A worldwide financial system built on the petrodollar has been one of the mainstays of the past 40 years, serving as an anchor for the dollar's reserve position.
Will the petrodollar's hegemony come to an end?
This was a future in which oil producers would sell their product to the US (and the rest of the world) for dollars, then recycle the revenues in dollar-denominated assets and expressly support the USD as the world reserve currency by investing in dollar-denominated markets. All of this would bolster the United States' position as the world's undeniable financial superpower.
The petrodollar system is tied to the history of the gold standard. After WWII, the world's economy needed to be rebuilt. Countries agreed to implement what is known as the Bretton Woods system (where the IMF was born, and which defined a set of reserve currencies).
Tying the currency to gold at a fixed rate, and leveraging the amount of its gold reserves and its position after the war, made the USD the de facto reserve currency. This state of affairs lasted until 1971, but after its collapse, the USD became a fiat currency (i.e. its value doesn’t arise from the material it sits on, like the paper it’s printed on, it arises from good accounting, pure “faith” but especially from a need to use that specific currency to make a specific purchase).
So now the U.S. could pursue any number of expansionist policies but, to avoid the side-effects, it needed to stimulate demand for the USD, i.e. it needed countries to hold and use USD.
Every country required oil, making it the best strategic option for the US. However, OPEC, which was formed in 1960, could effectively annihilate this US strategy, which could not be. As a result, following the Yom Kippur War, the United States used the USD's position as a reserve currency to rebuild ties with Saudi Arabia.
As a result, all oil-exporting nations must receive USD, which makes their national income dependent on the USD’s value. If the USD falls, so does the country's revenue, therefore if the oil importers were to somehow undermine the USD to make their oil purchases cheaper, the suppliers would have to react (even if a lower dollar grants them some debt relief). It may seem artificial and baseless, but this system works wonders.
Geopolitically, it maintained the USD status as the world’s reserve currency per excellence therefore (theoretically) it’s in no country’s interest to undermine the USD. The U.S. uses this advantage to push their foreign policy agenda but it’s in the economic realm where it really shines, as it allows the country to constantly run an account deficit by issuing USD denominated assets at very low rates of interest
The recycling of Petro Dollar
The petrodollar system creates surpluses, known as petrodollar surpluses. Since petrodollars are basically U.S. dollars, these surpluses lead to larger U.S. dollar reserves for oil exporters.
These surpluses need to be recycled, which means they can be channelled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States through the purchase of bonds and T-bills. This process helps create liquidity in financial markets in the U.S. By investing their surpluses, these exporters reduce their dependence on oil revenue.
Petrodollar recycling started with Saudi Arabia in 1979 as part of the U.S.-Saudi Arabian Joint Commission on Economic Cooperation. The U.S. dollars that were used to purchase oil contracts were recycled back to the U.S. via contracts with U.S. companies. These companies would then partake in infrastructure projects in Saudi Arabia, which would increase U.S. imports into the country, lead to higher wages for certain employees, and help the overall economy.
The recycling system was also used to invest surplus dollars into sovereign wealth funds, the profits of which were used to invest in activities not related to oil, reducing the nation's dependence on oil.
Why did Saudi Arabia decide to sell oil in Yuan?
The Saudis are angry over the U.S.’s lack of support for their intervention in the Yemen civil war, and over the Biden administration’s attempt to strike a deal with Iran over its nuclear program. Saudi officials have said they were shocked by the precipitous U.S. withdrawal from Afghanistan last year.
China buys more than 25% of the oil that Saudi Arabia exports, and if priced in yuan, those sales would boost the standing of China’s currency, and set the Chinese currency on a path to becoming a global petroyuan reserve currency.
As even the WSJ admits, a shift to a (petro)yuan system, "would be a profound shift for Saudi Arabia to price even some of its roughly 6.2 million barrels of day of crude exports in anything other than dollars" as the majority of global oil sales—around 80%—are done in dollars, and the Saudis have traded oil exclusively in dollars since 1974.
China has been stepping up its courtship of the Saudi kingdom in recent years, helping Saudi Arabia build its own ballistic missiles, consulting on a nuclear program, and investing in Crown Prince Mohammed bin Salman’s pet projects, such as Neom, a futuristic new city.
In March 2017, King Salman signed up to $65 billion deals with Chinese President Xi Jinping during his visit to Beijing as part of the six-country trip through Asia. Saudi Arabia is seeing Asia as a lucrative market and has been vying to increase market share in the region.
Again in 2019, Crown Prince Mohammed bin Salman visited China and signed an agreement to build a refining and petrochemical complex in Liaoning province as a joint Saudi-Chinese venture, among other deals.
The U.S. economic relationship with the Saudis is diminishing: the U.S. is now among the top oil producers in the world, a stark reversal from the 1980s when it imported 2 million barrels of Saudi crude a day, but those numbers have fallen to less than 500,000 barrels a day in December 2021.
By contrast, China’s oil imports have swelled over the last three decades, in line with its expanding economy. Saudi Arabia was China’s top crude supplier in 2021, selling at 1.76 million barrels a day, followed by Russia at 1.6 million barrels a day, according to data from China’s General Administration of Customs.
“The dynamics have dramatically changed. The U.S. relationship with the Saudis has changed, China is the world’s biggest crude importer and they are offering many lucrative incentives to the kingdom,” said a Saudi official familiar with the talks.
Can China really replace the Petro Dollar with Petro Yuan?
If the yuan displaces the dollar to a sufficient degree in the annual $14 trillion global oil trade—although what that sufficient degree would be is difficult to say—countries will have to maintain yuan reserves instead.
(At the moment, 2.48% of the world’s reserves are held in yuan, compared to 55% for the dollar, according to IMF data.)
Oil producers receiving yuan would have to spend it on Chinese debt and imports, further strengthening China’s economy, but if the world was particularly awash in yuan, other trade might start to be yuan-denominated: metals, say, or soybeans.
To preserve the yuan’s new role, China would have to ensure political stability and financial transparency, of the kind the US promised in the 20th century.
As a reminder back in March 2018, China introduced yuan-priced oil contracts as part of its efforts to make its currency tradable across the world, but they haven’t made a dent in the dollar’s dominance of the oil market, largely because the USD remained the currency of choice for oil exporters.