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.

Ukraine, Just the Beginning

Financial sanctions; diplomatic isolation; peer pressure – these are the tools the West is using to convince the Putin government that it should abandon its “Ukraine adventure.”

They are the wrong tools for the wrong job. The Russians are not in the Crimea and Eastern Ukraine to boost Putin’s popularity at home or out of a fit of pique that Ukraine had a revolution. Russian power is in motion as part of the first stage of an extended effort to secure the Russian homeland. Moscow will continue until the European Union and NATO either form an unbreakable wall of opposition or crumble.

Russian territory is part of an endless flatland unparalleled in the world. The open portions of the Eurasian steppe are nearly as large as the entirety of the US Lower-48. Web-working infrastructure across its arid plains proved so expensive that even the strategic-minded, price-insensitive Soviets sharply circumscribed their efforts. Even today, only one road and two rail corridors venture east of the Urals to lay claim to Siberia. Russia is a place where only a manpower-heavy military capable of swarming over vast tracks of land can rule effectively. Let’s call it the Hordelands.

Key to ruling the Hordelands is the ability to limit outsiders from entering them; once they do, any defender becomes locked in a war of mobility and attrition. The trick is to reinforce all nine of the lands’ access points: the Tien-Altay Gap, the Central Asian Corridor, the two Caucasus coastal approaches, the Crimea, the Bessarabian Gap, the Polish Gap, the Baltic coast and the White Sea coast. Failure transforms the Hordelands into a bloody buffet. The Soviet Union once controlled all nine. The day the Soviet Empire fell in 1992, those holdings were reduced to two. With Russia’s reacquiring of the Crimea in February, Moscow now is up to three.

That explains why, but not why now? The Russian resurgence began almost fifteen years ago, shortly after which Russia rationalized its finances and debt. As early as 2006, high energy prices granted the Kremlin more cash than it could spend. Russia proved it could implement complex and sustained intelligence and military operations as early as 2008. Why now, in 2014, is Moscow finally moving?

Simply put, it is running out of people.

Immediately after the Cold War’s end, the bottom fell out of the Russian birth rate, gutting the lower ranks of the Russian population structure. A quarter of a century later, there are more 50-somethings than teenagers. In five short years, those teenagers will prove inadequate to fill the Red Army’s ranks. If Russia is to use that army to re-anchor the Hordelands’ access points, it needs to do so while it has enough soldiers.

Instead, a would-be engineer must first apprentice with an established engineer for several years. Technical training in Russia collapsed before the Soviet fall, and now the youngest cadre of engineers who have the full suite of technical skills has entered their 50s. In chauvinist Russia, nearly all are men, and according to the last non-politicized data that escaped the Federal State Statistics Service, male mortality is only 59. Maintaining the Russian system — which includes everything from the national rail network to the natural gas fields to Moscow’s steam tunnels to the Red Army to the nuclear missile forces — for a territory as expansive as the Hordelands requires a huge skilled labor pool that Russia simply no longer has. In a few short years, Russia will degrade from having a very small and expensive skilled labor pool to not having one at all, forcing the Russians to choose which bits of their system to not maintain.

If the re-anchoring is not achieved soon, Russia will lose the ability to even try, which would condemn it to wither from within. While the overall Russian demography is failing, the damage is almost wholly concentrated among ethnic Russians. There are many minorities — largely Muslim minorities such as the Tatars and the Chechens — whose demographics are as young, healthy and growing as the Russians are aging, sick and shrinking. Adding Ukrainians and more to the mix will certainly make managing Russia’s “internal” issues more complicated, but intimidating minorities into compliance is a bit of a national pastime. Russia has been doing it — and doing it with frightening effectiveness — so long as there has been a Russia. Maintaining control over such diverse groups in a country with secure external borders is feasible. Doing it with exposed borders is not.

And so the Russians are coming. Coming for Crimea, and Donetsk and Torez and Luhansk and Slovyansk and Odessa. And not just for Ukraine, but for Georgia and Armenia and Azerbaijan and Moldova and Belarus. And when that is done Romania and Estonia and Lithuania and Latvia and Poland. In an era when there enough Russians to man Russia, Moscow thinks of the independence of all of these places as a disturbing academic exercise. In an era where Russia is running out of Russians, the independence of all of these places is a mortal threat. The Russians will not stop until either they re-anchor or are made to stop, and there currently simply isn’t a recognition in Europe that this has already gotten very real.

Which brings us to two outcomes: one financial, one strategic.

Financially, the Russians have far more room to maneuver than most think. They have $1 trillion saved in various funds — one of the upsides of a demography that is dying young is that retirement funds can be used for other things — and can survive any sanctions the West can throw at them. The Russians also are making a gambit for survival, and if pushed willing to walk away from everything – partnerships with ExxonMobil, debt payments, shipments of nickel, even long-term natural gas sales. Russia is happy to continue to sell the world its wares — and certainly prefers to — but if a choice is forced between Russia’s expansion to defensible borders and a few hundred billion in annual economic gains, bet on gritty austerity rather than capitulation to sanctions.

Strategically, three of the Hordelands’ access points — Bessarabia, Poland and the Baltic — will require the Russians challenging EU and NATO members. Aside from a few hundred troops rotating through NATO’s border states, there currently is no indication that any EU or NATO country is taking the Russian advance seriously. Moreover, the European countries — and this includes the five NATO/EU members that face the direct threat — have had 25 years to wean themselves off of Russian energy, but have instead moved in the opposite direction. Their strategic policy is to rely on Russia to keep the lights on, and to rely on America to protect them from Russia. The result of those (in)actions is a painfully uncomfortable question: will the Americans bleed for those who have proven unwilling to raise anything but the pitch of their voices in their own defense?

Those curious can find the answer to that question and the world that unfolds in its aftermath in The Accidental Superpower, available November 4, 2014.