When I wrote the original Petrodollar series, I had thought that I was done once I’d posted part 6. However, I was then told repeatedly that I’d missed out the last part of the story. That is: what happens if/when the Petrodollar System collapses?
So, if this is the first time you’re reading this, here’s the backstory*:
*although you probably only need to read Petrodollar Wars 106 for the summarised historical timeline.
- Petrodollar Wars 101: What was the Gold Standard? – including the briefest possible history of currency, and how the British Empire brought the world onto the Gold Standard.
- Petrodollar Wars 102: The US Dollar Gold Standard – including the various failures of the interwar period, Keynes’ grand idea that never was, and how the Americans got their way in the end.
- Petrodollar Wars 103: the Collapse of Bretton Woods – including a list of the various ways to arbitrage gold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly and unilaterally told the French (and everyone else) to sod off.
- Petrodollar Wars 104: Welcome The Fiat Currency – including an explanation of how there’s really not much of a difference between gold-backed paper money and unbacked paper money provided that the Central Bank behaves itself.
- Petrodollar Wars 105: The Global Currency of Reserve – including the function of a global reserve currency, how the global reserve currency gets chosen, and why a country might want to have their currency be the global kingpin.
- Petrodollar Wars 106: The Petrodollar Conspiracy – including a deal with the Saudi government, and the reason why the Americans “go to war over oil”.
A summary of where we stand today:
- The primary global currency of reserve (the American Dollar) operates off a Petrodollar (Oil) Standard.
- Because oil trade is denominated in dollars, you can be pretty sure that the dollar will maintain its value as long as:
- The world needs oil; and
- The oil trade continues to be denominated in dollars.
- And that’s not just a demand-for-oil story. It’s the other side as well:
- As the oil-producing countries get paid in dollars, so they need to invest the dollars somewhere.
- That place is American Financial Markets, because those markets are the only ones big enough to take those levels of investment.
- So the Oil Trade ensures a steady and constant demand for American (financial) products.
- Because the Oil Trade has created a status quo for dollar trade, and because most countries will therefore keep some of their Foreign Reserves denominated in US dollars (in order to pay for oil imports), the natural tendency is then to denominate most international trade in dollars.
- And the American people, by consuming plenty of imports, are actually helping to reinforce the dollar’s global dominance.
So, now, what happens if:
- The Oil-Producing Countries decide that American Markets are too risky; and/or
- We run out of oil, maybe?
Actually, maybe we should start by asking: “how likely are either of those scenarios?” Because, to my mind, the answer is “not very”.
The Oil-Producing Countries may well dislike the risk of American Markets – but they don’t exactly have a long list of alternatives. 40 years of investing oil surplus into the American financial markets have left them giant. A little googling gets to an answer of around 25% of the world’s capital being held in America’s financial markets. The other (less but still) big markets: Japan, Europe, China. One of those seems poised on the hyperinflation brink (thanks, Abenomics, thanks), another beset by general political and economic crisis, and the last closeted and running out of water. And (breathable) air. None of those sound especially appealing.
And more than that – if any of said countries attempted to break with the US dollar on oil, or any of the rules around it… Well just look at Iraq.
And as for Peak Oil and Oil Reserves
Peak Oil? We’ll die from Climate Change long before that happens. Or we’ll run out of water and food. Also, there’s the small fact that “proven oil reserves” (the figure that gets thrown around when someone from Forbes decides to be alarmist) actually refers to oil that companies are actually drilling for in existing fields.
Let me repeat that: “oil that companies are actually drilling for in existing fields“.
So when this graph gets thrown about:
…[and you’ll notice the USA looking all depressed about its small allocation]…
What you must remember is this:
That said, is there anything to suggest that the other big Oil Reserve players don’t face a similar outlook?
Well – there is an economic aspect to this. If you pay attention, you may notice that oil reserves go down when the oil price is low and they go up as the oil price increases… And that’s because the market price of oil determines how “recoverable” a particular well of oil is. At a higher oil price, the more difficult-to-access reserves might be extracted, meaning that those will count toward oil reserves. At a lower oil price, they won’t.
And in the United States, oil and gas law puts limits on what can be extracted from an oil well. In the rest of the world, those limits are either non-existent, or much higher. What does that mean? It means that significant US oil “reserves” are not economically feasible to extract, so they get excluded from proven oil reserve statistics*.
*the more oil you can pump out of a well per day or per year or whatever, the more oil revenue you have to cover the costs of extraction… After all, the big costs are capital investment and fixed salaries. Those costs won’t change with the volume of oil extracted.
As a long-term strategy, that does seem to suggest that the United States is setting itself up to be a future dominant player in energy. Presumably after she’s consumed most of what the other big players can extract.
But let’s assume that the Petrodollar System collapses anyway
What would happen?
At least – not for a while:
- As a result of inertia, pre-planning, and general custom, most global trade would already be planned to take place in US dollars, with multiple forward and futures contracts already in place.
- There are no real alternatives for large-scale financial investment, so the world would have to wait for a secondary market to develop and become accepted.
- The oil-producting nations, China and Japan would be holding large amounts of dollar reserves, so those countries would have a vested interest in the petrodollar system perpetuating, or at least emerging in an alternative form.
Whatever nay-saying might be out there, I think that the important point to remember is that “the petrodollar collapse” scenario is very similar to what people were expecting when the US dollar left the Gold Standard.
But when the dollar left gold, the dollar stayed the global currency of reserve for years in the interim while the Petrodollar system was developing…
So I think that we should all be more concerned by the threat of Climate Change. And/or the crisis of the world’s impending water shortage.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.