FX International Payments
By Frances Coppola
Subsequently, the rest of the world's high demand for dollars to spend on oil helped to establish USD as the world's premier currency, and thus the "exorbitant privilege" that economists say allows the U.S. to run large fiscal and trade deficits.
But that may be about to change. This article discusses the erosion of OPEC's influence at the hands of non-OPEC oil producers, which undermines OPEC's price control mechanism and hence the petrodollar's stability. It also discusses the potential rise of a "petroeuro."
Petrodollar recycling created a link between the oil price and the dollar. If OPEC could keep the oil price stable, the dollar's exchange rate would also be stable. The U.S.'s agreement with OPEC thus created an external anchor for the dollar which helped to control domestic inflation.
For a few years, this worked well. OPEC managed the oil price by setting quotas for its members, and the petrodollar recycling mechanism helped keep stable exchange rates for the U.S. dollar. But during this time, oil production by non-OPEC members such as Britain and Norway steadily rose, reaching 31 billion barrels per annum by 1978.1 It was a sign of things to come.
In 1979, there was a revolution in Iran, an OPEC member and one of the world's largest oil producers. Then, in September 1980, the weakened Iran was invaded by Iraq, another OPEC member and an even larger oil producer. The combined output of both countries fell from 6.5 million barrels per day to roughly 1 million, reducing worldwide crude oil production by 10 percent.2 As a result of that sudden supply shortage, the oil price shot up, rising from $14 per barrel in 1978 to $35 per barrel in 1981.3 For the next two decades, the oil price remained volatile.
Rising oil prices sparked inflation in the U.S., and the Federal Reserve acted: it raised interest rates to unprecedented levels, triggering a deep recession. Between 1981-85 the dollar's exchange rate soared4 in response to very high interest rates.
High oil prices and a strong dollar encouraged oil exploration and production by non-OPEC producers. Between 1981-85, non-OPEC production boomed, and the oil price gradually fell, helped by a soaring dollar exchange rate. OPEC members responded to falling oil prices by increasing production, ignoring their oil production quotas – but that caused crude oil prices to plummet, falling below $10 per barrel by mid-19865 despite the Plaza Accord (which was intended to hold down the U.S. dollar's exchange rate).
Oil prices remained weak thereafter, apart from a spike in 1990 when Iraq's invasion of Kuwait (both OPEC members) resulted in the first Gulf War. Both OPEC and non-OPEC production continued to expand, but as non-OPEC production by then far outstripped OPEC production, OPEC's quota system had little effect on the oil price.6 Exchange rates for the U.S. dollar also remained weak throughout this time,7 after the failure of the Louvre Accord forced the U.S. to allow the dollar to float freely.
By 1994, inflation-adjusted oil prices had fallen to the lowest level since 1973,8 and the U.S. dollar's exchange rate was at an all-time low.9 The oil price recovered from 1995-97, due to declining output in Russia and rising demand in the Asia-Pacific region,10 while the dollar's exchange rate also rose due to a strong U.S. economy.11
But in 1997, several Asian countries defaulted on their debts, followed by Russia in 1998. The sudden interruption in demand for oil from the Asia-Pacific region sent oil prices into a downward spiral. OPEC cut production quotas, but the price continued to fall throughout 1998 despite a slight fall in the dollar's exchange rate. However, as demand recovered in 1999, the price gradually moved above $25 per barrel.12
The European Single Currency – the euro – was created in 1999 and the "petroeuro" made its first appearance in October 2000, when Iraq abruptly shifted to invoicing its oil in euros. Soon afterwards, Jordan launched a bilateral trade scheme with Iraq, which was entirely in euros. And once the euro's exchange rate started to rise versus the U.S. dollar,13 other OPEC and non-OPEC producers were attracted by the size of the European bloc's actual and potential oil imports, which exceeded those of the U.S. by a considerable margin.14
By 2003, the euro had risen by some 30 percent since its October 2000 low,15 and Russia and Iran were both expressing an interest in moving to pricing oil in euros. Even more significantly, the two North Sea Oil producers, Britain and Norway, were both considering joining the euro; had they done so, the Brent crude benchmark price might have moved from dollars to euros.16
If the majority of oil producers had switched to pricing oil in euros, "petrodollar recycling" could have come to an abrupt end, triggering fast depreciation of the dollar's exchange rate and sharply rising U.S. interest rates. However, Saudi Arabia – still the largest oil producer in the world – continued to price oil in dollars, and most oil producers followed its lead.
Nonetheless, there continued to be rumors that the euro might displace the dollar as the currency in which oil was priced. In 2003, a coalition of Western forces led by the U.S. invaded Iraq. Many reasons have been given for the war, one of which was to ensure the stability of petrodollar recycling or even prevent a move to pricing oil in euros.17,18 But whatever the reasons, the war caused a significant fall in OPEC oil production which caused the price of oil to rise.19
In 2005, Iran announced the creation of a euro-denominated oil exchange. Some interpreted this as a challenge to the international dominance of the petrodollar.20 But the former director of the International Petroleum Exchange, who devised the scheme,21 says that the currency of exchange was not significant; they used euros because Iran's largest oil trading partner was the European Union, and it relied upon the highly liquid dollar/euro FX market.22
The rumors of dollar displacement temporarily terminated with the financial crisis of 2008 and the Eurozone crisis of 2012. But in 2015, the Financial Times's Alphaville blog once again began discussion of the euro as a possible petrodollar replacement.23
Petrodollar recycling has helped the U.S. to run large trade and fiscal deficits without fear of currency collapse or a buyer's strike – what economists call "exorbitant privilege." However, as non-OPEC production overtook OPEC's, and the European Union became the world's biggest oil importer, the possibility emerged that the euro might replace the U.S. dollar as the currency in which oil is priced. That could bring petrodollar recycling to an end, heralding a time of exchange rate volatility for which U.S. international businesses may need to prepare. So far, this has not happened.
The next article in this series discusses how the U.S.'s re-emergence as a dominant oil producer and its aim to regain direct control of global oil supply could affect petrodollar recycling and exchange rates for the U.S. dollar.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
2. “Daily Nominal Exchange Rate of the Euro,” European Central Bank; https://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
4. “Trade Weighted US Dollar Index: Major Currencies,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
5. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
7. “Trade Weighted US Dollar Index: Major Currencies,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
8. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
9. “Trade Weighted US Dollar Index: Major Currencies,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
10. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
11. “Trade Weighted US Dollar Index: Major Currencies,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
12. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
13. “U.S./Euro Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
14. “When will we buy oil in euros?”, The Guardian; https://www.theguardian.com/business/2003/feb/23/oilandpetrol.theeuro
15. U.S./Euro Foreign Exchange Rate, ibid.
16. “When will we buy oil in euros?”, The Guardian; https://www.theguardian.com/business/2003/feb/23/oilandpetrol.theeuro
17. “Why did we invade Iraq?” National Review; https://www.nationalreview.com/2013/03/why-did-we-invade-iraq-victor-davis-hanson/
18. “Petro Euros vs Petro Dollars,” Oil Empire; http://www.oilempire.us/euro.html
19. “Oil price history and analysis,” WTRG Economics; http://www.wtrg.com/prices.htm
20. “Will Iran’s ‘petroeuro’ threat lead to war?” WND; http://www.wnd.com/2006/02/34643/
21. “China Syndrome,” Chris Cook, Trend News Agency; https://en.trend.az/iran/business/2862164.html
22. Personal interview with Chris Cook, former director of the International Petroleum Exchange.
23. “Hello world, I’m the PetroEuro,” FT Alphaville; https://ftalphaville.ft.com/2015/06/25/2132956/hello-world-im-the-petroeuro/