Over the years, there has been a debate about the most appropriate currency to be used in the oil-producing countries and other nations that have a direct interest in the production of oil. Questions have often been raised about how the world market would change if the dollar was not the dominant currency used to trade oil. Consequently, this essay aims at providing a comprehensive description of the petrodollar, its origin and the effects it has on the world economy. In addition, the essay would expound more on the pros and cons of replacing the petrodollar system with a different form of currency.
Petrocurrency refers to the type of currency that it used to trade petroleum in oil producing and exporting countries. The value of the currency will fluctuate depending on the prices for oil on the markets at a particular time. Stability of oil prices means that the value of the currency will be stable, whereas fluctuation of the prices for oil results in inability to estimate its future value as it is dependent on oil prices (McCown, Plantier, & Weeks, 2006).
Petrocurrency is available in several forms even though there are few oil exporting countries. Due to massive oil exports from the North Sea, both the British pound and the Dutch guilder have once been regarded as petrocurrency. The Dutch guilder is said to have strengthened to a great extent in the late 1970s due to the raising of oil prices by the Organization of the Petroleum Exporting Countries (“Petrodollars,” n.d.). Also, due to extensive oil fields in Canada, petroleum forms the largest export commodity in the country. Therefore, the Canadian dollar has been seen as a petrocurrency for many years. In fact, its value has majorly been dependent on the value of the oil prices in the market, making its exchange rate with other currencies relatively strong when oil prices gain stability. Among the Organization of the Petroleum Exporting Countries, the US dollar has become a conventional currency used to trade oil. This was a result of the agreement concluded in the 1970s when the organization was formed (Clark, 2005).
Petrocurrencies have had a tremendous impact on the economic situation in the world. It has stimulated strengthening of economies of petroleum exporting countries. This is due to the fact that the value of their currency increases with the rise of the price for oil. Consequently, the revenues earned from exporting oil are considerable. Most of these countries have managed to recycle the revenues earned. Recycling means that rather than reinvesting the revenues in the extraction of more oil, they have invested in other income generating sectors such as manufacturing, processing and real estate industries. The outcome of these investments is a general growth in the economy due to an increase in the gross national product (GDP). However, is critical to acknowledge the fact that an adverse fluctuation in oil prices will mean a decrease in the value of currency in these countries. The effect is that the value of petroleum exports lowers and hence causes a decrease in revenue earnings.
When assessing the impact of petrocurrency on the overall world economy, it is notable that it largely determines the value of export and import in the world markets (McCown et al., 2006). This is due to the fact that the revenues from the export of petroleum circulate and return to the commodity markets. Therefore, increased revenue in petrocurrency implies that there is a vast supply of money in the world economy. The net effect of this condition is that it creates more demand for goods and services, hence increasing their prices in the world markets.
An increase in the prices for oil in the market has a huge impact on the oil importing countries, especially those in the third world that do not have adequate export commodities that generate revenue. This is because such countries rely heavily on importing petroleum, petroleum products and any other imports that are necessary to sustain their economies. The result of these activities is that the expenses on imports to those countries will exceed the income generated from their principal exports. This creates a balance of payment deficit in the economy. The effect of payment shortage is that a country will depend more on direct investments from foreigners and external borrowing to change the situation. However, extreme cases can range from slow economic growth due to a lower aggregate demand and reduced job opportunities to low standards of living among the people (Schulz, 2009).
To understand the reasons for the emergence of the petrodollar system, it is necessary to look into the dollars for gold system that existed in the early years. The dollars for gold system was introduced after the World War II at the Bretton Woods Conference. However, in the late 1960s, it was realized that this system had become unreliable; hence member countries that were in the agreement had almost lost trust in it. The United States of America, which are the primary beneficiaries of the accord, also knew that other members in the accord were having issues with it. However, the country tried to establish ways to get a better version of it that would work to their advantage, rather than reject the system. This is because the American government knew that if the Bretton Woods agreement was broken, it would reduce the global demand for the U.S. dollar. It is then that the idea of trading oil for dollars evolved.
In the early 1970s, Henry Kissinger, who was then the U.S. Secretary of State, met with the members of the Saudi royal family and negotiated a deal that led to the emergence of the petrodollar (McWhinney, 2015). In this arrangement, the American government agreed to provide military security for the Saudi oil fields and protect them from any eminent attacks from Israel. Saudi, on the other hand, agreed to sell their oil in dollars only. This implies that they were not to be allowed to conduct any transactions that involved the use of any other currencies to sell oil. By late 1974, most of the OPEC member countries agreed to enter into the treaty with the U.S. under the same terms and conditions. As a result, it not only made the demand for the U.S. dollars increase globally but also facilitated a rapid rise in the demand for oil around the world (Schulz, 2009). It can, thus, be said that the revenue generated from the export of petroleum by the OPEC member countries increased significantly. On the other hand, though indirectly, the U.S. were the primary beneficiaries of the increased oil trade.
Since the sale of petroleum is conducted in the U.S. dollars globally, it means that countries should always create a surplus of dollar reserves to facilitate oil purchases. To create a surplus of dollars in their economies, countries should invest in exports to international markets that use the U.S. dollar as a common currency (Tun, 2015). However, countries without significant export commodities have an option of obtaining dollars through the foreign exchange market, where they can trade their currency for the U.S. dollars. It is critical to note that the petrodollars became the best option to sell oil because, over the years, most countries globally have managed to hold their currency reserves in the U.S. dollars. Hence, the dollars are more widely in circulation compared to any other currency.
The petroleum exporting countries operate under a body referred to as the Organization of Petroleum Exporting Countries (OPEC) (Wirl, 2009). This is a cartel that aims at coordinating the petroleum policies of the member countries. It was formed in Bagdad, Iraq by five countries that were its founder members. These states include Kuwait, Saudi Arabia, Iraq, Venezuela and Iran. The main objectives of OPEC include:
It helps protect the interests of the member states. It has a duty to ensure that these member countries benefit maximally from the export of oil.
It ensures that the member states get the best prices for their oil. As a result, they ensure that the member countries get a fair share of returns from the sales of their oil.
They help protect the member states from fluctuation of prices in the oil markets by formulating policies that reduce unnecessary competition among the member countries.
OPEC is headed by a conference, which it the highest body of the organization. The conference consists of delegate heads from all the member countries. These representatives meet twice a year and are tasked with the policy formulation for the organization. They also have a duty to generate strategies that will oversee the implementation of these policies. Moreover, OPEC has a board of governors who are tasked with assessing any application for countries that would want to join the organization, overseeing that it is operating efficiently to the satisfaction of member countries and drafting an annual budget of the organization.
To maintain stability in oil prices, OPEC member countries maintain a constant production capacity. This ensures that the demand and supply forces of the market work in their favor. An increase in the production capacity of oil means that the provision of oil in the market will be excessive hence the price for oil will decrease (Wirl, 2009). On the other hand, a reduction in the production of oil will increase demand for oil and hence raise its price. However, a decrease in the capacity of petroleum extraction will imply that the countries exporting it will not utilize the resources at their disposal fully, which will result in a reduced rate of return.
The role of corporate social responsibility is a professional duty for any organization making its profit by selling goods or services to people. OPEC has not failed in this section too. It has made an enormous contribution to ensuring that the developing countries improve their economic conditions (Ramcharran, 2002). Over years, it has given loans and grants to poor countries to facilitate the formulation of development projects. OPEC has also taken an initiative to ensure that its activities in oil extraction do not have an adverse impact on the environment (McWhinney, 2015). Therefore, it has adopted safer methods of drilling oil, transporting it majorly through pipelines, and has taken measures to ensure that the wastes from oil refining are properly disposed to prevent environmental pollution.
Although OPEC has made efforts to increase its efficiency in controlling oil production and oil prices in the market, it has faced some challenges. It can be said that the biggest problem for OPEC is that it has lost its ability to control market forces. For instance, over the years, it has lost a part of its market share since new players are joining the oil production and exportation market. Countries have realized the power they can hold by producing and exporting oil. As a result, they are always searching for oil fields in their regions. Non-OPEC producers, for example, have joined the oil markets with no control of their oil production. Each has tried to maximize its oil production, hoping that it would narrow the gap between them and the OPEC member countries in terms of profit share (Grosskurth, 2006). They fail to realize that increasing oil production and supply to the market leads to reduced oil prices, which significantly affects the OPEC member countries. Efforts to promote cooperation with non-OPEC countries have not succeeded hence suggesting that OPEC has lost control.
It is critical to note that the need to conserve energy has also affected OPEC. This is due to the fact that the demand for oil and its products decreases as countries are opting for other methods of generating energy such as solar power and wind. The most notable approach, however, is the need to incorporate the use of nuclear power. This method has proven catastrophic in the past, but countries are willing to overlook its shortcomings and focus more on its benefits. Used appropriately, nuclear power can be environmentally friendly and produce enormous amounts of energy to sustain most of the global needs. By contrast, OPEC suffers from its success since countries such as the U.S.A. and China have reduced their dependence on oil over the recent years. This means that the revenues generated from the sale of oil to these countries have decreased (Grosskurth, 2006).
Another major problem facing OPEC is the oil futures trade. This trade is a serious concern for OPEC since its activities in most cases affect the price for oil in the market. Price speculators are constantly monitoring the activities of OPEC to speculate on future prices for oil. Through their operations, investors have an opportunity to put their money in this trade as to any other price speculations that favor them in order to make profit from it. In such markets, talks or rumors have a dramatic impact on how the prices for oil will be quoted at each time and as a result, they can have a negative influence on the prices both for OPEC and non-OPEC member countries.
The move to trade oil using a common currency has a significant impact on non-OPEC countries.
This is because they have an option to trade their oil either in dollars or any other currencies that their customers are willing to use in buying their oil. Assuming that non-OPEC countries decide to sell oil in dollars, they are likely to be affected by any fluctuations of the value of the dollar. This also means that they are affected by the policies put in place by OPEC regarding oil production. Any increase in the capacity of oil produced by OPEC countries increases its supply. The result is a fall in oil prices and an ultimate demand for the dollar to buy more oil. The net effect of this demand is an increase in the value of the dollar. Therefore, non-OPEC countries will benefit from selling their oil in dollars due to its high value. However, any other circumstances that are likely to reduce the value of the dollar will negatively influence the revenues from selling oil by non-OPEC countries (McWhinney, 2015).
On the other hand, it is critical to mention that it would be more profitable for non-OPEC countries to sell oil using any other currency that is relatively equal or higher in value than the value of the dollar. This step is likely to shield these countries from any negative value fluctuations of the dollar (“Petrodollars,” n.d.). It will also imply that their net returns will not be affected directly or indirectly by the policies formulated by OPEC regarding pricing and production of oil. Therefore, countries such as China and Russia have been encouraging this move for years, whereas the U.S. takes all possible measures to prevent it for its personal reasons.
It is possible to presume that OPEC would agree to the majority to substitute the petrodollar system with another alternative currency, for example, the Chinese Yuan. The primary reason for this decision would be to eliminate any restriction put on it by the U.S. government due to the petrodollar agreement. However, this decision will also have tremendous negative implications both for OPEC and the United States. The U.S. is likely to retaliate by withdrawing the troops that offer protection to the OPEC countries (Ramcharran, 2002). Moreover, they will no longer be supplied weapons for protection, which was a part of the petrodollar agreement. With the continuous reduction of prices for oil in the world market, the value of the dollar increases simultaneously owing to its high demand. This makes nonoil imports into OPEC countries very expensive. Hence, it would be appropriate to say that in the right circumstances, OPEC countries would agree to substitute the dollar for another currency that could better serve their interests.
The petrodollar system has a significant impact on the world economy. This is because the dollar is the major currency reserve in most countries of the world. This implies that all international trading activities are in most cases done using the dollar. Therefore, any policies made by the OPEC cartel will directly or indirectly affect the world economy. For instance, a drop in the prices for oil has a negative impact on the world economies since it increases the value of the dollar. As a result, the exchange rate for the dollar will be higher, and since most countries cannot do without it, they will be obliged to acquire more dollar reserves at a huge cost. The overall effect of this outcome is that it creates an economic crisis in dollar dependent countries while strengthening the American economy.
An increase in the value of the dollar has a huge impact on the value of imports. For any country making either oil or non-oil imports, it would require that incur huge expenses on these products. It is worse for countries that do not have a major export commodity to counter the effects of the massive costs of imports. These countries are likely to experience balance of payment deficits and thus may opt for foreign borrowing and investment to improve the situation. Therefore, most countries realized that if the petrodollar system is not replaced, world economies with dollar reserves will continue to face an economic crisis. According to Clark (2005), Russia and China have been in the front line to call for these reforms over the years. They have managed to convince some of the OPEC countries to trade oil in other currencies such as the Chinese yuan or even in gold bars, a move that has not received any warm welcome by the American government.
The move to make the dollar the controller of the international monetary system had a great importance in the political dimension. In the late 1960s, the dollars for gold system formed at the Bretton Woods Conference after the Second World War was failing (Katusa, 2014). The major stakeholders in this agreement had noticed this trend and were calling for reforms in it. At the time, all gold transactions were made in dollars and the surpluses invested in the U.S. Treasury. The U.S. government had to make a decision to correct the trend; otherwise they were bound to face an enormous economic crisis due to operating at the expense of dollar reserves invested in its treasury.
The U.S. government was then able to come up with the idea of using dollars for oil trade; hence they negotiated a deal with the Saudi royal family that was part of OPEC. Later on, other OPEC members joined in the deal, making the dollar the primary and only currency used to trade oil. This agreement proved to be the major turning point for the U.S. government since it became a significant replacement of the dollars for gold agreement. The most important outcome of the accord was that it provided the U.S. government with a broad access to financial credit facilities as all the surplus dollars from the oil trade were invested in the U.S. Treasury.
The petrodollar agreement had a great impact on the U.S. economy. Primarily, it made imports into the country relatively cheap as the use of the dollar went global. Secondly, they became able to invest in other industries as they had a sufficient pool of capital at their disposal. Moreover, the petrodollar agreement enabled the U.S. to increase their investment in the military, production and sale of sophisticated weapons. However, the agreement had a negative influence on the manufacturing sector. Since imports to the country were relatively cheap, the local industries were disadvantaged as the sales of their products dropped and thus their returns reduced (Robinson, n.d.). It can thus be said that although the U.S. are not the major producers of oil, they are the main beneficiaries of it, which accounts for its economic superiority status.
The international monetary system is a set of rules, regulations and policies that manage the international trade and trading agreements between countries. The petrodollar agreement directly affects these system because, for the international trade to exist, there must be a conventional currency that they can use in making transactions. With this in mind, the dollar becomes the primary currency to facilitate this trade since almost every country in the world holds dollar reserves (Robinson, n.d.). Therefore, any fluctuations in the value of the dollar will affect the international trade positively when the value of the dollar drops and negatively when there is an increase in the value of the dollar.
Questions have always been raised about how the removal of the petrodollar system would affect the world economies. On a global scale, the economies of countries are likely to improve economically because they would trade using currencies that favor their interests. The countries will be able to import commodities at relatively lower prices as compared to those set for importing them under the petrodollar system (Grosskurth, 2006). On the other hand, the removal of the petrodollar system would cause a historic economic crisis in the U.S. economy. This is because rejection of the petrodollar system would cause a fall in the value of the dollar by a great margin. Besides, since the OPEC countries invest their money in the U.S. treasury, it would mean the country would be in debt to an extent it would be declared bankrupt. For that reason, the U.S. government will always take measures to ensure that this change does not take place (Katusa, 2014).
The advantage of using the petrodollar system is that the dollar has high liquidity and is relatively deep. By being deep means that it can be bought or sold in large amounts without affecting its value. Moreover, the petrodollar system promotes the international trade by providing a common currency with which trade is conducted. On the other hand, some disadvantages have emerged due to the use of the petrodollar system. The most significant one is the fact that it has led to the poor performance of some world economies since they are entirely dependent on the dollar to import oil. Besides, the dollar is prone to fluctuations that ultimately make imports relatively expensive (Tun, 2015).
In conclusion, the petrodollar system has brought significant changes to the world economies, especially to the countries it directly affects, that is, the U.S. and the OPEC member countries. Proper maintenance of the system world ensure stability in the oil prices and consequently stable market prices for oil and the value of the dollar. However, the idea to replace the dollar may be even more efficient since the shortcomings of this system can then be handled. It is though not clear whether the denomination that would replace it would have more advantages the petrodollar.