Understanding Global Liquidity, Part 4: Petrodollars
When I talked about Eurodollars in Part 2 of this series, I briefly touched on their origin as US Dollars circulating outside the United States, which then became the basis for credit-money at foreign banks. In that post, I quickly moved on to the fact that the Eurodollar system switched to using US Bank Credit Dollars as collateral, which gave it the ability to grow faster and larger than anyone expected at the time.
Yet, the US continued to buy things from other countries and continued to pay for them with dollars (though it’s impossible to attribute those dollars to a specific fractional reserve banking system). Those dollars found their way into large asset accounts belonging to exporting nations, who used these dollars to fund their government spending. These dollars circulating outside the US became known as Petrodollars.
Along with the Eurodollar Banking System and the Bond Rehypothecation System, the Petrodollar System is a critical component in understanding global liquidity.
Bretton Woods Ends
In order to understand the Petrodollar System, we need to spend a little time covering what came before it: the Bretton Woods System.
Created by 44 ally nations in 1944, the Bretton Woods System setup up the dollar as the global reserve system for the post-WW2 era. Dollars were convertible to gold at $35 / oz. All other currencies were convertible into dollars at fixed exchange rates. Via the dollar, all currencies were indirectly pegged to gold.
The Bretton Woods System put the dollar at the center of global economic activity—something that made sense right after WW2, when the US had 80% of the gold supply and the only industrialized economy not bombed to hell.
As covered in Part 2: Eurodollars, the next 2 decades saw more and more dollars circulated outside the US, giving rise to the Eurodollar Banking System. By 1971, the global supply of dollars was so large compared to the global supply of gold, the $35 / oz price was indefensible. Many countries started converting their dollars to gold, and the US saw gold stockpiles depleted. In 1971, Nixon ended the gold-convertibility window, and dollars could no longer be traded in for US gold—officially ending the Bretton Woods System.
An interesting side note: some people have sophisticated knowledge of the breakdown of the Bretton Woods System and the rise of the Petrodollar System. However, they don’t have an understanding of the Eurodollar Banking System. In their point of view, the gold window was ended to enable uncontrolled dollar creation, which was driven by some sort of conspiracy involving a power-hungry Fed or “Washington officials”. With insight into how the Eurodollar Banking System had already led to uncontrolled dollar-creation, we can see that ending the gold convertibility window was a response to uncontrolled dollar-creation that was already on-going. From all accounts, US officials weren’t aware of what was happening, let alone have any control over was happening.
Petrodollars Are Born
I’ll provide a quick history of the origin of the Petrodollar System. For a more detailed description, check out this article from Bloomberg.
Here’s the geo-political context in 1973, when the Petrodollar System was created:
- The Vietnam War (1965 - 1973)
- The war cost $168B, or almost 11% of total federal tax receipts during that period
- Great Society Entitlements (1965)
- President Lyndon Johnson launched the Great Society, greatly increasing entitlement programs, financed with deficit spending
- Yom Kippur War (1973)
- The United States supplied arms to Israel, which were critical to its war with a coalition of Arab countries
- Oil Crisis (1973)
- As retaliation for supporting Israel, Saudi Arabia led an oil embargo against the United States and other countries that had supported Israel causing an oil crisis. Americans were forced to wait in long lines to buy rationed amounts of gasoline
After the oil embargo and resulting crisis, the US realized that their dependence on Middle East oil was a glaring national security vulnerability that needed to be closed. But how?
The answer was the creation of the Petrodollar System by joint agreement between the US and Saudi Arabia. The US would provide Saudi Arabia military equipment and, according to some sources, guaranteed protection from Israel. Whatever the particulars of the deal, the upshot was that the US would use its military power to help out its “friend” Saudi Arabia (if they played ball). If not, presumably, US military power would have been used against its “evil enemy”: the uncooperative Saudi Arabia that would hold the American Way of Life hostage.
In return for the military alliance, the US asked that the Saudis to price all their oil exports in dollars—and dollars only. All countries would have to pay for oil by first acquiring dollars. They also asked the Saudis invest the proceeds in US government bonds—which wasn’t a huge concession at the time, as the US represented 31% of world GDP and the safest place to park nation-sized wealth. The Saudis had one condition: the bond purchases must remain secret, so that the Saudis would not be accused of supporting an Israeli ally. Saudi holdings were only disclosed for the first time in 2016.
Both countries agreed and the Petrodollar System was born. By 1975, all OPEC countries had agreed, once again cementing the US dollar as the global reserve currency. This agreement is why you haven’t been able to buy oil with Euros, Yen, or Yuan, without first exchanging them for dollars (which is expensive on a national scale).
This “price” might have seemed relatively cheap to the Saudis, but it had 4 key advantages to the US:
- It resolved by the pressures that had led to the end of the Bretton Woods System, while restoring confidence in the dollar as a store of value and preserving the dollar as the global reserve currency
- It ensured the demand for US debt, at a time when deficit spending was growing significantly—and ensured that future demand would keep pace with the demand for oil
- It let the US print money for oil, something no other country could do (though the US did take on a unique responsibility for policing the dollar-price of oil to keep the system stable)
An Oil-Backed Currency
When people think of commodity-backed paper currencies, they think of currencies backed by precious metals (usually gold). Commodity-backed currencies require management to maintain price stability or requiring re-pricing the commodity in currency terms (something that makes the devaluation very obvious).
The coexistence of the Bretton Woods System and the Eurodollar Banking System made it impossible for the dollar to avoid a devaluation. The pressure from creation of Eurodollars built up until the peg broke.
From the US perspective, a gold-backed currency had a lot of problems in the 1970s. The growing global economy required a quickly expanding credit-money supply to support the growth, yet the gold supply was mostly fixed. The solution was to reprice gold higher with growing economic activity, but Bretton Woods had pegged the price for almost 20 years. To catch up, gold would have to be repriced significantly and all at once (a one-time impulse devaluation of the dollar). Not only does this hurt confidence in the dollars—but, as the global economy grew in the future, a gold-back currency would force an on-going series of devaluations with no end possible.
Who would use the dollar as a store of value of it was constantly losing value? And if dollars didn’t store very value well, interest rates on dollar-denominated debt would have to skyrocket to compensate for the decay. How could the US finance its deficit-spending in that world?
This might have been a time to reconsider the debt-fueled spending strategies the US has relied on ever since—but we know that didn’t happen. Instead, the US converted the backing of their currency to a different commodity: oil.
This worked WAY better than gold. As global economies grew, they needed more credit-money, and they also demanded more oil. The price of oil in dollars remained relatively stable as both the demand for oil and credit grew in tandem. It wasn’t quite as clean as ounces of gold—but when you had a fistful of dollars, you could think of the purchasing power in terms of barrels of oil quite clearly.
The critical piece was: though both the supply of credit-money and the supply/demand balance of oil were constantly changing, the same underlying force (economic growth) drove both. The dollar-price of oil at least had a chance of being maintained (with proper care)—as opposed to the dollar-price of gold, which was impossible to keep stable with an ever-expanding credit-money supply.
Once established, the Petrodollar system easily anchored all international transactions to dollars, since oil was such a large part of international trade.
Rise of the Sovereign Wealth Funds
Fast forward a few decades, and you’ve got a number of oil-exporting countries that have been collecting dollars for quite some time. They have far more than they spend on running their countries and invest in their local economies. They create Sovereign Wealth Funds (SWFs) that seek global opportunities to meet strategic or investment-return goals.
SWFs are critical to global liquidity. Liquidity is measured in the availability of dollars for investment, and SWFs have a lot of those. Plus, they can lever up their reserves as well anybody, so their wealth represents a ton of potential collateral for whatever fractional reserve banking system they choose (most choose Eurodollars for extra yield…)
In addition, as they’ve grown more sophisticated, they’ve also become more directly involved in filling the demand for dollar denominated credit. Since the 2008 crash, the other systems ran into problems (we’ll discuss those in detail later in the series). The role of SWF grew even bigger, making it even more important to understand the forces that drive them.
In good times, SWFs collect and invest the excess wealth of commodity-exporting nations. However, if countries face a situation where their revenue fails to meet their expenses, they have only a few choices:
- Raise taxes
- Cut spending
- Issue debt
- Sell assets from their SWF to pay for spending
Options 3 and 4 are by far the most politically palatable. They’ll probably issue debt before selling off assets, but if these countries get to a certain point, then SWFs will be forced to sell off assets, just like anybody. SWFs then reverse from global liquidity providers to liquidity sinks. As they unwind their investments, the suck up dollars.
As Darth Macro calls out, even the BIS might not be realizing the impact that SWFs are having on the current liquidity environment.
Conditions for Sustaining the Petrodollar
The Petrodollar System relies on—and attempts to create—a relatively stable dollar-price of oil. The world is a complicated place, and a stable oil price cuts through the noise to deliver a single message: the dollar is a good store of value because you can always use it to buy oil when you need it (and you’re always going to need oil, right?)
If the dollar-price of oil is stable, then you can move all your wealth into US government bonds and collect the positive carry (as opposed to paying the negative carry to store oil)—without fear that you’re about to suffer some major capital-destruction through a currency devaluation. You don’t have to worry constantly about currency depreciation, technological advancement, new oil deposit discoveries, etc. You just watch the dollar-price of oil for warnings.
This is actually really important. I’ve spent the last 10 months studying macroeconomics and trading, trying to ramp up as fast as possible. I still don’t have a measure of inflation that I trust. I’m still struggling with relative fundamental valuations of currencies. I’m working hard at this, and finding firm footing is a rare occurrence. If you’ve got trillions of dollars of assets—and a country to run—how valuable would a single, simple, clear indicator be?
The dollar-price of oil is just that. As Luke Gromen point out, from 1986 to 1999, a US Treasury bond maintained an incredibly stable value of 55–60 barrels of oil per bond. That’s the kind of stability that lets a sheik sleep at night. It also let the US issue debt at lower interest rates than anyone else.
On the flip side, if the price of oil becomes unstable, people start to fear they’re selling valuable commodities for so much paper. They also worry that all the wealth they’ve saved up over decades is about to become worthless. It’s critical that the dollar-price of oil remain stable, so the world can trust the dollar.
Given the logic of the Petrodollar System, there seem to be 5 major conditions required to maintain a stable dollar-price:
1. The demand for oil must grow in proportion to the creation of credit-money
A) The demand for oil cannot fall too far behind the creation of credit-money.
If this condition is violated, the dollar-price of oil collapses. Oil-exporting economies see their revenues slashed and are forced to raise taxes, cut spending, issue debt, or sell assets from the SWFs to make ends meet. They may also try to boost production, which only further lowers the price of oil. If the situation continues long enough, oil-exporting countries will be forced to cut spending, leading to potential civil unrest and disruption of supply, which could then cause a violation of condition 1B below.
Even before we get to that point, oil-exporting nations are likely to seek strategic answers to counter their losses, eroding their commitment to the Petrodollar System and potentially leading to geopolitical instability.
B) The demand for oil cannot outpace the creation of credit-money by too much.
If this condition is violated, the dollar-price of oil will spike, driving massive global inflation in basic materials, transportation, agriculture, manufacturing, and construction. (Oil is a significant cost component in pretty much everything.)
In the US, rising inflation rates lead to rising interest rates, making it more painful to the service the debt—and possibly destabilizing the US political system as deficit spending becomes untenable. Globally, the loss of purchasing power threatens peoples’ ability to feed themselves, directly leading to civil unrest.
2. Oil supply must grow, but only as fast as oil demand
A) Oil supply cannot outstrip oil demand.
If this condition is violated, then the price of oil collapses, and things play out just as if condition 1A were violated.
B) Oil supply cannot fall significantly behind demand.
If this condition is violated, oil prices spike, and things play out just as if condition 1B were violated.
3. All oil must be sold in dollars only
If a significant percentage of oil transactions take place in other currencies, the dollar credit-money supply will be spread over a smaller transaction pool. This leads to an oversupply of currency versus underlying trade, a collapsing dollar-price for oil, and the same crisis of confidence as if condition 1A were violated.
This can be counteracted by careful balancing of the exchange rates between currencies, but any significant break from the Petrodollar System is likely to be an impulse move. The subsequent rebalancing will first cause the crisis, destroying the equilibrium permanently.
4. The Middle East must remain militarily dependent on the United States
If the nations of the Middle East find other sources for military support, they significantly lower their consequences for violating condition 3 and making an irrecoverable violation of condition 3 much more likely.
5. The US must make maintaining the dollar-price of oil a top priority
By setting up the Petrodollar System, the US committed itself to defending the dollar-price of oil.
If the US instead prioritizes other interests over a stable dollar-price of oil (or is somehow prevented in acting to stabilize the price), then the dollar-price of oil will drift away from the stable value, potentially setting off reflexive loops that accelerate the destabilization.
In other words, if the US commitment to the Petrodollar System wavers or the US finds its hands tied, we’ll see the US allow destabilizing situations to persist until a crisis arrives.
Threats to the Petrodollar
Looking at the price chart of oil, we can see the Petrodollar System is under stress:
That is not a stable price chart.
Recent history is filled with clear challenges to the Petrodollar System:
- 2000 - Iraq received U.N. approval to sell oil for Euros
- Violation of condition 3
- 2003 - US invades Iraq
- The war was justified by the never-found Weapons of Mass Destruction (WMD), but it’s hard not to be suspicious of US motives, given Iraq’s clear violation of condition 3
- 2000 to 2004 - The Oil / US Treasury breaks the 55–60 range
- As Luke Gromen writes, in the 2000’s the US engaged in loose fiscal policy similar to that of the 1980’s—but in the ’80s, the US raised interest rates to defend the value of the dollar.
- The US did not do so this time around, a violation of condition 5.
- The dollar lost value, spiking the price of oil and leading to a violation of condition 1B a few years later
- Luke’s theory is the Dot Com Bubble left the US economy too financialized and debt-burdened to tolerate high interest rates
- 2009 - US Shale Oil Supply Starts Growing
- In 2009, US shale oil production was under 300k barrels per day (bpd). By 2015, it reached over 4,000k bpd. A clear stress of condition 2.
- 2011 - The Arab Spring
- High inflation in the cost of food was a key cause for the uprisings (an effect of violating condition 1A)
- 2015 - Russia intervenes in the Syrian Civil War
- Notably, Syria is the only oil-producing nation in the area. A clear violation of condition 4.
- 2016 - Iran begins asking for Euros for oil
- Another violation of condition 3
- 2017 - Saudi Arabia to buy defense systems from Russia
- A direct violation of condition 4
- 2017 - China to buy oil directly for Yuan with gold-backed futures contract
- Another challenge to condition 3, but so far, only Venezuela has started publishing oil prices in Yuan
I’m not expressing any particular opinion here about the policies and events listed above. However, it’s clear to see that each of these represent a violation to a greater or lesser degree of one the conditions necessary to holding the Petrodollar System together.
The Petrodollar System is a 50-year system that backed the value of the dollar with oil, simultaneously stabilizing it as a global reserve currency and driving demand for it. It’s the reason the US at the core of core-periphery model of the global economy. Without it, we’d have had multiple global reserve currencies, and the US would not have been able issue debt so cheaply and in such large quantities. The resulting special status of the dollar also gave rise to the Bond Rehypothecation System. It’s pretty much the reason the current global economy looks the way it does today.
That system is now under significant stress and failing to maintain a stable relationship between currency and commodity. Any predictions of about global liquidity must account for the multiple players reacting to the stress in the Petrodollar System and the likely actions those players will take to defend their interests.
That’s it for the parts of the series focused on the plumbing of the global financial system. In Part 6, I’ll attempt to explain what happened during the Global Financial Crisis using this framework.
DISCLAIMER: None of this intended as investment advice. This is a place for me to put down my ideas and share them with others, whom I fully expect will tear these ideas apart. I have no professional training or certifications, and I've probably already changed my mind on whatever you just read.