The term petrodollar is used in relation to revenues earned on the sale of petroleum by petroleum-exporting countries. The global oil trade is conducted almost entirely in U.S. dollars. The prefix “petro” in the term petrodollars is a reference to petroleum.
Since crude oil first became indispensable to the global economy in the early 1900s, it has found countless uses in industry, manufacturing and as a source of energy. It is a key element in the production of chemicals, plastics and fuels. Its versatility as a raw material has kept oil in strong demand, and has delivered notable income streams to oil-producing countries. Oil is the driving factor behind the economies of near-eastern countries like Saudi Arabia, Iraq and Iran. It also plays a major role in the economies of Venezuela, Nigeria and Russia, among other countries.
Crude oil is traded on global commodity markets, with the price being set in U.S. dollars per barrel. A barrel is made up of 159 liters of crude oil. The price fluctuates based on supply and demand. Oil-exporting countries act as suppliers. Oil-importing countries – primarily industrialized countries like China and post-industrialized countries like the U.S. and most European countries – determine demand.
Petroleum-exporting countries can influence the price by increasing or decreasing supply. However, they must maintain a balance between quantity and price. Increasing production results in higher sales of crude oil, but at lower per-barrel prices. The same principal applies vice-versa.
Because the global trade in crude oil is denominated by U.S. dollars, oil-exporting countries bear a significant level of currency exchange risk. In order to make use of income streams from oil exports in their home markets, these countries must exchange the U.S. dollars earned on the sale of oil for their own currencies. Strong fluctuations in the exchange rates of the U.S. dollar and the national currencies of oil-exporting countries can result in higher costs of exchanging dollars into national currencies. In order to mitigate this risk, some countries (such as Saudi Arabia) fix their currencies to the U.S. dollar, meaning that the exchange rate between the U.S. dollar and a unit of one of these currencies remains the same.
See also: Commodity currency