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The relationship between Gold and Petrodollar

The beginning of the end for the world reserve currency?

Published: 09-09-2013 00:00

The relationship between Gold and Petrodollar

As United States prepares to take military action against Syria, many people are been debating the country’s involvement in yet another Middle East conflict. For the last decade, United States has been mired in long drawn conflicts with Iraq and Afghanistan, leaving overall war weariness among Americans. A lot of resources have been drained and countless of lives have been sacrificed in these war efforts. To understand why the United States government is so keen to return to their favorite battleground in the Middle East, one of the world’s top oil producing regions, one has to trace back to the currency history and the development of the “petrodollar”.

In 1971, when President Nixon finally cut the last thread between gold and the dollar, he effectively changed the United States’ monetary system into a fiat currency system. The dollar began to weaken as a result of the costly Vietnam War, growing competition from developing economies and general lack of confidence of the fiat currency. In 1973, to prevent further devaluation of the dollar and to protect the status of the dollar as the world’s reserve currency, President Nixon made an agreement with the King of Saudi Arabia to buy and sell crude oil using US dollars. The reason why Saudi Arabia agreed to such a deal was because it suffered a humiliating defeat to Israel and had to rely on United States’ superior military forces to help it fend off their enemies, which also included Iran and Iraq. United States was in the bargaining position because their military technology was at least a generation ahead of its nearest competitor.

The strategic cooperation of United States and Saudi Arabia was a significant development in the history of the fiat currency system because it established the US dollar as the de-facto currency to trade crude oil. This effectively ensured that the US dollar became the “reserve currency” for global trades in virtually all the commodities and goods because foreign banks were forced to use the dollar as a form of international exchange for oil and other imports. Massive demand for US dollars ensued and pushed up the value of dollar. Many countries have the ability to print unlimited amount of fiat currency, however, US dollar has the unique privilege of being the only currency in the world in which oil could be purchased, making it the universal benchmark currency.

The petrodollar gave United States great power and lifted its economy to new heights. It was a brilliant political and economic move by United States because it ensured growing demand for both the dollar and Treasury bonds, while letting United States own the commodity for free as oil’s value is denominated in a currency that America controls and prints. During this period, no other currencies came close to usurping its position as the top currency.

The first major challenge to the petrodollar’s rule came in late 2000, when Saddam Hussein, under the influence of European countries, converted its oil transactions under the Oil-for-Food Programme to euros. United States retaliated shortly after in 2003 and invaded Iraq, ending the programme and its euro payment. In essence, the US invasion sent a stark warning to the rest of the OPEC producers which considered making the same switch to euros. It was also a message to the rest of the world that the petrodollar enabled United States to build a vastly superior military force and that it would go to great lengths to protect the petrodollar. The cost of not protecting the petrodollar system would be costly to United States because if gold or other currencies displaced the dollar as the reserve currency, then the dollar would quickly become irrelevant and worthless.

Even though Saudi Arabia has stood by United States for the past three decades, recent events in the past few years has made them change their stance. They were unhappy with the weakening dollar and the economic disadvantage of the West Texas Intermediate (WTI) contract. This is the oil contract which oil producers price their oil exports to United States. In 2009, Saudi Arabia announced that it would no longer use the WTI contract. In 2010, a UN report recommended to replace the dollar as the world’s reserved currency, as it had been unable to sustain its value. These developments, together with the country’s mounting national debt, dealt a heavy blow to the petrodollar. The world is slowly losing confidence in the petrodollar. To restore confidence in the dollar, one way could be for United States to carry out military invention in the Middle East conflicts and once again demonstrate to the rest of the world that it would defend its currency at all costs, just like in the case of the Iraq invasion.

The slow demise of the dollar means that countries have to start looking for a currency to fall back on. Three rising economic powerhouse nations, Russia, India and China are major gold producers. There is a possibility that if the petrodollar was displaced and trading in other currencies became too complicated, they might look to gold to keep the crude oil flowing. Gold has always been the currency to fall back on during uncertain times. It is considered a safe haven for investors when valuations for currencies become unpredictable.

The impending Syria war could also benefit gold. In a recent interview, Jim Rogers, who is based in Singapore, said that in the event that United States attacked Syria, gold and oil prices will surely shoot up. This is expected as historically, demand for food, energy and raw materials increased during war times and drove up prices. Investors should start to take action now and load up on gold bullion before its price rise significantly.