Part VI: Working for Alliance

 

So I was sitting having dinner on the Queenstown wharf last night, minding my own business, when New Zealand Prime Minister Bill English and Australian Prime Minister Malcom Turnbull walked by. Like literally right by. No more than six fee-, er, two meters from where I was sitting.

What is it with the world not leaving me alone on holiday??

Anywho, rugby rivalry aside, there are no two countries in the world that are closer politically, economically and culturally. New Zealand and Oz are brother countries who face many of the same challenges and so typically choose to face them together. The two primes were having their countries’ annual coordination powwow.

From what I can gather from local press, while their agenda dealt with a fair number of local issues, their top foreign policy concern was dealing with the Trump Effect. Specifically, both New Zealand and Australia were founding members of the consortium of countries that negotiated the TransPacific Partnership trade deal (TPP). As the United States was about half of the TPP’s economic heft, both Australasian states were more than a bit disappointed when President Trump nullified American participation in the process. While in Queenstown, English and Turnbull apparently explored ways to proceed with “TPP minus one”, although English himself noted that it wasn’t likely feasible and his efforts could probably just be chalked up to “naïve Kiwi optimism”.

Whether you are like me and you think that China’s days are numbered, or you’re more with the conventional wisdom and so you fear that we will all be bowing to our Chinese masters before long, you probably think it makes sense to diversify your trade portfolio away from all things Chinese. TPP would certainly help do that, and so it isn’t a surprise that the Kiwis and Aussies are groping for a way forward without the United States’ participation.

But this all brings me to a broader point.

Take a look at the map below; it’s broadly is how Washington saw the world at the height of the Cold War. The deep blue countries are the Americans’ back yard — places they were willing to fling nukes over. The medium blue were the core allies in the Bretton Woods system. The orange was the competition, and the light-blues the field of battle. The Cold War was global in scope, so everything was in play. Everything mattered.

Not anymore.

This next map shows how I anticipate the Americans viewing the world in 2020. U.S. perceptions of the world have been evolving slowly away from global engagement since 1992. It’s a process that picked up speed with the 2007 financial crisis, and is now rocketing into fast-forward under Trump. (Note: I put this map together in in 2015 — before the Trump Effect — so this might all come to pass earlier than I initially expected.)

There’s a lot of grey on this map; places the U.S. just doesn’t have a stake in. Those blue shades are countries that IMO it would behoove the Americans to have a constructive relationship, but that’s not the same as saying that the U.S. must have one. U.S. alignments are shifting, and since the stability that the United States imposed upon the world from 1945 to the present was designed to fight the Cold War, there aren’t all that many pieces of it that are going to hold without deliberate efforts from both the Americans and partners on the other side of the table.

So far Continental Europe has demonstrated vividly its obliviousness in this dawning era, while Britain very clearly understands where its bread is buttered. Japan has showcased it comprehends fully the new era’s more transactional nature.

The Kiwis and Aussies are somewhere in the middle. Australian Prime Minister Turnbull had a disastrous first call with Trump which apparently went something like this:

TURNBULL: So, Australia had this deal with Obama where you’ll take some illegal immigrants from us.
TRUMP: What sort of a dumb deal is that? I hate illegals.
TURNBULL: But you’re still going to take them, right?
TRUMP: *insert TrumpTantrumTM*
TURNBULL: Is that a yes?

Not the right topic to use to break the ice with the Donald.

Anywho, the Australian government has long been a very savvy operator because they have to be. Australia has but 24 million people. Its closest neighbor — Indonesia — has ten times that, and once you look at the teeming masses of South, Southeast and East Asia it is easy for an Australian to feel a bit overwhelmed. Canberra’s only option is excellent relations with the United States. I fully expect Australian-American relations to bounce back from what was reportedly a quite nasty diplomatic snafu, but the botched Turnbull-Trump call serves to underline the point.

NO relationship, NO alliance, NO trade deal, and NO relationship is safe. When the Americans rejigger things, there are no sacred cows. The United States wasn’t involved in the first three years of World War II, and they ended up leading Normandy and nuking Japan. The United States didn’t care about Korea, and then a year later had over 300,000 troops on the peninsula fighting Chinese human waves. The U.S. treated the Middle East like a backwater until 9/11, then it fought two hot wars and intervened unconventionally in over 20 countries.

The U.S. doesn’t care until it does. And the U.S. cares until it doesn’t. Its geographic position and military reach enable it to intervene and/or stop intervening in issues that are of core importance to every other country in the world in a matter of days, and right now everything is up for re-evaluation. Even the American alliance with Australia — probably the most worry-free, strategically-simple, culturally-easy alliance the Americans have — can see change.

Well, that’s my morning rant. I’m off to brunch in Wanaka where who knows who I’ll bump into. (Apparently Oprah is in town!)

Shale Gets Ready to Run

A data dump by the International Energy Agency this weekend indicates that OPEC is enjoying its best compliance showing at least since the 1970s, if not ever. Over 90% of pledged oil production reductions have already materialized, with a few countries – most notably Saudi Arabia – overcutting. All together over the course of the past few months, total OPEC output is down just over 1 million bpd. The past two years of low-ish prices have hit non-OPEC producers as well, forcing reductions in their collective output of another 400kbpd. Stores of both crude and refined products have thus dropped across the world. No wonder oil prices have managed to hold strongly over $50 a barrel of late.

The question now is how positive will the impact upon the American shale industry be? In this there are no good guides. The nature of shale has evolved radically not simply since the industry’s modern inception in 2007 (ish), but even more so since the plunge in the price of crude began in mid-2014.

  • Since then the most productive wells have become multilateral, with multiple horizontal spurs going off every vertical well shaft. Since each of these multilaterals is crafted by a single drill, the rig count watch is utterly irrelevant.
  • Micro-seismic techs are enabling operators to take much — if not all — of the guesswork out of drilling and fracking. Such precision drilling means not only looking at the volume of steel used per well or per barrel of output is immaterial, but also that mass layoffs of rig workers can occur with no reduction in oil production.
  • Water intensity per barrel of output continues to shrink as liquids pits are replaced wholesale by mobile water tanks. Less water usage means less cash flowing through the oil sector, gutting one of the last few “reliable” means of indirectly gauging end-output levels.
All these tech changes (and more) push down the full-cycle break-even cost of oil production, and most certainly steepens the production accelerations for future output. But it isn’t “only” technological innovation that is overhauling the industry. There are other factors in play that will have a much more immediate effect.
  • When prices were low, many operators only fracked minimal bits of their wells to start them up — preferring to wait for a price recovery before fracking them up to full capacity. That time is now, but there is no unified data whatsoever on the size of this “fracklog.”
  • Improved seismic techs enable operators to go back to previous wells and drill additional fairways. Such “indrilling” enables new production into old infrastructure, eliminating the need for new pipes, new leases or new negotiations, while generating new and sustained flows with the newest techs available.

Whereas technological changes impact national output figures over months to years in a sustainable way, these more mechanical characteristics give big one-off increases in weeks to months.

The only potential short-term ointment-fly I see is financing. Nearly all the shale operators who survived the price plunge of the past two years did so at least in part by borrowing. Even with prospects now brightening, many of them will find it difficult to take on yet more debt to expand operations. Yet even here things look surprisingly good. Capital flight out of Japan, China and the Eurozone continues to set new records. Shale bonds grant foreign investors a place to park their cash that is backed both by hard assets and revenue streams.

In my opinion shale’s next surge is going to not just hit much harder, but much sooner, than most expect. And it is likely about to get a lot better.

What do Donald Trump, Brexit, the Iranian Ayatollah, EU dysfunction, Japanese constitutional revisions and Chinese President Xi’s efforts to establish himself as emperor-of-all-he-sees-for-life all have in common? They are all great for the shale sector. Global instability of all stripes means more capital flight. More risk means higher oil prices means more stable American operators. More international recrimination means more interest in commodities both as an asset class and a security blanket.

This doesn’t “merely” mean that the output curve for the shale industry will be steeper now than in 2007-2013, but that adding a fresh million bpd to U.S. oil output in calendar year 2017 is a lazily conservative forecast. Shale isn’t just likely to overwhelm the entirety of OPEC’s cut, but the entirety of the global reduction in output all by itself.

And that’s just the start. By end-2017 all those new techs should have percolated throughout the shale patch. Full-cycle break-even prices for shale are already below $40. Give it a couple more years and $25 will be within reach.

And then the real shale revolution gets started.

As to what that looks like, sorry, but you’ll have to read the book. Check it out at this link.

Part V: Watch Mattis, Not Flynn

While the news focuses on the Flynn scandal, Mattis puts NATO – and the global system – on notice.

So apparently whenever I go on vacation the rest of the world has a busy week.

Let’s focus on the United States.

While I was kayaking in Milford Sound, National Security Advisor Lt. General Michael Flynn was excused from his 24-day-old job. Flynn has a reputation for being a bit…volatile and monochromatic, so his departure from what I consider to be the job in the U.S. government that requires the most calm, far-reaching and level-headed thinking isn’t something I consider to be all that bad.

The political issue surrounding Flynn’s dismissal is that he allegedly discussed national security matters with the Russian ambassador, and then lied to now-Vice President Mike Pence about it. If Flynn indeed told the Russians that a Trump administration would take a softer line on all things Russian over the course of a series of conversations, then this may indeed have altered the Kremlin’s response to the Obama administration’s sanctions. Among Democrats in general and more national-security-minded Republicans, this is certainly the biggest foreign policy issue of the new President’s term.

Under normal circumstances I’d agree wholeheartedly, but as I’m sure everyone with a pulse has noticed, we’re not exactly in normal circumstances these days. Instead, a far more critical evolution is taking place.

A personality I take much more seriously than Flynn is the Defense Secretary, General James Mattis. At a NATO defense minister’s summit the day after Flynn’s dismissal (when I was hiking the Kepler Track near Te Anau), the good general put the entire alliance on notice. He flatly warned the allies that they must raise their defense spending – quickly and sharply – or face the Americans backing away from their alliance commitments. Specifically he noted with a degree of subtlety that only a Marine general could muster: “No longer can the American taxpayer carry a disproportionate share of the defense of Western values. Americans cannot care more for your children’s future security than you do.”

In my opinion, Mattis is deadly serious – hell, in my opinion Flynn was deadly serious – and both were/are executing policy not only with the full knowledge of President Trump, but are doing so because it is policy, not because of some quid pro quo with the Kremlin. The Americans are getting out of the global management business, and a rationalization of its alliance commitments – Europe included – is simply par for the course. All that remains is to see how quick and how deep the changes will be.

We might not have to wait long.

It was also reported in the past days that the Russians have deployed the SSC-8 medium-range missiles in violation of the landmark Intermediate-Range Nuclear Forces Treaty (or INF) signed between President Ronald Reagan and Soviet leader Mikhail Gorbachev. The creatively-named treaty bans all short-to-intermediate range (500-1000 km, or roughly 300-600 miles) nuclear and conventional missiles by either party. The agreement served as a stepping stone to more aggressive nuclear arms reductions, and in no way is it an understatement to say that the INF remains the lynchpin of all post-Cold War U.S.-Russian relations.

Looking at a map, it’s easy to see why. The primary beneficiary is Russia (and its predecessor state, the USSR). After the agreement, U.S. military bases sprinkled throughout NATO countries can not serve as launching pads for missiles designed, essentially, to reach Russia; similarly, the removal of such missiles from Russia’s arsenal directly impacts the security of the United States’ European allies. But these missiles simply cannot reach the continental U.S.

While slight mention was made within American media about the Russian’s violation of the INF, the message is being heard loud and clear by NATO. But for all of the prodding and threats by Mattis and the White House, the reality is clear: as the United States remains determined to reduce its global military footprint, Europe faces a Russia already well into its operational mobilization while most of Europe remains functionally disarmed to respond to such a threat.

This weekend is the Munich security conference. The Munich conference involves leading defense and foreign policy thinkers from both the NATO and greater European communities. It has no direct, formal impact – it’s  just a talk shop – but it has a reputation for not only candid discussions, but being a place where top government leaderships announce fairly startling policy changes. In the past German, American and Russian leaders have indicate shifts that fairly dramatically adjusted the regional centers of power.

And this weekend Vice President Mike Pence will be in attendance.

Part IV: Bribes, Trade and the European Union

Some countries are adapting to Trump and some don’t know the rules of the global system have changed. 

The Japanese government leaked a provisional policy document to Reuters late Jan 31 titled “U.S.-Japan Growth and Employment Initiative,” which noodles over how Japan can invest more heavily into the United States in a variety of economic sectors. The policy was supposedly read out loud to Reuters staff, and it is very clearly in the under-development stage with a great many gaps.It is expressly meant to pave the way for Japanese Prime Minister Shinzo Abe’s upcoming summit with Donald Trump on Feb. 10. Among the document’s noodling includes possible investments into various infrastructure projects and the shale sector. The leaker indicated that the investment would be on a scale that could generate “hundreds of thousands” of American jobs.

(Before you discount that “figure” as ludicrous, keep in mind that the Japanese economy has been so moribund for so long thatthe Japanese regularly force the near-entirety of their pension system — with a huge dose of flat-out printed money — to invest in Japanese government debt, an asset with a zero percent return. It is well within the BOJ’s purview to instead purchase foreign assets if that serves Tokyo’s purposes, and to do so in a volume that quite literally reaches the high hundreds of billions of dollars.)

If this feels like a bribe, you’re thinking about things the right way.

The United States is backing away from the world writ large, a development that spells utter disaster for the many countries that designed their economic, political and military systems around the central concept of American engagement. Every bi- and multi-lateral relationship that the Americans have is in the process of being obviated. That includes everything from the UN to the WTO to NATO … to the Japanese alliance.

In Accidental Superpower I noted that in the coming Disorder there would only be a very short list of countries with which the Americans would choose to remain entangled, largely because the Americans perceive unmitigated benefits. If your country isn’t on that list, and you want to retain American engagement, you have to come to Washington and plead your case. And if you come empty handed the answer will almost certainly be “no”.

Abe apparently intends to try and flat out purchase American involvement. A bit crass for my tastes, but that doesn’t mean it won’t work.

The Japanese understand what’s happening. They know full well that their exposure to global energy markets and the fragility of their manufacturing supply chains makes them vulnerable. The Brits get it as well. The Canadians are desperately hoping that they are on the “unmitigated benefits” list (they probably are). The Mexicans are twisting in the wind, unsure if what’s coming out of the White House is rhetoric, policy or a negotiating strategy (it’s probably the latter). The Chinese are having problems coming to grips with just how bad things are about to get for them.

And the mainland Europeans are in flat-out denial.

American security involvement and American trade access are what ended the European civil war of roughly 1800 thru 1945, and generated the past 70 yoears of peace and prosperity. Europe is only able to import raw materials and export finished products because of American global overwatch, to say nothing for Europe’s (in)ability to defend itself (or in general get along with itself). In fact, without swap lines and loans from the Federal Reserve, it isn’t much of a stretch to assert that the Euro would have failed already. Without express U.S. involvement and strategic sponsorship, there is no European Union.

Rather than start tweaking themselves towards a system that might be sustainable without American overwatch and largess, most European politicians right up to the German and French premiers are engaging in a (not entirely) diplomatic back-and-forth with the Trump administration. It isn’t that I’m taking Trump’s side on any particular ethical, legal, constitutional, economic, strategic or practical issue, but instead that continental Europeans are acting as if the old rules still applied.

And unlike a week ago when the issues at stake didn’t hold immediate implications for the EU, now they do.

Apparently I was wrong. National Trade Council chair Peter Navarro is indeed aware of the existence of countries that are not China. Specifically, he knows where Germany is. On the same day the Japanese were testing the waters with their…consulting fee suggestion, Navarro laid into German trade policy. Specifically, he noted that the euro in essence functions as means of depressing the cost of German exports, constituting an unfair trade advantage.

Navarro is both wrong and right. Wrong in that the German intent for the euro isn’t to facilitate exports outside of the eurozone, but instead to induce economic convergence among the eurozone’s members and thus bulwark all of them against international volatility, and strengthen all of them as an internal trade bloc

But that’s not what has happened. The Europeans have proven completely incapable of grinding down financial, fiscal and political barriers within the bloc, so instead of helping everyone converge, the euro has instead established a dependency system in which Germany is the indisputable center of gravity. Since this is done in the context of a currency union, the weaker members have the effect of dragging the currency’s value down. And here’s where Navarro is dead-on correct: the failure of Europe to federalized has devolved the euro into an “implicit deutschemark that is grossly undervalued”. That was never the Germans’ intent, but it is most definitely the outcome — and will remain so until Portugal and Greece look more like the Frankfurt (which isn’t going to happen in our lifetimes).

It is highly unlikely that the Trump administration will be impressed with a “U.S.-Germany Growth and Employment Initiative”, even if Berlin had the political and economic bandwidth to fashion one. The accruing nature of everything threatening Europe is simply so multi-vectored, entrenched and damning that the Continent is now exactly the sort of commitment that the Americans are not interested in.

Yet if anything, that understates the challenge that Europe now faces.

The primary responsibility of the National Trade Council that Navarro leads is to prosecute trade wars. Which means it isn’t just that the European Union cannot exist without express U.S. support, but now also that the United States seems about to actively kick out the Union’s scaffolding.

Part III: Corporate Tax Reform and Global Trade

The simple tariff being discussed in D.C. might spell the end for global trade and security as we know it.

The Trump administration has requested that Congress focus on two major policies during the next few months. One is Obamacare, as excising Barack Obama’s legacy remains a core issue for Trump’s diehard supporters. The second is tax policy reform, specifically corporate tax reform. Trump has indicated that he wants the process to be more or less revenue-neutral, but he also wants the corporate tax rate to shift from today’s 35 percent (among the world’s highest) to 20 percent (among the world’s lowest). While undoubtedly such a cut would massively expand corporate activity and thus tax receipts, such a lower rate would still require replacement income to come from a new source.

From what I’ve heard from DC of late, it seems that Democrats and Republicans alike (not to mention the Trump team) are zeroing in on a common approach — a tariff system.

Administrating a tariff system can be somewhat tricky. The easiest way to manage one is to simply slap on a “border” tax and tax absolutely everything a set percentage as it comes across. The problem with this, however, is that if you have any manufacturing supply chains that cross the border more than once — like, say, everything Ford and Chevy do — things can get taxed multiple times. Such a turnover tax drastically increases the cost — and diminishes the competitiveness — of goods and smashes any supply chains the U.S. has that rely upon the NAFTA partners. That would — at a minimum — trigger an economic depression in places like Michigan and Texas.

A less disruptive option is to implement some sort of content-origin rule, so only the percentage of value of the product that isn’t American gets taxed, and that only once. This requires a more involved detection and labelling system and requires a degree of trust with your close trading partners, but within the NAFTA system something more or less like this already exists. You’d just need to layer in a new bureaucracy atop what’s already there.

This method has some interesting advantages.

In addition to very strongly encouraging American firms to keep their businesses within the U.S., this sort of tariff system is also fairly modular. Since you are already collecting product origin data you can adjust the tariff country-by-country and product-by-product, for example having tariff levels that favor trade with Honduras but disfavor trade with South Africa. Tariffs and trade access very quickly become a tool of state power. As the U.S. has the world’s largest consumer market, that’s no small factor. The biggest losers from such systems would be countries and industries whose supply chains are almost wholly non-North American in nature. China Inc’s gangly East Asian industries would wither, as would Germany’s fully Central European ones. From the Trump White House’s point of view, these are probably viewed more as features than bugs.

There are, however, two far-from-insignificant problems. First, such a system is flat out illegal under the rules of the World Trade Organization. The whole concept of tariffs are one that the U.S. has been browbeating out of the international system since 1944 as part of the move to globalized free trade. Going the tariff route by definition means either facing a fleet of international lawsuits (which the U.S. would almost certainly lose), or simply walking out of the WTO completely. The ability of the U.S. to export to anyone that it didn’t have a side deal with would almost certainly collapse.

The second major problem is that anything that has such a crushing effect on globalized trade will gut the export-led industries of every country that happens to have an export-led economy. Roughly two-thirds of the world’s population almost certainly would face economic depression.

The United States would definitely feel the pain of this, but it would be manageable. Only 8 percent of U.S. GDP is from merchandise exports, and one-third of that is to Canada and Mexico. Only the United States has a demography that’s full of consuming 20- and 30-somethings, and so only the U.S. has the necessary end-market that makes export-led economies around the world work. If Washington and Mexico City and Ottawa can find a way to forge a non-WTO way forward (three guesses what my next topic will be), then the U.S. would likely only suffer a mild recession.

 

For everyone outside of North America, however, the near-future would hold economic disaster.

The U.S. may be the least involved country in international trade from a trading perspective, but it is the most involved country from a trade-management perspective. Without unfettered access to America’s consumer market, the global market shrinks by about one-third. Without the only global navy providing freedom of access and freedom of the seas, maritime trade — the way four-fifths of global trade moves — is endangered if not outright impossible. That isn’t just a problem for computers and furniture, but for iron ore and, oh yeah, oil too. Like it or not, the U.S. is the indispensable country for the global order in its current form.

Remove the U.S. and we don’t get a new global order, we get disorder because there is no country or coalition of countries that can replace the United States in financial, consumptive or military terms. The world’s rising powers — most notably China — see trade as a plank of security policy that is most definitely a zero-sum game. Any attempt by them to impose their own global (or even regional) preferences would quickly lead to conflict with other powers that would lose out under Chinese management. In China’s case that’s a lengthy list that would involve everyone from Japan to Taiwan to Indonesia to India to Saudi Arabia to the United Kingdom.

The reason the U.S.-based system works is that U.S. has global reach but no global needs. It has been willing to sublimate its economic needs in order to build and preserve a global system. China is the opposite. It has global needs but no global reach. It wouldn’t be willing to sublimate anything for its economic goals, and so no one has any interest in deferring to Beijing.

This tax shift under discussion in Washington very well might be how the whole global structure comes crashing down.