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United States was being the largest importer of crude oil, the world oil market had been priced in United States dollars since the end of World War II. International oil prices were based on discounts or premiums relative to that for oil in the Gulf of Mexico. But, although oil sales prior to 1973 were denominated in U.S. dollars, nothing precluded settlement in local currency.
After the Bretton Woods conference in the year 1944, UK and its allies discontinued linking their currencies with gold but recognised US$ as reserve currency which was still pegged with gold. USA was following gold standard to benchmark at 35 US$/oz from 1941 to 1971.
In reality, the dollar was not worth of that much gold due to inflation by 1971. In view of other countries particularly France, started tendering US$ to encash in gold, then President Nixon unilaterally cancelled the convertibility of US$ to gold at a fixed rate and allowed US$ value to float against gold. In the absence of fixed value convertibility in gold and high inflation, US$ exchange rate had been falling due to less demand of US$ abroad.
In October 1973, OPEC declared an oil embargo in response to the United States' and Western Europe's support of Israel in the Yom Kippur War, and this tension (and the new power of OPEC) led to fear that the dollar would become insignificant in the oil trade.
In an effort to prop up the value of the dollar and end to the oil embargo, Richard Nixon successfully and wisely negotiated a deal during the year 1973, with Saudi Arabia that it would denominate all future oil sales in U.S. dollars in exchange for arms and protection from USA. Subsequently, the other OPEC countries agreed to similar deals thus ensuring a global demand for U.S. dollars and allowing the U.S. to export some of its inflation. Since these dollars did not circulate within the country and thus were not part of the normal money supply, economists felt another term was necessary to describe the dollars received by Organisation of Petroleum Exporting Countries (OPEC) in exchange for oil, so the term petrodollar was coined by Georgetown University economics professor, Ibrahim Oweiss.
The world wide demand for crude oil has increased many times and OPEC cartel has been actively fixing the oil price comparatively high to provide its people very high standard of living. In the absence of alternative means and to meet ever increasing crude oil consumption, the oil importing countries are forced to import oil whose price is fixed very high over its production cost. Since the oil is forced to be traded internationally in US$, artificial demand for US$ is generated and USA is able to issue/export its paper currency as reserve currency held by all countries relegating gold to second place. With the export of its currency as global reserve currency, USA has been able to achieve faster economic development on huge borrowed capital though its trade deficit has been consistently high.
Large inflows of petrodollars into a country often has an impact on the value of its currency. For Canada it was shown that an increase of 10% in the price of oil increases the Canadian dollar value versus the US dollar by 3% and vice versa.
Shale oil boom
With the advent of shale oil production boom in USA, USA has become almost self sufficient to cater the consumption of petro products by the year 2015. This has broken the win win relationship between USA and OPEC / oil exporting countries in international crude oil trade. For the first time, oil exporting countries are experiencing that weak US$ or higher crude oil price denoted in US$ is disadvantage to them in protecting their crude oil market share. Higher crude oil price in US$ is encouraging shale oil production in USA at the cost of their production. Due to drastic fall in Nymex crude oil price to as low as 40 US$/barrel, many oil exporting countries are unable to finance the national budgets with the oil export's income and unable to sell the US$ reserves also, fearing that it would lead to further US$ devaluation and encourage shale oil production in USA. They need to survive on selling non US$ reserves such as gold, national currencies, Euro, etc as first preference. Shale oil boom in USA has ended the OPEC ability to fix higher crude oil export price against market dynamics.
"Thirty years from now there will be a huge amount of oil – and no buyers. Oil will be left in the ground. The Stone Age came to an end, not because we had a lack of stones, and the oil age will come to an end not because we have a lack of oil."
In addition to the United States petrodollar, a petrodollar can also refer to the Canadian dollar in transactions that involve the sale of Canadian oil to other nations. In this sense, the term petrodollar is related to but should not be confused with petrocurrency which refers to the actual national currency of each petroleum exporting country.
- The Petrodollar
- Hamilton, James D. Historical Oil Shocks. Department of Economics. University of California, San Diego. Revised: February 1, 2011
- Adelman, M. A. (1972). The World Petroleum Market, Baltimore: Johns Hopkins University Press, Chapter 5.
- "Oil, Petrodollars and Gold". Retrieved 17 November 2015.
- The Oil Kings: How Nixon courted the shah.
- Correlation between the oil prices and the Canadian dollar
- "New Balance of Power". Retrieved 17 November 2015.
- "If OPEC is dead, how is Saudi Arabia still calling the shots in the oil market?". Retrieved 17 November 2015.
- "Everything Has Changed: Oil And The End Of OPEC". Retrieved 17 November 2015.
- Spiro, David E. (1999). The hidden hand of American hegemony : petrodollar recycling and international markets. Ithaca, NY : Cornell University Press.
- "Petrodollar profusion", "The Economist", Apr 26th 2012