You have probably noticed that news about oil, has been dominating the market throughout this year.
So I'll use this opportunity to explain about the highly influential and historically rich relationship between oil and USD.
After all, oil and USD have been uniquely correlated for over half a century.
This article will help you to better understand what this history is, so you can grasp the related price action flow and different correlations.
US stability is globally questioned
In the early 1970s, the international gold-backed USD standard (once known as the Bretton Woods arrangement) collapsed.
This was due to many foreign nations having serious concerns about the Bretton Woods arrangement and the state of the US economy generally.
Britain, France and Germany were a few of the leading nations with these concerns.
They were worried that the then cash-strapped and debt-laden United States, was in no position to be a leading global economy.
So like many other countries at the time, these countries began demanding gold in exchange for their USD's.
The US Government realised that in order to ensure their economic hegemony in the wake of the Bretton Woods collapse, it was imperative to preserve the demand and value of their USD's.
US and OPEC join forces
During the Nixon led regime in 1974, the US Government entered into a series of bilateral agreements with the largest exporter of Oil - Saudi Arabia.
The US economy was largely built around the need and use of Oil, so these arrangements had a series of profound benefits for the USD.
USD became known as the petrodollar because:
- USD was received by an oil producer in exchange for selling oil; and
- those USD's were then deposited into Western Banks.
This arrangement sounds simple, but it was actually quite complex:
...because these agreements included the US offering military protection for Saudi Arabia's oil fields and the supply of weapons...
...which perhaps most importantly, meant guaranteed protection from Israel.
The terms of this agreement included Saudi's promise that they would:
- price all of their oil sales in USD's only for their oil exports; but
- would be open to investing their surplus oil proceeds in U.S. debt securities.
The whole deal had a profound and immediate impact.
By 1975, all OPEC members had agreed to price their Oil in USD and to hold their surplus oil proceeds in US Government debt securities - in exchange for US protection, weapons and stability of USD investments.
Benefits of the petrodollar system
The Petrodollar deal provided immediate benefit to the United States, because it:
- increased global demand for USD
- increased global demand for US debt securities
- gave the US the internationally unique ability to buy oil with a currency it could simply print infinitely.
Today, USD's can be bought the moment they are needed to settle oil trades.
Or settlement can simply be done in any other agreed currency, at that currency's current USD exchange rate.
Since oil is priced in dollars, there is a strong inverse correlation.
In short, correlation means that both assets move in opposite directions and it shows how the USD is quintessential to the price of oil.
Another important thing to add:
...is that the USD has never been devalued…
...and its notes have never been invalidated.
The relative stability of the USD, also provides a certain amount of surety when compared to the bank failures, devaluation and inflation that many other nations have experienced.
For both traders and investors, business is easier to conduct when a stable currency is used.
That's why we call USD a safe haven currency.
Is there any alternative to USD?
Currently, the only realistic alternative for trading oil without just USD, would be to have a somewhat balanced basket of currencies.
But a basket of currencies is inherently unstable from a global perspective, because:
- the constant shifting of portfolios adds market volatility; and
- that volatility could cause huge, unwelcomed turmoil.
So no, at present there is no alternative to the USD.
I hope this article has clarified the relationship between USD and oil.
If anything is not clear enough, feel free to ask me in the comments section below.
Cheers and safe trading,