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Why The Petrodollar System Is Crippled

Politics / Global Financial System May 23, 2013 - 07:52 AM GMT

By: Andrew_McKillop


For Jerry Robinson ( the reasons why the so-called Petrodollar System must collapse is ultimately because the political and monetary drivers of the system date back to the fast-fading times of 1945-1971 when the the USA's global hegemony and monetary power was almost unchallenged.

After the collapse of the USSR in 1989, the US was the sole remaining hyperpower but also by 1989, the USA's economic power and monetary bases had been sapped.  Robinson cites the old saying "He who holds the gold makes the rules." This statement was a rock-solid truth for the US  in the post–World War II era - but only until the "Nixon Shock" of August 1971 when US president Nixon broke the link between gold and the dollar. Previous to this, at the end of World War II, Fort Knox held nearly 80% of all central bank gold in the world. The US dollar was the world’s undisputed reserve currency. Consecrated by the 1944 Bretton Woods arrangement, the dollar was “safer than gold.”

After 1971 it was not. In 1975, US military power was tested and broken in Vietnam, and oil prices had been pentupled in 1973-1974 by OPEC action led Saudi Arabia - and by the Chah's Iran. For internal political reasons hpwever, Nixon's successor Lyndon Johnson lauched "The Great Society", a project which added deficit to deficit, menacing to open the floodgates of runaway inflation.

Before Nixon broke the "gold standard" which fixed a price of about $38 for 1 Troy ounce of gold, the US received plenty of advance warning. The large and growing demand by foreign nations, including major allies like France for gold, instead of dollars, was a sure sign the United States had to get its fiscal house in order - but firstly Nixon, then Lyndon Johnson went out on a spending binge. As Washington went on racking up debt to fund its unwinnable Vietnam "adventure", killing an estimated 1.5 million Vietnamese, and to fund riproaring domestic demand for everything that US industry could not meet, fueling a constant growth of imports and the trade deficit, foreign nations sped up their demand to exchange dollars for gold from Fort Knox.

Overseas dollars, already needed by foreign buyers wherever oil was priced in dollars, and sold in dollars, were flooding back home with a vengeance, and the USA's gold stock was evaporating. As Robinson writes: "Soon the United States was bleeding gold. Washington knew that the system was no longer viable, and certainly not sustainable".

No formal proof exists for the repeated assertion, by serious historians and analysts that Nixon's Secretary of State, Henry Kissinger made a secret visit to Saudi Arabia as early as 1972, to fix and set what became called the "petrodollar system and petrodollar recycling". There, Kissinger would have sealed a deal whereby Saudi Arabia, henceforth, would formally and solely accept dollars for all its oil sales, and would apply its Arab regional power to ensure other Gulf exporters did the same. Saudi Arabia would then make available and place "surplus liquidities", unspent dollars, in the US Federal Reserve system, starting with the Federal Reserve Bank of New York.

The massive advantages of this to the US were plain. Worldwide, any buyer and importer of Arab oil would first need to buy and hold dollars, ensuring strong global demand for the US money. Secondly, the surplus or unspendable dollars - for Gulf Arab countries with populations under one-half present, and incomes under one-tenth today's - that each state would accumulate in its national treasury would flow back to the USA in a controlled and fixed way. There would be no tsunami of dollars flooding back to the USA but finding nothing to buy - would create hyperinflation. Instead, the "petrodollars" would go straight into the Federal Reserve system, backstop the US dollar, and enable the strategy of "controlled devaluation", needed to help service growing US debt by devaluing the money used to repay loans, to operate without running out of control and turning into an inflation rout.

Even more advantageous to the US, when or if oil prices "spiked" or stayed high, the advantages to the US from higher oil prices, and high petrodollar flows, outweighed the handicap to the US economy of higher oil prices. On balance and even if the economy lost out from high oil prices - the dollar won. This is a debatable conclusion - US inflation like that in all other major OECD countries, most of them importing much more oil than the USA, ran high from 1975. Petrodollar recycling may have shielded or "backstopped" the dollar, but it certainly did not limit inflation in the US.

Several decades later, the "recycling" advantage was able to morph into Petrodollar War - for example the imputed or theoretical "oil currency war" driver for the 2003 US-UK Iraq invasion, possibly motivated by Saddam's attempts to break away from the forced utilisation of dollars for sales of oil. Similar arguments are also used to explain the fall of Libya's Khadafi in 2011, as due to his attempts to use euros or gold for oil transactions, instead of dollars. Oil currency war is also often proposed as the main, or a main but hidden motive for war against Iran.

Variants of the Petrodollar War concept include the role of oil currency conflicts and rivalry, notably concerning US relations with Venezuela and Russia, and possibly with Europe concerning the gradual replacement of US dollars with the euro, for oil transactions. At least as important however, the fundamental basis of the petromoney system and the potential for Petrodollar War hinges on global oil import demand and the oil price. Both of these have to hold up.
This is simply no longer the case, in a world economic system which needs less oil, and a world monetary system now massively dominated by QE.

When or if oil demand and oil prices do not hold up, foreign oil importer nations who formerly found it necessary or beneficial to hold dollars to pay for oil, would have to find some other (completely unexplained) reason for huge holdings of dollars. Such holdings become even more impossible to rationalize when their oil imports decline and-or oil prices also decline. The massive role of QE in Europe and Japan, as in the USA (although in dollars), also sidelines and downsizes the potential role of petrodollar and petroeuro recycling today.

Using IEA data, world energy dependence on oil in 1973 was about 1.8 times today's dependence. In 1973 oil covered about 56% of world commercial energy supply; in early 2013 it covers about 32%.

Today also, the petro-energy system has to face massive growth of firstly gas, then oil resource availability revealed by the shale energy revolution, rising global oil production capabilities outside the Arab countries, stagnating or declining oil demand in the OECD, and rising renewable energy supplies in all major developed countries. The constantly declining role of oil in the economy also signals that the Petrodollar System's days are surely numbered, like the notion that $100-oil prices are "normal".

On that basis however ($100-oil) the estimated total transaction value of world oil trade is about $3.4 trillion a year, around 75% in dollars and 25% in euros. The percentage of this which still enters the Kissinger-era "recycling" system is unknown, but estimates by the Federal Reserve Bank of New York, which seem low or very low, place the value of petrodollar recycling today, with oil at current prices, at approximately $750 billion a year. Leverage is of course applied, but high-end estimates of the combined, dollar-equivalent financial and monetary impact of petrodollar and petroeuro recycling today are at most $6 trillion a year - near 10% of world GNP.

QE since 2008, and the known total liabilities of "bad banks" in the OECD countries which make QE Forever necessary, are at least 15 times larger, and could be over 20 times larger. Petromoney recycling's role has also been massively shrunk by the growing oil revenue "absorbtion capacity" of Arab oil exporter countries with declining capital-surpluses. In turn this sets the real menace of what will happen when the recycling system "formally" terminates.

At its simplest, the combined effects of lower oil import needs, and lower oil prices, together with non-dollar payment and settlement systems (including barter and offset trades) will result in world dollar purchases and holding - needed to pay for oil - declining further and perhaps rapidly. In turn, these former petrodollars can only be "returned to sender", to their known address the USA. Here, the inflation impact may be grave, at a critical time for "continuing the experiment" of QE which basically only works as long as there is no evident, impossible-to-hide inflation.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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