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Petro-Dollar's Endgame

Oddly, the drop in US oil imports is what could fatally wound the #1 reserve currency...
AUSTRIA, 1920-21: The government printed money to cover its debts from World War I, writes Addison Wiggin in The Daily Reckoning.
Food and fuel costs exploded. Banks urged their customers to convert Austrian Kronen into a more stable currency...even though it was against the law.
A law-abiding widow is wiped out on the day of a bank run. Her diary entry is reproduced in Adam Fergusson's book When Money Dies...
"Why don't you think the krone will recover again?" [I asked my banker.]
"Recover!" [he] said with a laugh..."just test the promise made on this 20 Kronen note and try to get, say, 20 silver Kronen in exchange."
"Yes, but mine are government securities: Surely, there can't be anything safer than that?"
"My dear lady, where is the state that guaranteed these securities to you? It is dead."
We've recounted the tale before. We tell it again now for two reasons. First as a reminder that most of the imbalances that caused the Panic of 2008 remain woefully out of balance. But you already knew that.
There's extra urgency to our telling now: The one "X factor" the pundit class touts as the US Dollar's savior? It might prove the Dollar's final undoing. Bank runs, capital controls, an effective default on the national debt – and all because of the "prosperity" we're enjoying now.
Our suspicions were first raised in January...when two "opposing" politicos held hands and sang in sweet harmony about America's energy boom.
"Cheap natural gas is going to allow us to basically reshore manufacturing," says Chicago Mayor and former Obama chief of staff Rahm Emanuel. As a result, manufacturing will be "coming back in ways we can barely anticipate," says former Republican presidential contender Steve Forbes. Together they were on CNBC to pitch an event called the 'Reinventing America Summit'.
Not that we disagree: It all sounds very familiar if you were following the "Re-Made in America" thesis of our own Byron King more than two years ago. Then it was radical. Now it's conventional wisdom.
Leave it to us to throw a cat among the pigeons: For as much prosperity as the US energy boom is creating will ultimately set off the next major economic crisis. Indeed, it will tank the US Dollar's status as the world's "reserve currency" once and for all.
We say this knowing we court the wrath of conventional wisdom.
"The US shale oil revolution which has been quietly unfolding behind the scenes has now begun to exert a direct influence on foreign exchange markets – to the benefit of the US Dollar," says a report from UBS...
"Global reserve currency status allied with less dependence on foreign investors will boost the currency on a five-year view," says a strategist at Société Générale...
Because of "the technological advances that enable oil and gas to be extracted from shale," says fund manager David Donora at Threadneedle Investments, "the Dollar will likely enjoy a period of sustained strength."
Right. Until it doesn't.
The very thing helping to prop up the US Dollar now will ultimately kick out all those props and topple the greenback from its status as the world's reserve currency. Not tomorrow or even next year. But the destination is set...and our arrival is certain. It won't look exactly like Vienna in 1921...but it will feel just as awful.
So strap in: Some of the ground we're about to cover might sound like old hat to you...but we promise you've never seen the dots connected in this way before.
US oil production averaged 7.5 million barrels per day during 2013. The increase over 2012 marked the biggest in US history. Indeed, it's the fourth-biggest annual increase by any country ever...and Saudi Arabia holds the top three spots.
And it only gets better from here. The peak year for US crude production was 1970 – a little shy of 10 million barrels per day. As you see from the "Back to the Future" chart, the US Energy Department projects the nation will once again equal that number by 2019.
In 2005 – only nine years ago – the United States imported 60% of its oil needs. By 2012, that number collapsed to 40%. Check out the chart nearby and you'll see the percentage is set to shrink even more over the next quarter-century. And make a mental note – we'll be coming back to this chart later.
As we go to press, a barrel of oil fetches $100, give or take. So every 1 million barrels per day of new supply means $100 million less imported oil every year. Lower import costs, a lower trade deficit, fewer Dollars flowing overseas – great news for the Dollar, huh? It's all good, right?
Well, yes...except that now the entire structure that's supported the global financial system for 40 years is starting to come unglued.
Since 1974, the world has run on "petroDollars".
The petroDollar arose from the ashes of the Bretton Woods system after President Nixon cut the Dollar's last tie to gold in 1971.
In the immediate post-World War II years, Bretton Woods made the Dollar the world's reserve currency – the go-to currency for cross-border transactions. If you were a foreign government or central bank, the Dollar was as good as gold – for every $35 you turned in to the US Treasury, you received one ounce of gold.
Chances are you know the rest of the story: Foreigners recognized Washington was printing too many Dollars, the French wanted more gold than Washington was willing to give up and Nixon "closed the gold window". But without gold, what would continue to cement the Dollar's position as the world's reserve currency?
After the "oil shock" of 1973-74, in which oil prices shot up from $3 a barrel to $12, Nixon's Secretary of State Henry Kissinger got an idea and convinced the Saudi royal family to buy in.
The deal went like this: Saudi Arabia would price oil in US Dollars and use its clout to get other OPEC nations to do the same. In return, the US government agreed to protect Saudi Arabia and its allies against foreign invaders and domestic rebellions.
The appeal for the House of Saud was obvious – the weight of the US military would keep the family's 7,000 princes living in the style to which they'd become accustomed.
The appeal for Washington was more subtle – but no less important. Anyone who wanted to buy oil now needed Dollars to do so. That meant perpetual demand for Dollars and a cycle that goes like this...
Dollars used to buy oil are deposited in the banking system to support international lending by the major banks. That lending supports the purchase of American goods – everything from Boeing airplanes to Archer Daniels Midland corn. Oh, and US Treasury debt. Can't forget that.
"This gave the Dollar a special place among world currencies, and in essence 'backed' the Dollar with oil," explained Rep. Ron Paul in a prescient speech on the floor of the US House in 2006.
"The arrangement gave the Dollar artificial strength, with tremendous financial benefits for the United States. It allowed us to export our monetary inflation by buying oil and other goods at a great discount as Dollar influence flourished."
Then came his forecast:
"The economic law that honest exchange demands only things of real value as currency cannot be repealed. The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil, rather than Dollars or Euros."
Strange as it might be to imagine...the great American energy boom is hastening that day's arrival. "Let's say the US is really not importing much Arab oil anymore," says Erik Townsend in a thought experiment.
"Well, if that were the case, it's really hard to see why the Arabs would continue to price their oil in Dollars, especially at that point; their biggest customers would be China and Brazil and countries that have no reason to deal in Dollars."
We're in debt to Mr.Townsend for helping tease out the petro-Dollar's endgame here. Erik parlayed the fortune from his first career as a software entrepreneur into a second career as a hedge fund manager who knows the oil futures market inside out.
Think about it, he says: Where's the incentive to keep pricing oil in Dollars and maintaining large Dollar reserves if the US is no longer your biggest customer?
"The petroDollar system breaking down, where oil is no longer paid for in Dollars internationally, essentially would be the death knell to the US Dollar as the reserve currency. It means the US can't borrow with 'exorbitant privilege' anymore, and it means the US Treasury market is set for an out-of-control interest rate spiral."
Suddenly, the fact the US needs fewer imports doesn't matter when "the rest of the world won't use Dollars for their currency."
As it is, the Arab oil sheiks have more Dollars than they know what to do with. In the three decades before 2000, total energy export revenue from the Middle East totaled $3.5 trillion. In the 13 years since, the total has swelled to more than $8 trillion. By one expert estimate, some $8-10 trillion in currency balances lie in Middle Eastern hands, much of it in Dollars.
How long will they want to keep all those Dollars lying around? Especially when Asia and the Pacific now account for one-third of global oil consumption and the US only 20 per cent?
Meanwhile, the world's leading oil importer – China took that crown from the United States last fall – is doing its part to undermine the petroDollar. In recent years, China has been striking agreements with many of its trade partners to do business using each other's currencies. China and Russia, China and Brazil, China and Australia, even China and its old/new enemy Japan – they all have currency swaps and other arrangements in place to bypass the Dollar.
Last November brought word the Shanghai Futures Exchange was thinking about pricing its new crude oil futures contract in both Yuan and Dollars, with the aim of making that contract the new Asian benchmark. "The Yuan has become more international and more recognized by the financial market," the head of a Chinese trading firm told Reuters.
But while the Arabs fret about the value of their Dollars...and the Chinese move actively to diversify away from the might be the Russians who deliver the final blow.
"Tuesday, March 4, to me, was as big as the Cuban missile crisis in the history of the world," says Erik Townsend, with an eerie portent of future events.
On the surface, the worst of the crisis between Ukraine and Russia appeared to be over. Markets were calming down as Russia's President Putin spoke up on the issue for the first time – pledging he would use force in Ukraine only as a "last resort" if the Russian-speaking population was in danger.
Two other speeches by lesser Russian officials got much less attention.
Kremlin economic aide Sergei Glazyev said if faced with Western sanctions, Russia could figure out how to avoid using the Dollar for international transactions. "We would find a way not just to reduce our dependency on the United States to zero but to emerge from those sanctions with great benefits for ourselves.
"An attempt to announce sanctions would end in a crash for the financial system of the United States, which would cause the end of the domination of the United States in the global financial system."
Hyperbole? Yes. Is Glazyev a junior figure? Sure. But then as if to underscore those remarks, Foreign Ministry spokesman Alexander Lukashevich said hours later, "We will have to respond...if provoked by rash and irresponsible actions by Washington...and not necessarily symmetrically."
Yes, he's only a spokesman...but he speaks on behalf of Russia's wily foreign minister Sergei Lavrov. And as we go to press, he still has his job.
"That's about the strongest language I've ever heard from a diplomat," says Erik Townsend. "And it sounds to me like Russia is really saying: 'United States, if you want to play this game, come and tell us what we can do in our country, because you're the United States, and you think that ignoring international law is your right because you've got inborn American arrogance or something – if that's what you think, we're going to push a button and we're going to put your country into a bond and currency crisis that ends its economic hegemony over the world, and we have the power to do that.'
"I wouldn't be surprised if somebody in China heard him say that and maybe his phone is ringing.
"Those two countries controlling the reserve currency, being in charge of it themselves, that would just completely change everything overnight. So if you were them, why wouldn't you be consorting to do that? Imagine if they could make it work, a combination of China and Russia asserting a new currency and saying, 'We're not going to use the Chinese Yuan. We're going to create this new currency. It's called the Asiabuck or something, and it's backed by something real, preferably gold.'"
Understand that's a possibility, not a forecast. But almost no one noticed.
Since that day, there's been little letup in the Russian chest-thumping. The website of the Voice of Russia – the new name for the Radio Moscow of old – featured a commentary in late April titled, "Time Is Running out for the US Dollar".
It quoted a Russian economist saying, "The US doesn't have that much time in order to prepare for a serious weakening of the US Dollar on the global stage and, conversely, for a serious strengthening of regional currencies' role. The maximum amount of time they can count on is 18 months."
From the Russians' standpoint, 18 months might be a little optimistic.
"I doubt that a US bond and currency crisis is going to happen on Obama's watch," says Erik Townsend. "He's only got a couple more years; we're getting close. But to go eight more years – assuming the next president gets two terms – to go from 2016 all the way to 2024 without the US bond market blowing up for one reason or another, I can't see it.
"That means our next president is going to be the one to preside over the most technically complex, sophisticated financial disaster in history. 2008 will look like a backyard weenie roast compared with what I see coming."
Lost jobs, lost homes, lost hope...and then what?
That's when US leaders sit down with their "partners" from Europe and elsewhere and tell them China and Russia are about to become the biggest and baddest world powers – unless the West joins forces for a new global reserve currency. "We're going to merge the Dollar and the Euro and whoever else we can get onboard to do that.
"What you do if you're the US is you say, 'Look, we can't have that other new world. It's just too radical. It would mean the end of life as we know it. Therefore, all other countries that are not aligned with China and Russia, you gotta be on our side.' And what we'll do is we'll set it up so that basically the very well-connected political elites always are taken care of, but everybody else is going to get screwed."
That is, there will be one conversion rate between the Dollar and the new currency for the elites...and another for everyone else.
Revolt in the streets? Maybe, maybe not. Mr. Townsend suggests the conversion mechanism will be so complicated few will even realize what's happening – much like the 2008 bailouts. "The government is very good at making things overly complicated for the purpose of obscuring what's really going on from the public."
And to think it all began with the newfound American prosperity brought about by abundant made-in-America energy.
When does Judgment Day arrive? When might the Saudis or the Russians or the Chinese – or any or all of them in cahoots – pull the plug on the petroDollar?
Mr.Townsend says not on Obama's watch. That seems believable.
Perhaps the most logical time is when America reaches the point of minimum reliance on foreign oil supply – the moment when petroDollars will be least necessary to grease the wheels of international commerce. That's when the sheiks and the oligarchs and the Central Committee can make their escape.
We've gone from importing 60% of our oil needs in 2005 to only 40% now. Within another five years, the amount will shrink further to only 30%.
This "30% threshold" might well be your cue that the crisis is nigh. No guarantees, of course...but it's not hard to believe someone in Riyadh or Moscow or Beijing is watching this very data as the US Energy Information Administration posts it online every month.

Publisher of Agora Financial, Addison Wiggin is also editorial director of The Daily Reckoning. He is the author, with Bill Bonner, of the international bestsellers Financial Reckoning Day and Empire of Debt, and best-selling author of The Demise of the Dollar.

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Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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