The Oily Dollar, RIP

Marin Katusa

are swirling that India and Iran are at the negotiating table right
now, hammering out a deal to trade oil for gold. Why does that matter,
you ask? Only because it strikes at the heart of both the value
of the US dollar and today’s high-tension standoff with Iran.

Tehran Pushes
to Ditch the US Dollar

The official
line from the United States and the European Union is that Tehran
must be punished for continuing its efforts to develop a nuclear
weapon. The punishment: sanctions on Iran’s oil exports, which are
meant to isolate Iran and depress the value of its currency to such
a point that the country crumbles.

But that line
doesn’t make sense, and the sanctions will not achieve their goals.
Iran is far from isolated and its friends – like India –
will stand by the oil-producing nation until the US either backs
down or acknowledges the real matter at hand. That matter is the
American dollar and its role as the global reserve currency.

The short version
of the story is that a 1970s deal cemented the US dollar as the
only currency to buy and sell crude oil, and from that monopoly
on the all-important oil trade the US dollar slowly but surely became
the reserve currency for global trades in most commodities and goods.
Massive demand for US dollars ensued, pushing the dollar’s value
up, up, and away. In addition, countries stored their excess US
dollars savings in US Treasuries, giving the US government a vast
pool of credit from which to draw.

We know where
that situation led – to a US government suffocating in debt
while its citizens face stubbornly high unemployment (due in part
to the high value of the dollar); a failed real estate market; record
personal-debt burdens; a bloated banking system; and a teetering
economy. That is not the picture of a world superpower worthy of
the privileges gained from having its currency back global trade.
Other countries are starting to see that and are slowly but surely
moving away from US dollars in their transactions, starting with

If the US dollar
loses its position as the global reserve currency, the consequences
for America are dire. A major portion of the dollar’s valuation
stems from its lock on the oil industry – if that monopoly
fades, so too will the value of the dollar. Such a major transition
in global fiat currency relationships will bode well for some currencies
and not so well for others, and the outcomes will be challenging
to predict. But there is one outcome that we foresee with certainty:
Gold will rise. Uncertainty around paper money always bodes well
for gold, and these are uncertain days indeed.

The Petrodollar

To explain
this situation properly, we have to start in 1973. That’s when President
Nixon asked King Faisal of Saudi Arabia to accept only US dollars
as payment for oil and to invest any excess profits in US Treasury
bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi
Arabian oil fields from the Soviet Union and other interested nations,
such as Iran and Iraq. It was the start of something great for the
US, even if the outcome was as artificial as the US real-estate
bubble and yet constitutes the foundation for the valuation of the
US dollar.

By 1975 all
of the members of OPEC agreed to sell their oil only in US dollars.
Every oil-importing nation in the world started saving their surplus
in US dollars so as to be able to buy oil; with such high demand
for dollars the currency strengthened. On top of that, many oil-exporting
nations like Saudi Arabia spent their US dollar surpluses on Treasury
securities, providing a new, deep pool of lenders to support US
government spending.

The “petrodollar”
system was a brilliant political and economic move. It forced the
world’s oil money to flow through the US Federal Reserve, creating
ever-growing international demand for both US dollars and US debt,
while essentially letting the US pretty much own the world’s oil
for free, since oil’s value is denominated in a currency that America
controls and prints. The petrodollar system spread beyond oil: the
majority of international trade is done in US dollars. That means
that from Russia to China, Brazil to South Korea, every country
aims to maximize the US-dollar surplus garnered from its export
trade to buy oil.

The US has
reaped many rewards. As oil usage increased in the 1980s, demand
for the US dollar rose with it, lifting the US economy to new heights.
But even without economic success at home the US dollar would have
soared, because the petrodollar system created consistent international
demand for US dollars, which in turn gained in value. A strong US
dollar allowed Americans to buy imported goods at a massive discount
– the petrodollar system essentially creating a subsidy for
US consumers at the expense of the rest of the world. Here, finally,
the US hit on a downside: The availability of cheap imports hit
the US manufacturing industry hard, and the disappearance of manufacturing
jobs remains one of the biggest challenges in resurrecting the US
economy today.

There is another
downside, a potential threat now lurking in the shadows. The value
of the US dollar is determined in large part by the fact that oil
is sold in US dollars. If that trade shifts to a different currency,
countries around the world won’t need all their US money. The resulting
sell-off of US dollars would weaken the currency dramatically.

So here’s an
interesting thought experiment. Everybody says the US goes to war
to protect its oil supplies, but doesn’t it really go to war to
ensure the continuation of the petrodollar system?

The Iraq war
provides a good example. Until November 2000, no OPEC country had
dared to violate the US dollar-pricing rule, and while the US dollar
remained the strongest currency in the world there was also little
reason to challenge the system. But in late 2000, France and a few
other EU members convinced Saddam Hussein to defy the petrodollar
process and sell Iraq’s oil for food in euros, not dollars. In the
time between then and the March 2003 American invasion of Iraq,
several other nations hinted at their interest in non-US dollar
oil trading, including Russia, Iran, Indonesia, and even Venezuela.
In April 2002, Iranian OPEC representative Javad Yarjani was invited
to Spain by the EU to deliver a detailed analysis of how OPEC might
at some point sell its oil to the EU for euros, not dollars.

This movement,
founded in Iraq, was starting to threaten the dominance of the US
dollar as the global reserve currency and petro currency. In March
2003, the US invaded Iraq, ending the oil-for-food program and its
euro payment program.

There are many
other historic examples of the US stepping in to halt a movement
away from the petrodollar system, often in covert ways. In February
2011 Dominique Strauss-Kahn, managing director of the International
Monetary Fund (IMF), called for a new world currency to challenge
the dominance of the US dollar. Three months later a maid at the
Sofitel New York Hotel alleged that Strauss-Kahn sexually assaulted
her. Strauss-Kahn was forced out of his role at the IMF within weeks;
he has since been cleared of any wrongdoing.

War and insidious
interventions of this sort may be costly, but the costs of not protecting
the petrodollar system would be far higher. If euros, yen, renminbi,
rubles, or for that matter straight gold, were generally accepted
for oil, the US dollar would quickly become irrelevant, rendering
the currency almost worthless. As the rest of the world realizes
that there are other options besides the US dollar for global transactions,
the US is facing a very significant – and very messy –
transition in the global oil machine.

The Iranian

Iran may be
isolated from the United States and Western Europe, but Tehran still
has some pretty staunch allies. Iran and Venezuela are advancing
$4 billion worth of joint projects, including a bank. India has
pledged to continue buying Iranian oil because Tehran has been a
great business partner for New Delhi, which struggles to make its
payments. Greece opposed the EU sanctions because Iran was one of
very few suppliers that had been letting the bankrupt Greeks buy
oil on credit. South Korea and Japan are pleading for exemptions
from the coming embargoes because they rely on Iranian oil. Economic
ties between Russia and Iran are getting stronger every year.

Then there’s
China. Iran’s energy resources are a matter of national security
for China, as Iran already supplies no less than 15% of China’s
oil and natural gas. That makes Iran more important to China than
Saudi Arabia is to the United States. Don’t expect China to heed
the US and EU sanctions much – China will find a way around
the sanctions in order to protect two-way trade between the nations,
which currently stands at $30 billion and is expected to hit $50
billion in 2015. In fact, China will probably gain from the US and
EU sanctions on Iran, as it will be able to buy oil and gas from
Iran at depressed prices.

So Iran will
continue to have friends, and those friends will continue to buy
its oil. More importantly, you can bet they won’t be paying for
that oil with US dollars. Rumors are swirling that India and Iran
are at the negotiating table right now, hammering out a deal to
trade oil for gold, supported by a few rupees and some yen. Iran
is already dumping the dollar in its trade with Russia in favor
of rials and rubles. India is already using the yuan with China;
China and Russia have been trading in rubles and yuan for more than
a year; Japan and China are moving towards transactions in yen and

And all those
energy trades between Iran and China? That will be settled in gold,
yuan, and rial. With the Europeans out of the mix, in short order
none of Iran’s 2.4 million barrels of oil a day will be traded in

With all this
knowledge in hand, it starts to seem pretty reasonable that the
real reason tensions are mounting in the Persian Gulf is because
the United States is desperate to torpedo this movement away from
petrodollars. The shift is being spearheaded by Iran and backed
by India, China, and Russia. That is undoubtedly enough to make
Washington anxious enough to seek out an excuse to topple the regime
in Iran.

Speaking of
that search for an excuse, this is interesting. A team of International
Atomic Energy Agency (IAEA) inspectors just visited Iran. The IAEA
is supervising all things nuclear in Iran, and it was an IAEA report
in November warning that the country was progressing in its ability
to make weapons that sparked this latest round of international
condemnation against the supposedly near-nuclear state. But after
their latest visit, the IAEA’s inspectors reported no signs of bomb
making. Oh, and if keeping the world safe from rogue states with
nuclear capabilities were the sole motive, why have North Korea
and Pakistan been given a pass?

There is another
consideration to keep in mind, one that is very important when it
comes to making some investment decisions based on this situation:
Russia, India, and China – three members of the rising economic
powerhouse group known as the BRICs (which also includes Brazil)
– are allied with Iran and are major gold producers. If petrodollars
go out of vogue and trading in other currencies gets too complicated,
they will tap their gold storehouses to keep the crude flowing.
Gold always has and always will be the fallback currency and, as
mentioned before, when currency relationships start to change and
valuations become hard to predict, trading in gold is a tried and
true failsafe.

2012 might
end up being most famous as the year in which the world defected
from the US dollar as the global currency of choice. Imagine the
rest of the world doing the math and, little by little, beginning
to do business in their own currencies and investing ever less of
their surpluses in US Treasuries. It constitutes nothing less than
a slow but sure decimation of the dollar.

That may not
be a bad thing for the United States. The country’s gargantuan debts
can never be repaid as long as the dollar maintains anything close
to its current valuation. Given the state of the country, all that’s
really left supporting the value in the dollar is its global reserve
currency status. If that goes and the dollar slides, maybe the US
will be able to repay its debts and start fresh. That new start
would come without the privileges and ingrained subsidies to which
Americans are so accustomed, but it’s amazing that the petrodollar
system has lasted this long. It was only a matter of time before
something would break it down.

Finally, the
big question: How can one profit from this evolving situation? Playing
with currencies is always very risky and, with the global game set
to shift to significantly, it would require a lot of analysis and
a fair bit of luck. The much more reliable way to play the game
is through gold. Gold is the only currency backed by a physical
commodity; and it is always where investors hide from a currency

The basic conclusion
is that a slow demise of the petrodollar system is bullish for gold
and very bearish for the US dollar. As for any more specific suggestions
on how to profit, check out our newsletters.

Smart investors
realize oil, like gold, is destined to rise dramatically and that
in the right energy companies now will be like getting into the
yellow metal 10 years ago.

      26, 2012

      Katusa is Chief Energy Investment Strategist for Casey

      © 2012 Casey
      and Associates