Bi-Weekly Geopolitical Report – The Issue of the Terms of Trade (June 12, 2023)

Bill O’Grady | PDF

In a recent Bi-Weekly Geopolitical Report, we discussed the emergence of the petroyuan.  One of the important aspects of that report was that foreign nations were beginning to pay for oil in their own currencies.  As we noted in the report, George Shultz and Henry Kissinger negotiated a deal with the Saudis, where in return for providing security support, the Kingdom of Saudi Arabia agreed to price oil in U.S. dollars.  The ability to pay for oil in one’s own currency is powerful.  Essentially, a country can then print money for oil, but obviously, it’s not quite that simple.  If a country abuses that power, it could find itself losing its ability to do so.

In the aforementioned report, we noted that America’s aggressive use of financial sanctions was leading some countries to explore alternatives to the dollar-based reserve system.  After the U.S. sanctioned Iran and Russia, effectively isolating both nations from the global payments system, other nations worried about also running afoul of Washington and began to work on developing an alternative payment mechanism, which included the ability to pay for oil in a currency other than U.S. dollars.

What has surprised us, so far, is the absence of response from Washington to this development.  If the Nixon administration felt that paying for oil in dollars was important, if President Carter expanded the U.S. security role to include the Persian Gulf’s oil flows, and if President Bush liberated Kuwait, why hasn’t there been more of a pushback against denominating oil in other currencies?

Examining this question has led to an unexpected outcome—America’s terms of trade (TOT) have now changed due to the shale revolution, and that adjustment has changed the risk profile for the global economy.  Our assertion is that the U.S. realizes that, due to this change, insisting on pricing oil in U.S. dollars could foster financial instability.  And so, for now, Washington is willing to tolerate the pricing of oil in other currencies.

In this report, we will begin with an examination of U.S. TOT, including an analysis of its effect on the dollar.  Once this context is established, we will detail the risks that come from the dollar/oil relationship, which has led the U.S. to no longer insist on pricing oil in dollars.  We note the factors that have led to this change in the terms of trade may not be permanent, which could lead the U.S. to reverse its stance to allowing oil to be priced only in dollars.  We will close with market ramifications.

Read the full report

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