Will This Deal Be A Blow To The Petrodollar?

As we wrote yesterday, China launched its first ever Yuan denominated oil futures contract this week.

If you missed it, you can read about it here.

This could pose a threat to the petrodollar, a deal that has been in place since the 1970s.

In fact, China could be getting close to dealing a deathblow to the petrodollar…

But first, let me give you a bit of background.

After the Second World War devastated Europe, the US was one of the few countries left with a strong economy.  This allowed the US to proclaim the US dollar as the world reserve currency during the 1944 Bretton Woods monetary system

In the Bretton Woods system, each US dollar issued was backed by the US gold reserves stored at Fort Knox. That is, other currencies would be pegged to the US dollar and the US dollar would be pegged to gold.

Any country holding US dollars could exchange the paper money for physical gold.

This put the US in an advantageous position. It was the only country with the ability to print US dollars, and all international trade was going through their currency.

This worked well at first…but it didn’t last long.

You probably know what happened next: the US started up the printing press.

The US printed more dollars than they could back with gold. So when the French demanded to get gold for every dollar they held, the system crumbled.

In 1971, US President Richard Nixon brought an end to gold convertibility. The US dollar became a fiat currency, one backed by nothing but trust.

And how do you maintain the world’s demand for the US dollar when it is not backed by anything?

By using it for a commodity…in this case, oil.

That’s when the current petrodollar deal came about. The Saudis agreed to price oil barrels in US dollars in exchange for military aid and protection.

Anyone that wanted to buy oil would need to buy US dollars first, making the US dollar the world currency for commodities.

Saudi Arabia would invest any excess money in US Treasury bonds, to finance expenses. This in turn kept borrowing costs down for the US and added more liquidity.

China’s oil futures contract could be a game changer

The new oil futures contract is one of the many Chinese efforts to internationalise their currency. Yet the adoption pace has been slow.

According to SWIFT data, the US dollar still makes up about 40% share of all international payments. The Chinese Renminbi makes only about 1.5%.

But, according to January’s SWIFT RMB tracker, there could be a couple of catalysts that could cause the currency to grow quicker. 

One is the possibility of an increase in use of Renminbi for the One Belt One Road Initiative (OBOR) — renamed Belt and Road Initiative (BRI). The project seeks to revive the old silk route and bring Europe, Asia, Africa and Oceania closer.

The other is the use in commodity trading. As SWIFT wrote:

One area, according to DBS Bank, could be greater use of the RMB [Renminbi] in commodity trading. If Saudi Arabia follows in Russia’s footsteps with RMB settlement for oil transactions, for instance, the industry could go through a paradigm shift…

While the future of RMB growth is uncertain for 2018, key programmes are being put in place that could lead to growth in RMB usage over the longer term.

In other words, if Saudi Arabia starts accepting Chinese currency in exchange for oil, it could increase the Renminbi’s growth.

As we wrote yesterday, some countries like Iran and Russia have already started accepting Yuan for oil. If Saudi Arabia follows, it could deal a massive blow to the petrodollar.

Russia is China’s largest oil supplier. Along with Saudi Arabia, they both provide around 30% of oil to China.

The Saudis have not turned their backs on the US…yet. But they are starting to make changes, diversifying their alliances.

Russia and Saudi Arabia have been enemies for decades.

Yet in October 2017, King Salman from Saudi Arabia visited Russia for the first time. In fact, he was the first Saudi king to ever visit Russia. The visit resulted in a US$3 billion arms deal.

Saudi Arabia has also been drifting closer to China.

In March 2017, Chinese President Xi Jinping met with Saudi King Salam. They signed an economic trade deal involving energy and other sectors to the tune of US$65 billion.

Saudi Arabia had even announced it was considering funding through ‘Panda bonds’ in Chinese Yuan last August, to cover the budget deficit caused by lower oil prices. Panda bonds are Yuan-denominated bonds from non-Chinese issuers sold in China.

China is also looking to take part in Saudi’s Aramco’s initial public offering. The Saudi state-owned firm is preparing for a public listing.

This would bring both countries closer.

Saudi Arabia is the world’s largest oil exporter, and much of what it exports goes to China.

Yet Saudi Arabia recently lost its spot as China’s biggest oil supplier to Russia. While Saudi doesn’t accept Chinese Yuan as payment yet, they may have to change their stance as they drift towards China.

And they may very well do. China is one of their biggest clients.

If they start to sell oil to China in Yuan, it would deal a huge blow to the petrodollar.