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The End of Petrodollar Investing

Written By Geoffrey Pike

Posted October 12, 2015

petrodollarWe continue to live in unprecedented times, especially when it comes to economics and monetary policy. The global economy is one big contradiction.

On the one hand, human prosperity has never been greater in history. There is a smaller percentage of people lacking basic needs (food, clean water, shelter) than ever before. We also live in an unbelievable technological revolution.

On the other hand, the advanced countries of the world are struggling with major financial problems. In the U.S., the median household income (in real terms) has been stagnant or even slightly down over the last few decades.

In the U.S., life goes on. Life is just a bit harder for some people. They have luxuries such as cell phones that previously didn’t exist for the middle class, but they also struggle to pay their bills.

But the U.S. has struggled less than other places such as Western Europe. Life goes on in Greece too, but just barely. It is extreme poverty in many places of Greece relative to what Americans enjoy.

Another seeming contradiction that exists today is that of the U.S. dollar. The last few years have seen a very strong dollar when compared to the other major currencies of the world. I have to consistently point out though that it isn’t so much that the dollar is strong, but that the other currencies are that much weaker.

The euro and the Japanese yen have been terrible currencies over the last few years. The economies are in rough shape in both Japan and Western Europe, and the central banks have been on a money creation spree.

While the U.S. dollar has been the king of the major currencies, some of the major world players have been quietly (and not so quietly at times) been turning their backs on the dollar.

China and Japan are still loaded up with U.S. Treasuries, but even China is beginning to realize that they don’t need to always use the dollar as a middleman in global trade. The Russians are turning away from the dollar, but this is understandable from their perspective, especially since the U.S. government slapped on certain sanctions. They almost had no choice in the matter.

Sometimes it pays to pay attention to the smaller players too, as smaller countries can often provide a good sample of what is to come.

The Sinking Petrodollar

One of the primary reasons that the U.S. dollar has held up as the world’s reserve currency for as long as it has is because of oil. The big oil countries sell their oil on international markets using the U.S. dollar as the middleman.

This creates more demand for the dollar, particularly as reserves. Foreign countries want to hold some U.S. dollars in reserve for the purpose of using them in global trade. This demand is a factor in propping up the dollar.

U.S. allies – or more accurately, U.S. government allies – such as Saudi Arabia and Qatar continue to obey the U.S. government. They will not do a full turn away from the petrodollar any time soon because they rely on the support (military and other) from the U.S. government.

But not everyone is obeying, and it is easy to forget that there are many countries out there that produce oil.

One country that may be getting rid of the petrodollar is Norway. The government’s budget deficits have been going up, and they rely on the petroleum sector to cover this. The petroleum industry accounts for about one quarter of Norway’s GDP.

But Norway’s sovereign wealth fund is falling short of covering the deficits, as the inflow of money is falling short.

The government there does depend on its petroleum industry for revenues to help fund its expenditures. From a free market perspective, the government should be spending a lot less and not depending on more money coming in, whether from direct taxes or through oil revenue. But the reality of the situation is that the Norwegian government is going to react to the situation.

The problem of sinking oil revenues for Norway (and elsewhere) is a double whammy. First, the price of oil is down significantly from its highs. Second, the U.S. dollar has been strong, meaning that other countries lose out on the exchange rate when they convert the dollars back into their own currencies.

In the case of Norway, the sovereign wealth fund that would help fund their deficits in the past is holding steady in terms of the Norwegian krone. But in terms of dollars, the fund has significantly shrunk.

So the prior savings kept in kroner is not suitable for global trade for Norway because they are taking a hit in the exchange rate with the dollar. So the answer for the Norwegian government, instead of buying more dollars, may just be to stop using the petrodollar. Is it possible that a strong U.S. dollar could actually encourage some countries to not use it?

Of course, the problem of a weak krone can largely be blamed on the Norwegian central bank. They are all inflating to one degree or another, which let’s the petrodollar live on longer than it should.

Still, it will be interesting to see if Norway – and others in a similar situation – will stop using the petrodollar, meaning not using the dollar as a middleman currency.

More countries are coming to the realization that, in our global economy, they don’t really need a middleman.