Several readers asked me to discuss the petrodollar. Here are two pertinent theories.
Theory #1 – War Is a Boon for the Petrodollar
Wall Street Journal writer Diana Choyleva claims The Iran War Is a Boon for the Petrodollar
America strikes back against China’s patient challenge to the U.S. currency’s supremacy.
A Deutsche Bank report making the rounds argues the Iran war represents a “perfect storm” for the petrodollar, the primary currency in which oil is bought and sold. The report says that U.S. military entanglement in the Gulf, the weaponization of the Strait of Hormuz, and reports that Tehran is granting passage in exchange for yuan-denominated payments add up to a historic blow to dollar dominance. The argument is superficially compelling. It is also exactly backward.
Start with the threat to the petrodollar before this conflict began. China had spent years methodically building the infrastructure to supplant dollar dominance in oil trade: yuan settlement corridors; the mBridge platform, which allows financial institutions to bypass dollar rails and move digital currencies across borders; and deepening financial and technological ties with Gulf producers. Beijing’s ambition wasn’t a dramatic overnight coup. It was patient structural erosion. Shift enough oil settlement into yuan, recycle enough petrodollar surpluses into Chinese assets, and the architecture of dollar dominance quietly hollows out.
The petrodollar system, born from the 1974 security-for-oil-pricing bargain between the U.S. and Saudi Arabia, rests on three pillars: oil priced in dollars, transactions settled in dollars, and oil revenue recycled into dollar-denominated assets. Because oil is so central to global manufacturing and transport, paying for it in dollars creates a gravitational pull that dollarizes trade, saving and reserves across the global economy. Undermine that dollar-based oil trade, and the whole edifice begins to shift.
Washington has noticed. Gulf states, led by Saudi Arabia, supported the U.S. campaign against Iran and have so far viewed American military performance favorably for the most part. Whatever one thinks of the conduct of the war, one thing is clear: When the security commitment was tested, it held.
The petrodollar has two legs: the “petro” and the “dollar.” China was making progress on both. For now the U.S. is pushing back hard in the Gulf, in Caracas, and at the Strait of Hormuz. The dollar’s long-term fate will ultimately depend on whether Washington sustains this strategy and on whether the global energy transition eventually makes the contest moot. Neither outcome is certain. But those who conclude that the petrodollar is already in its death throes are reading the map upside down. The storm is real. The dollar is fighting back.
Ms. Choyleva is founder and chief economist at Enodo Economics and the author of “Petrodollar to Digital Yuan: China, the Gulf and the 21st Century Path to De-Dollarization.”
Three Pillar Petrodollar Theory
- Oil priced in dollars
- Transactions settled in dollars
- Oil revenue recycled into dollar-denominated assets
Pillar number one is nonsense. The pricing unit, outside of something totally illiquid like Yap Island stones, is irrelevant.
Yet, masses of economic illiterates still believe the Iraq war started because Hussein was going to price oil in euros.
Here’s the theory: Hussein made a threat to price oil in euros. War started. So the war was over the pricing unit.
Here’s the reality: Major currencies are fungible and can be traded at will. It does not take dollar reserves to buy oil anymore than it takes dollars to buy gold (which is not at all).
Even settlement is not that important. The reason is the same. Currencies are fungible. Something immediately settled in dollars does not have to remain in dollars.
What Really Matters
What does matter is where a nation holds its reserves. But that is largely forced by trade surpluses, not conscious decisions.
Q: Why did the Gulf states hold US dollars?
A: Mainly because they accumulated them. For a long time the US had major trade deficits with the Gulf states. Those nations accumulated US dollars as a direct result. Then they recycled the dollars into weapons, planes, or other purchases.
Oil priced in euros would not have changed that picture.
US Independence
Direct Gulf state accumulation of dollars from the US has declined because the US is now largely (but not totally) oil independent. The US buys more from Canada for our needs than the Mideast.
Thus, the Gulf states are now dependent on Europe and Asia (especially China and India) for oil sales instead of the US.
Theory #2 – The Demise of the Dollar
Bloomberg writer Aaron Brown says The Iran War Just Broke the Petrodollar
The virtuous loop that has seen America underwrite stability in the Middle East in exchange for Gulf states recycling their dollar revenues into US Treasuries has been broken.
The understanding traces back to 1974, when Henry Kissinger struck one of the most consequential financial deals in modern history. Saudi Arabia would price its oil in dollars and park the surpluses in US assets — Treasuries above all. Other Gulf states followed. In exchange, America provided security guarantees and a stable global order.
The arrangement was elegant in its circularity: Oil consumers paid dollars for energy, those dollars flowed to Riyadh and Abu Dhabi, and from there back into Washington’s debt. For 50 years, this petrodollar loop quietly subsidized American borrowing costs and cemented the greenback’s role as the world’s reserve currency.
The US-Israeli war with Iran has fractured this arrangement — at both ends.
Start with the importing side. Since the strike on Iran on Feb. 28, foreign central banks have been net sellers of Treasuries for five consecutive weeks. Holdings at the Federal Reserve Bank of New York have dropped by roughly $82 billion to $2.7 trillion, the lowest level since 2012.
The mechanism is straightforward. Turkey, India, Thailand and other oil-importing nations are caught in a brutal arithmetic: Oil priced in dollars has surged past $100 a barrel while their currencies weaken against the greenback. To limit depreciation — which would push domestic oil prices even higher, forcing either fiscal subsidies or household pain — central banks intervene in currency markets. That requires dollars. The most liquid dollar asset any central bank holds is Treasuries. So they sell.
The petrodollar loop requires two moving parts: dollars earned and dollars invested. Both have stopped.
There is a longer structural story that the war is accelerating rather than creating. The share of Treasuries held by foreign investors had already fallen to around 32%, down from half in the early 2010s. Central banks became net sellers in early 2025. For the first time since 1996, global central banks now hold more gold in aggregate than US government bonds. These were slow-moving trends, easy to dismiss as noise. The Iran war is making them look like signal.
For starters, gold reserves are primarily up because the dollar value of gold is up, not because of a sudden major shift to buying gold.
Second, Brown’s discussion of US treasuries is simply wrong.
The official reserve numbers are errant because they do not include China’s State Owned Enterprises (SOEs) or its holdings of US Agencies. Nor do they include China’s US dollar assets held in Europe.
Brad Setser Chimes In
Setser: The “fit” with global dollar reserves is actually much better if total purchases of Treasuries and agencies are counted v dollar reserves during this period (this captures Agencies managed by private fund managers, non US custodied Treasuries, etc).
Shadow Reserves
Setser: The FT’s Big Read is on the China sock 2.0 (one of my favorite phrases) and the pink paper endorsed the concept of “shadow reserves”!
Articles preaching mass selling of US treasuries miss all of Setser’s accurate observations.
Simple Trade Math
- The US constantly runs a trade deficit.
- Those dollars (no longer for oil) get accumulated as US dollar denominated reserves somewhere.
Q: But what does that mean for petrodollars?
A: The decline of petrodollars originating from the US is actually a US success story.
The US is mostly free of Mideast imports. As a direct result, the gulf states accumulate less petrodollars that originate here.
Oil in Euros
Those posts typify the conspiratorial nonsense about something totally irrelevant.
Few understand how markets work. Those who understand the least, tend to scream the loudest.
Here’s someone who understands.
It’s Happening
A Curious Thing
Allegedly, the war will be a boon to, as well as the demise of the Petrodollar.
Aaron Brown (Bloomberg) and Diana Choyleva (WSJ) both make the same error regarding the pricing unit.
However, they expect completely different results from their errors.
Pricing Fact Check
Q: Would oil priced in yuan or euros change the oil price in dollars?
A: No
Q: Would pricing oil in something other than dollars force countries to hold receipts in something other than dollars?
A: No.
Q: Then why would it matter?
A: It wouldn’t. End of story
How Significant Is Oil in Global Trade?
I have no doubt some of you are unconvinced by the above irrefutable logic, so let’s for a second assume I am wrong.
For the purpose of this experiment, let’s assume the “petrodollar” immediately dies. Every “petrodollar” becomes a petroeuro, petroyuan, or a petro-whatever.
How would that impact global trade in dollars?
Oil ranks among the top traded commodities by value, but it represents a modest slice of total global trade (goods + services).
- Global Trade Total: Roughly $35 trillion (2025 UNCTAD estimate).
- Oil’s Share: Roughly $1.31 trillion for crude (OEC data for 2024) That’s about 3.7 percent of total trade.
- Mideast Assignment: Let’s generously assign 60 percent of that $1.31 trillion to Mideast petroyuan. The Mideast petroyuan would then be 2.2 percent of total global transactions that was a previously mix of dollars and euros.
The dollar share of global transactions as measured by payments is 50 to 60 percent. That would make the dollar-related transaction hit 3 to 4 percent.
Q: That’s it?
A: Yes. Even if 100 percent of all Mideast oil transactions were priced in yuan, settled in yuan, and reserves held in yuan, global US dollar transactions would only decline by 3 to 4 percent.
In contrast to the theories of Brown and Choyleva, I see a continued slow drip abandonment of dollars.
Slow Drip Abandonment
- Trump’s actions have increasingly alienated US allies. Countries are genuinely sick of Trump, for the right reasons.
- The US has weaponized the US dollar (both Trump and Biden did this). Countries are fearful of getting caught in the crossfire.
- Tariffs and tariff avoidance.
- Trump has turned the US into an unreliable trading partner with his repeat threats, contradictions, and constant position shifts.
- America First has become a “My way or no way” set of demands, not negotiation tactics.
- Trade with the US is down and heading further down as a direct result of points 1 through 5.
- Importantly, it’s not just petrodollars. There is pressure on all dollar-denominated transactions.
- There’s a global incentive to shift away from dollars, when and where possible.
When and where possible is the key component of the slow drip abandoment idea. Dollar avoidance is not that easy or it would have happened in a major way already.
“When and Where Possible” Canadian Style
Carney says the days of sending 70 cents of every dollar in military spending to the United States are over and gets a standing ovation
Realistically, how fast will that happen? But it will happen, eventually.
Carney is leading the global charge with his anti-US speeches. Actions will follow.
Consider Spain
Trump has turned the US into an unreliable trading partner.
There are long-term consequences to Trumps threats. One of those consequences is US dollar avoidance.
My next example directly pertains to petrodollars.
Gulf Allies Turn Away From U.S. for Fresh Ammo
The Wall Street Journal reports Gulf Allies Turn Away From U.S. for Fresh Ammo
Six weeks of relentless air bombardment sapped air defense stocks in the Middle East. Now begins the scramble to rearm.
With a fragile cease-fire in place between the U.S. and Iran, America’s closest allies in the region—and some of the best customers for U.S. weapons systems—are scanning the world for alternative missile defenses, getting creative about ways to bolster defenses quickly.
Saudi Arabia, Qatar and the United Arab Emirates are turning to South Korean missile-defense systems, Ukrainian drones that smash into targets midair and traditional American Gatling guns.
They are also looking to tap new kit from startups, including Britain’s Cambridge Aerospace, which the U.K. said on Friday will be supplying Gulf states with small, low-cost missiles designed to take out drones and other munitions.
It also exposes the arms industry’s lack of capacity despite a surge in demand since Russia invaded Ukraine four years ago. The U.S. arms industry, in particular, could lose out potential orders.
Saudi Arabia has reached out to Japan, which makes Patriot interceptors, and it has asked South Korea’s Hanwha and LIG Nex1 about bringing forward an order for their M-SAM system, according to people familiar with the matter.
The M-SAM, a midrange surface-to-air system that can intercept drones, missiles and planes, has been used by the U.A.E. to down Iranian munitions, a South Korean lawmaker said.
The Gulf states have figured out the US can no longer protect them. So now, they are turning to South Korea, Japan, the UK, and amusingly Ukraine.
If the Mideast states start holding yuan reserves, guess what it will be for.
Yet, petro-whatever is at most 2.2 percent of total transactions, or 4 percent of US denominated transactions.
I don’t want to downplay this too much, but it’s not the death of anything. It’s a long-term slow drip trend.
TINA Déjà Vu
For now, where are Saudi Arabia, Canada, and Europe going to get military jets?
Unless China is willing to part with its top fighters, (hint, it won’t) there is no current alternative (TINA) to the F-35.
More importantly (much more), the US remains the the global consumer of last resort.
The desire to shift away from dollars is strong, and easy to see. Spain, China, and Canada provide the evidence. But desire and doing are two different things.
Reserve Currency, Petroyuan, Death of the Dollar Nonsense
China and Germany have export driven models. Export mercantilism and huge shifts away from the dollar are incompatible.
I have been discussing reserve currency, petroyuan, death of the dollar, gold-backed yuan, bitcoin reserves, and related nonsense since at least 2011.
Here’s an interesting one from April 21, 2018: Petroyuan’s Crash at Birth
Economist and book author Daniel Lacalle pretty much sees things the way I do regarding the petroyuan hype.
Lacalle compiled some amusing stats in his post on the Petroyuan’s Lacklustre Birth.
The biggest mistake made by China in its launch of the yuan oil contract has been to think that a currency with capital controls and an expensive market that trades for barely a few hours a day would be a fantastic incentive for global oil transactions.
Death of Dollar Silliness
The idea that the yuan will soon replace the dollar as the world’s reserve currency was then, and still is ridiculous for currency reasons, political reasons, and economic reasons.
Consider my October 25, 2017 take called Gold-Backed Petro-Yuan Silliness.
A massive amount of hype is spreading regarding China’s alleged ambitions to dethrone the dollar. The story this time involves China’s plan is to price oil in yuan using a gold-backed futures contract. Even if that were true, the impact would be zero. CNBC is now in on the hype: China has grand ambitions to dethrone the dollar. It may make a powerful move this year.
Repeat after me: It’s meaningless what currency oil is quoted in. Once you understand the inherent truth in that statement, you immediately laugh at headlines like that presented on CNBC.
Nothing has fundamentally changed regarding the yuan replacing the dollar as a major reserve currency.
China Flunks Five of Five Reserve Currency Tests
- Currency Requirement: If China wants to assume the role of having the world’s reserve currency, something I highly doubt actually, it will need to have a free-floating currency.
- Bond Market Requirement: If China wants to assume the role of having the world’s reserve currency, it will need to have a very large, if not largest, freely trading global bond market.
- Balance of Trade Requirement: China would have to be willing to run trade deficits instead of seeking trade surpluses via subsidized exports.
- Reserve Currency Curse Requirement: Having the world’s reserve currency is a curse because it necessitates a willingness to have endless trade deficits . Mathematically, as long as China runs surpluses, foreign holding of yuan will not match foreign holding of dollars. A mathematical corollary to having massive trade deficits year in and year is the need to have a very large, freely trading bond market. Adding gold into the yuan-futures mix does not alter the picture other than to add costs.
- Capital Controls Requirement: The currency must move freely without capital controls.
No fundamental requirements have changed. Yet, here we go with “Déjà Vu all over again” on the petroyuan discussion.
The one thing that has changed is the desire to avoid dollars has grown stronger. There is a definite leak in the US dollar desirability boat.
But it’s a slow leak. And the petroyuan has little, if anything, to do with it.
Rather, persistent fiscal deficits and Trump’s treatment of allies have everything to do with it. The US has weaponized the dollar with sanctions on Russia and China.
Trump and Biden are both guilty of excess sanctions and weaponizing the dollar, but the origin of this mess starts well before either of them.
The Dollar Exodus Beginning
The dollar exodus had its beginnings way back in February 1965 when French President Charles de Gaulle announced his intention to exchange its U.S. dollar reserves for gold at the official exchange rate of $35 per ounce.
Lyndon Baines Johnson was then president. The War in Vietnam and Johnson’s “War on Poverty” accelerated the US deficit and inflation.
On a campaign that promised to restore law and order to the nation’s cities and provide new leadership in the Vietnam War, Richard Nixon won the election in 1968.
Arthur Burns was Fed chair.
In 1971 President Nixon appointed the then Democrat John Connally as Treasury Secretary. That’s when things started rolling.
Our Currency But Your Problem
Shortly after taking the Treasury post, Connally famously told a group of European finance ministers worried about the export of American inflation that the dollar “is our currency, but your problem.”
By 1971, US money supply had increased by 10%. In May 1971, West Germany left the Bretton Woods system, unwilling to revalue the Deutsche Mark. Switzerland also started redeeming dollars for gold.
On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar to protect the dollar against “foreign price-gougers“.
On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system.
On August 15, 1971 Nixon directed Connally to suspend, with certain exceptions, the convertibility of the dollar into gold or other reserve assets, ordering the gold window to be closed such that foreign governments could no longer exchange their dollars for gold. He also issued Executive Order 11615, imposing a 90-day freeze on wages and prices in order to counter inflation. This was the first time the U.S. government had enacted wage and price controls since World War II.
So Much for Temporary
The move was not temporary. Abandonment of the gold standard removed all constraints on deficit spending.
There have not been any restraints on deficit spending since. Wars became easy to finance. Deficits? No problem. Congressional spending is out of control.
Paul Volcker, who replaced William Miller as Fed Chair, expressed regret over the abandonment of Bretton Woods.
China Joined the World Trade Organization (WTO)
China officially joined the World Trade Organization (WTO) on December 11, 2001
China’s inclusion into the WTO exacerbated global trade problems but did not cause them.
China did take advantage of WTO rules, accelerating the “Reserve Currency Curse” problems.
What to Do About It?
Gold provided an enforcement mechanism that would have ended these imbalances.
No one wants to go back to gold because every nation and central bank wants to inflate at will.
China (and the world) would greatly benefit if China voluntarily stopped its export mercantilism. But China won’t.
Until this setup blows up in a global currency crisis, expect continual small leaks (mostly unrelated to oil) in global dollar-denominated transactions.
When? I don’t know. Nor does anyone else.
Meanwhile, expect relentless Déjà Vu hype over meaningless “oil priced in whatever” nonsense.
Finally, China is becoming more dependent on Europe for exports, adding to those drips. This is poised to become a major problem for Europe.
Article posted with permission from Mish Shedlock
