Petrodollar System Flirts With Collapse… What It Means for Gold, Oil, and the Dollar

by Nick Giambruno, International Man:

It’s been rightly said that “he who holds the gold makes the rules.”

After World War 2, the US had the largest gold reserves in the world, by far. Along with winning the war, this let the US reconstruct the global monetary system around the dollar.

The new system, created at the Bretton Woods Conference in 1944, tied the currencies of virtually every country in the world to the US dollar through a fixed exchange rate. It also tied the US dollar to gold at a fixed rate of $35 per ounce.

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The dollar was said to be “as good as gold.”

The Bretton Woods system made the US dollar the world’s premier reserve currency. It forced other countries to store dollars for international trade or to exchange with the US government for gold.

However, it was doomed to fail.

Runaway spending on warfare and welfare caused the US government to print more dollars than it could back with gold at the promised price.

By the late 1960s, the number of dollars circulating had drastically increased relative to the amount of gold backing them. This encouraged foreign countries to exchange their dollars for gold, draining the US gold supply at an alarming rate.

To plug the drain, President Nixon “temporarily” suspended the dollar’s convertibility into gold in 1971. This ended the Bretton Woods system and severed the dollar’s last tie to gold.

The “temporary” suspension is still in effect today. And it’s had profound geopolitical consequences.

Most critically, it eliminated the main reason foreign countries stored large amounts of US dollars and used the US dollar for international trade. As a result, oil-producing countries began to demand payment in gold instead of rapidly depreciating dollars.

It was clear the US would have to create a new monetary system to stabilize the dollar. So it concocted a new scheme… and chose Saudi Arabia as its ally. This agreement came to be known as the “petrodollar system.”

The US handpicked Saudi Arabia because of the kingdom’s vast petroleum reserves and its dominant position in the global oil market.

In essence, the petrodollar system was an agreement that the US would guarantee the House of Saud’s survival. In exchange, Saudi Arabia would do three things.

First, it would use its dominant position in OPEC to ensure that all oil transactions would only happen in US dollars.

Second, it would recycle hundreds of billions of US dollars from annual oil revenue into US Treasuries. This lets the US issue more debt and finance previously unimaginable budget deficits.

Third, it would guarantee the price of oil within limits acceptable to the US and prevent another oil embargo.

The petrodollar system gave foreign countries another compelling reason to hold and use the dollar. And it preserved the dollar’s unique status as the world’s top reserve currency.

But… why oil?

Unmatched Geopolitical Power

Oil is the largest and most strategic commodity market in the world.

As you can see in the chart below, it dwarfs all other major commodity markets combined. The annual production value of the oil market is ten times bigger than the gold market for example.

Global Commodity Markets (Billions)

Every country needs oil. And if foreign countries need US dollars to buy oil, they have a compelling reason to hold US dollars.

Think about it… If Italy wants to buy oil from Kuwait, it must purchase US dollars on the foreign exchange market to pay for the oil first.

This creates a huge artificial market for US dollars.

This is what differentiates the US dollar from a purely local currency, like the Mexican peso.

The dollar is just a middleman. It’s used in countless transactions, amounting to trillions of dollars that have nothing to do with US products or services.

Since the oil market is enormous, it acts as a benchmark for international trade. If foreign countries are already using dollars for oil, it’s just easier to use the dollar for other international trade.

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