What is the petrodollar- and why does it give the U.S. so much power?

Unless you are quite up to date with the world and its finances, the word ‘petrodollar’ seems like quite the confusing and daunting term which seems to be a combination of ‘petrol’ and ‘dollar’. But what exactly is it, and as the title implies, which of its inherent qualities further establishes the USA as a major global power?

Fig. 1 What is the petrodollar?

The literal definition of petrodollars refers to the US Dollars earned by crude oil exports. It is not a currency of its own, just USD earned by oil exporters. As was done in the past, and is done today, oil is traded in the world’s most widely used and reserve currency which is the USD. It’s use became heightened around the 1970s when the USA made deals with oil-exporting nations such as Saudi Arabia to recycle the petrodollar.

But now another question comes up? What does recycling the petrodollar mean? Simply put, it is when oil-exporting countries earn more USD than they can domestically spend, causing them to reinvest it in the financial world, whether it be to purchase foreign goods or acquire US treasury securities.

Now that it is clear what the petrodollar is, and how its used, the main part is to be answered, why is it so important to the United States of America? Because each nation needs to hold USD in order to buy oil to support the energy demands of its people, this creates a sustained worldwide demand for the US Dollar, which can lead to it rising in strength in comparison to other currencies and maintaining global dominance as the currency which international trade takes place in. The real benefit comes from the fact that the US government can print large amounts of USD without consequences as the global demand accounts for the excess supply, and their ability to borrow cheaply (time to link back to petrodollar recycling). As there is high demand for the US National Debt (demand for US Treasury bonds), the USA has a way to fund its national debt and run larger deficits as there will always be buyers, whether they be in the form of other nations, banks, companies, or even individuals willing to reinvest their USD. The large number of available buyers then reduces the interest rate for borrowing as higher bond prices lead to lower yields (returns), making it cheaper for the US to issue bonds.

Fig.2 The recycling/cycle of petrodollars

However, the fact that all countries are financially tied to this singular currency that gives a nation the power over the world’s financial trades (ability to easily impose sanctions or restrictions), seems unfair. It would be odd if no country tried to challenge something like this. And, it has not gone without challenge, as countries which opposed this scheme such as Libya or Iran have faced retaliation from the USA, who want to preserve their power (slightly controversial). From a more economic perspective, the BRICS bloc comprising of major powers like Russia, China, the UAE, and Brazil also oppose the petrodollar, with the concept of a ‘petroyuan’ also slowly coming about. But the limitations with this idea is that the Chinese national currency (Yuan) is not held as widely as the US dollar, it is not as freely issued/accessible (only carefully issued by the Central Bank of China) and does not have much opportunity for reinvesting/recycling the way the US Dollar does. For these reasons, even though there is resistance against the petrodollar in recent times, it is unlikely that we see de-dollarization and a shift to trade in another major currency.

Fig. 3 Petrodollar vs Petroyuan (and why it isn’t a feasible option compare to USD)

To conclude, petrodollars are dollars earned by nations/companies for their crude oil exports that further establish the US’s dominance and importance in global trade. The petrodollars remain a point of controversy, however, like any coin with two sides, they also provide an opportunity for reinvestment (that leads to financial gains) and funding of the US debt to enable continuous US spending due to cheap borrowing systems.