The Iran Conflict and the Erosion of the Petrodollar System

The Iran conflict has raised fundamental questions about the petrodollar system. Since 1974, this system has served as the foundation for a bargain between the U.S. and Gulf nations, trading oil for security. As the U.S. has become energy independent, it has significantly reduced its reliance on Gulf oil. Now, the Trump administration has attempted to disrupt the sensitive and volatile Middle East region.

Such events demonstrate that the U.S. is no longer the guarantor of security in the Middle East, but rather a source of instability and conflict. The petrodollar agreement between the U.S. and Gulf nations is becoming practically obsolete.

The U.S. has much to lose from its decline. Following the collapse of the Bretton Woods system in 1971 and the 1973 oil shock, then-Secretary of State Henry Kissinger brokered a deal where Saudi Arabia agreed to sell oil exclusively in U.S. dollars.

The proceeds from these trades were funneled into dollar assets, and in return, Saudi Arabia received military equipment and security guarantees from the U.S. This agreement was a diplomatic coup that brought Arab states into the U.S. sphere of influence, while creating massive demand for U.S. military hardware and dollar assets, sustaining the American economy.

Furthermore, by severing the link to gold and moving to a fiat currency, the U.S. was able to maintain demand for its currency.

According to Callum Pickering, chief economist at Peel Hunt, the petrodollar system was the centerpiece of the U.S. economic model, providing low-cost capital that fueled American innovation and growth.

The petrodollar agreement worked well for decades, but its foundations began to weaken even before the Iran conflict. In the 1970s, the U.S. was the world's largest crude oil importer. By the 2010s, the shale revolution dramatically increased domestic production, reducing the need for imported energy. By 2017, China had surpassed the U.S. as the top crude oil importer.

The U.S. intention is clear: it seeks to reduce dependence on energy supplies outside its direct control. For Gulf nations, this means the U.S. security umbrella is no longer what it once was.

By 2020, the U.S. became a net exporter of fossil fuels. Under the Trump administration's energy dominance policy, U.S. exports are expected to rise significantly. The President has relaxed land laws and permitting systems to encourage domestic drilling. Additionally, following the ousting of Venezuelan President Nicolás Maduro earlier this year, U.S. oil companies are poised to access those energy resources.

The U.S. intention is clear: it seeks to reduce dependence on energy supplies outside its direct control. For Gulf nations, this means the U.S. security umbrella is no longer what it once was.

The ongoing conflict has also struck at the security arrangements that underpinned the petrodollar deal. The U.S. defense umbrella, meant to protect Gulf partners from Iranian attacks, has proven weak. Dozens have been killed, and critical infrastructure has been damaged. Iran has effectively targeted energy production centers in the Gulf, including an attack on Qatar's Ras Laffan natural gas facility, which damaged approximately 20 percent of its production capacity, with impacts expected to last five years.

This problem is not limited to the failure of U.S. security capabilities; the conflict has exposed deep, fundamental issues with the petrodollar system under President Donald Trump.

The U.S., alongside Israel, acted as an aggressor in the conflict, launching attacks without consulting regional allies and disregarding their interests. Now, these nations must calculate the costs, and the impact on their economic models may be worse than the direct damage from the attacks.

Gulf nations had planned to diversify their economies by exporting energy to become hubs for international finance, trade, and technology. With each shock from the war, that possibility diminishes.

Naveen Girishankar, Chair of the Economic Security and Technology Department at the Center for Strategic and International Studies, states, "It is hard to believe that the credibility of long-standing U.S. security commitments has not been eroded while the Gulf's main economic assets are under constant attack."

The U.S.-dependent security system now appears to be a burden. According to Mallika Sachdeva of Deutsche Bank, "Gulf nations may re-evaluate their security relationship with the U.S. They may diversify and localize their defense systems, utilizing their substantial dollar reserves to achieve this goal."

While Gulf economies may not have as much invested in the U.S. Treasury market as Japan or China, their importance is significant. Official U.S. data shows that at the end of January, Saudi Arabia and the UAE held approximately $250 billion in U.S. debt securities.

This figure does not include holdings by other Gulf nations or their broader portfolios of U.S. assets, which are now at risk of liquidation.
The system was built on the concept that the U.S. would buy Gulf oil in exchange for reliable security. Now, under Trump, the U.S. is reducing energy imports and shows little interest in protecting its partners. In fact, it appears willing to undermine global security for its own narrow interests.

The petrodollar system is truly in trouble. The arrangement that has circulated dollars into U.S. debt markets and supported American capital markets for the last 50 years is faltering. With these events, another pillar of American economic supremacy is dissolving.

(From Financial Times)