iraq, Libya, Syria and Yemen. They would probably like to free themselves from dollar domination. The case of Turkey is interesting in that geopolitical considerations have to be taken into account. The recent fall of the Turkish lira shows how weak the Turkish economy is when faced with international pressure. Turkey might even promote closer relations with Russia in order to avoid being subjected to pressure from the US and seek to escape from dollar domination.

Chart

There are several studies on how the petrodollar system functions, and the IMF has article after article about how the flow of petrodollars influences the global economy. The collapse of the petrodollar has been examined in detail in the economic collapse blog.

What is clear and should be taken into account by investors is that the US by virtue of the dollar being the dominant global reserve currency and the most-traded currency in Forex markets enjoys a special status. The US can have huge balance of trade deficits and still have a currency that is in demand. Practically the US exports dollars to keep the global economy supplied with liquidity, and a good part of the demand for dollars is due to the oil markets because oil is the most important commodity traded internationally.

Chart: The True Size of the Oil Market

Recent developments indicate that US dollar global dominance is going to be challenged. Russia has built up a system for payments that bypasses the US dollar, and China and Russia have set up payment systems that do not require dollars. This is a recent new development.Iraq and Iran are in discussions to avoid the US dollar and Euro for oil transactions. The EU has so far only voiced interest in setting up a payment system that does not require dollars.

Investors should be aware of what is going on even if at the present time the US dollar is even gaining strength against other currencies. The most recent Forex quotes show the dollar is still doing well.

It is quite possible that the US dollar will further increase in value in the short term due to economic conditions, but the long-term prospect for the dollar is negative. One reason for this is that the US has taken on far more debt than it should have. The current federal projected budget deficit for 2019 is over one trillion. That will be added to the current debt level that is over 21.7 trillion and still rising. Take a look at the debt clock.

As mentioned above the trade balance is deep in the red and has been for some time. The reason why this is so and the dollar can still keep its value is that the demand for dollars is slackening off at a slow pace as the US provides liquidity for the global economic system. China holds over one trillion dollars of US securities and thus finds itself in the embarrassing situation of planning to promote the renminbi as the most important global reserve currency while not wanting to lose substantial amounts of money because of the falling value of the US dollar. The PBoC also insists on regulating the outflow of money and so far the renminbi has not fully penetrated the global Forex market.

The conclusion that one can draw from the current situation and what is to be expected in the next five to ten years is that the dollar will gradually lose value in Forex markets as many countries seek to avoid having to deal with dollars in foreign trade. The Chinese will try to promote the renminbi as the currency to trade in as they little by little sell off US securities and redeem what they already have so as to diminish their vulnerability to a fall in value of the US dollar. The Chinese plan many years ahead, and that means twenty or thirty, not five or ten.

The strategy that will ultimately prove to be successful in such an environment will require continuous attention on the part of investors to developments in the Forex markets. Even if at the present time the US dollar seems to lord it over other currencies, US investors could start diversifying investments and carefully choose to invest in foreign markets. That would also include foreign real estate. Luxembourg REITs are a real possibility.

The role of Saudi Arabia is a key one in the oil business, and investors should pay attention if the Saudis decide to accept currencies other than US dollars as payment for crude oil. Once Saudi Arabia frees itself from the petrodollar strait jacket, other countries may do the same with a consequent diminution of demand for US dollars. The agreement that Saudi Arabia entered into with Russia to buy the S-400 anti-missile system is an indication that the Saudis have established close ties with the Russians. The proposal of blocking US arms sales to Saudi Arabia is a symptom that US-Saudi relations are not what they used to be. This is a new development and bodes ill for the future of the petrodollar.

Some slight weakness in the dollar may follow as it is to be expected that the deal will entail the Saudis buying rubles with US dollars to pay for the system. In any case investors will see signs of this tectonic shift in the global economic system when dollar weakness becomes more evident. Currency diversification is one way of countering future dollar devaluation. De-dollarization is going to be a subject that traders should be aware of in their daily dealings even if the US dollar is presently gaining against other currencies. Investors should plan far ahead and begin diversification. It should be noted that alternative investment is also a way of avoiding dollar depreciation. Gold still offers one possibility of a safe haven. Energy stocks do better in a stagnant or deteriorating market and can serve as a hedge in a recession. In any case investors are going to have to deal with a US dollar that continues losing value. It is the beginning of the end game for the petrodollar that is going to have to live with the petroyuan. This is not to argue that the US dollar is going to disappear, but rather that a great reset in Forex is underway and that investors should take preventative measures in order to preserve their wealth. The boy scout motto Semper paratus (Always prepared) should always be kept in mind by investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article expresses solely the author's opinions, is produced for informational purposes only, and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please always conduct your own research and consider your investment decisions very carefully.