The relationship between the US and Saudi Arabia continues to garner headlines in the global financial and political press. While this is expected to continue in the near future, considering President-Elect Trump’s stubborn stance on the issue, it is currently unclear how these issues will conclude.
In order to fully appreciate the background of these issues and the relationship between the US and Saudi Arabia, it is important to understand the system that underpins this connection: the ‘Petrodollar’.
In this article, we will explore the history of the relationship between these two nations and the formation of the Petrodollar system, with the ultimate aim of comprehending the implications on the world economy and the potential decline of the US dollar.
This article is part of a series that will provide the reader with an overall understanding of the situation, concluding with a breakdown of the current issues and potential solutions for this ongoing matter.
The Yom Kippur War, US ‘shuttle diplomacy’ and OPEC retaliation
The fascinating origins begin with the Yom Kippur War, commencing on 6 October 1973 when Arab countries (including Egypt and Syria) launched an attack on Israel on Yom Kippur day, causing Israel to go on full nuclear alert.
In an attempt to defuse the conflict, the US acted as an intermediary between the parties with Secretary of State Henry Kissinger facilitating the ‘shuttle diplomacy’, beginning on 5 November 1973. Nevertheless, they opt to supply Israel with war material and other supplies.
In retaliation, OPEC countries triggered an oil price increase from 3 USD per barrel to as high as 17 USD per barrel. In addition to this, they also chose to reduce oil production by 25%.
The consequences of this action were severe for the US. They entered the worst recession since World War II experiencing rising inflation, decreasing industrial production, and a plunge in the stock market, which continued for a number of years until finally coming to an end in the early 1980s.
‘Nixon Shock’ creates issues in OPEC countries
Following the famous ‘Nixon Shock’ economic measures, the US chose to cancel the convertibility of the US dollar to gold in 1971. As a result, the US dollar experienced a significant reduction in purchasing power during the period 1971 – 1973.
Interestingly, prior to this decision economist (and Nobel Prize winner) Milton Friedman warned President Nixon that the gold price could fall to as low as USD 6 per ounce if the US went ahead. In fact, the gold price rose madly from 35 USD per ounce in 1967 (the fixed convertibility price) to as high as 135 USD per ounce in 1973.
The weakening power of the dollar severely affected the accounts of the OPEC countries and provided them with further motivation to increase the oil price. In addition to this, a further issue became how to motivate these countries to hold US dollars, considering it had now become a fiat currency and was in a state of losing value.
With the situation worsening, the US began to devise a range of policies to address the situation, including a military solution. Unofficial accounts towards the end of 1973 reveal a scenario under which the US were preparing for a military invasion of Saudi Arabia to secure the oil fields and avoid disruption of supply to the West.
At this point, there were multiple issues to be addressed, including:
- Neutralising oil as an economic weapon.
- Influencing OPEC’s decisions (where the Saudi are the most relevant party) so that they do not undermine and disarticulate the World monetary system.
- Avoiding the Soviet Union from taking advantage of the strained relationship and expand its political, ideological, and military influence over the Saudi kingdom.
Diplomatic option gains traction and a deal is made
In March 1974, the situation began to improve. OPEC lifted the oil embargo and the US took the opportunity to redesign an oil policy, which could achieve the goal of normalising the political relationship and avoiding further oil strains.
The diplomatic option began to gain traction and in July 1974, Kissinger sent the newly appointed Treasury Secretary William E. Simon (named the ‘Energy Czar’ and a former Wall Street investment banker) and his deputy, Gerry Parsky, on a secret mission to Saudi Arabia to broker a deal.
The deal would involve persuading the Saudi to finance the increasing US deficit with oil profits. Unofficial sources reported that the mission was desperate and the US president was not willing to consider failure as an option.
The deal that Simon offered was simple: the Saudis would agree to price oil in dollars and to reinvest those dollars into US Treasury securities and Eurodollar deposits in US banks.
In exchange, the US would commit to take steps to stabilise the exchange value of the US dollar and agree to sell advanced weapons to the Saudi kingdom. Weapons that, according to some accounts, were the result of the massive overproduction triggered by the Vietnam War and that the US were eager to place.
There was also a little known additional piece: US banks would use the Petrodollars as loans to emerging markets in Latin America, South Asia and Africa. In turn, those countries would purchase US, European, and Japanese exports. The ultimate goal was to reignite global growth and increase demand for oil. A win-win solution for all parties involved.
With these deals being made, the Saudi strongly demanded a non-disclosure clause: the US would have to agree to maintain confidentiality regarding the Saudi investments. This was agreed and maintained for over forty years, until May 2016, when the US Treasury finally revealed the size of Saudi holdings in US Treasuries.
However, the official figure for these holdings could potentially be misleading, since it ignores US Treasury securities owned by Saudi Arabia but held by offshore intermediaries in the Cayman Islands and other offshore banking centres.
Implementation issues create further headaches
While the deal appeared to have been made, there were several problems in the implementation. The Saudis are notorious for delaying in decision-making and in this case, they chose to vacillate and not commit immediately. They wanted time to consider alternative mechanisms for oil pricing, such as gold for example. Additionally, the resignation of Kissinger in 1974 as a result of the Watergate scandal provided them with another excuse for delays.
To overcome the gridlock, the US sought to apply pressure on Saudi Arabia by openly discussing the military option of occupying Saudi Arabia. On 1 January 1975, Commentary magazine published one of the most famous articles in the history of American foreign policy.
The article was written by Robert W. Tucker, head of the American Foreign Policy Institute and a member of the inner circle of the White House. The title was “Oil: The Issue of American Intervention” and it made explicit references to the military scenario the US was working on.
The article served its purpose and convinced the Saudis to sign the deal.
The Petrodollar era
Despite a range of highs and lows, all administrations ever since President Carter have shown commitment to the mantra of a “strong dollar”. For 35 years, from 1975 to 2010, the Petrodollar deal has remained intact, despite oil price increases and dollar volatility. The dollar has solidified its role as the leading reserve currency and the leading payments currency.
By 2009, a new economic crisis eroded the stability of the Petrodollar deal. In September of the same year, world leaders gathered for the G20 Leaders’ Summit and President Obama proposed a plan to boost world growth based on a simple idea: each major economic block or region would commit to move away from a sector it has over-relied and toward an area that offered growth potential.
For China and Japan, this would mean moving from capital investment to consumption. Europe would move from exports to investment and the US itself would take on the task of increasing exports.
The main obstacle in attaining a growth in export was that without being able to double the size of labour force or the productivity of labour (the main drivers of industrial production growth), the only viable option would be to cheapen the currency.
By July 2011, just 18 months after the meeting, the dollar index stood at 80.48, which represented a decline of 8% and a new all-time low. A currency war had started which continues to survive until today.
Relations between Saudi Arabia and the US have deteriorated sharply over the course of the Obama administration. There are a number of causes:
- The Iran-US nuclear negotiations and the US acknowledgment of Iran as the leading regional power.
- The release of a top-secret 28-page section of the 9/11 Commission Report that clearly reveals links between members of the Saudi royal family and the 9/11 hijackers. The Saudis have threatened to sell their US Treasury securities in response but they have so far failed to keep their word.
- The US is now a net exporter of energy and, supposedly, has the largest oil reserves in the world
- In response to the weakening of the US dollar, several OPEC nations are allowing oil transactions to be carried out in other currencies:
- In January 2016, India and Iran agreed to settle their oil sales in Indian rupees.
- In 2014, Qatar agreed with China to be the first hub for clearing transactions in the Chinese yuan.
- In December 2015, the United Arab Emirates (UAE) and China created a new currency swap agreement for the yuan.
All the above strongly indicate that the Gulf States are taking measures to reduce their dependence and exposure to the US dollar.
All of the conditions that gave rise to the Petrodollar agreement now stand in the exact opposite position of where they were in 1975. Neither the US nor Saudi Arabia have much leverage over the other.
A new oil pricing mechanism is possible and, once identified and announced, it will signify the end of the US dollar as the leading currency. The oil price will pave the way and will certainly soon be followed by other goods and commodities.
Will this be the start of a new era?
By Nicholas Puri & Lorenzo Beriozza
