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China, the Petrodollar System, and Why it Matters

Overview

On March 26th, 2018, the Shanghai International Energy Exchange launched a new crude oil futures contract. The most notable aspect of this contract is that it is priced in Chinese Yuan and not U.S. Dollars. If widely adopted, this has the potential to be a seismic shift in energy markets and global trade since currently, all open international oil sales are denominated in dollars, also known as Petrodollars. Petrodollars, as defined by Investopedia are “oil revenues denominated in U.S. dollars. Because petrodollars are denominated in U.S. dollars, the true purchasing powering of them are reliant on both the core rate of U.S. inflation and the value of the U.S. dollar.”

The Rise of the Petrodollar

The Petrodollar system came about officially in 1974 when President Richard Nixon sent then Secretary of State Henry Kissinger to Saudi Arabia after the U.S. abandoned the gold standard making it a completely fiat currency. The following deal was offered to the ruling House of Saud by the U.S.:

  1. America’s military would guarantee protection of Saudi Arabia and its oilfields.
  2. The U.S. would also sell the Saudis any weapons needed.
  3. The U.S. would guarantee Saudi Arabia protection from Israel and other countries in the region.
  4. The Saudi family was assured they would rule in perpetuity.

The one stipulation the U.S. requested in return was that Saudi Arabia ensures all oil sales are conducted only in U.S. Dollars. The impact of this request demanded that all countries importing oil must build up a supply of dollars to exchange for oil. However, countries don’t stockpile dollar bills; they buy U.S. treasuries, bonds, and notes. Thus, since 1974, this currency stockpiling method enabled the U.S. to continually finance its ever growing debt due to the fact that there are willing buyers who need U.S. Dollars to pay for their oil imports.

China Steps Away

Flash forward to 2017 when China surpassed the US as the largest global importer of crude oil. China’s growing need for oil is one of the reasons that China is such a large purchaser of U.S. debt. However, China started taking small steps towards bypassing the dollar. One of these steps is committing to an “Agreement on Cooperation” between the Bank of China and VTB, Russia’s second largest financial institution.  This agreement confirmed that both parties agreed to pay each other in their respective domestic currencies. This was immediately followed by a a $450 Billion natural gas deal between China and Russia later that year.

Why is China doing this? As China’s population continues to grow so does its need for petroleum resources to keep the economy running as it increases. China is a net importer of oil purchasing $109 Billion in 2016 with that figure continually rising.  China realized that pricing oil contracts in Yuan allows them to cease purchasing U.S. Dollars to then exchange for oil.  The long term implications of this could result in the end of the Petrodollar system, likely ending the U.S. Dollar’s reserve currency status, which would likely lead to a multi-currency reserve system. In this type of multi-currency system, the Yuan would not be limited to purchasing oil, but could purchase many of the other natural resources that the Chinese economy voraciously consumes on a yearly basis. The most tangible benefit of operating in a multi-currency reserve system is that China can always artificially print more.  Right now, they are unable to do that given that the Yuan is pegged to the dollar.  Should they print more, the value of the Yuan would decline and, in turn, weaken China’s ability to purchase the resources its economy needs.

Not Forgetting the Saudis

A major piece in this puzzle is Saudi Arabia; the progenitors of the Petrodollar.   The U.S. is no longer  the largest purchaser of Saudi oil. That title now belongs to China.  One can assume that the Chinese, if they are not already, will be pushing hard for the Saudi’s to accept Yuan in exchange for oil. If that happens OPEC (Organization of the Petroleum Exporting Countries) will almost certainly follow and the Petrodollar system will likely collapse in spectacular fashion. Analyst Comment: Moving to the Yuan will not be that simple due to the multi-tiered security situation in the Middle East and the current pre-dominance of U.S. military & political power in the region.

FAO GLOBAL ASSESSMENT

While significant, this shift in petrodollars is unlikely to come about for many years and must overcome a plethora of geo-political, military, and economic hurdles before countries will look to the Chinese Yuan as the stable guarantor of oil currencies. What is certain is that going forward China will continue looking for ways secure natural resources without having to use the U.S. Dollar, thus reducing its reliance on the U.S. This will likely take the form of direct investments in 2nd and 3rd world countries with large reserves of natural resources as well as infrastructure projects through the One Belt, One Road initiative, which are all financed using Yuan. Over time, given China’s economic investment into many developing and developed countries, this may be possible if the U.S. significantly pulls back from the world stage whether through isolationist policies or through lack of funding to due debt limitations.


Author Bio: Andrew Sturm is the Founder and CEO of Eversia Capital Inc. which trades and invests in futures, options and equities based out of the Washington, DC area. Prior to Eversia Capital, Andrew as over 10 years’ experience in a variety of leadership and policy roles. He has worked on multiple projects in both Washington, DC and South Korea.  He has an MBA from Georgetown University’s McDonough School of Business and a bachelors from the University of Mary Washington.