by Jacob L. Shapiro
March 27, 2018
The petrodollar is in decline. This is not because it is now possible, as of March 26, to buy yuan-denominated oil futures on the Shanghai International Energy Exchange. It is because the United States does not buy as much oil as it used to.
Since 2012, U.S. crude oil production has been increasing thanks to technological advances in hydraulic fracturing and horizontal drilling. A byproduct of the United States’ reducing its reliance on oil imports and becoming an oil exporter is that countries dependent on oil sales need new customers. The most promising new customer is China, which last year surpassed the U.S. as the world’s largest oil importer. China, understandably, would like to pay for oil in yuan rather than dollars, and beggars like Saudi Arabia can’t afford to be choosers. It would be a mistake, however, to conclude that the decline of the petrodollar also portends the decline of the dollar’s status as the world’s reserve currency.
To understand the consequences of the petrodollar’s demise, it is necessary to remember that the impetus for the creation of the petrodollar system was not strictly economic – it was also strategic. The Middle East was one of the main areas of competition between the Soviet Union and the United States during the Cold War. The U.S. wanted to ensure that it would always have access to the oil produced by OPEC countries, which at the time accounted for more than half of total oil production. To do so, Washington offered Saudi Arabia and other Gulf oil producers weapons and protection. In exchange, they agreed to accept the dollar exclusively for oil sales and to invest their revenue into U.S. Treasuries. The economics benefited both sides, but Cold War strategic challenges were just as important, if not more so.
All of this has since changed. OPEC now produces only about 40 percent of the world’s oil, and the days when it could dictate global oil prices are over. The U.S. is one of the key reasons: It has surpassed Saudi Arabia in both recoverable oil reserves and total hydrocarbon production, and U.S. shale production has put a ceiling on the price of oil. In addition, the U.S. has become a significant oil exporter, increasing exports by a factor of 20 in the past four years, which means the U.S. has gone from major consumer of Saudi oil to competitor practically overnight. In 1977, the U.S. imported 1.38 million barrels of oil per day from Saudi Arabia. In 2012, that figure had not changed much – just under 1.37 million bpd. Since then, U.S. oil imports from Saudi Arabia have fallen by 30 percent to 949,000 bpd.
Saudi Arabia’s strategic importance to the U.S. has also slipped. U.S. involvement in the Middle East is no longer about collecting allies to oppose Soviet acolytes. What the U.S. needs more than anything in the Middle East are partners strong enough to manage the region’s chaos without running to Washington for help every time the Houthis fire a missile or the Iranians develop a new proxy. The U.S. has also not forgotten Saudi Arabia’s use of radical Islamist proxies and the Saudis’ involvement in the spread of radical Islamist ideologies, which played a major role in the formation of groups such as al-Qaida and the Islamic State. The U.S., which has been trying to extricate itself from its wars in the Muslim world for 17 years, now faces an aggressive Iran and a defiantly independent Turkey, and its Saudi ally has been no help.
While the U.S. is weaning itself off foreign oil, China is growing more dependent. This does not come without certain benefits for Beijing. The U.S. is a prime example of the power consumers hold over producers, especially in a world where most countries export more than they can use. But unlike the U.S., China does not have the benefit of being able to access the world’s oceans at will. Also unlike the U.S., China cannot offer a country like Saudi Arabia much in the way of security or protection. And even as the yuan’s usage increases, countries will still value the dollar over all currencies for reasons that have nothing to do with what currency China uses to pay its oil suppliers.
The dollar was established as the world’s reserve currency at the 1944 Bretton Woods Conference. It is true that the rise of the petrodollar helped the dollar maintain this position in the 1970s after President Richard Nixon took steps that led to taking the U.S. off the gold standard. But just because there was once a direct link between the dollar’s position as a global reserve currency and the petrodollar system does not mean the link is still definitive.
This is not to say the decline of the petrodollar system will be without consequence. The quantity of dollars abroad matters, and since the U.S. will be buying less oil, there will be fewer dollars abroad. But the dollar will retain its position as the global reserve currency as long as it is seen as the safest and most reliable currency one can hold, and there is little reason to think global confidence in the dollar is waning simply because the U.S. is buying less foreign oil.
Confidence can be tricky to quantify, but global preference for the dollar is not abstract. The latest data from the International Monetary Fund shows that in the third quarter of 2017, 54 percent of official foreign exchange reserves were held in U.S. dollars. That was an increase of 13 percent over the previous year, which means the U.S. position is not only dominant – it is increasing. By comparison, just 1 percent of foreign exchange reserves were held in Chinese renminbi in the third quarter. The Bank for International Settlements, which produces a survey of foreign exchange turnover every three years, revealed in its latest edition in December 2016 that the yuan was used in 4 percent of foreign exchange transactions in 2016, just barely more than that of the Mexican peso. By comparison, the U.S. dollar was used in 88 percent of foreign exchange transactions.
China can certainly strong-arm countries into using yuan to increase its global usage. But being able to force countries like Saudi Arabia or Venezuela to use yuan is very different from countries choosing to use the yuan because it is preferable to the alternatives.
To vie for global reserve currency status, China does not need an oil futures market – it needs to prove it can carry out transparent monetary policy, refrain from routinely manipulating the yuan’s value and lift capital controls. China is light-years from all three. What China can do with this move is increase the use of the yuan in the world. Ironically, as China does this, it will become more dependent on the Middle East and on maritime trade routes to get there, just as the U.S. is becoming less dependent on the same. This will increase China’s need to develop power-projection capabilities and may bring it into conflict with the prevailing world order. In the meantime, as long as Saudis and speculators are the only ones taking yuan, the dollar’s position as global reserve currency should be safe.