Saudi Arabia Takes Stock

Deputy Crown Prince Mohammed bid Salman laid out part of his country’s strategic challenge in an April 25 interview.

“We have a problem with military spending,” the prince told Al Arabiya. “When I enter a Saud military base, the floor is tiled with marble, the walls are decorated and the finishing is five stars. I enter a base in the U.S., you can see the pipes in the ceiling, the floor is bare, no marble and no carpets. It’s made of cement. … We are the third- or fourth-largest in terms of military spending in the world, yet our army is ranked in the twenties.”

If anything, the crown prince-designate is being overly generous to his military establishment. Going back to the foundation of modern Saudi Arabia, the Saudi military has been an expensive paperweight. Riyadh has used its oil heft to purchase foreigners to fight its wars. When Saddam Hussein’s Iraq invaded Kuwait in 1990, the Saudis flat-out paid a coalition to defend their country and liberate their neighbor. In the years since, Riyadh hired so many Pakistani pilots that the Saudi air force for a time felt as Pakistani as Pakistan’s own. Even today Riyadh maintains vast warehouses packed with shrink-wrapped Abrams tanks and Apache attack helicopters awaiting foreign operators to fight wars on Riyadh’s behalf.

In the Saudi mind those operators would always be American, a people so dependent upon energy imports and so wrapped up in maintaining the global order that they would fight and die to defend the Saudi nation and way of life.

America’s shale revolution has changed all that. Shale oil production has proven increasingly cost-effective. So much so that U.S. oil output is holding steady despite the oil price collapse. This is doing more than edge the Americans towards energy independence, it is also remaking American industry. Cheap oil and nearly free natural gas is overhauling sectors ranging from petrochemicals to electricity to manufacturing and placing an extra $2000 a year per family in the citizenry’s pockets.

Between shale’s cavalcade of changes and a rationalization of America’s foreign policy that is as long-overdue as it is all-encompassing, the Americans no longer need Saudi oil and no longer really care if the Persian Gulf stays open.

And so the Saudis are taking their first (grumbling) steps towards standing on their own feet — and firing their own guns. It will be a long, hard, costly slog. Saudi Arabia has no indigenous regular military expertise, no related skill sets in logistics or industry to call upon. What they do have is loads of pre-purchased equipment and a metric butt-ton of cash to hire trainers from every corner of the globe. And even before the crown-prince-to-be’s announcement, their new stratagem is bearing fruit.

The Saudis’ primary concern is Iran, a country eager to move into the vacuum the Americans’ absence is creating. An early Iranian move helped trigger (another) civil war in Yemen, a country in southern Arabia largely irrelevant to anyone who doesn’t border it. Unfortunately for the Saudis, their country is one of the two. In the war, the Saudis have intervened directly, boldly, and at the head of an alliance of states who likewise fear the Iranian rise. The Saudi effort has been marred by a mess of mistakes: high civilian casualties, lots of friendly fire, logistical bottlenecks and outright shortages, extreme unit attrition caused by inexperience in fighting guerrilla forces, and so on.

Yet I cannot help but be impressed by what the Saudis have achieved. A year ago I felt that Yemen presented the Saudis with a chance to showcase their utter military incompetence. Instead Iran’s efforts have been heavily unwound and there is absolutely no chance that Iran’s proxies will carry on to victory so long as the Saudis remain committed. Yemen has proven to be a great test of the Saudis’ war-fighting, and it is a test in which they get a passable grade. Just as importantly, the Saudis have not been fighting alone or limited their activities to Yemen; they now lead a coalition of Gulf Arab states in Syria and Libya as well.

This military and diplomatic activity will prove great practice for the fight to come.

Iran is beginning to comprehend that the Saudis see this as a fight to the death. When that truly sinks in, Iran will realize it has to go for the throat and remove the Saudis’ primary enabler: the Saudi oil fields. That can only be done via outright military occupation. Prince Salman realized this nearly two years ago and everything — from the oil price war to destabilize Iran’s finances to the Yemen and Syrian conflicts to challenge Iran’s strategic position to today’s announcement on military rationalization — is about preparing Saudi Arabia to fend off a direct Iranian assault, and to do so without meaningful American assistance.

Cuba: Life After the Cold War

Outside of the political protestations regarding Obama’s visit to Cuba (it is a presidential election year, after all), the United States has a strong strategic interest in returning Havana to the American sphere of influence.

The geopolitical rationale is twofold:

A hostile Cuba, backed by a meaningful external power (such as the Soviet Union during the Cold War) could threaten control of America’s internal waterways—most notably anything exiting the Mississippi, as these exports have to pass either the Florida or Yucatan straits. Also at risk are the Intracoastal Waterway along the Gulf Coast. As the US becomes less interested in international trade, domestic exchange becomes more important, and so too does the political relationship with and within Cuba.

Cuba is the only portion of the Western Hemisphere through which American power does not thoroughly penetrate. That it is so close to US shores only heightens Washington’s interest.

After the collapse of the Soviet Union, Venezuela became Cuba’s key political and economic ally. With Caracas itself caught in the throes of political and social unrest, Cuba has no choice but to normalize relations with the US. And so it is.

There will be three primary changes that will emerge from the thawing of the last vestiges of the Cold War:

1) Tourism. Already underway, Cuba’s tourism sector is poised to soon become the top Caribbean destination for American tourists, and within a decade should be well on its way to resume its position as a sort of tropical Las Vegas. The embargo doesn’t even have to be lifted for this to happen.

2) Sugar. Cuba’s sugar industry is historically far stronger than America’s, and has operated with far lower costs. The island’s proximity to the Intracoastal Waterway and the Mississippi will vastly simplify the logistics of the sugar trade and distribution within the US market. Sugar production is set to at least double in the half-decade following the lifting of the embargo as investment flows into Cuba’s cash-and-tech starved sugar industry. The biggest obstacle is the US sugar lobby (far more powerful than most people realize), but America’s other agricultural producers will likely prove more formidable as they clamor to access a Cuban market heavily dependent on food imports.

3) Manufacturing. Perhaps one of the most frequently overlooked impacts of an American détente with Cuba. Although Cuba’s educational and vocational training system is vastly outpaced by the United States, Cuban wages are a mere fraction of what they are in the US. Cuba’s proximity means that the island can be integrated into US infrastructure and supply chains relatively easily, as well as NAFTA/CAFTA. Training, infrastructure and industrial plant buildout will take a decade, but the economic argument behind integration is solid.

Making the Next Mao

Chinese President Xi Jinping is already poised to be the most powerful man in Chinese history after Mao Zedong, and proposed reforms to the country’s paramilitary police force would all but guarantee that position if they are passed. The People’s Armed Police Internal Guard Corps is a 600,000 strong paramilitary police force with military-grade weapons and specialized training in counter-terrorism and anti-riot policing. Right now, the Corps answers to China’s civilian leadership as well as the Communist Party’s Central Military Commission. Proposed reforms would place the paramilitary force under the control of the Chinese president, relocating a key structure in containing social unrest and domestic security from a fractured control system scattered throughout the Chinese system to the direct control of Xi Jinping.

As Beijing and the Communist Party ready themselves for the 19th Party Congress in 2017, President Xi has been in the midst of a frequently mentioned but often misunderstood factional reshuffling. President Xi is consolidating authority and attempting to control the evolution of China’s political and social reforms in the face of an unavoidable slowing of the economy. If the proposed reforms to the leadership of the People’s Armed Police go through, expect Xi to follow through with reforms targeting the most ossified and entrenched (read: corrupt and powerful) factions of the Party, with the full force of 600,000 paramilitary forces poised to reign in any threats of resistance or unrest.

Brussels Attacks Are Just a Symptom

Coordinated terror attacks rocked Brussels this morning, following a successful raid earlier this week that saw French and Belgian security forces capture the surviving would-be suicide bomber and participant in Paris’ November 2015 terror attacks. ISIS affiliates have claimed responsibility for the attack, leaving today’s coordinated bombings at a metro station and the Brussels airport the latest of the organization’s high profile actions in Europe.

Belgium’s Arab community have come under greater scrutiny in recent months, as have many of Western Europe’s Muslim and Arab communities, but Brussels faces an uphill climb in guaranteeing its own security. The basic definition of statecraft is the ability to control one’s borders—as the de facto capital of the European Union, Belgium sits in the middle of a conglomeration of relatively wealthy European governments with little to no border controls. Add to this years of political deadlock and a police system that favors human rights and adheres to strict privacy protections at the expense of security, and it’s easy to see why Belgium and terrorism have been occupying headlines so frequently as of late.

Europe is still clinging to a world that functionally no longer exists. European capitals are digging in their heels and pushing for civility and, well, Europeaness while the Continent’s broader periphery rapidly devolves into chaos. The most obvious (but far from the only) source of the disruption is Syria, a state that is rapidly de-civilizing. Considering the weakness of next-door Iraq, Lebanon and Jordan, this is only the beginning of a larger civilizational breakdown.

So morally, the European position is worthy of respect and acclaim. Functionally, however, it is idiotic.

The problem — well, part of the problem — is that there’s been a geopolitical shift immediately on Europe’s southeastern border. Turkey, for all intents and purposes, is no longer part of the civilizational block that is known as the “West.” You can certainly argue (accurately) that Turkey never fully joined the West in whole — there were always a host of linguistic, religious, ethnic, historical and cultural barriers to true merger — but in the past decade Europe and Turkey have slid further and further apart, and in recent weeks the Turkish government took over the last remaining independent media outlet of significance. From an ethical point of view, the split is now complete.

Persian Gulf Image

Turkey is now unhinged — as seen by last week’s suicide bombings in Ankara and Istanbul — eliminating any chance that the Europeans had of managing their terror or migration problems. For now, the best case scenario for the Europeans is that Turkey rounds up the migrants into camps, and then invades and occupies Syria in order to destroy both the Assad government and the Islamic State.

Put simply, the EU’s anti-terror, migration and strategic policies are now little more than hope that Turkey, a freshly illiberal state that doesn’t think very highly of Europe (and is technically in a state of war with one of its members) fully militarizes and starts invading its neighbors.

This will end (very) badly.

Iran Sanctions Lifted

On Jan 17 the IAEA gave the green-light to the Iranian nuclear industry – indicating that Tehran was implementing the U.S.-Iranian nuclear deal in both the spirit and letter. With that stamp of approval, some of the sanctions that have hindered the Iranian energy sector are immediately lifted. The Iranian government issued a flurry of celebratory statements, including one from the Oil Ministry indicating that Iranian exports would increase by 500,000 bpd within a week and by another 500,000bpd by year’s end.

Mmmmm….not so fast.

Yes, the rapprochement between the Americans and Iranians massively shifts the regional (and global) geopolitics. And yes, now that sanctions are lifting Iran’s energy output will rise, but an extra 1 million bpd of Iranian crude this year is, well, silly.

First of all, Iran’s not yet out of the proverbial woods. The next step in the normalization is that the United States has to formally lift a raft of sanctions – and the Republican-dominated U.S. Congress gets a say. Considering that the Obama administration couldn’t get a bill passed that criminalizes the president’s own Democratic Party right now if it tried, the idea that there will be any agreement on a topic as touchy as Iran is, well, ludicrous. The Republicans, unfortunately from their point of view, probably lack the votes needed to veto the deal, but they’ll do what they can to increase the controversy and to try to milk the issue for as much political capital as possible. The soonest that the United States is likely to flash its own green light will be April. Only then will non-American firms feel sufficiently confident to start sniffing around the Iranian oil patch.

Second, it isn’t as if the only obstacles to renewed Iranian oil output growth are American. Iran’s laws to facilitate foreign investment into its energy sector are, in a word, unhelpful. Until recently the Iranians used a complicated system called buy-back, in which energy producers would sink in cash, do their work, and produce crude without any ownership interest in the field or the oil. Iran then “allowed” the foreign firms to “buy back” the crude at a price that Tehran determined on a whim. Given that foreign investors have no ownership, profitability, guarantees, consistency or recourse, Iran has probably damaged its own production capacity more than U.S. sanctions. This system is in the process of being overhauled, but it will be – bare minimum – a year before it’s clear if the new system makes more sense. Or works at all.

Persian Gulf Image

Kharg Island, Iran

Third, between buy-back and sanctions, much of Iran’s oil output has been shut-in and many fields will have to be re-evaluated before production can be re-started. That process alone will take several months, and until it is done what foreign investment that manifests will be sunk into exploration, not production. Add in the fact that global energy prices are low (and seem to be going lower) and there just isn’t much reason for foreign companies to get too involved too quickly.

What work will be done in the Iranian oil patch will simply be because Iran itself can once again purchase the equipment it needs for its domestically-run projects. That’s far from insignificant, but the total for new output for 2016 will probably be in the range of one-quarter of the Iranians’ idealized numbers.

Which doesn’t mean that Iranian oil won’t hit the market. Iran probably has about 30 million barrels in storage depots and tanker ships in various places around the world. One of the sanctions that already has been lifted because of the IAEA go-ahead opens these volumes up for sale. Assuming that Iran floods the markets with this oil at the rate of 500,000 bpd, these stored volumes can flow for a full two months. Even if this pushes prices as low as $20 a barrel, that’s still over a half billion dollars in income.

Funny thing is, the world might actually get an extra blast of Middle Eastern crude this year – it just won’t be coming from Iran. Instead, the source will be Saudi Arabia and its allies in Kuwait, Qatar and the UAE. The primary reason the Saudis launched their price war in late 2014 – and doubled down on it in late 2015 – wasn’t to crush the American shale patch, but instead to crush Iran before it could fully recover from its sanctions. Iran’s commitments in Syria, Lebanon, Yemen and more all show the classic signs of costly over-leverage. In Riyadh’s mind, now that Iran’s sanctions are on the way out, the financial pressure on Iran needs to be redoubled. The result will be an intensification of Riyadh’s two-track strategy: up the money flowing to foes of Iran in all theaters and up the flow of Saudi oil to minimize interest in and output from Iran’s oil fields. Which leads us to a weird world in which oil prices go lower for longer even as the Middle East gets more violent.

Saudi and Iranian Tensions Surface

It has been quite the week-end in the Middle East, and things are just getting started.

 

On Jan 2nd, Saudi Arabia executed 47 Shia dissidents including cleric Nimr al-Nimr. Rhetoric from Shia-dominated Iran flowed fast and furious within minutes, with protestors setting fire to the Saudi embassy in Tehran. In retaliation the Saudis severed diplomatic ties with Iran the following day.

 

Despite a year of weak prices, shale output has continued to ratchet up in the United States. That, plus a mix of trade and demographic shifts as well as a long-overdue strategic realignment in the aftermath of the Cold War and the Iraq war, is nudging the United States away from actively managing the Middle East. Without the … calming effect of U.S. active involvement in the region, there is nothing to prevent Saudi and Iranian regional fears and ambitions from colliding. And so they are.

 

Saudi Arabia and Iran have now faced off on opposite sides in blood feuds in Syria, Lebanon, the Palestinian Territories, Yemen, and Afghanistan. Both have attempted to keep the conflict one of the cold or proxy variety.

 

33-alt2

The Persian Gulf

The execution of al-Nimr indicates that this at-arm’s-length strategy is now changing. Iran has long encouraged rebellion among the Saudis’ Shia minority in the country’s Eastern Province, with attempts to foment Shia unrest – like al-Nimr’s dissidence – as one of their chief tools.

 

Al-Nimr’s execution and the severing of relations indicate that the Saudis, at least, are ready for the conflict’s next stage. It’s unlikely that the rest of the world is: Eastern and Khuzestan, unfortunately, are home to the bulk of the two country’s oil production facilities.

The U.S. Federal Reserve raise interest rates

The US Federal Reserve raised interest rates on Wednesday for the first time since 2006.

After weeks of anticipation (or are we up to years already?) the U.S. Federal Reserve ended its zero-percent interest rate policy on December 16th. Chairwoman Janet Yellen kept to the script of advertising a gradual increase in interest rates for the foreseeable future, with pundits around the world guesstimating that rates will be in the vicinity of 1.25% by the end of 2016.

 

The U.S. dollar immediately spiked higher against, well, pretty much every currency in the world. U.S. exporters bemoaned the impact a strengthening currency would have on their businesses.
9Of course, the Fed isn’t the only force at work. There is China, of course, where the “mystery meat” is turning out to be less hot dogs and more rancid horse offal. My favorite bit of new economic terror is from November when the government started to prosecute stock traders who didn’t lose money during the summer market meltdown. Not exactly the sort of activity that engenders confidence in the world’s second-largest economy.

 
Europe isn’t exactly shaping up either, although the whiffs of financial panic that accompany the Eurozone crisis have at least abated for now. Greece sinks into the morass a bit more with every passing month; even the Greek government has stopped manufacturing the fiction that a recovery will happen anytime soon. Now we have the Schengen agreement – which regulates the ability of Europeans to border-jump without document checks – under varying degrees of suspension in Hungary, Slovenia, France, Germany, Denmark, Austria and the Netherlands (and I probably missed a couple).

 

A rising dollar combined with a fading Europe and stumbling China is of course the worst possible news for commodity markets. Sure, overproduction in global oil markets (and American natural gas markets) sets the tune, but there are plenty of supporting actors. Brazilian and Australian miners – backed both directly and indirectly by Chinese money seeking any safe haven outside of China – doubled down on production facilities during the 2005-2014 boom. Now with demand stalled a reckoning is due – and that’s the best case scenario. Should the Chinese recovery prove as unlikely as I believe, the entire commodities world is in for a very dark half-decade…which just pours more energy into the dollar.

 

All told 2015 has shaped up to be a year of record U.S. inflows. When all the data is crunched, we’re looking at over $2 trillion in capital flight flooding into U.S. markets. The kicker is that even should China and Europe stabilize, this is just the beginning. The American Boomers continue their inevitable march into retirement, and alllll of their foreign holdings – the money that financed everything from subprime to the BRIC boom to the commodities swell – will be rolling back during the next few years.

 

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China, Europe, commodities, the Boomers. These are all trillion dollar questions. Or perhaps it is more accurate to say they are all trillion dollar answers that the world just hasn’t quite internalized just yet.

 

Funny thing is, the Fed has quietly started us on the road to a much bigger split. As of this week the U.S. Federal Reserve is the only central bank in the world that is tightening monetary policy. The current expansion is coming up on seven years old, making it one of our longer periods of economic growth. We are due for a recession before long. The next time the global economy contracts, the United States will be the only country in the world with any monetary tools available.

Breaking News – OPEC dissolved as a meaningful organization at their Dec 4 summit.

Rather than adjusting OPEC’s production ceiling in an attempt to raise prices, or even generate a common policy to coordinate output, OPEC instead launched a production free-for-all. No longer will there be a quota – any quota. All members can now invest as much as they want, produce as much as they want, export as much as they want. Oil producers the world over are undoubtedly shivering in terrified anticipation. The Arab states of the Persian Gulf have by far the lowest production costs in the world, and if they do truly flood the market with low cost crudes, few – if any – have a hope of competing.

 

The Saudis’ goal can be summed up quite simply – force as many high-cost producers out of the oil markets as possible. This is accurate, but it is also incomplete. Yes, the Saudis would like to force its competitors to the financial breaking point, and yes, U.S. shale is an industry that the Saudis would like to wreck. But cracking apart the American shale sector is only one of many goals, and it is certainly not the primary one.

 

First and foremost, the Saudis are targeting Iran. With the Americans steadily stepping back from actively managing the Middle East, the Saudis are finding themselves forced to deal with their Iranian adversaries themselves. In this the Saudis are poorly positioned. While Saudi Arabia has plenty of top-notch military hardware, the Saudi people have no concept of what a military culture means. Iran has 30 years of experience building up insurgent movements and has proxies sprinkled throughout the Middle East. But the Saudis know full well that such proxies are expensive, and in a game of checkbook diplomacy the Saudis simply have more income and a bigger bank account.

 

Once sovereign wealth funds and less orthodox financial caches are factored in, the Saudis have – very conservatively — $1 trillion to throw at this problem, and that’s not even counting the personal assets of the royal family. The Saudis can sustain themselves in a low-price environment not for years, but for decades. Compare that to Iran’s hand-to-mouth budgeting. For the Saudis timing is critical; America’s rapprochement with the Iranians heralds increases in Iran’s oil output (albeit not likely in meaningful quantities until 2017). Best to drive prices down now and try to bankrupt Iran’s ability to wage proxy wars in Yemen, Lebanon, Syria and Iraq as well as the internal subsides that keep Iran’s population from revolting.

 

While Iran is clearly Saudi Arabia’s clear-and-present-danger, it is far from the only target.

 

Second on the list is Russia, whose oil output has risen to a new post-Cold War high. Russia is the world’s second-largest exporter, so a friendly Saudi-Russian relationship has never been in the cards. But the rivalry between Riyadh and Moscow is about more than just oil. The two have sparred indirectly for decades over the broad swath of weaker Muslim states that lie between them, and Russia’s ongoing rivalries with the United States consistently results in Russian actions that threaten Saudi interests. Russia’s intermittent sponsorship of Iran, and Russia’s involvement in the Syrian civil war opposite Saudi Arabia’s own proxies being cases in point. No wonder that the Saudis flooded the oil markets in the mid-1980s in a (successful) attempt to bankrupt the Soviet Union. No wonder the Saudis sponsored the mujahedeen in Afghanistan to gut the Soviet war machine. No wonder that the Saudis funded the Chechen rebellion in the 1990s. And no wonder the Saudi oil minister expressly called out the Russians when forcing upon OPEC the produce-as-much-as-you can policy.

 

oilsands

 

The third target of the new policy is a bit more obvious – those high price oil producers that have eroded Saudi market share over the decades, all of which are the prime beneficiaries of Saudi Arabia’s yesteryear policies of reducing oil output to bolster prices. With very few exceptions, none of these countries have ever actually reduced output themselves, instead relying upon the Saudis, Kuwaitis and Emiratis to bear the entire burden.

 

  • Canada: the world’s highest-cost producer is likely to be the biggest loser.
  • Norway: the Saudis particularly hate how reliable Norwegian output has been the past 20 years.
  • Russia: the multi-faceted nature of Saudi Arabia’s competition with Moscow earns Russia spot in this list as well.
  • Iran: with the strategic contest heating up, Iran also earns a double mention.
  • Libya: while its production costs are not all that high, the deepening civil war there threatens to remove Libyan production from the market completely. Lower oil prices could well be the factor that forcibly devolves Libya from chaos to anarchy – and destroys the entire energy complex.
  • Venezuela: while an OPEC “ally” who has always argued for lower production levels, Venezuela has not only never willingly reduced output, its output surges are what broke the 1970s Arab oil embargo – something that the Saudis have neither forgotten nor forgiven.
  • Nigeria: like Venezuela, the Nigerians have a nasty habit of putting Saudi money where their mouth is.

 

Collectively these countries are responsible for over 20 million barrels of daily oil output, and that oil income is responsible for the vast majority of their export earnings as well as the social stability that is required to produce the oil in the first place. As the Saudi thinking goes, break even one or two of them and a vast quantity of crude will fall off the market.

 

That just leaves us with American shale. When you add in the light condensates that shale output favors that are not technically crude, U.S. oil output is now above 12 million barrels per day. Largely courtesy of shale, American imports of crude have dropped by seven million barrels per day, five million of which used to come from OPEC members. Between shale’s success and continental integration, the NAFTA trio is now only two million barrels per day of outright energy independence. And by the end of 2017 the United States will surpass Qatar, Australia and Russia to become the world’s largest natural gas exporter.

 

basin-texas

 

Funny thing is, the Saudis were convinced until very recently that U.S. shale was just a PR campaign. They didn’t really admit shale was for real until 2013, and it wasn’t until 2014 that they realized shale would not simply reshape global oil markets, but contribute to the end of the American commitment to Saudi security. The Saudis would love to put a bullet in shale’s head.

 

But that time has already passed. Sure, back in 2012 the shale producers required oil prices at $90 or more to make a profit, but after a decade of technical advancement the industry is emerging from its infancy. New technologies like multi-lateral drilling and micro-seismic are vastly improving the amount of crude produced per well while vastly reducing the per-barrel production costs. More output per well means that surface infrastructure is now comprised of fewer, larger gathering pipes rather than an expensive crazy-quilt of tiny ones. New re-fracking and re-completion techniques are resetting older wells to their original output levels – or even higher. Taken together the full-cycle break-even price for the four major shale plays – Bakken, Permian, Eagleford and Marcellus – are already below $45 a barrel. By the time these new techs fully proliferate across the industry, the shale sector’s break-even is likely to be right around $30 – and that’s likely only a year away.

 

Which would put the destruction of shale firmly out of Saudi Arabia’s reach. But that’s ok.

 

The Saudis may miss on shale, but they have a very target-rich environment in front of them. There will be plenty of casualties.

Beginning of the End – Russia and Shale Oil

This is the first in a short series that discusses recent events as they relate to the analysis developed in The Accidental Superpower. Each of these developments — and dozens more — are symptoms of an underlying change the global order.

Part 1: Shale and the Breakdowns to Come

The Russian economy is a mess. The ruble keeps plumbing new lows, lending across the country has all but stopped, sanctions (and counter-sanctions) are raising the specter of Soviet-style goods shortages, and even the Russian government now predicts 2016 will bring with it the worst recession since at least 1998.

 

Many — rightly — see the economic carnage being wrought in Russia as an outcome of the Putin government’s adventures in Ukraine and subsequent economic sanctions against Moscow. But that is only part of the story.

 

In Russia the core issue isn’t so much Ukraine as it is shale. U.S. energy output has skyrocketed and North America has already achieved functional energy independence. The consequent shockwaves through global energy markets are hiving what used to be the largest importing market — the United States — off of the global market. One consequence among many is collapse in oil prices. Russia has never — in any age — managed to maintain a strong economic structure without robust commodity export income. The ruble crash is still only in the very early stages. Cascading defaults are now inevitable.

 

Nor will the carnage be short lived. U.S. shale is – somewhat unbelievably – still in its infancy. The merging of horizontal drilling and hydraulic fracturing technologies is really only a decade old and technological improvement is only now reaching critical mass. As of December 2015 full-cycle break-even costs in the three main U.S. shale oil basins — Bakken, Permian and Eagleford — are for the most part below $45 a barrel. Stunning new technologies are being developed, bundled into packages, and deployed as companies seek to find ways to produce more from fewer wells to save money.

 

And “full-cycle cost” is no longer a good measure of the total cost to drill a well as it includes everything from the drilling rights to the cleanup. As lower energy prices force consolidation, the remaining U.S. shale operators will acquire the single most expensive aspect of their operations — those drilling rights — at steep discounts. The dizzy year-on-year expansion in U.S. oil output is slowing, but it shows few signs of reversing.

US-Production-Crude-Oil

Base Week: September 30, 2005

More broadly, there is not a single oil producer anywhere in the world that has budgeted for an oil price below $50, with most — and most notably, Russia, Iran and Venezuela — requiring prices to be roughly double their current level. Many of these countries’ spending is so high because they have come to rely on petrodollars to fund social programs or military funding that stabilizes their political systems. While it may take some time, civil breakdowns and economic meltdowns are the new normal for a vast raft of commodity-based countries

The Nuclear Deal and Iran’s Vulnerability

57The Iranian nuclear deal is moving forward as President Obama just recently secured the last vote necessary to prevent the US legislature from blocking the agreement. This agreement gives Iran some significant concessions regarding uranium enrichment and there is considerable hand-wringing in the United States over Iran’s nuclear potential.
But the truth is that I find it unlikely that Iran actually wants a bomb. Should Iran nuclearize, it would encourage Iran’s regional rivals to follow suit. As Iran is clearly the region’s superior conventional power, all nuclearization would do is neutralize its current advantage.

 

So if nukes don’t serve Iran’s long-term strategic needs, why bother? It’s less about the nuclear weapon and more about the nuclear program.

 

Having a nuclear program allows Iran to sue for terms with the US (and to a lesser degree, with Israel). And it looks like the strategy is paying off. A degree of collaboration between Washington and Tehran is in both powers’ best interest. But the Iranian nuclear deal is really a product of Iran’s vulnerability and this deal presents an opportunity to lessen that vulnerability and prepare for the next phase of the American empire.

 

Iran’s leverage in the global system was the result of its ability to threaten the most important oil producing region in the world. But the shale revolution is bringing an end to the era of U.S. preoccupation with oil — in the Middle East or elsewhere.

 

This geopolitical shift not only eliminates Iran’s leverage, but it also becomes vulnerable as so much of its economy is dependent upon maritime exports of oil. Moreover, as the U.S. withdrawal accelerates, Iran finds itself overextended – not against an easily-distracted America.
Instead Iran faces an awkwardly consolidating Iraq, an awakening Turkish giant, a frightened but focused Israel, a battle hardened Pakistan, a desperately violent Russia and a Saudi Arabia who is willing to write any check if it will weaken Iran.

 

The question — as in many things — is timing.

 

Americans haven’t yet internalized that North America’s dependence upon foreign oil is down by roughly two-thirds from what it was seven years ago, and that by 2017 that dependence will be approaching net zero. The speed at which the region is becoming irrelevant to U.S. interests will at some point be matched with a tidal shift in American policy in the region. In the latter half of 2015, therefore, we’re in this odd geopolitical moment where the U.S. doesn’t care all that much — but it does not quite yet not care at all. For Iran this means that the window to extract concessions is very, very small. If the current nuclear deal does not go through for whatever reason, the next round of talks will be with a United States that is largely immune to whatever Iran can throw at it.

 

Iran’s regional rivals both fear this development and are hoping/trying to reshape the regional geopolitic to create an American-style containment of Iran…without the Americans.

KEY POINTS

  • Israel is playing the emotional card to try to persuade Americans that their Middle East policy should be all-Israel, all the time. The strategy obviously didn’t fly with the Obama administration, and the groundswell of American public support Israel was hoping for just hasn’t manifested. And so Israel has had little choice but to reach out to allies old and new, most notably Turkey and Saudi Arabia.

 

  • Turkey thought it could convince the Americans to bear the burden of burning through ISIS. That strategy too has failed and now Turkey is reluctantly and fearfully preparing to relaunch regional imperial strategies it last used over a century ago. Any meaningful Turkish resurgence will almost by definition wreck a panoply of Iranian interests. Ankara is very ready for that shift militarily and economically, but it’s barely considered it philosophically or intellectually. Everything with the Turks these days is softly softly. But one day the dam of restraint will break and the Turks will surge. The only question is where will they surge first? As a vastly inferior power to Turkey, the Iranians are particularly obsessed with that question.

 

  • As a country with no military tradition worthy of the name, Saudi Arabia is by far the most terrified of American disengagement and so hopes to scuttle the entire American-Iranian entente. Not because Riyadh thinks it will keep the Americans involved, but because it will hamstring Iranian options. This strategy includes pushing full force against Iranian interests in every regional theater — Lebanon, Gaza, Syria, Iraq, Kurdistan, Yemen, Iran and Pakistan — so that Iran bleeds from a dozen cuts. It is now the Saudis — not the Chinese or Russians or Iranians — that have the most violent and aggressive foreign policy in the world.