Welcome to The GERM Report by Dan Graeber, a commentary on the intersection between geopolitical events and the price of oil. GERM stands for Geopolitical Energy and Risk Monitoring. Our indicator is based on the expected price volatility by the end of the current trading week.
Risk level: Orange
RED: Severe (+/- 4%) ORANGE: High (+/- 2%) YELLOW: Elevated (+/- 1%) BLUE: Guarded (+/- ½%)
THE BOOSTER SHOT
- Treaties and trade agreements are forces of stability.
- Brent looks to recover from the 7 percent slap in the face.
- Life in the international arena may be “nasty, brutish and short.”.
It was largely another quiet week on the geopolitical front, though Washington did slap sanctions on Iran’s top diplomat. BP CEO Bob Dudley told Bloomberg News last week added that his company was no longer sending British tankers through the Strait of Hormuz. Royal Dutch Shell later made a similar announcement. That ostensibly hurts Iraq, one of OPEC’s largest exporters. But it was conflict of a different sort that ultimately sent the price of crude oil spiraling lower after Tariff Man struck again. One day after the US Federal Reserve cut its interest rate for the first time since 2008, and while trade talks appeared to be going well, President Trump threatened to impose new tariffs on Chinese goods starting September 1. The next day, with NATO’s blessing, the Trump administration pulled out of a Reagan-era nuclear arms treaty. The limits that constrain the behavior of global actors are unraveling and the risks of a mistake in this who-blinks-first era are increasing at an alarming rate.
Expect a volatile week for crude oil prices. The market never recovered from last week’s one-two punch of confusing statements about rate adjustments from US Fed Chair Jerome Powell and Trump’s threat of tighter sanctions on China. Taken together, the statements were enough to increase the odds of a US recession. Four days of gains were not enough to make up for the 7.2 percent drop in Brent crude oil prices on Thursday. In the end, the global benchmark settled 2.5 percent lower on the week at $61.27 per barrel.
Expressing frustration with drawn-out trade negotiations, Trump last week said he’d put a “small additional tariff” on the remaining $300 billion worth of Chinese imports on September 1. Trump in March threatened to impose tough sanctions on Mexico in an effort to coerce it into doing more on border security, sending Mexican officials scrambling to Washington to resolve the issue. Mexico, however, is not China. Instead of racing to appease the Trump White House, Beijing pledged to respond with the “necessary countermeasures.” Chinese Foreign Ministry spokesperson Hua Chunying said that nobody wins a trade war, though Beijing has no reservations about fighting one if necessary.
Turning the ire on Russia, with the blessing of NATO allies, Washington unceremoniously dumped the Reagan-era nuclear treaty, which constrained the arms race in the late stages of the Cold War. US Secretary of State Mike Pompeo said Russian fielding of the non-compliant 9M729 missile led to the demise of the treaty. Russia’s Foreign Ministry countered that it was US propaganda that ruined the deal, accusing Washington of intentionally sabotaging the treaty in order to “free itself from the existing restrictions.”
Freedom from restrictions is synonymous with the state of nature, a condition without government. Thomas Hobbes in Leviathan observed that existence in the state of nature was “nasty, brutish and short.” Existence in this state is primarily a do-it-yourself project, something that Adam Smith suggested could be beneficial. Pursuing an advantage for one’s self, Smith observed, can also benefit other members of society.
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner,” he wrote in Wealth of Nations, “but from their regard to their own self-interest.”
Like Thrasymachus in Plato’s Republic, a nation operating in this chaotic state may be able to establish ways to play the game to its own benefit if the conditions are right. This may have been the case with the US governance of Europe during the Marshall Plan, but in matters such as nuclear treaties, freedom from restriction can spark an arms race. In the security dilemma, defensive actions can take on offensive tones and lead to war that nobody wants. Columbia University’s Robert Jervis told the American Political Science Association at the beginning of the new century that the fundamental causes of war are both the condition of anarchy and the security dilemma. In response to the collapse of the INF treaty, the Council of Foreign Relations noted the historic achievement of arms constraint is gone and a new round of a nuclear race is underway.
In terms of trade, treaties as trade agreements can restrain destructive behavior by suppressing the “consuming ambitions” that Jean-Jacque Rousseau feared would lead to the maldistribution of the gains that Smith envisioned. In a self-help system, a trade agreement can level out gains that zero-sum games erase. As in conventional war, trade wars threaten established constraints that stabilize the system. After the Second World War, the United States created an asymmetrical global economy that strengthened Europe and Japan not because of benevolence, but so that the United States would have strong trading partners. Tariffs, on the other hand, backfire when trading partners are weak. Tariffs prop up government coffers in the form of higher taxes, which incentivizes opponents to hit back. Like the security dilemma, the cycle repeats and the economies of warring parties are the casualties.
While big hitters such as BP and Chevron have already released earnings, there are still bellwethers like Diamond Offshore Drilling and Duke Energy out there. Monday brings the July reading of the ISM non-manufacturing index in the United States. With US crude oil inventories on a steady decline, watch for Tuesday evening movement in crude oil prices after the American Petroleum Institute releases its estimates on the US energy sector. Wednesday is the EIA’s turn. Thursday brings data from China on import and export levels and Friday brings Chinese consumer and producer price indices. Sell signals are lit across the board, though Brent is at or near support levels indicating buyers may be coming back. Brent may still look to correct from the 7 percent slump last week, so another Orange alert is in place, with movement of around plus or minus 2 percent expected.