Petrodollars

What Are Petrodollars?

Petrodollars are U.S. dollars paid to an oil-exporting country for the sale of the commodity. Put simply, the petrodollar system is an exchange of oil for U.S. dollars between countries that buy oil and those that produce it.

The petrodollar was the result of the oil crisis in the mid-1970s when prices spiked to record levels. It helped increase the stability of oil prices denominated in U.S. dollars. The term regained notoriety in the early part of the 2000s when oil prices rose once again. 

Although petrodollars initially referred primarily to money that Middle Eastern countries and members of the Organization of the Petroleum Exporting Countries (OPEC) received, the definition has broadened to include other countries in recent years.

Understanding Petrodollars

Petrodollars are oil revenues denominated in U.S. dollars. They are the primary source of revenue for many oil-exporting members of OPEC, as well as other oil exporters in the Middle East, Norway, and Russia.

Because petrodollars are denominated in U.S. dollars — or greenbacks — their true purchasing power relies on both the core rate of U.S. inflation and the value of the U.S. dollar. This means petrodollars will be affected by economic factors the same way the U.S. dollar is affected. So if the value of the dollar falls, so does the value of petrodollars, and thus the government's revenue.

History of the Petrodollar System

The origins of the petrodollar system go back to the Bretton Woods Agreement, which replaced the gold standard with the U.S. dollar as the reserve currency. Under the agreement, the U.S. dollar was pegged to gold, while other global currencies were pegged to the U.S. dollar. But because of massive stagflation, President Nixon announced in 1971 that the greenback would no longer be exchanged for gold to boost economic growth for the U.S.

That led to the creation of the petrodollar system, where the U.S. and Saudi Arabia agreed to set oil prices in U.S. dollars. That meant any other country that purchased oil from the Saudi government would have to exchange its currency into U.S. dollars before completing the sale. That led the remaining OPEC countries to follow suit and price their oil in U.S. currency.

Petrodollar Recycling

The petrodollar system creates surpluses, known as petrodollar surpluses. Since petrodollars are basically U.S. dollars, these surpluses lead to larger U.S. dollar reserves for oil exporters.

These surpluses need to be recycled, which means they can be channeled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States through the purchase of bonds and T-bills. This process helps create liquidity in financial markets in the U.S. By investing their surpluses, these exporters reduce their dependence on oil revenue.

Petrodollar recycling started with Saudi Arabia in 1979 as part of the U.S.-Saudi Arabian Joint Commission on Economic Cooperation.The U.S. dollars that were used to purchase oil contracts were recycled back to the U.S. via contracts with U.S. companies. These companies would then partake in infrastructure projects in Saudi Arabia, which would increase U.S. imports into the country, lead to higher wages for certain employees, and help the overall economy.

The recycling system was also used to invest surplus dollars into sovereign wealth funds, the profits of which were used to invest in activities not related to oil, reducing the nation's dependence on oil.

Advantages and Disadvantages of the Petrodollar

The petrodollar greatly helped to elevate the U.S. dollar's standing in the financial markets, as the price of the most important commodity in the world, oil, was linked to the dollar. This has partly aided the dollar in being the world's most dominant currency, which allows the dollar to continuously finance its account deficit by issuing dollar-denominated assets at very low rates. This has also allowed the U.S. to wield significant control economically over the globe.

The Collapse of the Petrodollar System?

With the decline in the purchasing power of the greenback, some nations started to debate the benefits of the petrodollar system. Countries like Iran, Russia, and India have considered shifting the base value of their exports in their own currency rather than the U.S. dollar.

Venezuela dropped the petrodollar in 2017 and began pricing oil in euros and the yuan.

China is also moving away from using petrodollars and pricing the commodity in yuan, particularly putting pressure on Saudi Arabia to use petroyuan instead of petrodollars.

Petrodollar FAQs

How does the petrodollar work?

Petrodollars work as an exchange of U.S. dollars for oil. An oil-importing country pays U.S. dollars to an oil-exporting country in exchange for oil. A country whose currency is not the U.S. dollar will have to use their U.S. dollar reserves to purchase the oil or convert their currency into U.S. dollars to do so.

What happens if the petrodollar collapses?

If the petrodollar collapses there would be a significant economic fallout as this would mean the dollar's value as the world's reserve currency may not hold, impacting the dollar balances of a variety of nations. However, if the petrodollar was phased out gradually and replaced with another currency, such as the yuan, markets may remain stable but the dollar would lose significant power. Many countries favor the de-dollarization.

Is the U.S. dollar backed by oil?

The U.S. dollar is not backed by oil but oil prices are quoted in U.S. dollars, meaning that if you are going to purchase crude oil, you will be paying for it in dollars.

Who started the petrodollar?

The petrodollar was started by the United States in an agreement with Saudi Arabia in the 1970s with the intent of standardizing oil sales and purchases in U.S. dollars.

The Bottom Line

Petrodollars are U.S. dollars that are used by oil-importing countries to pay oil-exporting countries for crude oil. Petrodollars were created in the 1970s to stabilize oil markets. The petrodollar has strengthened the U.S. dollar, helping it to become the world's dominant currency, as any country that wants to purchase oil has to do so in dollars. In recent years, the petrodollar has been challenged by some countries, primarily China, which wishes to reduce the dependence on the U.S. dollar.