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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 oil.
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 System
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 its 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 Dilemma
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 yuan.
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
petrodollars.
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 storm. The basic
conclusion is that a slow demise of the petrodollar system is bullish for
gold and very bearish for the US dollar.
[Smart
investors realize oil, like gold, is destined to rise dramatically and that investing in the right energy companies now will be like
getting into the yellow metal 10 years ago.]
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