TL;DR

A 50-year deal with Saudi that has provided support for the dollar and reduced US interest rates is over. Saudi’s withdrawal last week from the deal that required global oil transactions to be completed in US dollars will likely increase interest rates in US as well as increase the cost of overseas products (including oil) purchased in the US in the coming years.

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In July 1974, during the final days of the Nixon presidency, Secretary of State Henry Kissinger struck a little-noticed economic agreement with Saudi Prince Fand Ibn Abdel Aziz. Though the Nixon administration soon ended, Kissinger’s petrodollar deal would influence the global economy and the US’s role in it for 50 years—until last week, when Saudi Arabia decided not to renew the deal.

Our friends over at ChAI, a London based consultancy working at the intersection of global commodities and artificial intelligence, have concluded that “the expiration of the petrodollar agreement represents a fundamental shift in global economic and financial dynamics”. Their projection is “this transition may lead to higher borrowing costs for the U.S., increased volatility in oil markets and significant changes in global trade patterns”.

To understand what’s driving these conclusions, let’s look at the key points of the 1974 petrodollar deal:

**Saudi Arabia agreed to price and trade their oil exports exclusively in US dollars, creating a consistent worldwide demand for dollars. Any country wanting to buy oil from Saudi (and by extension, any OPEC member) had to first convert their local currency into dollars, thus the term “petrodollar.”

**Saudi Arabia agreed to invest their oil profits in US Treasuries and securities, effectively “recycling” those petrodollars back into the US economy.

**The US agreed to provide military aid and protection to Saudi Arabia.

In effect, the US exchanged some of its military capability for economic stability, and that deal has served it well.

As a result, virtually all oil traded globally was traded in petrodollars, creating high global demand for US dollars as the world’s primary reserve currency. This increasing demand for petrodollars drove US Treasury bond prices up (and US consumer interest rates down) from 1980 through 2020.

An additional, often overlooked benefit of the petrodollar deal was stabilized foreign exchange rates, especially after Nixon eliminated the gold standard for the US dollar in 1971. This effectively ended the Bretton Woods agreement, which had prevented wide swings in exchange rates since the end of WWII. In some ways, oil became the new gold—a global commodity with a transparent price in a global currency (the US dollar) on which most other major currencies could be based.

What does Saudi’s decision mean for the future? Likely a combination of some or all of these effects:

**A weaker US dollar as Saudi Arabia, likely along with other countries, welcomes other currencies into the oil market, potentially creating an inflationary cycle due to higher prices for imported goods, which could incite the Fed to increase interest rates.

**Weaker US Treasury auctions as Saudi Arabia’s obligation to participate expires, potentially resulting in lower bond prices (and increasing interest rates). Beyond the consumer impact of higher rates, this creates a federal budget issue as interest expenses rise, putting pressure on continued deficit spending.

**A realignment of global power as oil, the most heavily traded commodity in the world, moves away from its long-standing dollar-centric pricing and trading systems, freeing many countries from the political ties that were necessary due to their petrodollar dependence.

**Increased volatility in oil (and consequently fuel and gasoline) prices as currency fluctuations play a larger role.

Overall, the petrodollar deal has benefited US consumers for decades: It pushed interest rates lower as demand for dollars pushed Treasury bond prices higher (remember that inverse relationship); it reduced volatility in the bond markets as the constant demand for oil (and therefore dollars) remained constant; and it stabilized prices in the US for products made overseas by stabilizing exchange rates.

There’s no question this decision in Riyadh will eventually build inflationary pressure in the US economy. The big question is whether the combination of today’s margin inflation and the petrodollar collapse will create enough inflationary pressure to trigger a full-blown recession over the next 12-18 months.

As with all things about the future, we won’t know until we know. Until then, the collapse of this deal will demand even more vigilance in managing the bond/interest rate side of any portfolio. Stay safe out there.