Gold and the Petrodollar

Gold and Petrodollar

What is a petrodollar? A Petrodollar is a US dollar earned by a country through the sale of petroleum. The term was coined by Ibrahim Oweiss, professor of economics at Georgetown University in 1973. After the collapse of the Bretton Woods accords and of the gold exchange standard in 1971 the price of gold skyrocketed from $35 to top $850 an ounce in January 1980. The US government to finance the Vietnam war expanded the currency base by printing dollars. This started inflation and that even with price controls.

A note from the Deputy Assistant Secretary for International Finance and Development (Sidney Weintraub) to the Under Secretary of the Treasury for Monetary Affairs (Paul Volcker) stated that “US objectives for the world monetary system – a durable, stable system, with SDR as a strong reserve asset at its centre – are incompatible with a continued important role for gold as a reserve asset.” He continues by saying that “It is the US concern that any substantial increase now (1974) in the price at which official gold transactions are made would strengthen the position of gold in the system, and cripple the SDR” and therefore also the US dollar which now was a major component of the SDR.

To protect the US dollar after the collapse of the gold exchange standard secretary of State Henry Kissinger skilfully negotiated in 1973 a deal with Saudi Arabia from which the so-called petrodollar emerged. The US agreed military support to Saudi Arabia and in exchange the Saudis agreed to sell oil only in US dollars. They also agreed to reinvest those dollars back into US Treasuries. Saudis also agreed to persuade other OPEC nations to accept only dollars for oil and reinvest them in US Treasuries likewise.

NixonUS President Richard Nixon shaking hands with King Faisal of Saudi Arabia and US Secretary of State Henry Kissinger

With inflation exploding, the dollar collapsing and the price of gold skyrocketing it is easy to speculate that oil producing countries would have converted their oil sale profits into gold. Gold is and has been consider in North Africa and the Middle East (major oil producers in the 70s) a traditional store of value. It was also immediately after the collapse of the London Gold Pool and the rush by European central banks to convert US dollars into gold. We have also seen how fast countries who found themselves in conflict with the US converted their dollar reserves into gold (Muammar Gaddafi in Libya, Saddam Hussein in Iraq, Ayatollah Khomeini in Iran, Hugo Chávez in Venezuela).

Soon after the Saudi-US agreement all oil producers followed suit. Every oil importer needed US dollars and every oil exporter received US dollars. All those dollars were then recycled into US Treasuries. This money then was spent into the US economy. End of the Bretton Woods accords and therefore collapse of the gold exchange standard in 1971 and the new petrodollar standard created an enormous and consistent demand for US dollars. This saved the dollar from a total collapse.

In 1971 I was on holiday in Paris and found myself incapable to exchange US dollar American Express travel checks. Only a few months before the dollar was king. In the same month a similar experience happened to author Janet Tavakoli but in Rome. It was the first time American Express decided to create travel checks in other currencies than the US dollar like the Swiss franc, British pound, Japanese yen, etc. When I mention today that there was a time when nobody wanted to accept a US dollar nobody wants to believe me but it did.

However, everything has an end and we are witnessing now the end of the petrodollar. The collapse of the Soviet Union has brought to the world markets Russian oil and new oil extraction technology made the US the largest oil producer. This new technology allowed the US not to be as depended as it was on Middle East oil. This allowed the US to negotiate a disarmament agreement with Iran permitting now Iran to sell easier and cheaper oil on the world markets. In 2015 the US imported only 11% oil from Saudi Arabia and Asia is now the most important oil buyer for Saudi Arabia with China importing 14% of the Saudi oil the same as the US. China also indicated it wants from now on that most of its trade be done in yuan or other currencies than the US dollar. Russia made similar statements. Both China and Russia have also created oil and gold futures exchanges that trade in ruble for Russia and yuan for China. They also talk of future collaboration.

Since the New York World Trade Centre attack the special relation between the US and Saudi Arabia has deteriorated and in the recent months even degenerated. After threats to freeze Saudi assets in the US, US-Saudi relations degraded even fast. The Saudis recently threatened to dump $750 billion of U.S. assets, mostly U.S. Treasuries, if Congress passes a bill authorizing the release of sensitive information implicating Saudi Arabia in the 9/11 attacks. Saudi Arabia’s 40-year pact with the United States is on the verge of ending. So the petrodollar is not only under attack from China and Russia but also from Iran and Saudi Arabia. Deputy Administrator of National Energy Administration of China Zhang Yuqing said his country is planning to buy 50% of Iran’s gas exports. Both China and Iran have indicated all this gas will be paid in other currencies than the US dollar.

US SaudiUS President Barack Obama meets with Saudi King Salman bin Abdulaziz, 2016. Photograph: Saudi Press Agency/EPA

With the rise of China and India continuing in the coming years, the Saudis do have more options for military protection than they did back in the 70s but they are not ready yet to break the defense agreement negotiated by Henry Kissinger in 1973. Back then, the US was the only major market for Saudi oil but now all future growth in oil demand is coming from Asia making the US even less important in Saudi eyes. China replaced the US as the world’s largest net oil importer in 2013.

This new negative US-Saudi relation threatens the Saudi riyal-US dollar peg and an important demand for US dollars. China could put pressure on Saudi Arabia in its strategy of eliminating the “hegemon” dominance in the international monetary system and convince Saudi Arabia to accept the yuan rather then the US dollar for future oil purchases. Recent threats by the US of asset confiscation could convince Saudis to accept China’s offer. In 2015, Russia surpassed Saudi Arabia in oil supplies to the Chinese market putting even more pressure on Saudi Arabia in future negotiations with China.

CjOagLuUgAAr-hZ.jpg-large

With major weakness of the reserve fiat currencies like the EU euro, British pound and the Japanese yen it leaves few alternatives to the Saudis besides gold to store their reserves. Saudi Arabia has not made public its gold reserves since 2009 but I expect they already doubled by now their 2008 reserves of 322.9 tonnes.

Oil Rig and Ruble

A recent Sputnik article states that “After the West imposed economic sanctions against Moscow, Russia and Beijing established a powerful energy alliance which changed the global oil market. In addition to increasing trade operations with oil and gas, the two countries are set to challenge dominance of the US dollar in setting prices for crude.” It also says “Petro-yuan is a strategic payment tool which would facilitate switching to a multipolar monetary system which would include various currencies and reflect the global balance of power.”

Yuan Oil

With the de-dollarization process continuing and even accelerating I expect gold to profit since both the yuan and the ruble need gold’s support to challenge the “exorbitant privilege” of the dollar. The euro would have been an alternative to the US dollar but it is facing existential problems that make it unattractive as safe alternative to the US dollar. This is why in my view we have seen an increase in gold reserves since the 2008 financial crisis and not in the euro. The end of the petrodollar and with a large amount of dollars outside the US not being needed anymore I can easily see a run out of the US dollar similar and even many times larger then in 1971 and into gold.

The latest article by Kenneth Rogoff, former chief economist of the IMF and Professor of Economics and Public Policy at Harvard University, that describes gold as an extremely low-risk asset with average real returns comparable to very short-term debt and a highly liquid asset I am sure will not go unnoticed and will encourage developing markets’ central banks to sell US Treasuries and dollars and buy gold. They have been major buyers of gold already since the 2008 crisis.

Oil Rig and Gold

 

Chart Annex:

Petrdollars Gold 1

Petrdollars Gold 2

Petrdollars Gold 3

 

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