Why are oil prices headed relentlessly higher? Most likely because a hot war is coming to the Middle East.

Why are oil prices headed relentlessly higher? Most likely because a hot war is coming to the Middle East.

What I Learned This Week

May 10, 2018

We have warned for many months of rising tensions between Iran and Israel and the extreme ambitions for regional control by the young leaders of Saudi Arabia and Abu Dhabi, respectively MBS and MBZ.

Geopolitical crises in the Middle East have been possible for so long that investors have become desensitized to the risks—precisely at the moment when conditions are most dangerous. Long-term clients may remember our warning on August 29, 2001, thirteen days before 9/11—“The world’s greatest threat: Islamic fundamentalists. Are energy stocks a buy?”

Last issue, we wrote about the military leader of Iran, Qassem Soleimani, and how he has been preparing for modern and advanced warfare for decades and has used Syria to try out new tactics and new weapons. We also reported that the Russians experimented with 150 new weapons systems in Syria in recent years.

At the same time that this is happening, energy equities are confirming the move in oil and are breaking out on strong volume after many years of underperformance. The OSX Index has gained 23.1% since December 7, 2017, when we noted that it was trading at its cheapest relative strength in at least two decades. (Please see the charts below.) This supports the view that the move in oil is far from over—and as always happens—oil prices could go farther than anyone thinks possible.

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Source: StockCharts.com

In section 11, we write again of one of the great universal truths and a constant in history: “The Middle East remains, as it has been since the beginning of history, the crucible of conflict and the graveyard of empires.”

We also think that natural gas will follow oil prices higher. Natural gas has experienced one of the worst bear markets in history, causing trillions of dollars of capital write-offs and burning huge numbers of investors who tried to pick the low too early and will never come back!

It’s well known that natural gas is the most volatile of all commodities and asset classes. And when it moves, it really moves.

Why has gold not responded to higher oil prices and the outbreak of hostilities in the Middle East? It will. As has been the case for years—but especially since 2011—the “authorities” and their representatives have actively suppressed the price through enormous “paper gold” sales on the CME. They don’t want gold to send an inflationary signal. But soon they may have other more pressing problems to worry about—like rising inflation and bond yields and maybe even a dollar crisis—and the market’s desire to be free will triumph.

It would be hard to avoid discussing China U.S.-trade relations this week, which has absorbed a lot of our trip in the region the past month. While it’s a highly-volatile situation, our tentative conclusions are as follows:

First, the U.S. is likely to block key technology exports to China. This is a win for the U.S. in the short term, but a loss in the long-term. China will devote every resource and use every trading partner, who has such technology, to develop its own industry—rushing way ahead of schedule into technology independence.

Second, by forcing China to take this route, America is inadvertently advancing the very goal it wants to prevent.

This will have a long-term devastating impact on many technology suppliers around the world, including U.S. semiconductor producers themselves. China is the largest buyer of semiconductors—accounting for 60.6% of global consumption in 2016, representing $214.5 billion value annually. Presently, China produces only about 15% of global semiconductors.

Third, this will set off a serious reversal of globalization that could create trading blocs, technology blocs and shifts in military alliances based on who is perceived to have the most advanced weaponry. China and Russia are aggressively pursuing innovative weapon systems for asymmetric advantage. For instance, hypersonic missiles travel Mach 5 and above, and no current missile defense system is capable of intercepting them. China has two to three times more hypersonic development facilities than the U.S. and has conducted 20% more hypersonic missile tests in recent years.

The battle for technology leadership between China and the U.S. is taking place on many fronts. The 5G race may be the most important race of the next five years, because the networks will be the connective tissue between AI and quantum computers in the cloud and networks of autonomous cars and the digital nervous system of the IoT. The 5G leader will drive global standards and could determine who ultimately wins the AI race by rapidly acquiring better data for superior results.

Fourth, if America can cut off exports of key technology, why not food and LNG? Or, impose sanctions on countries it’s unhappy with—like it has done with Russia, Iran, North Korea, Cuba and now even collapsing Venezuela. Has this action improved America’s trade and geopolitical position in the world or irreparably damaged it? “It’s China today, but tomorrow it could be my country.”

We also can’t help but focus on the EU-U.S. trade relations, which are deteriorating despite the efforts of President Macron. As we have written, intellectual property is where the wealth is and where the trade battles of the future will be fought.

The EU’s new privacy regulation is just the first salvo in a major battle between the two trading blocs.

Of more importance, there is at heart a fundamental schism between America and Europe. President Trump is an economic nationalist who favored and supported Brexit, while Europe must remain vehemently pluralistic because the breakup of the euro would be an existential crisis for the euro zone. That is too fundamental a difference to have any hope of their really working together.

While the EU and the United States might be normal allies in the fight to “contain” China, if anything, Europe will be moving towards China on trade.

An editorial in today’s Financial Times describes the situation in blunt terms: “Washington has rarely been so isolated. Mr. Trump has scorned the advice of America’s closest allies. The French, Germans, Japanese and British all sought to persuade him that, despite its imperfections, the JCPOA is achieving its aim: to stall Iran’s capacity to develop nuclear weapons. By slapping on sanctions, the U.S. is asking these same allies to abide by the rules of a rule breaker… Hinting that European countries could shield companies from the new sanctions regime, Bruno Le Maire, the French finance minister said: ‘The international reach of U.S. sanctions makes the U.S. the economic policeman of the planet, and that is not acceptable.’”

Susan Rice, the U.S. national security advisor from 2013-2017 and the former U.S. Ambassador to the UN, wrote today in a The New York Times op-ed as follows: “When the United States unilaterally abrogates an international agreement in the absence of any breach, we undermine international perceptions of our reliability and responsibility. That is precisely what we have already done with the Paris climate agreement and the Trans-Pacific Partnership.”

Then, we have the ongoing negotiations on NAFTA, and from what we can gather, the U.S. demands are too extreme to ever be agreed to by Mexico. (And that reminds us of the egregious and impossible demands Austria required from Serbia after the assassination of Archduke Ferdinand in 1914. As it turned out, amazingly, the Serbians agreed to all but one request—as extreme as they were—but the Austrians wanted war anyway and with the backing of Germany launched World War I. They quickly found out that the Serbians had a much better Army and had to rely on Germany to save themselves. But the Hapsburg Empire collapsed anyway.)

If the NAFTA negotiation does not get done by May, Washington will most likely have to contend with a new populist Mexican president. In a classic case of unintended consequences, President Trump’s attacks on Mexico and his call for a “wall” have bolstered the popularity of Andres Manuel Lopez Obrador, aka AMLO. He leads all polls against establishment rivals by double digits and is likely to win the presidency on July 1.

Obrador wants a deathblow against the ruling political class, calling them “Filthy pigs!”… “Hogs!”…“Swine!” to popular acclaim among the millions of impoverished Mexicans that form his base.

While he has supposedly tempered his extreme socialist views and moderated his anti-NAFTA rhetoric, we have studied him for years and he is as populist a leader as will ever come to power in Latin America. And that could mean nationalization of Pemex and a variety of other extreme actions that will impact foreign producers, further squeezing America’s supply chain at a time when inflation in the U.S. is already headed higher.

Looking at the trade situation from 100 thousand feet, why has America chosen to attack all of its major trading partners at the same time? Why not take one on at a time, negotiate a deal and move on to the next?

We have been predicting for years that the end of the unipolar world and the beginning of a multipolar world would bring enormous geopolitical shifts and the shattering of alliances. The markets are only starting to come to grips with the significance of it all—but it has to be one of the greatest changes that has occurred in the world in decades.

Winston Churchill once wrote that democracy is the worst form of government except for all the others. What was left out of that widely-circulated quote is the following—“Democracy is more vindictive than Cabinets. The wars of peoples will be more terrible than those of kings.” And he said this before WWI and WWII.

We are now seeing trade wars and intellectual property wars, but wait until you see the coming financial wars. We have recently read a book by Juan C. Zarate entitled “Treasury’s War: The Unleashing of a New Era of Financial Warfare”. It was published in 2013 and is an especially prescient book. It describes how the author was one of the architects of America’s financial warfare. We quote as follows:

Over the past decade, the United States has waged a new brand of financial warfare, unprecedented in its reach and effectiveness. This “hidden war” has often been underestimated or misunderstood, but it is no longer secret and has since become central to America’s national security doctrine. In a series of financial pressure campaigns, the United States has financially squeezed and isolated America’s principal enemies of this period—Al Qaeda, North Korea, Iran, Iraq, and Syria. Far from relying solely on the classic sanctions or trade embargoes of old, these campaigns have consisted of a novel set of financial strategies that harness the international financial and commercial systems to ostracize rogue actors and constrict their funding flows, inflicting real pain. America’s enemies have realized they have been hit with a new breed of financial power. And they have felt the painful effects…

The 2008 financial crisis was a major blow to American power. It caused a fundamental loss of confidence in the American financial system and capital model, shaking the foundations and perceptions of American economic power. In its wake, many countries and investors questioned whether dependence on New York and the US dollar should dictate their well-being and national fortunes…

This loss of perceived power has now met with an increased willingness to use economic influence for national interests. We have entered a new era of financial influence where financial and economic tools have taken pride of place as instruments of national security. The conflicts of this age are likely to be fought with markets, not just militaries, and in boardrooms, not just battlefields. Geopolitics is now a game best played with financial and commercial weapons…

In the past ten years, the United States had demonstrated to the world—and to its competitors, in particular—that it was willing to leverage economic and market powers to influence international security. China and other countries have resented the use of this influence to affect their economic interests and influence. The powerful financial tools that the US Treasury has honed over this decade are now proliferating, particularly to major competitors. They have been and will continue to be used against the United States and its allies in the future, not only because of an increased foreign understanding of the means of financial pressure, but also because of a decreased reliance on the dollar and on American banks and the US financial system.

Importantly, the states and nonstate actors that the United States has targeted are inventing new means of avoiding sanctions. The United States has little influence over the separate financial and monetary systems that are emerging particularly in the cyber-realm. Further, there are increasing efforts, including by some US allies, to limit the United States’ unilateral leverage in the financial sphere.

These trends are weakening the ability of the United States to use its financial power to promote US national security interests.